Normative Finance Theory

Normative finance theory prescribes how investors *should* behave, focusing on optimal decision-making based on rational expectations and utility maximization. It contrasts with behavioral finance, which acknowledges psychological biases that often deviate from rational behavior.

A cornerstone of normative finance is the Efficient Market Hypothesis (EMH). The EMH posits that asset prices fully reflect all available information. Under the strong form of the EMH, even insider information is already incorporated into prices. Semi-strong form asserts that all publicly available information is reflected, and weak form suggests that past prices cannot be used to predict future prices. If markets are efficient, investors cannot consistently outperform the market using active trading strategies, only through luck or by bearing higher levels of risk.

Modern Portfolio Theory (MPT), developed by Harry Markowitz, is another fundamental concept. MPT suggests that investors should construct portfolios to maximize expected return for a given level of risk or minimize risk for a given level of expected return. It emphasizes diversification, arguing that by combining assets with different correlations, investors can reduce overall portfolio risk without sacrificing returns. The efficient frontier represents the set of optimal portfolios that offer the highest expected return for each level of risk. MPT uses statistical measures such as standard deviation (risk) and correlation to quantify portfolio characteristics.

The Capital Asset Pricing Model (CAPM) builds upon MPT, providing a framework for determining the expected rate of return for an asset or portfolio. The CAPM suggests that the expected return of an asset is equal to the risk-free rate plus a risk premium, which is proportional to the asset's beta (a measure of its systematic risk relative to the market). The CAPM assumes that investors are rational, markets are efficient, and that investors hold well-diversified portfolios. The security market line (SML) graphically depicts the CAPM, showing the relationship between expected return and beta.

Options Pricing Theory, particularly the Black-Scholes model, provides a method for calculating the theoretical value of options contracts. It relies on factors such as the current stock price, the strike price, time to expiration, volatility, and the risk-free interest rate. While the Black-Scholes model has limitations and makes simplifying assumptions, it has become a widely used tool in financial markets for pricing and hedging options.

Normative finance provides a valuable framework for understanding financial markets and making investment decisions. However, it's crucial to acknowledge its limitations. The assumptions of rationality, market efficiency, and perfect information are often violated in reality. Behavioral biases, market imperfections, and unforeseen events can significantly impact investment outcomes. Despite these limitations, normative finance provides a benchmark for evaluating actual investor behavior and identifying potential opportunities for improvement.