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Financial Markets: Lecture 2 Transcript
January 16, 2008
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Professor Robert Shiller:
Today I want to spendThe title of today's lecture is: The Universal Principle of
Risk Management, Pooling and the Hedging of Risk. What I'm really referring to is what I think is the very
original, the deep concept that underlies theoretical financeI wanted to get that first. It really is probability
theory and the idea of spreading risk through risk pooling. So, this idea is an intellectual construct that
appeared at a certain point in history and it has had an amazing number of applications and finance is one of
these. Some of youThis incidentally will be a more technical of my lectures and it's a little bit unfortunate
that it comes early in the semester. For those of you who have had a course in probability and statistics, there
will be nothing new here. Well, nothing in terms of the math. The probability theory is new. Others though, I
want to tell you that it doesn'tif you're shoppingI had a student come by yesterday and askhe's a little
rusty in his math skillsif he should take this course. I said, "Well if you can understand tomorrow's lecture
that's today's lecturethen you should have no problem."
I want to start with the concept of probability. Do you know what a probability is? We attach a probability to
an event. What is the probability that the stock market will go up this year? I would saymy personal
probability is .45. That's because I'm a bear butDo you know what that means? That 45 times out of 100 the
stock market will go up and the other 55 times out of 100 it will stay the same or go down. That's a
probability. Now, you're familiar with that concept, right? If someone says the probability is .55 or .45, well
you know what that means. I want to emphasize that it hasn't always been that way and that probability is
really a concept that arose in the 1600s. Before that, nobody ever said that.
Ian Hacking, who wrote a history of probability theory, searched through world literature for any reference to
a probability and could find none anywhere before 1600. There was an intellectual leap that occurred in the
seventeenth century and it became very fashionable to talk in terms of probabilities. It spread throughout the
worldthe idea of quoting probabilities. But it wasIt's funny that such a simple idea hadn't been used
before. Hacking points out that the word probabilityor probablewas already in the English language. In
fact, Shakespeare used it, but what do you think it meant? He gives an example of a young woman, who was
describing a man that she liked, and she said, I like him very much, I find him very probable. What do you
think she means? Can someone answer that? Does anyone know Elizabethan English well enough to tell me?
What is a probable young man? I'm asking for an answer. It sounds like people have no idea. Can anyone
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 Spring '08
 RobertShiller

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