Overview of Financial Economics PDF

Overview of Financial Economics  What is finance?  Finance: decisions on resource allocation over time  Costs and benefits are:  Spread out over time  Not known with certainty in advance  Financial system  Financial markets  Financial institutions...

Overview of Financial Economics  What is finance?  Finance: decisions on resource allocation over time  Costs and benefits are:  Spread out over time  Not known with certainty in advance  Financial system  Financial markets  Financial institutions 2  Why study finance?  Manage personal resource  Participate in business interaction  Career opportunities in finance  Decisions in a market-oriented society 3  Financial decisions of individuals/households  Consumption vs. saving  Investment decisions  Financing decisions  Risk-management decisions 4  Preference, Choice, and Utility  Utility theory: developed by Neumann and Morgenstern (1944)  Utility maps preference to a numerical scale  Decision makers (individuals; firms) are rational agents trying to maximize utility  E.g., when u($10) > u($1), choose $10  Functional forms of utility function can describe more subtle features of preference  E.g., concave, convex, and linear utilities  Risk-aversion, risk-loving, and risk-neutral 5  St. Petersburg Paradox  The payoff of a lottery is determined by tossing a fair coin till a head appears  If the head appears on the first toss, the payoff is $1; if appears on the second toss, the payoff is $2…; if appears on the nth toss, the payoff is $2n-1  How much would you pay for this lottery?  $1(1/2) + $2(1/4) + $4(1/8) + … + $2n-1(1/2n) =   u(1)(1/2) + u(2)(1/4) + u(4)(1/8) + … + u(2n-1)(1/2n) = ?  If u(x) = log(x), the payoff  $2 6  State of the world  A convenient way to model risky payoffs  Future events that matter to decisions  E.g., the future price of a stock that is selling at $16  State 1: economic boom; $25  State 2: normal; $18  State 3: recession; $5  Mutually exclusive and collectively exhaustive  Probability distribution: 1/3, 1/3, 1/3; 20%, 60%, 20%  Expected price = $25*1/3 + $18*1/3 + $5*1/3 = $16 7