P A R T 1 - Introduction -- C H A P T E R 1 On the Role of Financial Markets and Institutions -- 1.1 Finance: The Time Dimension -- 1.2 Desynchronization: The Risk Dimension -- 1.3 The Screening and Monitoring Functions of the Financial System -- 1.4 The Financial System and Economic Growth -- 1.5 Financial Intermediation and the Business Cycle -- 1.6 Financial Markets and Social Welfare -- 1.7 Conclusion -- References -- Complementary Readings -- Appendix: Introduction to General Equilibrium Theory -- Pareto Optimal Allocations -- Competitive Equilibrium -- C H A P T E R 2 The Challenges of Asset Pricing: A Road Map -- 2.1 The Main Question of Financial Theory -- 2.2 Discounting Risky Cash Flows: Various Lines of Attack -- 2.3 Two Main Perspectives: Equilibrium versus Arbitrage -- 2.4 This Is Not All of Finance! -- 2.4.1 Corporate Finance -- 2.4.2 Capital Structure -- 2.4.3 Taxes and Capital Structure -- 2.4.4 Capital Structure and Agency Costs -- 2.4.5 The Pecking Order Theory of Investment Financing -- 2.5 Conclusions -- References -- P A R T 2 - The Demand for Financial Assets -- C H A P T E R 3 Making Choices in Risky Situations -- 3.1 Introduction -- 3.2 Choosing Among Risky Prospects: Preliminaries -- 3.3 A Prerequisite: Choice Theory Under Certainty -- 3.4 Choice Theory Under Uncertainty: An Introduction -- 3.5 The Expected Utility Theorem -- 3.6 How Restrictive Is Expected Utility Theory? The Allais Paradox -- 3.7 Generalizing the VNM Expected Utility Representation -- 3.7.1 Preference for the Timing of Uncertainty Resolution -- 3.7.2 Preferences That Guarantee Time-Consistent Planning -- 3.7.3 Preferences Defined over Outcomes Other Than Fundamental Payoffs -- 3.7.4 Nonlinear Probability Weights -- 3.8 Conclusions -- References -- C H A P T E R 4 Measuring Risk and Risk Aversion -- 4.1 Introduction -- 4.2 Measuring Risk Aversion.

4.3 Interpreting the Measures of Risk Aversion -- 4.3.1 Absolute Risk Aversion and the Odds of a Bet -- 4.3.2 Relative Risk Aversion in Relation to the Odds of a Bet -- 4.3.3 Risk-Neutral Investors -- 4.4 Risk Premium and Certainty Equivalence -- 4.5 Assessing the Level of Relative Risk Aversion -- 4.6 The Concept of Stochastic Dominance -- 4.7 Mean Preserving Spreads -- 4.8 Conclusions -- References -- Appendix: Proof of Theorem 4.2 -- C H A P T E R 5 Risk Aversion and Investment Decisions, Part 1 -- 5.1 Introduction -- 5.2 Risk Aversion and Portfolio Allocation: Risk-Free versus Risky Assets -- 5.2.1 The Canonical Portfolio Problem -- 5.2.2 Illustration and Examples -- 5.3 Portfolio Composition, Risk Aversion, and Wealth -- 5.4 Special Case of Risk-Neutral Investors -- 5.5 Risk Aversion and Risky Portfolio Composition -- 5.6 Risk Aversion and Savings Behavior -- 5.6.1 Savings and the Riskiness of Returns -- 5.6.2 Illustrating Prudence -- 5.6.3 The Joint Saving-Portfolio Problem -- 5.7 Separating Risk and Time Preferences -- 5.8 Conclusions -- References -- C H A P T E R 6 Risk Aversion and Investment Decisions, Part II: Modern Portfolio Theory -- 6.1 Introduction -- 6.2 More About Utility Functions -- 6.3 Description of the Opportunity Set in the Mean-Variance Space: The Gains from Diversification and the Efficient Frontier -- 6.4 The Optimal Portfolio: A Separation Theorem -- 6.5 Conclusions -- References -- Appendix 6.1: Indifference Curves Under Quadratic Utility or Normally Distributed Returns -- Part I -- Part II -- Proof of the Convexity of Indifference Curves -- Appendix 6.2: The Shape of the Efficient Frontier -- Two Assets -- Alternative Hypotheses -- Perfect Positive Correlation (Figure 6.2) -- Imperfectly Correlated Assets (Figure 6.3) -- Perfect Negative Correlation (Figure 6.4) -- One Riskless and One Risky Asset (Figure 6.5).

Appendix 6.3: Constructing the Efficient Frontier -- The Basic Portfolio Problem -- Generalizations -- Nonnegativity Constraints -- Composition Constraints -- Adjusting the Data (Modifying the Means) -- Constraints on the Number of Securities in the Portfolio -- P A R T 3 - Equilibrium Pricing -- C H A P T E R 7 The Capital Asset Pricing Model (CAPM) -- 7.1 Introduction -- 7.2 The Traditional Approach to the CAPM -- 7.3 Valuing Risky Cash Flows with the CAPM -- 7.4 The Mathematics of the Portfolio Frontier: Many Risky Assets and No Risk-Free Asset -- 7.5 Characterizing Efficient Portfolios (No Risk-Free Assets) -- 7.6 Background for Deriving the Zero-Beta CAPM: Notion of a Zero Covariance Portfolio -- 7.7 The Zero-Beta Capital Asset Pricing Model -- 7.8 The Standard CAPM -- 7.9 Conclusions -- References -- Appendix 7.1: Proof of the CAPM Relationship -- Appendix 7.2: The Mathematics of the Portfolio Frontier: An Example -- C H A P T E R 8 Arrow.Debreu Pricing, Part I -- 8.1 Introduction -- 8.2 Setting: An Arrow-Debreu Economy -- 8.3 Competitive Equilibrium and Pareto Optimality Illustrated -- 8.4 Pareto Optimality and Risk Sharing -- 8.5 Implementing Pareto Optimal Allocations: On the Possibility of Market Failure -- 8.6 Conclusions -- References -- C H A P T E R 9 The Consumption Capital Asset Pricing Model (CCAPM) -- 9.1 Introduction -- 9.2 The Representative Agent Hypothesis and Its Notion of Equilibrium -- 9.2.1 An Infinitely Lived Representative Agent -- 9.2.2 On the Concept of a "No-Trade" Equilibrium -- 9.3 An Exchange (Endowment) Economy -- 9.3.1 The Model -- 9.3.2 Interpreting the Exchange Equilibrium -- 9.3.3 The Formal Consumption CAPM -- 9.4 Pricing Arrow-Debreu State-Contingent Claims with the CCAPM -- 9.5 Testing the Consumption CAPM: The Equity Premium Puzzle -- 9.6 Testing the Consumption CAPM: Hansen-Jagannathan Bounds.

