Financial markets theory. Equilibrium, efficiency and information (Q5892419)

The book concerns the most important and discussed issues of the modern financial markets theory. It provides a detailed and comprehensive review of theories, models, puzzles and open problems discussed in the literature concerning quantitative finance. The presentation of the subject is performed with relatively simple mathematical methods and is tractable, yet it is very rigorous formally. The content of the book covers a wide variety of topics, starting from classic portfolio theory, risk measures and theory of choice in risky situation, thorough general equilibrium theory in one-period and multi-period models with risk, to the most current issues concerning failures of classic financial theory, behavioral finance and markets microstructure. In addition to the mathematical theory of markets, the book presents also a broad survey of empirical literature, including the most recent findings. The list of references contains more than one and half thousand positions. The first two chapters contain introductory material and prerequisites for further analysis. The first chapter contains an overview of basics of decision theory, elements of general equilibrium theory in the one-period deterministic setup and conclusions concerning optimality of the equilibrium. The second chapter moves on to the theory of decision making in risky situations. It starts with the presentation of preferences over lotteries and their representation with the von Neumann-Morgenstern utility function. Then some concepts connected with the expected utility principle are presented, like certainty equivalence, measures of risk aversion and stochastic dominance. The next three chapters are devoted to the analysis of equilibrium in single-period models. The presentation is structured as follows: first there is an analysis of choices of a single decision-maker (investor), then the mathematical theory of general equilibrium is presented, and at the end the authors turn to empirical tests of the theory. In Chapter 3 the authors consider an economic agent who tries to maximize his expected utility from the final wealth. They present some general results and some closed-form solutions for specific assumptions on utility functions and distributions of returns in the second period. In particular, they consider a quadratic utility function and normal distribution of returns and show that the optimization problems lead to mean-variance criteria. Then the authors deal with optimization problems with risky assets and a risk-free one. This leads to classical Markovitz's portfolio theory. The authors present properties of effective frontier and mutual fund separation theorems. Chapter 4 is devoted to general equilibrium theory in a risky setting. The authors consider two-period models with finite sample spaces. The chapter starts with the definition of Pareto optimality and effective allocations of risk in the society of many economic agents. Then the authors present several models and concepts of equilibria. They consider classical Arrow-Debreu models with complete future markets and the Radner concept of equilibrium. The authors consider complete and incomplete models of markets and the consequences of completeness on efficiency. The chapter ends with the theory of asset pricing in the absence of arbitrage. The authors provide a proof of the fundamental theorem of asset pricing and present the link between the martingale theory of asset pricing and the general equilibrium. In Chapter 5 the authors present the main asset pricing models, like CAPM, consumption based capital asset pricing model (CCAPM) and arbitrage pricing theory (APT). They provide a link between the equilibrium theory and the pricing models. The main advantage of this chapter is the broad review of the literature concerning empirical tests of the models. In this regard the authors present both the outline of general trends and the detailed overview of current empirical findings. Chapters 6 and 7 are devoted to multi-period of financial markets. Chapter 6 provides a theory and Chapter 7 contains a review of empirical literature. Chapter 6 describes the information flow in multi-period setting. It also provides the theory of optimizing expected utility from consumption using dynamic programming. For some special cases explicit solutions are given. At the end of the chapter some models of the term structure of interest rates are presented. Chapter 7 gives an extensive review of empirical research concerning testing multi-period models. In particular, it provides a survey of the literature about some phenomena that are inconsistent with the classical theory, like excess volatility, risk-free rate puzzle and equity premium puzzle. In the next three chapters the classical assumption about behavior of agents on financial markets are relaxed and the authors turn to non-classical models of behavioral finance. Chapter 8 considers a role of information. The main tool used by the authors is a three-period model with incomplete information. The authors provide a notion of the Green-Lucas equilibrium with rational expectation. The rest of the chapter contains an extensive survey of literature concerning multi-period models with imperfect information. In Chapter 9 the authors drop the assumption about maximizing expected utility. They provide an overview of some recent trends in empirical finance. In particular, they focus on questions such as a distinction between risk and uncertainty, hyperbolic discounting, time-inconsistency, heterogeneity of economic agents and markets' imperfections. Chapter 10 turns to the question of financial microstructure. It explores the role of different kinds of market participants (informed traders and uninformed ones). The authors analyze different types of market design (quote-driven and order-driven) and the importance of market liquidity and depth. In this chapter they present mainly a literature overview without detailed mathematical analysis. Each chapter ends with a set of exercises, which allow the reader to better understand the content of the chapter. Chapter 11 provides the detailed solutions to selected exercises.