AFF 502 Chapter Notes - Chapter 1: Risk Neutral, Budget Constraint, Risk Premium

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Individuals and firms are self-interested agents who attempt to optimize to the best of their ability in the face of constraints on resources. Fundamental assumptions about people: people have rational preferences across possible outcomes or states of nature, people maximize utility and firms maximize profits, people make independent decisions based on all relevant information. A person can compare all possible choices and assess preference or indifference. Most people know what they like and what they do not like. (2) assumption: transitivity does not seem to be too strong an assumption for most people. If transitivity does not hold, we cannot determine an optimal or best choice. Denoted as u( ) , assign numbers to possible outcomes so that preferred choices receive higher numbers. Outcome: a bundle of goods e. g. choose between 2 loaves of bread + 1 bottle of water, or 1 loaf of bread. + 2 bottles of water u(2 bread, 1 water) > u(1 bread, 2 water)

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