A market utility approach to investment valuation

Abstract

The paper presents a unified approach for determining the market value of any generic investment lottery, through the concept of a market utility function. Rather than making assumptions about individual investor preferences and their aggregation, we turn the problem around by treating the market as a composite decision maker, empirically infering the nature of the market utility function from capital market behavior, and then applying decision theoretic tools to price other risky assets. The proposed approach can be used to value both primary and derivative assets (whether traded or not), is applicable to both CAPM and non-CAPM economies, and does not rely on the ability to trade, replicate or otherwise justify risk neutral valuation in pricing contingent claims. Numerical simulation results suggest that a number of plausible market utility functions (e.g., the quadratic, exponential, generalized logarithmic, and power utilities) can be ‘calibrated’ from market data and then used consistently for valuing company stock and options. The consistency of the market utility valuation lends new support to the rationality of market pricing, and reconciles the market value estimates of finance theory with breakeven reservation values obtained from decision analysis.