9.7 Some Extensions -- 9.7.1 Reviewing the Diagnosis -- 9.7.2 The CCAPM with Epstein-Zin Utility -- 9.7.3 Habit Formation -- 9.7.4 Distinguishing Stockholders from Nonstockholders -- 9.8 Conclusions -- References -- Appendix 9.1: Solving the CCAPM with Growth -- Appendix 9.2: Some Properties of the Lognormal Distribution -- P A R T 4 - Arbitrage Pricing -- C H A P T E R 10 Arrow-Debreu Pricing, Part II -- 10.1 Introduction -- 10.2 Market Completeness and Complex Securities -- 10.3 Constructing State-Contingent Claims Prices in a Risk-Free World: Deriving the Term Structure -- 10.4 The Value Additivity Theorem -- 10.5 Using Options to Complete the Market: An Abstract Setting -- 10.6 Synthesizing State-Contingent Claims: A First Approximation -- 10.7 Recovering Arrow-Debreu Prices from Options Prices: A Generalization -- 10.8 Arrow-Debreu Pricing in a Multiperiod Setting -- 10.9 Conclusions -- References -- Appendix 10.1: Forward Prices and Forward Rates -- C H A P T E R 11 The Martingale Measure: Part I -- 11.1 Introduction -- 11.2 The Setting and the Intuition -- 11.3 Notation, Definitions, and Basic Results -- 11.4 Uniqueness -- 11.5 Incompleteness -- 11.6 Equilibrium and No Arbitrage Opportunities -- 11.7 Application: Maximizing the Expected Utility of Terminal Wealth -- 11.7.1 Portfolio Investment and Risk-Neutral Probabilities -- 11.7.2 Solving the Portfolio Problem -- 11.7.3 A Numerical Example -- 11.8 Conclusions -- References -- Appendix 11.1: Finding the Stock and Bond Economy That Is Directly Analogous to the Arrow-Debreu Economy in Which Only State Claims Are Traded -- Appendix 11.2: Proof of the Second Part of Proposition 11.6 -- C H A P T E R 12 The Martingale Measure: Part II -- 12.1 Introduction -- 12.2 Discrete Time Infinite Horizon Economies: A CCAPM Setting -- 12.3 Risk-Neutral Pricing in the CCAPM.

12.4 The Binomial Model of Derivatives Valuation -- 12.5 Continuous Time: An Introduction to the Black-Scholes Formula -- 12.6 Dybvig's Evaluation of Dynamic Trading Strategies -- 12.7 Conclusions -- References -- Appendix 12.1: Risk-Neutral Valuation When Discounting at the Term Structure of Multiperiod Discount Bond -- P A R T 5 - Extensions -- C H A P T E R 13 The Arbitrage Pricing Theory -- 13.1 Introduction -- 13.2 Factor Models -- 13.2.1 About the Market Model -- 13.3 The APT: Statement and Proof -- 13.3.1 A Quasi-Complete Market Hypothesis -- 13.3.2 Statement and Proof of the APT -- 13.3.3 The Meaning of λ0 and λ1 -- 13.4 Multifactor Models and the APT -- 13.5 Advantage of the APT for Stock or Portfolio Selection -- 13.6 Conclusions -- References -- C H A P T E R 14 Portfolio Management in the Long Run -- 14.1 Introduction -- 14.2 The Myopic Solution -- 14.3 Variations in the Risk Free Rate -- 14.3.1 The Budget Constraint -- 14.3.2 The Optimality Equation -- 14.3.3 Optimal Portfolio Allocations -- 14.3.4 The Nature of the Risk Free Asset -- 14.3.5 The Role of Bonds in Investor Portfolios -- 14.4 The Long-Run Behavior of Stock Returns -- 14.4.1 Solving for Optimal Portfolio Proportions in a Mean Reversion Environment -- 14.4.2 Strategic Asset Allocation -- 14.4.3 The Role of Stocks in Investor Portfolios -- 14.5 Background Risk: The Implications of Labor Income for Portfolio Choice -- 14.6 An Important Caveat -- 14.7 Another Background Risk: Real Estate -- 14.8 Conclusions -- References -- C H A P T E R 15 Financial Structure and Firm Valuation in Incomplete Markets -- 15.1 Introduction -- 15.1.1 What Securities Should a Firm Issue if the Value of the Firm Is to Be Maximized? -- 15.1.2 What Securities Should a Firm Issue if It Is to Grow as Rapidly as Possible? -- 15.2 Financial Structure and Firm Valuation -- 15.2.1 Financial Structure F1.

15.2.2 Financial Structure F2.