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The intuition underpinning these results is straightforward. In a highly connected system, the counterparty losses of a failing institution can be more widely dispersed to, and absorbed by, other entities. So increased connectivity and risk sharing may lower the probability of contagious default. But, conditional on the failure of one institution triggering contagious defaults, a high number of nancial linkages also increases the potential for contagion to spread more widely. In particular, high connectivity increases the chances that institutions which survive the effects of the initial default will be exposed to more than one defaulting counterparty after the rst round of contagion, thus making them vulnerable to. | Theory of Financial Decision Making Jonathan E. Ingersoll Jr. Yale University Preface In the past twenty years the quantity of new and exciting research in finance has been large and a sizable body of basic material now lies at the core of our area of study. It is the purpose of this book to present this core in a systematic and thorough fashion. The notes for this book have been the primary text for various doctoral-level courses in financial theory that I have taught over the past eight years at the University of Chicago and Yale University. In a11 the courses these notes have been supplemented with readings selected from journals. Reading original journal articles is an integral part of learning an academic field since it serves to introduce the students to the ongoing process of research including its mis-steps and controversies. In my opinion any program of study would be amiss not to convey this continuing growth. This book is structured in four parts. The first part Chapters 1-3 provides an introduction to utility theory arbitrage portfolio formation and efficient markets. Chapter 1 provides some necessary background in microeconomics. Consumer choice is reviewed and expected utility maximization is introduced. Risk aversion and its measurement are also covered. Chapter 2 introduces the concept of arbitrage. The absence of arbitrage is one of the most convincing and therefore farthest-reaching arguments made in financial economics. Arbitrage reasoning is the basis for the arbitrage pricing theory one of the leading models purporting to explain the cross-sectional difference in asset returns Perhaps more important the absence of arbitrage is the key in the development of the Black-Scholes option pricing model and its various derivatives which have been used to value a wide variety of claims both in theory and in practice. Chapter 3 begins the study of single-period portfolio problems. It also introduces the student to the theory of efficient markets the .
