2010 | Buch

# Financial Economics

## A Concise Introduction to Classical and Behavioral Finance

verfasst von: Thorsten Hens, Marc Oliver Rieger

Verlag: Springer Berlin Heidelberg

2010 | Buch

verfasst von: Thorsten Hens, Marc Oliver Rieger

Verlag: Springer Berlin Heidelberg

Financial economics is a fascinating topic where ideas from economics, mathematics and, most recently, psychology are combined to understand financial markets. This book gives a concise introduction into this field and includes for the first time recent results from behavioral finance that help to understand many puzzles in traditional finance. The book is tailor made for master and PhD students and includes tests and exercises that enable the students to keep track of their progress. Parts of the book can also be used on a bachelor level. Researchers will find it particularly useful as a source for recent results in behavioral finance and decision theory.

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Abstract

This first chapter provides an overview on financial economics and how to study it: you will learn how we have designed this textbook and how you can use it efficiently; we will give you an overview of the essence of financial economics and some of its central ideas; we will finally summarize how research in financial economics is done, what methods are used and how they interact with each other.

Abstract

How should we decide? And how do we decide? These are the two central questions of Decision Theory: in the prescriptive (rational) approach we ask how rational decisions should be made, and in the descriptive (behavioral) approach we model the actual decisions made by individuals. Whereas the study of rational decisions is classical, behavioral theories have been introduced only in the late 1970s, and the presentation of some very recent results in this area will be the main topic for us. In later chapters we will see that both approaches can sometimes be used hand in hand, for instance, market anomalies can be explained by a descriptive, behavioral approach, and these anomalies can then be exploited by hedge fund strategies which are based on rational decision criteria.

Abstract

Indeed we will start our journey to financial markets with only one step: the step from one time period (in which we invest into assets) to another time period (in which the assets pay off). To make this two-period model even simpler, we assume in this chapter mean-variance preferences. We will see later that this model is a special case of two-period models with more general preferences (Chap. 4) and that we can extend the model to arbitrarily many time-periods (Chap. 5). Finally we generalize to continuous models, where the time does not any longer consists of discrete steps (Chap. 8). For now, the assumptions of two periods and mean-variance preferences allow us to get some intuition on financial markets without being overwhelmed by an overdose of mathematical formalism. Nevertheless, we want to point out that this simplicity comes at a price: we need to impose strong and not very natural assumptions. In Sec. 2.3, we have seen some of the potential problems of the mean-variance approach. In practical applications, however, this approach is still standard. We will use it to develop a first model of asset pricing, the so-called “Capital Asset Pricing Model” (CAPM). This model has been praised by many researchers in finance, and in 1990 Markowitz and Sharpe were awarded the Nobel Prize in economics for its development.

Abstract

In the last chapter we have assumed that investors base their decisions on the mean-variance approach. This helped us to develop a model for pricing assets on a financial market, the CAPM. In this chapter we want to generalize this model in that we relax the assumptions on the preferences of the investors.

Abstract

In the previous two chapters, we have restricted ourselves to the case of two time periods, one for investing and one for receiving payoffs. For many applications it is, however, necessary to allow for models with more than two time periods. In particular one can then study re-trading on the arrival of new information. Nevertheless we will see that many of the insights we have won for the two-period model will be useful also for multi-period models.

Abstract

We will now extend the financial economy ε
_{
F
} to cover problems of production and production units, i.e. firms. Among other things, this allows conclusions about the behaviour of firms in markets. So far we assumed bond payoffs to be exogenous, ignoring the decision-making process of the bonds’ issuers. A precise theory of the firm will analyze this process, resulting in bonds whose payoff structure is determined by various economic parameters.

Abstract

So far we assumed common knowledge about the (state-contingent) pay-offs of assets. Imagine now that some agents know the payoffs better than others. Then – besides intertemporal substitution, risk sharing and betting on the occurrence of the states of the world – a seller of an asset might want to sell it because he knows it has very low pay-offs. Anticipating this no agent would buy at a price allowing the seller to make a profit and ultimately no transaction is made. In the subprime mortgage crisis this aspect of asset markets became overwhelming so that asset markets broke down completely.

Abstract

Trading on a stock market is obviously a discrete process, as it consists of single transactions performed at distinct times. There are, however, so many transactions in such a high frequency that it is for many applications better to model them in a time-continuous setting, i.e., to assume that they take place at all times. In this chapter we will provide a short introduction to timecontinuous models. An important difference will be that prices are exogenously given. In particular, we will derive the famous Black-Scholes model for asset pricing as it has been introduced by Fischer Black and Myron Scholes [BS73] and by Robert C. Merton [Mer73]. In 1997, the Nobel prize has been awarded for this work.