INTRODUCTION

Uncertainty plays an important role in many real world situations. As we have seen in the earlier chapters, financial decisions are often intertemporal decisions. Such decisions involve choices whose consequences extend into the future. Since the future is unknown, it is often likely that the financial decisions are inevitably taken under conditions of uncertainty. For instance, a stock may not pay a constant dividend and may not grow at a constant rate (see Chapter 4 for a detailed discussion). In such a case buying and selling of stocks takes place in an uncertain environment. Thus, buying a stock here is taking the form of playing a game or lottery whose outcome is not known with certainty. Uncertainty often arises because of lack of necessary information, so that an uncertain set-up cannot be converted into a certain framework. If we do not have sufficient information on expected growth rate of a company, then it is not possible to make a conclusive statement on expected output on equity. In many economic situations outcome depends on what others do. Thus, an individual may not be able to predict the outcome of the corresponding situation with certainty. An example is the diplomatic behavior.

The objective of this chapter is to look at the consumption and investment decisions under uncertainty and their implications for the valuation of uncertain prospects. A well-accepted theory of prospect choice under uncertainty is the expected utility hypothesis. Under this hypothesis an individual’s consumption and investment decisions are guided by maximization of expected utility. A utility function, satisfying this hypothesis, is called a von Neumann–Morgenstern (1944) utility function. We discuss such utility functions in the next section of the chapter. The Arrow (1963)–Pratt (1964) measures of risk aversion for von Neumann–Morgenstern utility functions have been employed extensively for analyzing problems on uncertainty.