Risk Finance and Asset Pricing: Value, Measurements, and Markets

CHAPTER 6

Applied Utility Finance

OVERVIEW

Utility theory underlies the foundations of traditional finance. Portfolio theory, developed by Harry Markowitz (who shared the Nobel Prize in 1990), is based on a mean-variance valuation that implies a quadratic utility function. Similarly, topics and models such as the capital asset pricing model (CAPM), kernel pricing or stochastic discount factor (SDF), and their many applications to financial theory and practice are themselves applications of utility. These concepts are both important and have been applied to many financial issues seeking to value, price, and reach better decisions. This chapter highlights a sample of such applications including the valuation of portfolios, the valuation of infrastructures, and so forth. These applications emphasize the intricate and complementary relationships between value and price. Value is ascribed by persons’ (or firms’) needs while price is a mechanism that is set by risk sharing between parties of various needs and means in a personal exchange or in a market exchange.

RISK AND THE UTILITY OF TIME

Discounting is used to price future prospects, whether risk-free or not. A question such as, “What is the value (now) of a dollar next year?” epitomizes the value of time and its price—the discount factor. Valuation of payments is generally time- and risk-dependent, defined in terms of the payments, their uncertainty, as well as the information relevant to these payments at any given instant ...