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Intermediate Financial Theory, 3rd Edition by John B. Donaldson, Jean-Pierre Danthine

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Chapter 3

Making Choices in Risky Situations

Chapter 3 initiates the discussion of the demand for financial assets of different risk classes by individual investors. This amounts to a discussion of how to model individual choice among uncertain payoff streams. Von Neumann-Morgenstern (VNM) expected utility theory is presented as the principal device for the subjective evaluation of these payoff streams. The discussion is extended to alternative perspectives which are generally classified as ‘behavioral.’

Keywords

Random variable; state-by-state dominance; economic rationality; Allais paradox; Prospect Theory; VNM; expected utility

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