Recently I embarked on 8 weeks online course from Coursera.org that covers the basics of financial markets. It is taught by Professor Robert J. Shiller, an American Nobel Laureate and also a sterling professor of Economics Yale University.

The course will run from the start of December 2015 to the end of January 2016 and it will take approximately 8 hours of my time per week to finish watching the lecture videos and completing the weekly quiz in order to move on to next week’s lessons.

My weekly summary of the key lessons I have learnt in this course will be updated on this website. So please subscribe for free on my website and also share it with your friends.

Week 1 of the course is about the basic principles of Finance and Risk Management.

History of Financial Markets

Throughout the 100 years history of financial markets, the average annual returns of US stock are 10% after inflation. On average all of the countries stock did better than the bond because, for stock which is riskier, they are warranted the extra return. That is the risk premium.

On average all of the countries stock did better than the bond because, for stock which is riskier, they are warranted the extra return. That is the risk premium.

There is no such thing as best investment in this world. There is only a trade-off between risk and return. If you want more return, you will have to be willing to take on more risk and vice versa.

efficient portfolio

As you can see from the chart of efficient portfolio above, never go for a full 100% bond holdings because for the same amount of risk, you can get a higher return by putting in 50% in stocks and 50% in bonds. Both have the same amount of risk in which the standard deviation is 10%, but the return is higher for the latter allocation at 12% annual return.

Both have the same amount of risk in which the standard deviation is 10%, but the return is higher for the latter allocation at 12% annual return.

The more different kind of assets you put into the portfolio, the lower the standard deviation for a given expected returns provided that the assets are not correlated.

An example of three risky assets we can have in our portfolio is oil, bonds and stocks. Why oil? Oil is important because our economy runs on it. Although we know that some stocks price is directly correlated with the oil price, for example, Exxon Mobil and Keppel Corporation stock.

capm

The idea of capital asset pricing model is that investors have to be compensated in their investments for the time and amount of risk they take. That is why the model includes the risk-free rate of a risk-free security to compensate for time and the risk premium, which takes into account the Beta of the stock times the expected return of the stock minus the risk-free rate. This CAPM model is widely used as the discounted rate that people take when calculating the intrinsic value of a stock.

That is why the model includes the risk-free rate of a risk-free security to compensate for time and the risk premium, which takes into account the Beta of the stock times the expected return of the stock minus the risk-free rate. This CAPM model is widely used as the discounted rate that people take when calculating the intrinsic value of a stock.

This CAPM model is widely used as the discounted rate that people take when calculating the intrinsic value of a stock.

Insurance and risk management

At the end of the day, financial institutions are only an invention and structure that someone had designed a long time ago to fulfill certain financial needs. The insurance company is an example of such inventions.

The insurance company is an example of such inventions.

The fundamental concept of insurance is in risk polling. The idea came from ancient Rome where people form organizations to insure people from certain liabilities. For example, in ancient Rome, the belief was that Death insurance pays for funeral bills and proper burial. Otherwise, the soul would wander forever!

The idea came from ancient Rome where people form organizations to insure people from certain liabilities. For example, in ancient Rome, the belief was that Death insurance pays for funeral bills and proper burial. Otherwise, the soul would wander forever!

Insurance people associate insurance with guilt.

It all started with a concept that goes back to a guy called Mr. Countoldenberg in 1609. “Why don’t we start a fund where people pay 1% of the value of their home and we will use the fund to replace for a policy holder’s house in the case of a fire. I had no doubt that using the calculations that were made over 30 years, the loss will not amount to a good deal as compared to the sum collected. There would not be that many fires!”

I had no doubt that using the calculations that were made over 30 years, the loss will not amount to a good deal as compared to the sum collected. There would not be that many fires!”

Aristotle the philosopher wrote in ancient times. To succeed in many things many times would be difficult making it once or twice is easy. Law of probability is that the more the policies the less the standard deviation.

These are the basic types of insurance:

  1. Life insurance (insures your family against loss of breadwinner to protect the young children, used to be very important when there were a lot of early death)
  2. Health insurance (when you are sick and needs medical care)
  3. Property and casualty insurance (assuring your house and car).
    Many of these insurance types are ultimately an invention to fulfill human needs.

Though it is an invention, to make it work reliably involves a lot of details. There needs to be a contract design that specifies and exclude risks that are inappropriate.

An example of an inappropriate risk is moral hazard which refers to the effect of insurance on people’s behavior that is undesirable. For example, it happens when someone pays for the policy for fire insurance and they burn their own house deliberately to get the payout. Also, when someone pays for a life insurance policy and kill themselves to support their family with the payout.

This could be fatal to the insurance business.

Hence, what insurance company does is that they exclude risks that are vulnerable to moral hazard, exclude certain causes of death that look like a suicide. They also made sure to never insure the house for more than its worth so that there is no point for the policy holder to burn their own house down.

They also made sure to never insure the house for more than its worth so that there is no point for the policy holder to burn their own house down.

Another example is selection bias, some people who signed up for insurance policy knew that they were at a higher risk. People who knew that they have terminal disease signs up, the immense cost will be incurred by the insurance company. Hence for this hazard, insurance company have to charge a higher premium.

People who knew that they have terminal disease signs up, the immense cost will be incurred by the insurance company. Hence for this hazard, insurance company have to charge a higher premium.

Therefore, Life insurance excludes certain causes of death that are likely to be known before the customer signs up for the policy.

Therefore, it is extremely crucial that insurance company have specific precise definitions of loss.

With ambiguity, there are a lot of legal wrangling and problems. They use a mathematical model of risk. They need a collection of statistics on risks and quality of data.

Some insurance is mutual (non-profit). Some are government designed. The problem with insurance is that people will pay the premium for many years before they collect the payout, which is why you need government regulators to regulate these companies.

The course also talks about a case study about AIG, a big insurance company which got bailed out by the US government during 2008 mortgage crisis.

AIG was founded back in 1919 in Shanghai. an American named Cornelius Vander Starr who decided go to Asia and started an insurance business. Moved HQ to New York right before Chairman Mao took over and became the CEO for AIG for 49 years.

Before he died, he appointed Hank Greenberg as CEO in 1962 and he ran the company for 37 years until 2005.

Since 2005, he has been succeeded by 3 CEOs. The problem arose after Greenberg left and the company had to be bailed out primarily due to a failure of independence assumption under their risk modeling as they are exposed to real estate risk.

Their idea was that it doesn’t matter if they took a risk when home price fall because it won’t ever fall everywhere. What actually happened after Greenberg left was that they took big exposure for that and prices for homes fell everywhere.

They were insuring against default on company whose credit dependent on the real estate market.

They were also investing directly in real estate securities and in mortgage-backed securities and depended on the real estate market for their success.

When all failed at once, AIG was about to fail and the federal government decided in 2008 to bail out AIG, total amount committed was US$182 billion and not all was spent.

A lot of people are angry about this.

It came from TARP (troubled asset relief program that was created by the Bush administration and loans from Federal Reserve).

Why did they do that? The main reason was their concern about systemic risk (All other policies would all be subject to failure because the company they bought it from which was AIG, was going to be bankrupt.

Banks may fail too because they are involved in business dealings with AIG and they will be a victim of AIG bankruptcy).

The big worry was that if AIG fails, it would destroy the whole financial system in the United States and that is why the Federal US Government bailed the company out.

Read: The whole Summary of Yale University Financial Markets Course series here.

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