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Questions and Answers
What is a key characteristic of financial decisions, as described in the text?
What is a key characteristic of financial decisions, as described in the text?
- They are primarily focused on maximizing current income.
- They are typically made with complete certainty about future outcomes.
- They are always simple and straightforward to make.
- They involve allocating resources across different time periods. (correct)
What is the main purpose of the financial system, according to the provided information?
What is the main purpose of the financial system, according to the provided information?
- To eliminate all uncertainty and risks associated with financial decisions.
- To facilitate the allocation of resources through financial markets and institutions. (correct)
- To guarantee high returns on all savings.
- To ensure all investments are risk-free.
Which of the following is NOT a core financial decision faced by individuals or households?
Which of the following is NOT a core financial decision faced by individuals or households?
- Choosing between spending and saving.
- Determining the amount of debt to take on.
- Evaluating different investment opportunities.
- Selecting which political candidates to support. (correct)
In the context of utility theory, what is the meaning of a concave utility function?
In the context of utility theory, what is the meaning of a concave utility function?
What is the St. Petersburg Paradox trying to illustrate?
What is the St. Petersburg Paradox trying to illustrate?
What is the key assumption regarding decision-makers in utility theory?
What is the key assumption regarding decision-makers in utility theory?
What purpose do 'states of the world' serve in financial decision-making?
What purpose do 'states of the world' serve in financial decision-making?
What is the expected price of a stock if the probability distribution for its future price is as follows: State 1 (boom) = $25 (probability = 1/3), State 2 (normal) = $18 (probability = 1/3), and State 3 (recession) = $5 (probability = 1/3) ?
What is the expected price of a stock if the probability distribution for its future price is as follows: State 1 (boom) = $25 (probability = 1/3), State 2 (normal) = $18 (probability = 1/3), and State 3 (recession) = $5 (probability = 1/3) ?
Flashcards
Finance
Finance
Decisions on resource allocation over time, considering costs and benefits.
Utility Theory
Utility Theory
A theory that maps preferences to a numerical scale to maximize decision maker's satisfaction.
Rational Agent
Rational Agent
Individuals or firms making decisions aimed at maximizing their utility.
St. Petersburg Paradox
St. Petersburg Paradox
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State of the World
State of the World
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Mutually Exclusive Events
Mutually Exclusive Events
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Collectively Exhaustive Events
Collectively Exhaustive Events
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Expected Price
Expected Price
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Study Notes
Overview of Financial Economics
- Finance involves decisions about resource allocation over time.
- Costs and benefits are spread over time and uncertain.
- A financial system includes financial markets and institutions.
What is Finance?
- Finance encompasses decisions about resource allocation over time.
- Costs and benefits are spread out over time and not known with certainty.
- The financial system consists of financial markets and institutions.
Why Study Finance?
- Understanding finance helps manage personal resources.
- Participating in business interactions is crucial.
- Career opportunities in finance exist.
- Decisions in a market-oriented society require knowledge of finance.
Financial Decisions of Individuals/Households
- Decisions include consumption versus saving.
- Investment decisions are important considerations.
- Financing decisions are essential.
- Risk management is a key element.
Preference, Choice, and Utility
- Utility theory, developed by Neumann and Morgenstern (1944), maps preferences to a numerical scale.
- Decision-makers (individuals and firms) aim to maximize utility.
- Example: Choosing $10 when utility of $10 is greater than that of $1.
- Functional forms of the utility function explain subtle preference features like concavity, convexity, and linear utility.
- Features like risk aversion, risk-loving, and risk-neutrality are also included.
St. Petersburg Paradox
- The lottery's payoff is determined through coin tossing until a head appears.
- Payoffs increase exponentially.
- Expected payoff is infinite but rationality suggests a finite price.
State of the World
- A framework for modeling risky payoffs.
- Future events, such as economic states (boom, normal, recession), affect decisions.
- An example is a stock's price fluctuating based on economic conditions.
- Different states have specific probabilities and associated payouts.
- This framework allows for accurate prediction of a financial variable's expected value
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