Foundations for Financial Economics

Abstract

This is a textbook that is both lucid and elegant. It covers all the topics appropriate for an introductory Ph.D. course in finance, and, because it presumes very little mathematics beyond elementary calculus and matrix algebra, it should be accessible to most students. While it was still in manuscript form I used sections of the book for teaching Ph.D. students, and my informal and very unscientific survey of the students revealed general enthusiasm for it. The book is organized along fairly conventional lines. The first part (Chapters 1 through 6) deals with two period models. In Chapter 1 a clear and concise treatment of the von Neumann-Morgenstern expected utility function is presented along with some discussion of the violations of the Independence Axiom in experimental work and Machina utility. Also included is the development of risk aversion measures and preference conditions for two-fund separation. Chapter 2 is a very good presentation of the conditions for first- and second-degree stochastic dominance. In addition Ross's stronger measures of risk aversion are presented. Chapter 3 is focused on the mathematics of the mean variance efficient frontier, and Chapter 4 develops the distributional conditions for two-fund separation and then in turn presents the CAPM and the APT. Chapter 5 concerns the optimality of allocations obtained in complete markets and the pricing of state contingent claims. Models of pricing with a representative agent and the conditions for aggregation are also included. Chapter 6 concludes the first section with a discussion of options. Arbitrage bounds on option prices are discussed and the Black-Scholes equation is derived not by an arbitrage argument but rather by making assumptions about preferences in a discrete time setting.

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