TABLE OF CONTENTS: List of boxes xi Preface xiii 1 Introduction 1 1.1 What Finance theory is about 1 1.2 Some history of thought 2 1.3 The importance of the puzzles 7 1.4 Outline of the book 9 2 Contingent claim economy 10 2.1 The commodity space 10 2.2 Preferences and ordinal utility 14 2.3 Maximization 16 2.4 General equilibrium 23 2.5 The representative agent 32 Notes on the literature 35 Problems 35 3 Asset economy 37 3.1 Financial assets 37 3.2 Pricing by redundancy 41 3.3 Radner economies 46 3.4 Complete markets (and uniqueness of Arrow prices) 53 3.5 Complications arising from market incompleteness 60 Notes on the literature 65 Problems 65 4 Risky decisions 68 4.1 Bernoulli's St.Petersburg paradox 69 4.2 Using more structure: probabilities and lotteries 71 4.3 The von Neumann -Morgenstern representation 75 4.4 Measures of risk preference 81 4.5 Assumptions and evidence 86 4.6 Often used specifications 91 Notes on the literature 99 Problems 99 5 Staticfinance economy 102 5.1 An economy with von Neumann -Morgenstern agents 102 5.2 Efficient risk-sharing 107 5.3 A representative NM agent 112 5.4 Who holds what kind of portfolio? 121 5.5 The stochastic discount factor 126 5.6 The equilibrium price of time 130 5.7 The equilibrium price of risk 132 5.8 Some important special cases 134 Notes on the literature 138 Problems 138 6 Dynamicfinance economy 141 6.1 A static dynamic model 141 6.2 Dynamic trading 149 6.3 Models of the real interest rate 162 6.4 Portfolio selection 168 Notes on the literature 170 Problems 170 7 Empirics and the puzzles 172 7.1 Collecting the right data 172 7.2 The equity premium puzzle 176 7.3 Alternative interpretations of the data 184 7.4 Excessive volatility 192 7.5 Anomalies 197 Notes on the literature 198 8 Adapting the theory 199 8.1 Assumptions of the mainstream model 199 8.2 Non-standard preferences 201 8.3 Heterogeneity 214 8.4 Efficiency failure 225 Notes on the literature 238 9 Epilog 239 9.1 A mystery 240 9.2 A challenge 241 9.3 The party's over 242 Appendix A Symbols and notation 245 Appendix B Solutions to the problem sets 247 Bibliography 269 Index 285
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