Uncovering Flaws in Economic Theories and Exploring Utility in Modern Finance
This lecture explores flaws in classical economic theories, challenges traditional decision-making, and discusses the concepts of utility and expected utility in modern finance.
00:00:00 This lecture discusses flaws in classical theories of individual demand, supply and demand analysis, and rational behavior in finance. It also presents examples to challenge traditional economic decision-making.
The classical theory of individual demand is flawed and cannot work due to computational reasons.
The theory of supply is irrational as the profit maximizing formula is provably false.
Rational behavior in finance is provably irrational.
00:06:04 The lecture explains why people often make decisions that go against economic theory, citing risk aversion, loss aversion, personal beliefs, and subjective vs. objective probabilities.
📚 People often make choices that go against economic theory, such as opting for a safer option even when the expected value is higher.
🤔 Loss aversion and personal beliefs, including religious beliefs, can influence decision-making in finance.
🎲 Subjective versus objective probability plays a role in decision-making, with expected return being different from actual outcomes.
00:12:09 The lecture discusses the flawed reading of the expected return approach in conventional finance theory and the distinction between objective and subjective probability. It explores the criticism of indifference curves and proposes using repeated gambles to determine utility.
📊 The conventional finance theory relies on a flawed understanding of probability and doesn't account for subjective odds.
📚 The expected return approach in economics was developed based on the concept of objective probability, but it was misinterpreted and used in modern finance theory.
🔢 Von Neumann proposed a method to measure utility using numerical estimates and argued against the use of indifference curves in economic theory.
00:18:15 This lecture discusses how a numerical value for utility can be calculated, allowing for comparisons of utility. It explores the concept of expected utility and its application in modern finance, including the Capital Asset Pricing Model.
🔑 The lecturer discusses the concept of numerical utility and the development of a numerical value for utility using a set of axioms.
📊 He explains how utility can be measured and compared using probabilities and repeated gambles.
📈 The lecture delves into the application of numerical utility in modern finance, specifically discussing Sharpe's Capital Asset Pricing Model (CAPM).
00:24:18 This video explains the key concepts of Sharpe's Capital Asset Pricing Model (CAPM) in finance. It discusses the prediction of market behavior, maximization of utility, and the benefits of diversifying a portfolio.
📚 Sharpe's CAPM model aims to predict the behavior of capital markets by maximizing utility subject to constraints.
📈 Investment opportunities are represented by the investment opportunity curve, where higher expected returns and lower standard deviations lead to increased utility.
🔄 Diversification reduces risk in a portfolio, and portfolios lie on a straight line if assets have perfect correlation, otherwise they follow a curved path.
💰 Investors can borrow or lend money to create portfolios along a riskless asset and a risky asset, choosing the optimal point on that line.
00:30:24 The lecture discusses the assumptions made in finance theory, including a common rate of interest and homogenous investor expectations. These assumptions lead to the concept of an equilibrium outcome and efficient portfolios.
🔑 The video discusses the process of going from individual investor theory to market theory.
💡 The lecture presents two assumptions: a common pure rate of interest and homogeneous investor expectations.
🔍 The speaker criticizes these assumptions as unrealistic and counterfactual, questioning the validity of the theory.
00:36:28 This video discusses the relationship between individual assets, systemic risk, and efficient portfolios in finance markets. It explains how to calculate beta and the trade-off between risk and return.
📈 The capital asset market line represents individual assets above the line due to lack of diversification and the correlation of an individual share with the stock market.
💼 The value of a single investment can be determined using the tangency of the capital market line, the risk-free rate of return, and beta.
⚖️ There is a trade-off between risk and return, and the efficient markets hypothesis suggests creating a diversified portfolio based on a person's risk profile.
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