Lecture%2016%20-%20%20Uncertainty%20and%20State%20Preferences

Lecture%2016%20-%20%20Uncertainty%20and%20State%20Preferences

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1 FIN 580 FE Financial Economics Lecture 16:  State Preferences, Prospect Theory,  Professor Nolan Miller
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2 Announcements Problem Set #5 is available on Compass.  It is due on October  19. Problem 2, (ii): “log”   “ln” Problem Set #6 is due Tuesday, Oct. 26. The second midterm is Thursday, Oct. 28. MSFE: In Class (8am – 9:20). MSF: 7 – 8:20.  BIF 3007 (MSF1) and 3041 (MSF2). Office Hours next week W 2:00 – 4:00
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3 Today … Three big topics Prospect Theory CCAPM and Equity Premium Puzzle
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4 Road Map – Part 1 States of the world Contingent Commodities Examples Utility and budget sets with contingent commodities. State prices
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5 States of the World So far, we have considered uncertainty in terms of lotteries/random variables. A risky asset is a distribution of payoffs across states of the world. But, we can think about uncertainty a different way. A risky asset is a bundle of commodities, each of which pays $1 in a particular  state of the world. This second way is closer to the static model we considered earlier. And, it gives insight into certain asset pricing problems, like options. Note: this is not an options pricing class.  My goal is to illustrate the link between utility  maximization, general equilibrium and options.  We will not be covering options pricing.
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6 Contingent commodities A contingent commodity is a good that: is worth a positive amount if a particular state of the world occurs. is worth zero otherwise. For example, insurance is a contingent commodity. If a loss occurs, it pays for the damages. Otherwise, it pays nothing. A bet on the Chicago Bears to win their next game is a cont. comm.: It the bears win, it pays. Otherwise, it pays nothing. “$1 in good times” is a contingent commodity. It pays: $1 if times are good. $0 otherwise.
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Contingent Commodities If the states are mutually exclusive and exhaustive, once uncertainty about the  state is resolved, only one contingent good will have non-zero value. But, ahead of time, there are a number of contingent goods to choose from. These goods behave just like the apples and oranges in the static consumer  model. We can consider how the consumer allocates wealth among contingent  commodities in order to maximize utility. This approach is the basis for “Arrow-Debreu” asset and option pricing models.
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Lecture%2016%20-%20%20Uncertainty%20and%20State%20Preferences

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