Lecture2-TheUniversalPrincipleofRiskManagement:PoolingandtheHedgingofRisksOverview:Statisticsandmathematicsunderliethetheoriesoffinance.ProbabilityTheoryandvariousdistributiontypesareimportanttounderstandingfinance.Riskmanagement,forinstance,dependsontoolssuchasvariance,standarddeviation,correlation,andregressionanalysis.Financialanalysismethodssuchaspresentvaluesandvaluingstreamsofpaymentsarefundamentaltounderstandingthetimevalueofmoneyandhavebeeninpracticeforcenturies.Readingassignment:JeremySiegel,StocksfortheLongRun,chapter1andAppendix2,p.12FinancialMarkets:Lecture2TranscriptJanuary16,2008ProfessorRobertShiller:TodayIwanttospend--Thetitleoftoday'slectureis:TheUniversalPrincipleofRiskManagement,PoolingandtheHedgingofRisk.WhatI'mreallyreferringtoiswhatIthinkistheveryoriginal,thedeepconceptthatunderliestheoreticalfinance--Iwantedtogetthatfirst.Itreallyisprobabilitytheoryandtheideaofspreadingriskthroughriskpooling.So,thisideaisanintellectualconstructthatappearedatacertainpointinhistoryandithashadanamazingnumberofapplicationsandfinanceisoneofthese.Someofyou--Thisincidentallywillbeamoretechnicalofmylecturesandit'salittlebitunfortunatethatitcomesearlyinthesemester.Forthoseofyouwhohavehadacourseinprobabilityandstatistics,therewillbenothingnewhere.Well,nothingintermsofthemath.Theprobabilitytheoryisnew.Othersthough,Iwanttotellyouthatitdoesn't--ifyou'reshopping--Ihadastudentcomebyyesterdayandask--he'salittlerustyinhismathskills--ifheshouldtakethiscourse.Isaid,"Wellifyoucanunderstandtomorrow'slecture--that'stoday'slecture--thenyoushouldhavenoproblem."Iwanttostartwiththeconceptofprobability.Doyouknowwhataprobabilityis?Weattachaprobabilitytoanevent.Whatistheprobabilitythatthestockmarketwillgoupthisyear?Iwouldsay--mypersonalprobabilityis.45.That'sbecauseI'mabearbut--Doyouknowwhatthatmeans?That45timesoutof100thestockmarketwillgoupandtheother55timesoutof100itwillstaythesameorgodown.That'saprobability.Now,you'refamiliarwiththatconcept,right?Ifsomeonesaystheprobabilityis.55or.4