Contemporary Finance

3Information, Preferences, and Asset Prices

3.1 Information and the Quantification of Risk

The practical difference between the two categories, risk and uncertainty, is that in the former the distribution of the outcome in a group of instances is known (either through calculation a priori or from statistics of past experience), while in the case of uncertainty this is not true, the reason being in general that it is impossible to form a group of instances, because the situation dealt with is in a high degree unique.

Knight, Risk, Uncertainty, and Profit [1921], p. 233

Markets are the process by which households and firms, with disparate goals and fragmentary, dispersed, uncertain, and partial information, meet and exchange goods and services for mutual benefit. Financial intermediation can be viewed as intermediation of information and facilitation of cooperation. The merchant banker connecting equity investors to ventures is intermediating between new to ideas/techniques and information about savings available to invest. Asset prices are among the most important information sources in this process because they signal to market participants what assets are more and less sought after or shunned and, through those signals, what changes might be occurring and how other market participants view them.

Financial models simplify the world along a number of analytically useful but potentialy misleading dimensions: thinning out the range of possible outcomes among which market participants ...