The next two class meetings will be devoted to covering various topics in probability and statistics that are important for Finance 4335. On Tuesday, August 29, class will begin with a quiz on the assigned readings (“The New Religion of Risk Management” and “Normal and standard normal distribution“). Furthermore, Problem Set 1 will be due at the beginning of class that day.
While I have your attention, let me briefly explain what the main “theme” will initially be in Finance 4335 (up to the first midterm exam, which is scheduled for Tuesday, September 26). Specifically, we will delve into decision theory. Decision theory addresses decision making under risk and uncertainty, and not surprisingly, risk management lies at the very heart of decision theory. Initially, we’ll focus our attention upon variance as our risk measure. Most basic finance models (e.g., portfolio theory and the capital asset pricing model, or CAPM) implicitly or explicitly assume that risk = variance. We’ll learn that while this is not necessarily an unreasonable assumption, circumstances can arise where it is not an appropriate assumption. Furthermore, since individuals and firms are typically exposed to multiple sources of risk, we need to take into consideration the portfolio effects of risk. To the extent to which risks are not perfectly positively correlated, this implies that risks often “manage” themselves by canceling each other out. Thus the risk of a portfolio is typically less than the sum of the individual risks which comprise the portfolio.
The decision theory provides us with a very useful framework for thinking about concepts such as risk aversion and risk tolerance. The calculus comes in handy by providing an analytic framework for determining how much risk to retain and how much risk to transfer to others. Such decisions occur regularly in daily life, encompassing practical problems such as deciding how to allocate assets in a 401-K or IRA account, determining the extent to which one insures health, life, and property risks, whether to work for a startup or an established business, and so forth. There’s also quite a bit of ambiguity when we make decisions without complete information, but this course will at least help you think critically about costs, benefits, and trade-offs related to decision-making whenever you encounter risk and uncertainty.
After the first midterm, we’ll move on to other topics including demand for insurance, asymmetric information, portfolio theory, capital market theory, option pricing theory, and corporate risk management.