Modern Finance and Its Impact in the Real World Financial Markets, - PowerPoint PPT Presentation

Modern Finance and Its Impact in the Real World Financial Markets, Day 1, Class 1 Jun Pan Shanghai Advanced Institute of Finance (SAIF) Shanghai Jiao Tong University April 18, 2019 Financial Markets, Day 1, Class 1 Modern Finance and Its Impact in the Real World Jun Pan 1 / 14

Outline for Day 1 Class 1: Modern fjnance and its impact in the real world. Class 2: Estimation using fjnancial data. Class 3: Alpha, Beta, and the CAPM. Class 4: Quant investing and multifactor models. Class 5: Quant investing and other cross-sectional patterns. Class 6: Review and quiz. Financial Markets, Day 1, Class 1 Modern Finance and Its Impact in the Real World Jun Pan 2 / 14

Outline for Class 1 Class logistics. Modern fjnance. Impact in the real world. Financial Markets, Day 1, Class 1 Modern Finance and Its Impact in the Real World Jun Pan 3 / 14

How Grades are Determined? 20% Class attendance 20% Class participation 20% In-Class Tests 20% Group Project 20% Individual Project Financial Markets, Day 1, Class 1 Modern Finance and Its Impact in the Real World Jun Pan 4 / 14

Modern Finance and Its Impact in the Real World Often, the most creative ideas and the best trading strategies arise Jun Pan Modern Finance and Its Impact in the Real World Financial Markets, Day 1, Class 1 also infmuence how research is done in the academic world. The real and sometime painful experiences from the capital markets from research papers written by fjnance professors. innovations in fjnancial products since the 1970s. Finance as an academic discipline has a direct and lasting impact on by academics are instrumental in advancing the tremendous The dynamic asset pricing models and hedging techniques developed be quantifjed and priced in relation to the economic fundamentals. It ofgers an assset-pricing framework through which fjnancial risk can institutions. the development of capital markets and the practice of fjnancial 5 / 14

Modern Finance: Theory, Practice, and Lessons Financial Markets, Day 1, Class 1 Jun Pan Modern Finance and Its Impact in the Real World 6 / 14 4 2 0 0 1 9 Mortgage 0 6 1 9 8 2 0 9 5 0 1 5 1 First Stock 2 8 9 9 2 1 Backed 3 1 9 Investments and Index Futures 8 0 9 0 1 8 3 0 6 Securities 0 Capital Structure 5 6 1 0 2 1 9 (Fannie (Modigliani and Miller) 8 9 2 2 1 1 Two-Fund 19 WorldCom 8 0 9 Mae) 0 7 4 0 Financial 6 0 Separation Scandal 5 7 79 2 2 1 Crisis 9 (Tobin) 9 2 19 01 1 Enron 9 85 0 OTC Derivatives 1 6 0 6 20 Scandal 5 8 3 19 8 Interest 1 19 7 9 2 0 9 Rate 8 00 CAPM Rise of Dot-Com 0 1 55 6 1 64 1 Swaps 0 (Sharpe) Junk Bonds Peak 9 20 77 2 19 987 1 (Michael Stock 1998 1999 9 Dodd-Frank 9 Efficient Markets 4 1 Milken) 10 20 6 Market 5 5 Hypothesis 6 9 Index Mutual 7 Crash 988 1 LTCM European 3 1 19 (Samuelson, Fama) 9 Funds (Bogle) 1 1 Crisis Sovereign 66 5 1 9 5 19 S&L Bailout Crisis 7 01 9 2 1 7 9 Asian 8 01 Collapse of 9 9 1 2 52 9 6 9 Crisis 4 2 8 7 Junk Bonds 1 Trade 1 9 7 1 9 2 51 1 1 7 9 First Credit 0 War 90 0 9 Mutual Funds 1 99 2 Portfolio 6 1 3 TIPS Derivatives 8 Study (Jensen) 7 3 7 1 Theory 0 19 1 9 1 1 First US Options (CDS) 1 9 2 6 9 0 (Markowitz) 3 9 0 9 6 7 Exchange, CBOE Chinese 2 9 1 1 9 9 95 1 4 1 6 2 1 9 7 1 9 Stock 7 2 1 0 1 Option Pricing Theory 1 7 1 9 1 9 5 0 0 Trump 1 9 2 9 Market 5 (Black, Scholes, Merton) Birth of Index 2 9 1 1 Crash Funds (McQuown) 9 4 9 9 3 9 1 Large Derivatives Losses

