CHAPTER 1: FOUNDATION OF FINANCE EXPECTED UTILITY THEORY
Behavioral finance: Combines social and psychological theory with financial theory as a mean of understanding how
price movements in the securities market occur independent of any corporate actions
Neoclassical Economics
Neoclassical economics assumptions:
1. People have rational preferences across possible outcomes or states of nature
2. People maximize utility and firms maximize profits
3. People make independent decisions based on all relevant information
Utility = usefulness, happiness, beneficial, satisfaction received from a particular outcome
Rational preferences two key assumptions:
Completeness ordering what is liked best
Transitivity preferences after one another, little differences x > y and y > zàx > z (logic)
Utility function: Assign numbers to possible outcomes so that preffered choices receive higher numbers
u(w) = ln(w) w=wealth
EXPECTED UTILITY THEORY
Used to define rational behavior when people face uncertainty Individuals should act when confronted with decision-
making under uncertainty in a certain way Theory is really set up to deal with risk, not uncertainty:
Risk= you know the possible outcomes and it can be measured by probability
Uncertainty = you don’t know the possible outcomes
Prospect: Series of wealth outcomes associated with a probability
(money related to risk)
- U(P)= PRa, * U(Wa) + (1 - PRa), * U(Wb)
if P1 = (. 7,300,600) – Utility of probability = 0.7*square root 300+-
0.3* square root 600
RISK ATTITUDE
1. Risk averse:avoiding risk, not willing to accept a fair gamble
2. Risk seeking: going for the more riskier option
3. Risk neutrality: looking for the best solution, not based upon risk
Loss aversion = loses loom larger than gains – this is always there no matter which risk attitude you have
, CHAPTER 2 FOUNDATIONS OF FINANCE II: ASSET PRICING, MARKET EFFICIENCY, AND AGENCY
RELATIONSHIPS
Trade-off risk and return: positive correlation = higher risk gives higher return
Mean return of a portfolio: Weighted average * returns
1. Modern Portfolio Theory (MPT): Practical framework that assumes that investors are risk averse and preferences are
defined in terms of the mean and variance of returns
± 30 or more stocks
Reduce unique risk through diversification Different sectors and regions, they need to have a negative
correlation
Efficient frontier:
Represents that set of portfolios that maximize expected return for a given level of risk (portfolio G)
Types of risk:
Systematic risk cannot be avoided by diversifying (market risk)
Unique (of a specific company) risk can be avoided by diversifying
Adding a risk-free asset =Like adding an exchange mechanism that allows investors to borrow and lend Two-fund
separation - means that investors maximize utility by combining the risk-free asset with a fund of risky assets
Capital market line (CML):
Gives combinations of the risk-free asset and market portfolio Choose portfolio on line highest return with lowest risk
2. Capital Asset Pricing Model (CAPM):
Equilibrium model
Only risk related to market movements is priced by market (because other risk can be diversified away)
Investors will not be compensated for taking on diversifiable risk unrelated to market movements
Expected return= Risk-free rate + Beta * (Return market – Risk-free rate)
Beta: CAPM’s measure of systematic/undiversifiable risk
B=1 Move with market
B=0.5 Market -10%, you -5% Market +10%, you +5%
Market risk premium: (Return market – Risk-free rate)
The more risk you take, the more return you want
Value is what a security should be worth based on careful analysis
Price is what the market says it is worth
Behavioral finance: Combines social and psychological theory with financial theory as a mean of understanding how
price movements in the securities market occur independent of any corporate actions
Neoclassical Economics
Neoclassical economics assumptions:
1. People have rational preferences across possible outcomes or states of nature
2. People maximize utility and firms maximize profits
3. People make independent decisions based on all relevant information
Utility = usefulness, happiness, beneficial, satisfaction received from a particular outcome
Rational preferences two key assumptions:
Completeness ordering what is liked best
Transitivity preferences after one another, little differences x > y and y > zàx > z (logic)
Utility function: Assign numbers to possible outcomes so that preffered choices receive higher numbers
u(w) = ln(w) w=wealth
EXPECTED UTILITY THEORY
Used to define rational behavior when people face uncertainty Individuals should act when confronted with decision-
making under uncertainty in a certain way Theory is really set up to deal with risk, not uncertainty:
Risk= you know the possible outcomes and it can be measured by probability
Uncertainty = you don’t know the possible outcomes
Prospect: Series of wealth outcomes associated with a probability
(money related to risk)
- U(P)= PRa, * U(Wa) + (1 - PRa), * U(Wb)
if P1 = (. 7,300,600) – Utility of probability = 0.7*square root 300+-
0.3* square root 600
RISK ATTITUDE
1. Risk averse:avoiding risk, not willing to accept a fair gamble
2. Risk seeking: going for the more riskier option
3. Risk neutrality: looking for the best solution, not based upon risk
Loss aversion = loses loom larger than gains – this is always there no matter which risk attitude you have
, CHAPTER 2 FOUNDATIONS OF FINANCE II: ASSET PRICING, MARKET EFFICIENCY, AND AGENCY
RELATIONSHIPS
Trade-off risk and return: positive correlation = higher risk gives higher return
Mean return of a portfolio: Weighted average * returns
1. Modern Portfolio Theory (MPT): Practical framework that assumes that investors are risk averse and preferences are
defined in terms of the mean and variance of returns
± 30 or more stocks
Reduce unique risk through diversification Different sectors and regions, they need to have a negative
correlation
Efficient frontier:
Represents that set of portfolios that maximize expected return for a given level of risk (portfolio G)
Types of risk:
Systematic risk cannot be avoided by diversifying (market risk)
Unique (of a specific company) risk can be avoided by diversifying
Adding a risk-free asset =Like adding an exchange mechanism that allows investors to borrow and lend Two-fund
separation - means that investors maximize utility by combining the risk-free asset with a fund of risky assets
Capital market line (CML):
Gives combinations of the risk-free asset and market portfolio Choose portfolio on line highest return with lowest risk
2. Capital Asset Pricing Model (CAPM):
Equilibrium model
Only risk related to market movements is priced by market (because other risk can be diversified away)
Investors will not be compensated for taking on diversifiable risk unrelated to market movements
Expected return= Risk-free rate + Beta * (Return market – Risk-free rate)
Beta: CAPM’s measure of systematic/undiversifiable risk
B=1 Move with market
B=0.5 Market -10%, you -5% Market +10%, you +5%
Market risk premium: (Return market – Risk-free rate)
The more risk you take, the more return you want
Value is what a security should be worth based on careful analysis
Price is what the market says it is worth
