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Until now we have ignored risk aversion. The Bernoulli brothers were the first to suggest a tractable way of representing risk aversion. They pointed out that an explanation of the St. Petersburg paradox might be that people care about expected utility instead of expected income, where utility is some concave function, such as the logarithm. One of the most famous and important models in financial economics is the Capital Asset Pricing Model, which can be derived from the hypothesis that every agent has a (different) quadratic utility. Much of the modern mutual fund industry is based on the implications of this model. The model describes what happens to prices and asset holdings in general equilibrium when the underlying risks can't be hedged in the aggregate. It turns out that the tools we developed in the beginning of this course provide an answer to this question.
This course attempts to explain the role and the importance of the financial system in the global economy. Rather than separating off the financial world from the rest of the economy, financial equilibrium is studied as an extension of economic equilibrium. The course also gives a picture of the kind of thinking and analysis done by hedge funds.
