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1、±±±±±±±±±±±±±±±±±±±FOUNDATIONSOF±±±±±±CHAPTER±±±±1±±±±FINANCEI:EXPECTED±UTILITYTHEORY1.1INTRODUCTIONThebehaviorofindividuals,practitioners,markets,andmanagersissometimescharacterizedas“irrational,”butwhatexactlydoesthatmean?Toanswerthisquestion,wemusttakesevera
2、lstepsbackandfullyunderstandthefoundationsofmodernfinance,whicharebasedonrationaldecision-making.Thefirsttwochap-tersofthebookaredesignedtoaccomplishthisgoal,withthefirstpresentingthestandardtheoryofhowindividualsmakedecisionswhenconfrontedwithuncertainty.Asbac
3、kground,wefirstconsiderwhatstandard(orneoclassical)economicsar-guesaboutrationalbehaviorwheneconomicdecisionsaremadeandthereisnouncertaintyaboutthefuture.Inthenextsection,itisarguedthatindividualsshouldmaximizeutility(orhappiness)basedontheirpreferences,thecons
4、traintstheyface,andtheinformationattheirdisposal.InSection1.3,wenotethatdeci-sionsbecomecomplicatedwhenthereisuncertainty.Anextensionofutilitytheoryhasbeendevelopedforthispurposeandisknownasexpectedutilitymaximiza-tion.Thebasicprocedureistoascertaintheutilityle
5、velgeneratedbyvaryinglevelsofwealth,andthen,whenchoosingamongprospects,whicharedefinedtobeprobabilitydistributionsofdifferentwealthlevels,tocalculatetheexpectedlevelofutilityofeachoftheseprospects.Finally,thedecision-makerchoosesthepros-pectwiththehighestexpect
6、edutility.Inthefollowingsection,wediscusstheroleofriskattitude.Specifically,sincepeopleprefertoavoidrisk,itisnecessarytocompensatethemforassumingit,andthedegreetowhichtheymustbecompen-sateddependsontheirriskaversion.Despitetheeleganceofexpectedutility,therearea
7、numberofoccasionswhenmanypeopleactcontrarytoit.Thebest-knowninstanceistheAllaisparadoxpresentedinSection1.5.Thefinaltwosectionsofthechapterlookaheadtotheimportanceofhowaproblemispresented,thatis,34CHAPTER1thedecisionframe,andtoprospecttheory,theprincipalalterna
8、tivetoexpectedutilitymaximization,whichwillbethemajorfocusofChapter3.1.2NEOCLASSICALECONOMICSTraditionalfinancemodelshaveabasisineconomics,andneoclassicaleconomicsisthedomin
