040205 KU Microeconomics II (MA) (2024W)

The course ‘Microeconomics II’ aims at a thorough understanding of decisions and markets in an uncertain environment.

The course starts with preferences and the extension to expected utilities in the case of uncertainty- as these are the underlying forces driving individuals’ decisions and their interaction with the market. We introduce the utility maximization under constraints in portfolio optimization problems. Additionally, we also explore deviations from rationality in the decision-making process through behavioral preferences and perceptions.

The second part of the course starts with an evaluation of the investment opportunity set with respect to the mean return and the variance of returns. We examine the potential mean-variance-combinations which can be achieved different portfolio weights in a portfolio of two assets. Then, we extend the model to multiple assets and introduce a risk-free asset. The mean-variance optimization in the market leads to the CAPM (with risk-free asset) and the Zero-beta-CAPM (without risk-free asset).

In the third part of the course, we introduce state-contingent claims, which offer us the opportunity to price a payment at one specific time and state in the future. It is followed by a discussion about the relationship between the assets available for trade and market completeness. Additionally, we discuss how to complete the market through the introduction of additional assets (such as options).

Finally, we are going to cover factor models, in which specific factors are used to explain the return generating process. The assumption of quasi-completeness of the market leads to the APT (Arbitrage Pricing Theory).

The topics of the course follow are summarized below:
PART 1: Decisions under Uncertainty
• Preferences under certainty
• Expected utility theory
• Risk aversion and stochastic dominance
• Portfolio optimization problems
• Behavioral Biases in preferences and perceptions
o Allais paradox
o Prospect theory
o Epstein-Zin preferences

PART 2: Capital Asset Pricing Model
• Investment opportunities in the mean-variance space
o Two assets without risk-free asset
o Multiple assets without risk-free asset
o Multiple assets with risk-free asset
• CAPM
• Zero-beta CAPM

PART 3: Complete Markets and Arrow Debreu Pricing
• Arrow-Debreu setup and state-contingent claims
• Market completeness
• Pareto-optimality
• Completing the market with options

PART 4: Arbitrage Pricing
• Factor models
• Arbitrage Pricing Model (APT)