Financial Economics: A Concise Introduction to Classical and Behavioral Finance / Edition 1

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More About This Textbook

Overview

Financial economics is a fascinating topic where ideas from economics, mathematics and, most recently, psychology are combined to understand financial markets. This book gives a concise introduction into this field and includes for the first time recent results from behavioral finance that help to understand many puzzles in traditional finance. The book is tailor made for master and PhD students and includes tests and exercises that enable the students to keep track of their progress. Parts of the book can also be used on a bachelor level. Researchers will find it particularly useful as a source for recent results in behavioral finance and decision theory.

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Product Details

  • ISBN-13: 9783540361466
  • Publisher: Springer Berlin Heidelberg
  • Publication date: 7/9/2010
  • Edition description: 2010
  • Edition number: 1
  • Pages: 384
  • Product dimensions: 6.10 (w) x 9.20 (h) x 1.10 (d)

Table of Contents

Part I Foundations

1 Introduction 3

1.1 An Introduction to This Book 3

1.2 An Introduction to Financial Economics 5

1.2.1 Trade and Valuation in Financial Markets 5

1.2.2 No Arbitrage and No Excess Returns 7

1.2.3 Market Efficiency 8

1.2.4 Equilibrium 9

1.2.5 Aggregation and Comparative Statics 10

1.2.6 Time Scale of Investment Decisions 10

1.2.7 Behavioral Finance 11

1.3 An Introduction to the Research Methods 12

2 Decision Theory 15

2.1 Fundamental Concepts 16

2.2 Expected Utility Theory 20

2.2.1 Origins of Expected Utility Theory 20

2.2.2 Axiomatic Definition 28

2.2.3 Which Utility Functions are "Suitable"? 36

2.2.4 Measuring the Utility Function 43

2.3 Mean-Variance Theory 47

2.3.1 Definition and Fundamental Properties 47

2.3.2 Success and Limitation 48

2.4 Prospect Theory 52

2.4.1 Origins of Behavioral Decision Theory 53

2.4.2 Original Prospect Theory 56

2.4.3 Cumulative Prospect Theory 60

2.4.4 Choice of Value and Weighting Function 67

2.4.5 Continuity in Decision Theories* 71

2.4.6 Other Extensions of Prospect Theory* 73

2.5 Connecting EUT, Mean-Variance Theory and PT 75

2.6 Ambiguity and Uncertainty* 80

2.7 Time Discounting 82

2.8 Summary 85

2.9 Tests and Exercises 86

2.9.1 Tests 86

2.9.2 Exercises 89

Part II Financial Markets

3 Two-Period Model: Mean-Variance Approach 95

3.1 Geometric Intuition for the CAPM 96

3.1.1 Diversification 97

3.1.2 Efficient Frontier 99

3.1.3 Optimal Portfolio of Risky Assets with a Riskless Security 99

3.1.4 Mathematical Analysis of the Minimum-Variance Opportunity Set* 100

3.1.5 Two-Fund Separation Theorem 105

3.1.6 Computing the Tangent Portfolio 106

3.2 Market Equilibrium 107

3.2.1 Capital Asset Pricing Model 107

3.2.2 Application: Market Neutral Strategies 108

3.2.3 Empirical Validity of the CAPM 109

3.3 Heterogeneous Beliefs and the Alpha 110

3.3.1 Definition of the Alpha 112

3.3.2 CAPM with Heterogeneous Beliefs 116

3.3.3 Zero Sum Game 120

3.3.4 Active or Passive? 124

3.4 Alternative Betas and Higher Moment Betas 126

3.4.1 Alternative Betas 127

3.4.2 Higher Moment Betas 128

3.4.3 Deriving a Behavioral CAPM 130

3.5 Summary 135

3.6 Tests and Exercises 136

3.6.1 Tests 136

3.6.2 Exercises 139

4 Two-Period Model: State-Preference Approach 141

4.1 Basic Two-Period Model 141

4.1.1 Asset Classes 142

4.1.2 Returns 143

4.1.3 Investors 145

4.1.4 Complete and Incomplete Markets 151

4.1.5 What Do Agents Trade? 152

4.2 No-Arbitrage Condition 152

4.2.1 Introduction 152

4.2.2 Fundamental Theorem of Asset Prices 154

