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15.401 - Finance Theory @ MIT

Here are my notes on Finance Theory I from professor Andrew Lo at MIT. All the lessons can be watched on youtube for free.

I recently noticed that many people around me (digitally) were talking about finance, however I do not have a framework for thinking of finance because of my background. I am a programmer, a scientist, but I was never introduced to the subject of economy. I never had a class in economy in my education so I consider myself an humble beginner, I started reading Economics in one lesson by Henry Hazltt which got me interested to learn more, so I began watching these lessons on youtube.

Introduction

The introductory lesson from Andrew Lo left me both speechless and uncomfortable. The highlight of the lecture was an auction performed in class, which went as follows. The teacher put two boxes on his table and randomly selected one, just a tiny little box. He then asked the students how much were they willing to pay for that box. The auction was real and he expected to be paid in cash, so students had to say amounts that they would actually pay with their money. One dollar, two, five, 15… by the end the box was sold for 45$. The teacher took a moment to reflect on the fact that nobody knew what was in the box, or what his value was. Nobody could come closer to inspect the object, yet they bet on Its value. Well, now the value of the box was 45$, they agreed on this price and so be it. What the class just did is called price discovery, and It is something that an economist has to do constantly.

On my logical mind I was like "they are just choosing a random number and that Its his value, what a bs, this is so stupid". And I though about how do people value art pieces, or luxury items, or many other things. This makes no sense yet the world works like this, I thought.

Moving on, the teacher writes about the six fundamental principles of finance, namely:

  • There Is No Such Thing As A Free Lunch
  • Other Things Equal, Individuals
    • Prefer more money to less (non-satiation)
    • Prefer money now to later (impatience)
    • Prefer to avoid risk (risk aversion)
  • All Agents Act To Further Their Own Self-Interest
  • Financial Market Prices Shift to Equalize Supply and Demand
  • Financial Markets Are Highly Adaptive and Competitive
  • Risk-Sharing and Frictions Are Central to Financial Innovation

The teacher explains to the class that all business activities reduce to two functions: valuation of assets and management of assets. Yet, once you are able to evaluate assets, managing becomes really easy. Just to feel smarter, the economist threw an equation as if they wanted to act like mathematicians. 

Objecives + Valuations -> Decision

Another random equation is the definition of finance: 

Mathematics + $$$ = Finance

From this equation we also derive that: 

Mathematics = Finance - $$$

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