A MARKET UTILITY APPROACH TO INVESTMENT VALUATION

The paper presents a unified approach for determining the market value of any generic investment lottery, through the concept of a market ut ility function. Rather than making assumptions about individual invest or preferences and their aggregation, we turn the problem around by tr eating 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 asse ts. The proposed approach can be used to value both primary and deriva tive assets (whether traded or not), is applicable to both CAPM and no n-CAPM economies, and does not rely on the ability to trade, replicate or otherwise justify risk neutral valuation in pricing contingent cla ims. Numerical simulation results suggest that a number of plausible m arket utility functions (e.g., the quadratic, exponential, generalized logarithmic, and power utilities) can be 'calibrated' from market dat a and then used consistently for valuing company stock and options. Th e consistency of the market utility valuation lends new support to the rationality of market pricing, and reconciles the market value estima tes of finance theory with breakeven reservation values obtained from decision analysis.