The economics and finance of uncertainty

FINANCE AND THE ECONOMICS OF UNCERTAINTY......Page 1
Contents......Page 5
List of main symbols......Page 10
Introduction......Page 13
Part 1 Valuation by Arbitrage......Page 19
1 Financial instruments: an introduction......Page 21
1.2 Bonds......Page 22
1.3 The Spot Curve......Page 25
1.4 Stocks......Page 27
2 Derivatives Markets......Page 28
2.1 Futures Markets for Commodities and Currencies......Page 29
2.2 Futures Markets for Financial Instruments......Page 33
2.3 Options......Page 37
Exercises......Page 39
2 Arbitrage......Page 40
1.2 Securities......Page 41
1.3 Absence of Arbitrage Opportunities and Valuation......Page 44
1.4 Complete Markets......Page 48
1.5 Risk-Adjusted Probability......Page 50
2.1 Time Structure......Page 51
2.2 Instantaneous Arbitrage......Page 52
2.3 Dynamic Arbitrage......Page 53
2.4 Probabilistic Formulation: Risk-Adjusted Probability......Page 62
Exercises......Page 64
Part 2 Exchanging Risk......Page 69
1.1 Individual Demand for Savings......Page 71
1.2 Equilibrium, Optimum......Page 75
2 Introducing Uncertainty......Page 77
Bibliographical Note......Page 78
3 Investors and their information......Page 81
1 Choice Criteria......Page 82
1.1 Von Neumann Morgenstern Utility and Risk Aversion......Page 83
1.2 Standard von Neumann Morgenstern Utility Functions......Page 85
2.1 Markets and Budget Constraints......Page 86
2.2 The Demand for One Risky Security and Risk Aversion......Page 89
3 Subjective Expectations and Opportunities for Arbitrage......Page 93
4 Convergence of Expectations: Bayesian Learning......Page 96
5 The Value of Information......Page 99
Bibliographical Note......Page 103
Exercises......Page 104
4 Portfolio choice......Page 106
1 Mean–Variance Efficient Portfolios......Page 107
1.1 Portfolio Composition and Returns......Page 108
1.2 Diversification......Page 110
1.3 The Efficiency Frontier in the Absence of a Riskless Security......Page 111
1.4 Efficient Portfolios: The Case with a Risk-Free Security......Page 113
2 Portfolio Choice under the von Neumann Morgenstern Criterion......Page 115
3 Finance Paradigms: Quadratic and CARA Normal......Page 117
3.1 Hedging Portfolios......Page 119
3.2 The Demand for Risky Securities......Page 120
Exercises......Page 122
5 Optimal risk sharing and insurance......Page 126
1.1 The Model......Page 127
1.2 Insuring Individual Idiosyncratic Risks......Page 128
1.3 Optimality: Characterization......Page 130
2.1 Complete Markets......Page 134
2.3 The Role of Options......Page 136
3 Market Failures......Page 140
Bibliographical Note......Page 142
Exercises......Page 143
6 Equilibrium on the stock exchange and risk sharing......Page 147
1 The Amounts at Stake......Page 148
2 The Stock Exchange......Page 149
2.2 Investors......Page 150
2.3 Equilibrium......Page 151
3 The CAPM......Page 152
3.1 Returns......Page 153
3.2 Equilibrium Prices......Page 155
4 The General Equilibrium Model and Price Determination......Page 156
4.1 Prices of Risky Securities......Page 157
4.2 The Allocation of Risks......Page 159
4.3 Determination of the Interest Rate......Page 160
Bibliographical Note......Page 162
Exercises......Page 163
7 Trade and information......Page 168
1 Short-Term Equilibrium......Page 169
1.1 Investors......Page 170
1.2 Equilibrium......Page 171
2 Public Information and Markets......Page 174
2.1 Ex ante Complete Markets and Public Information in an Exchange Economy......Page 175
2.2 The Impact of Information: Production and Incomplete Markets......Page 178
3.1 Equilibrium with Naïve Traders......Page 182
3.2 Private Information and Rational Expectations......Page 184
3.3 Revelation of Information by Prices......Page 186
4 Information: The Normal Model......Page 188
4.1 Rational Expectations and the Aggregation of Information......Page 189
4.2 Noise and the Transmission of Information by Prices......Page 192
4.3 Insiders......Page 194
5 Formation of Expectations and Investments......Page 197
Bibliographical Note......Page 200
Exercises......Page 201
8 Intertemporal valuation......Page 206
1.1 The Economy......Page 207
1.2 The Spot Curve: A Review......Page 208
2.1 The Interest Rate Curve and Its Evolution......Page 209
2.2 The Valuation of Risky Assets......Page 211
3.1 The Interest Rate Curve......Page 214
3.2 Spot and Forward Curves: An Example......Page 217
3.3 The Dynamics of Securities Prices......Page 219
4.1 Isoelastic Utilities......Page 222
4.2 Beyond the Representative Agent......Page 224
5 Fundamental Value and Bubbles......Page 226
Bibliographical Note......Page 228
Exercises......Page 229
Part 3 The Firm......Page 231
9 Corporate finance and risk......Page 239
1.1 Financial Backers......Page 240
1.2 The Net Cash Proceeds......Page 242
2.1 The Accounting Framework......Page 243
2.2 Value of the Firm......Page 245
2.3 Stock Market Valuation......Page 247
2.5 Comments on the Leverage Effect......Page 250
3 Financial Structure......Page 252
3.1 Complete Markets......Page 253
3.2 Incomplete Markets......Page 256
Bibliographical Note......Page 258
Exercises......Page 259
10 Financing investments and limited liability......Page 261
1.1 Complete Markets......Page 262
1.2 Incomplete Markets......Page 268
1.3 Multiplicative Risk......Page 270
2 Investments, Equity Financing, and Insider Information......Page 271
3.1 The Market without Dysfunction......Page 275
3.2 Default Risk......Page 277
3.3 Equilibrium......Page 280
Bibliographical Note......Page 285
Exercises......Page 286
Index......Page 291