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22. Risk Aversion and the Capital Asset Pricing Theorem

Financial Theory (ECON 251) Until now we have ignored risk aversion. The Bernoulli brothers were the first to suggest a tractable way of representing risk aversion. They pointed out that an explanation of the St. Petersburg paradox might be that people care about expected utility instead of expected income, where utility is some concave function, such as the logarithm. One of the most famous and important models in financial economics is the Capital Asset Pricing Model, which can be derived from the hypothesis that every agent has a (different) quadratic utility. Much of the modern mutual fund industry is based on the implications of this model. The model describes what happens to prices and asset holdings in general equilibrium when the underlying risks can't be hedged in the aggregate. It turns out that the tools we developed in the beginning of this course provide an answer to this question. 00:00 - Chapter 1. Risk Aversion 03:35 - Chapter 2. The Bernoulli Explanation of Risk 12:38 - Chapter 3. Foundations of the Capital Asset Pricing Model 22:15 - Chapter 4. Accounting for Risk in Prices and Asset Holdings in General Equilibrium 54:11 - Chapter 5. Implications of Risk in Hedging 01:09:40 - Chapter 6. Diversification in Equilibrium and Conclusion Complete course materials are available at the Open Yale Courses website: http://open.yale.edu/courses This course was recorded in Fall 2009.