A Bridge Between Portfolio Theory & Behavioral Finance, The Market Indifference Curve

33 Pages Posted: 1 Apr 2012 Last revised: 29 Mar 2013

Roger Dayala

The Hague Executive Campus - Department of Finance

Date Written: March 30, 2012

Abstract

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.

Keywords: Asset Pricing, Risk & Return, Modern Portfolio Theory, CAPM, Utility, Indifference Curves

JEL Classification: G10, G12, G15

Suggested Citation

Dayala, Roger, A Bridge Between Portfolio Theory & Behavioral Finance, The Market Indifference Curve (March 30, 2012). Available at SSRN: https://ssrn.com/abstract=2032150 or http://dx.doi.org/10.2139/ssrn.2032150

Roger Dayala (Contact Author)

The Hague Executive Campus - Department of Finance ( email )

United Kingdom

HOME PAGE: http://www.the-hague-executive-campus.nl

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