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On the foundation of finance theory
送交者: jingchen 2019年02月19日19:21:27 于 [教育学术] 发送悄悄话

On the foundation of finance theory


Finance roughly consists of two parts, invest theory and corporate finance. The foundation of investment theory is CAPM. The foundation of corporate finance is Modigliani and Miller theory. Both theories, in their original forms, are very elegant. However, they fit data badly. After more than half century since their inception, thousands of empirical works have been done and increasingly complex modifications of these models have been proposed.  It is time to re-examine their theoretical foundation.


Modigliani and Miller theory is accepted to be valid for any perfect market. However, it was proved only when the expected cashflow on investment is constant to perpetuity. When the cashflows are more general, it can be shown that MM’s propositions are no more valid. Specifically, using WACC to value growth firms will systematically overestimate the value of these firms. Empirical tests often show that growth firms are overvalued. This is generally attributed to behavioral biases of the investors. However, we first need to check that the valuation models are correct. 

In CAPM, investors are assumed to maximize their utilities. William Sharpe, in his paper on CAPM, discussed in great detail how investor utility affects asset pricing. However, in the final section where formal model was developed, utility theory was not employed.  We can derive the return distributions of assets from utility theory. They differ from CAPM predictions. They are more consistent with empirical data. 


Detailed discussions are presented in the following two papers.


The Scope of Validity of Modigliani and Miller Propositions

https://www.researchgate.net/publication/331135239_The_Scope_of_Validity_of_Modigliani_and_Miller_Propositions


On the Inconsistency between CAPM and the Utility Theory

https://www.researchgate.net/publication/331135169_On_the_Inconsistency_between_CAPM_and_the_Utility_Theory



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