A Bridge Between Portfolio Theory & Behavioral Finance, The Market Indifference Curve
The Hague Executive Campus - Department of Finance
March 30, 2012
A core premise of Modern Portfolio Theory is that investors utilize two parameters for their decision making process only: expected value and standard deviation. Ergo - if only to determine the fair expected return for the Market Portfolio itself - a fair price of total risk exists. Assuming rational investors with homogeneous expectations and varying risk appetites, this paper explains supply and demand dynamics for pricing risk by investors trading relative (personal perceptions of) utilities. Subsequently, at any time t the equilibrium price of total risk is normally a (community) mean-variance indifference curve originating in the risk free rate, reflecting market implied risk-return equivalence for any amount of total risk vs. the risk free rate; such based on the aggregate risk aversion among investors at that time. The latter, a time sensitive consensual phenomenon by default, provides the missing link between Modern Portfolio Theory and Behavioral Finance.
Number of Pages in PDF File: 33
Keywords: Asset Pricing, Risk & Return, Modern Portfolio Theory, CAPM, Utility, Indifference Curves
JEL Classification: G10, G12, G15
Date posted: April 1, 2012 ; Last revised: March 29, 2013