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1 BasicConcepts

1 BasicConcepts - Basic Concepts Financial intermediation...

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Basic Concepts Financial intermediation utilizes many concepts of financial economics. It is therefore imperative that these concepts be understood. These key concepts include: Expected Utilization Theory Financial economics is interested in studying how people and societies choose to allocate scarce resources and distribute wealth among one another over time. It is important to recognize that individuals have different tastes in terms of what and when to consume as well as different degrees of risk aversion. Financial economists recognize these differences but do not deal with why they exist or what causes them; other social sciences (e.g., psychology, political science, sociology, etc) study these problems. The theory of investor choice has come to be known as utility theory . Expected utility can be used to rank risky alternatives. These related utility functions are specific to individuals; there is no way to compare one individual’s utility function to another’s. However, we can group utility functions based on degree of risk aversion in one of three functions: (1) Risk Lover: U[E(W)] < E[U(W)] (2) Risk Neutral: U[E(W)] = E[U(W)] (3) Risk Averter: U[E(W)] > E[U(W)] Suppose we establish a gamble between 2 outcomes, a and b , with the probability of a being α and the probability of b being (1- α ). The actuarial value, or expected value, of the gamble can be determined as the sum of the product of the probability of an outcome times the payoff if that outcome occurs: ( α )( a ) + (1- α )( b ) To determine which of these three functions best defines your level of risk aversion, utility theory asks the question, “Would you prefer the actuarial value of the gamble (i.e., the gamble’s expected or weighted average outcome) with certainty, or the gamble itself”? EXAMPLE: Would you prefer to receive \$10 with certainty, or would you prefer to ‘roll the dice’ in a gamble that pays \$30 with a probability of 20% and \$5 with a 80% probability? The person who prefers the gamble is a risk lover; the one who is indifferent is risk neutral; and the one who prefers the actuarial value with certainty in risk averse. The expected wealth, E(W), or actuarial value of the gamble in this example is: E(W) = (.2)(\$30) + (.8)(\$5) = \$10 Diversification Dr. Harry M. Markowitz, known as the father of Modern Portfolio Theory, developed a theory concerning the behavior of rational investors. The central theme of this theory was that rational investors have an inherent aversion to increased risk (defined as the

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uncertainty or variability of returns as measured by the standard deviation of expected returns around the mean) without compensation by an adequate increase in expected return. Combining this conception of risk with investors’ assumed aversion to risk, Markowitz believed investors should try to minimize deviations from the mean be diversifying their security selections for portfolios. More importantly, he pointed out that simply holding different issues would not significantly reduce deviations or variability of a portfolio’s expected return. Markowitz stated that
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