Risk, Value, and Financial Prices
The utility approach provides an economic foundation to financial decision making and risk management. The capital asset pricing model (CAPM) model and the stochastic discount factor (SDF) or kernel pricing and many aspects of corporate finance are essentially based on utility theory. This chapter begins with an introduction to value and price, risk and money, and subsequently introduces fundamental contributions of utility theory to finance. In practice, utility in finance is important for portfolio theory, pricing, financial risk management, risk sharing, insurance, and the many areas of financial analysis and financial management.
VALUE AND PRICE
Value is derived from needs and the ability to meet these needs. A price, however, reflects the complex and interacting forces of demand and supply of a security being traded. J. B. Say, a French economist, as early as the seventeenth century pointed out that price is a clearing mechanism, at which an equilibrium is reached between demand and supply. Say that many investors want to buy IBM shares, while other and fewer investors are willing to sell their shares. An excess demand will contribute then to an increase in the price of IBM’s shares, until an equilibrium price, equating the demand for IBM shares and their supply, is reached. Prices, in both real and financial markets, are thus relative to the many buyers and sellers participating in these markets, their alternatives, ...