4.2.3 Pricing of Derivatives 160

4.2.4 Limits to Arbitrage 162

4.3 Financial Markets Equilibria 167

4.3.1 General Risk-Return Tradeoff 168

4.3.2 Consumption Based CAPM 169

4.3.3 Definition of Financial Markets Equilibria 170

4.3.4 Intertemporal Trade 174

4.4 Special Cases: CAPM, APT and Behavioral CAPM 177

4.4.1 Deriving the CAPM by 'Brutal Force of Computations' 178

4.4.2 Deriving the CAPM from the Likelihood Ratio Process 180

4.4.3 Arbitrage Pricing Theory 182

4.4.4 Deriving the APT in the CAPM with Background Risk 183

4.4.5 Behavioral CAPM 184

4.5 Pareto Efficiency 185

4.6 Aggregation 188

4.6.1 Anything Goes and the Limitations of Aggregation 188

4.6.2 A Model for Aggregation of Heterogeneous Beliefs, Risk- and Time Preferences 194

4.6.3 Empirical Properties of the Representative Agent 195

4.7 Dynamics and Stability of Equilibria 201

4.8 Summary 206

4.9 Tests and Exercises 207

4.9.1 Tests 207

4.9.2 Exercises 209

5 Multiple-Periods Model 221

5.1 The General Equilibrium Model 221

5.2 Complete and Incomplete Markets 226

5.3 Term Structure of Interest 228

5.3.1 Term Structure without Risk 229

5.3.2 Term Structure with Risk 232

5.4 Arbitrage in the Multi-Period Model 234

5.4.1 Fundamental Theorem of Asset Pricing 234

5.4.2 Consequences of No-Arbitrage 236

5.4.3 Applications to Option Pricing 236

5.4.4 Stock Prices as Discounted Expected Payoffs 238

5.4.5 Equivalent Formulations of the No-Arbitrage Principle 239

5.4.6 Ponzi Schemes and Bubbles 240

5.5 Pareto Efficiency 244

5.5.1 First Welfare Theorem 244

5.5.2 Aggregation 245

5.6 Dynamics of Price Expectations 246

5.6.1 What is Momentum? 246

5.6.2 Dynamical Model of Chartists and Fundamentalists 247

5.7 Survival of the Fittest on Wall Street 252

5.7.1 Market Selection Hypothesis with Rational Expectations 252

5.7.2 Evolutionary Portfolio Theory 253

5.7.3 Evolutionary Portfolio Model 254

5.7.4 The Unique Survivor: λ* 258

5.8 Summary 259

5.9 Tests and Exercises 259

5.9.1 Tests 259

5.9.2 Exercises 260

Part III Advanced Topics

6 Theory of the Firm* 267

6.1 Basic Model 267

6.2 Modigliani-Miller Theorem 274

6.2.1 When Does the Modigliani-Miller Theorem Not Hold? 277

6.3 Firm's Decision Rules 278

6.3.1 Fisher Separation Theorem 278

6.3.2 The Theorem of Drèze 282

6.4 Summary 285

7 Information Asymmetries on Financial Markets* 287

7.1 Information Revealed by Prices 288

7.2 Information Revealed by Trade 290

7.3 Moral Hazard 292

7.4 Adverse Selection 293

7.5 Summary 295

8 Time-Continuous Model 297

8.1 A Rough Path to the Black-Scholes Formula 298

8.2 Brownian Motion and Ito Processes 301

8.3 A Rigorous Path to the Black-Scholes Formula 304

8.3.1 Derivation of the Black-Scholes Formula for Call Options 304

8.3.2 Put-Call Parity 307

8.4 Exotic Options and the Monte Carlo Method 308

8.5 Connections to the Multi-Period Model 310

8.6 Time-Continuity and the Mutual Fund Theorem 315

8.7 Market Equilibria in Continuous Time 318

8.8 Limitations of the Black-Scholes Model and Extensions 321

8.8.1 Volatility Smile and Other Unfriendly Effects 321

8.8.2 Not Normal: Alternatives to Normally Distributed Returns 322

8.8.3 Jumping Up and Down: Lévy Processes 327

8.8.4 Drifting Away: Heston and GARCH Models 329

8.9 Summary 332

Appendices

Mathematics 335

A.1 Linear Algebra 335

A.2 Basic Notions of Statistics 338

A.3 Basics in Topology 341

A.4 How to Use Probability Measures 343

A.5 Calculus, Fourier Transformations and Partial Differential Equations 347

A.6 General Axioms for Expected Utility Theory 351

Solutions to Tests and Exercises 355

References 357

Index 367

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