Markowitz (1952) The beginning of Modern Finance. Introduces the concept of risk and return tradeofg. Risk is central to the process of investing. Forms the foundation for all subsequent theories on quantifying risk. Financial Markets, Day 1, Class 1 Modern Finance and Its Impact in the Real World Jun Pan 7 / 14

Tobin (1958) Two-fund separation: one risky and one riskfree. The optimal risky portfolio is the same for all mean-variance investors, regardless of his level of risk aversion. The level of risk aversion afgects the relative allocation between the risky and riskfree. Financial Markets, Day 1, Class 1 Modern Finance and Its Impact in the Real World Jun Pan 8 / 14

Sharpe (1964) A model with huge impact on the practice of Jun Pan Modern Finance and Its Impact in the Real World Financial Markets, Day 1, Class 1 The reward is proportional to the exposure to variance, but its covariance with the market The riskiness of a stock is measured not by its own important risk: systematic risk. becomes the market portfolio and the single most The optimal risky portfolio in Tobin (1958) investors behave optimally and the markets clear. Brings Markowitz (1952) to equilibrium: all fjnance, especially in asset management. 9 / 14 portfolio: β i = cov ( R i , R m )/ var ( R m ) . systematic risk: E ( R i ) − r f = β i ( E ( R m ) − r f ) .

Black and Scholes (1973) A pricing frame work with huge infmuence on generations of academics and practitioners. The continuous-time arbitrage-free pricing framework establishes the foundation for fjnancial innovations on Wall Street since the 1970s. The multi-trillion dollar OTC derivatives market would not have been possible without their work. Such fjnancial innovations ofger a whole new dimension of risk taking by giving people the fmexibility to choose the risk to take or avoid. Financial Markets, Day 1, Class 1 Modern Finance and Its Impact in the Real World Jun Pan 10 / 14

Vanguard and the Birth of Index Mutual Funds Vanguard, with $5.3 trillion in assets under management, is the Jun Pan Modern Finance and Its Impact in the Real World Financial Markets, Day 1, Class 1 index funds with their wallets, and they continue to do so. Vanguard Total Stock Market Index Funds.) Investors have voted for equity fund in the world. (The second largest, at $180 billion, are the the S&P 500 Index total $200 billion, together constituting the largest $11.3 million, a 93% shortfall from the goal ($150 million). 11 / 14 derogated and ridiculed. that passive equity management could outpace active management was Index Fund, wrote Bogle, founder of The Vanguard Group and of the Vanguard 500 In a commentary published on the Wall Street Journal in 2011, John largest provider of mutual funds and the second-largest of ETFs. ▶ Vanguard Total Stock Market Index (VTSMX): net assets $757 billion. ▶ Vanguard 500 Index (VFINX): oldest index mutual fund ($448 billion). ▶ On August 31, 1976, the fjrst index mutual fund was born. The idea ▶ When the books were closed, the underwriting produced just ▶ Today (September 2011), the assets of the Vanguard funds modeled on

The Growth of Index Mutual Funds Source: 2017 Investment Company Fact Book Financial Markets, Day 1, Class 1 Modern Finance and Its Impact in the Real World Jun Pan 12 / 14

Cumulative Flow Since 2007 Source: 2017 Investment Company Fact Book Financial Markets, Day 1, Class 1 Modern Finance and Its Impact in the Real World Jun Pan 13 / 14

From Academic to the Real World rigor of academic insights. Jun Pan Modern Finance and Its Impact in the Real World Financial Markets, Day 1, Class 1 that lay ahead: taking on the industry establishment. ” much more forceful, strengthening my backbone for the hard task from Nobel laureate economist Paul Samuelson: “ Samuelson was In his 2011 WSJ article, Bogle credited his success to the support impact, not just short-term profjts, root your practice fjrmly in the The implementation of a great idea does not always travel in a academic insights. If you are in this world to make a long-term It is through such examples that we learn to appreciate the power of research can lead the industry practice. BlackRock ($5.98 trillion), is a perfect example of how academic the emergence of giants such as Vanguard ($5.3 trillion) and The slow, but persistent rise of Indexing and Factor Investing, with straight line. Reshaping an industry takes years, even decades. 14 / 14