Hi,I am new to finance field ... i come from a stat background and i have been takin a course in corp fin where there is a constant reference to utility - for eg, in the derivation of CAPM ... but I am completely ignorant about utility theory ... can someone suggest me a good reference book or website ? i would prefer something which goes smooth on fundaes and pretty easily accessible ...i was going through the forums here and in one of the posts i found this " i prefer to stay relatively clear of utility theory for two reasons - the standard portfolio results can also be obtained by making assumptions about the distribution of asset returns; and there's so little known about the level of risk aversion of individuals " ... sorry i copied this stuff yesterday and i dont remember which thread it was or who wrote it. Can someone elaborate me more about this ? particularly, the first one ? looking for valuable suggestions ...Thanks,Anjali

Utility theory comes from microeconomics. If you walk into the student textbook store and go the the introductory microeconomics texts and skim one, it will probably tell you what you want. I believe Varian has a good book on this. Utility theory is how economists try to explain consumer preferences. A "util" is a standard of how you personally value something. In apples and oranges terms, you might like an orange 10 utils worth, but an apple only 5 utils worth. So to you, an orange is worth twice an apple. But if you already had 20 oranges, the next one would not be that valuable to you and maybe would only be worth 1 util. Thus, the term 'diminishing marginal utility'. No, I am not kidding. This is just a way to organize how to look at things. Quickly students move on to learn things that are more useful and applied. Others will likely disagree with me on this, but the only book I have seen that explores utility theory and continous time finance to any extent is Ingersol's book. Hope I helped some.

<blockquote>Quote<hr><i>Originally posted by: <b>SanFranCA2002</b></i>In apples and oranges terms, you might like an orange 10 utils worth, but an apple only 5 utils worth. So to you, an orange is worth twice an apple.<hr></blockquote>That's kind of misleading. In basic microeconomic theory, utility is usually assumed to be ordinal unless a cardinal utility framework is specified.What does liking something twice as much mean? Does it mean you would pay twice as much for it? Or wait twice as long for it? etc.

In standard portfolio theory, either you assume that your utility function is quadratic or the distribution of returns is normal. In a nutshell, that is the reason why it is call mean-variance theory. Therefore, either you care only about the low moments of the distribution or mean-variance are enough to account for the distribution.Though it was a pathbreaking analysis, you have several reasons to distrust: why should you care about only the mean and variance?; at the same time, why the distribution of returns should be well behaved?Regarding the first issue: after portfolio theory, Markwotiz (with Levy and other people) published several papers trying to justify the use of a quadratic utility function showing that it represents a large class of relevant cases (I do not like this effort but it is worth reading it!). Regarding the second issue, there are many attempts to deal with it. On the utility side, larger moments, stoch dominance, downside risk. On the returns side, testing for leptokurtosis, skewness.I tried to put it as simple as possible.

Ingersol's Theory of Financial Decision-Making has an excellent treatment of utility theory as it applies to quantitative finance. It's much more than you need for introductory corporate finance, but it will help you if your statistics background is good and you plan to do advanced work in finance. The book is also good on many other topics, although it is quite dense.The statement you quoted reflects a common attitude in finance. Utility theory is a murky area filled with logical contradictions, empirical inconsistency and modeling traps. Any result that depends on strong utility assumptions is therefore suspect. If you restrict payoff functions, the difference between utility functions is less important, often you can get away with a single "risk aversion" parameter or dispense with utility altogether. Finkbarton's explanation of using multivariate normal asset returns instead of quadratic utility functions (which are inconsistent) is one example.More generally, financial assets are designed to produce the kinds of distributions people can price. If an asset had a return distribution such that the price depended on subtleties of investor utility, it would be hard to price and trade. Someone would reengineer it into more palatable securities, more easily digested by the financial system.

VodkaChapter 1 in Huang and Litzenberger will provide with a complete overview. Read chapter 1 in Cochrane to see how utility theory is applied to asset pricing [how the risk neutral measure is the MRS].There is a new book which has been published recently in financial economics: Principles of Financial Economics by Stephen F. LeRoy , Jan Werner which is much easier to read than Ingersoll or H&L. The book will provide a complete overview of financial economic theory.Coming to your question: The surprising and noteworthy aspect of Markowitz's result [two-fund seperation] is that regardless of the utility function every agent will invest the same ratio of his endowment between the risky asset and riskless asset. The efficient frontier results follow from that.Utility theory is fun and very much more useful when looking at incomplete markets. But you will notice that every major theory in recent financial econonomics [markowitz, Sharpe's CAPM, Modigliani-Miller's introduction of Arbitrage, and Black-Scholes's PDE] provides a result which does not depend on the utility function which means it is independent of the agent's preferences [the fundamental assumption you need to make is about the price/return process]Hope this helpsZakduka

Anjali,Utility theory tends to be fruitful when looking at decision making at the micro level (e.g. how much would I be willing to pay to enter a certain bet or avoid a certain risk) but of much less use when thinking about market prices because it is difficult to aggregate across individuals when utility and expectations differ. Preference-free theories have ruled financial thinking for thirty years. I remember a very interesting story from my finance studies about a 18th Dutch thinker named Daniel Bernoulli, who solved what was called the St. Petersburg paradox. Mathematicians had previously thought that people maximized expected outcomes in conditions of uncertainty, but this was at odds with observed behaviour. The St. Pertersburg paradox was a coin toss gamble that had an infinite expected value (the payoff grew faster than the decrease in the probability of the favourable outcome), yet no one was willing to pay more than a small finite sum to participate in the gamble. Bernoulli solved the paradox by reasoning that instead people maximized expected utility of income and further that utility was concave in income (i.e. more utility is derived from you first dollar of income than your last). Concave utility functions are consistent with risk aversion and have even been used to justify progressive income taxation on the basis that a rich man gives up less utility per marginal dollar of tax than a poor man. Hence you can take more proportionately from the rich.