Jan Mossin's Theory of Financial Markets

Abstract

* As one whose own work and education have been greatly influenced by Jan Mossin's ideas, I greet the opportunity to review Mossin's recent monograph' with some measure of humility. The admiring pupil must respectfully defer to the master. Those who have enjoyed the cogency and elegance of Mossin's published papers will not be disappointed. Where his monograph is redundant of his earlier work and where the related work of others is reviewed, the reader will find a fresh presentation with new insights; where new materia 1 is developed, Mossin preserves his characteristic laconic incisiveness. The dominant theme-integration of portfolio theory, security valuation, financing-investment decisions of firms, and the optimality of security market allocation into a cohesive and logically satisfying model reflects the modern development of financial theory under uncertainty, a dramatic burst of ideas fueled, to a large extent, by Mossin's own prior work. Mossin was among the first to perceive the implications of the mean-variance security valuation model and the objective of maximization of the value of corporate securities for corporate financial decisions. Like the classical construction of a play, Mossin moves from a brief Prologue (Chapter 1 ) into Act I, personal financial theory (Chapters 2 and 3), to Act II, security valuation (Chapters 4-6), and to Act III, corporate financial theory (Chapters 7 and 8), with the climax appropriately in Act Il-statement of the mean-variance security valuation equation. Chapter 2, Taking and Risk Aversion, contains one of the most readable and compact treatments of the relevant features of utility theory for financial analysis: the axiomatic basis of measurable utility, comments on Savage's simultaneous axiomatization of utility and subjective probability, the simplest version of the portfolio selection problem under uncertainty (one risk-free security with zero rate of return and one risky security with two states-of-theworld), implications of risk aversion, justification and insurance analysis of absolute and proportional risk aversion,2 comments on indirect utility functions, and the significance of the distinction between temporal and timeless prospects in the two-period consumption allocation problem.3 This would also have been an appropriate place for a development of temporal measures of risk aversion,4