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Lecture

Risk Aversion and Complete Markets

In course

FIN-406: Macrofinance

This course provides students with a working knowledge of macroeconomic models that explicitly incorporate financial markets. The goal is to develop a broad and analytical framework for analyzing the interaction of financial decisions, macroeconomic events ...

Description

This lecture covers the concepts of risk aversion and complete markets in the context of macro-finance. The instructor discusses the implications of uncertainty in a two-period model, focusing on optimal behavior, risk neutrality, and the log case example. The lecture also explores the individual's expected utility, Arrow-Debreu securities, and the marginal rate of substitution. Furthermore, it delves into the current account, interest rates, and the law of comparative advantage. Overall, the lecture provides a comprehensive overview of how risk aversion influences decision-making in financial markets.

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Instructors (3)

Stylianos Tsiaras

I am a scientific collaborator at the Luisa Lambertini's Chair of International Finance at the Swiss Finance Inst i tute. Previously I was a Max Weber Fellow at the European University Institute. I got my PhD in economics at the University of Surrey. My thesis was supervised by Professor Martin Kaae Jensen and Dr. Tom Holden. My recent research explores the set of unconventional monetary policies by the European Central Bank and their impact on the macroeconomy, welfare and inequality.

Luisa Lambertini

Luisa Lambertini is Full Professor at the Ecole Polytechnique Federale de Lausanne (EPFL), where she holds the Chair of International Finance. She received her Ph.D. in Economics from the University of California at Berkeley in 1995, her Master of Science in Economics from Warwick University in 1989 and a Laurea cum Laude from the Universita' degli Studi di Bologna in 1987. Prior to coming to EPFL, Professor Lambertini was Associate Professor at Claremont McKenna College 2005-06, Associate Professor at Boston College 2003-06 and Assistant Professor at the University of California at Los Angeles 1995-03. Professor Lambertini's research is in international finance, open-economy macroeconomics and political economy. She studies how monetary and fiscal policies affect the economy, how they interact and how they can be used to achieve good economic outcomes and improve social welfare. Professor Lambertini's research focuses on how monetary and fiscal institutions should be designed to successfully mitigate the impact of unexpected shocks while pursuing long-run goals consistent with price stability and fiscal sustainability. These issues are even more important for small open economies in an interdependent world and for countries that adopt a common currency. Professor Lambertini has published articles in the American Economic Review, the Review of Economic Studies, the European Economic Review, the Journal of International Economics and the Economic Journal, among others. She was a Consultant in the Fiscal Policies Division of the European Central Bank and she has organized several international conferences. More details on my CV

Christian Pröbsting

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Related concepts (32)

Risk aversion

In economics and finance, risk aversion is the tendency of people to prefer outcomes with low uncertainty to those outcomes with high uncertainty, even if the average outcome of the latter is equal to or higher in monetary value than the more certain outcome. Risk aversion explains the inclination to agree to a situation with a more predictable, but possibly lower payoff, rather than another situation with a highly unpredictable, but possibly higher payoff.

Loss aversion

Loss aversion is a psychological and economic concept which refers to how outcomes are interpreted as gains and losses where losses are subject to more sensitivity in people's responses compared to equivalent gains acquired. Kahneman and Tversky (1992) have suggested that losses can be twice as powerful, psychologically, as gains. When defined in terms of the utility function shape as in the Cumulative Prospect Theory (CPT), losses have a steeper utility than gains, thus being more "painful" than the satisfaction from a comparable gain as shown in Figure 1.

Marginal utility

In economics, utility refers to the satisfaction or benefit that consumers derive from consuming a product or service. Marginal utility, on the other hand, describes the change in pleasure or satisfaction resulting from an increase or decrease in consumption of one unit of a good or service. Marginal utility can be positive, negative, or zero. For example, when eating pizza, the second piece brings more satisfaction than the first, indicating positive marginal utility.

Incomplete markets

In economics, incomplete markets are markets in which there does not exist an Arrow–Debreu security for every possible state of nature. In contrast with complete markets, this shortage of securities will likely restrict individuals from transferring the desired level of wealth among states. An Arrow security purchased or sold at date t is a contract promising to deliver one unit of income in one of the possible contingencies which can occur at date t + 1.

Hyperbolic absolute risk aversion

In finance, economics, and decision theory, hyperbolic absolute risk aversion (HARA) refers to a type of risk aversion that is particularly convenient to model mathematically and to obtain empirical predictions from. It refers specifically to a property of von Neumann–Morgenstern utility functions, which are typically functions of final wealth (or some related variable), and which describe a decision-maker's degree of satisfaction with the outcome for wealth. The final outcome for wealth is affected both by random variables and by decisions.

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