Fundamentally, there are two ways to evaluate a random cash flow: (I) directly, using measures such as expected value and variance; and (2) indirectly, by reducing the flow to a combination of other flows which already have been evaluated This chapter focuses on these two approaches, showing how they apply to single-period investment problems—and showing how they work together to produce strong and useful pricing relationships.
This chapter is more abstract than the previous chapters and serves primarily as preparation for the study of general multiperiod problems in Parts .3 and 4. The reader may wish to skip ahead to Chapter 10 (or even Chapter 11) since most of the material in Part 3 can be understood without studying this chapter. One strategy is to study the first part of this chapter—the first five sections, which cover expected utility theory. Then later, when approaching Part 4, the reader can come back to the second part of this chapter to study general pricing theory Other readers may wish to study this chapter in sequence, for it is a logical culmination of the single-period framework,
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