— Ch. 1 · Foundations Of Decision Theory —
Financial economics.
~6 min read · Ch. 1 of 6
In 1952, a paradox involving a coin toss and infinite money challenged the way economists thought about risk. The St. Petersburg paradox showed that people would not pay an infinite amount to play a game with infinite expected value. This contradiction forced researchers to rethink how individuals make choices under uncertainty. William F. Sharpe later defined financial economics as a field where money appears on both sides of a trade. The discipline relies on microeconomic principles to explain these decisions. Present value allows decision makers to aggregate future cash flows into a single number for comparison. Expected utility theory adds probabilities to this calculation, adjusting weights based on whether an individual is poor or rich. Risk aversion becomes central when investors prefer certainty over potential high returns. The fundamental theorem of asset pricing formalizes these ideas by linking arbitrage-free prices to equilibrium states. Rational choice assumes that agents maximize their subjective value given specific axioms. These concepts form the bedrock upon which all modern financial models rest.
Asset Pricing And Equilibrium
The Journal of Economic Literature classifies Financial Economics under code JEL: G, placing it between Monetary and International Economics and Public Economics. Arbitrage-free pricing requires that no profitable trades exist without risk in a complete market. Walter Schachermayer described this condition as existing if at least one risk-neutral probability measure is equivalent to physical probabilities. A market achieves equilibrium when supply equals demand across all possible states of the world. Arrow-Debreu securities pay one unit of currency only if a specific state occurs in the future. State prices represent the cost of buying insurance against a particular outcome. The stochastic discount factor divides expected utility at a future period by current wealth utility. This ratio acts as a pricing kernel for all assets. Investors construct portfolios using mean-variance efficiency to balance return and risk. The Capital Asset Pricing Model determines required returns based on covariance with aggregate market risk. Beta measures how much a security moves relative to the entire market. Risk premiums compensate investors for unpredictable cash flows. Equilibrium implies that asset prices reflect all available information simultaneously.