Theory Of Financial Decision Making

Theory of Financial Decision Making Jonathan E. Ingersoll, Jr. Yale University Preface In the past twenty years the quantity of new and exciting research in finance has been large, and a sizable body of basic material now lies at the core of our area of study. It is the purpose of this book to present this core in a systematic and thorough fashion. The notes for this book have been the primary text for various doctoral-level courses in financial theory that I have taught over the past eight years at the University of Chicago and Yale University. In a11 the courses these notes have been supplemented with readings selected from journals. Reading original journal articles is an integral part of learning an academic field, since it serves to introduce the students to the ongoing process of research, including its mis-steps and controversies. In my opinion any program of study would be amiss not to convey this continuing growth. This book is structured in four parts. The first part, Chapters 1-3, provides an introduction to utility theory, arbitrage, portfolio formation, and efficient markets. Chapter 1 provides some necessary background in microeconomics. Consumer choice is reviewed, and expected utility maximization is introduced. Risk aversion and its measurement are also covered. Chapter 2 introduces the concept of arbitrage. The absence of arbitrage is one of the most convincing and, therefore, farthest-reaching arguments made in financial economics. Arbitrage reasoning is the basis for the arbitrage pricing theory, one of the leading models purporting to explain the cross-sectional difference in asset returns, Perhaps more important, the absence of arbitrage is the key in the development of the Black-Scholes option pricing model and its various derivatives, which have been used to value a wide variety of claims both in theory and in practice. Chapter 3 begins the study of single-period portfolio problems. It also introduces the student to the theory of efficient markets: the premise that asset prices fully reflect all information available to the market. The theory of efficient (or rational) markets is one of the cornerstones of modern finance; it permeates almost all current financial research and has found wide acceptance among practitioners, as well. In the second main section, Chapters 4-9 cover single-period equilibrium models. Chapter 4 covers mean-variance analysis and the capital asset pricing model - a model which has found many supporters and widespread applications. Chapters 5 through 7 expand on Chapter 4. The first two cover generalized measures of risk and additional mutual fund theorems. The latter treats linear factor models and the arbitrage pricing theory, probably the key competitor of the CAPM. Chapter 8 offers an alternative equilibrium view based on complete markets theory. This theory was originally noted for its elegant treatment of general equilibrium as in the models of Arrow and Debreu and was considered to be primarily of theoretical interest. More recently it and the related concept of spanning have found many practical applications in conting