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How to apply the Game Theory to the finance?

Posted 17 September By Master Financial Risk Management Universidad AlcaláIn Finance Banking, FinanzasTagged banca y finanzas, financial risk, master0 comments

We have already analyzed what is Game Theory, a fundamental part that is taught in our Master in Quantitative Finance. Next, we will give you a detailed explanation of how this theory affects in particular. If you want to know more, check our Financial Risk blog or request more information on our website. Now, as far as we’re concerned, let’s investigate a little more about Game Theory!

What is the Game Theory?

Let’s start at the beginning: the theory of games is a branch of applied economics also to many other areas that analyze decision-making based on our point of view and that of other participating members.

This theory is based on the Nash equilibrium. It is a theory that states that in a situation where there are two or more players and none of them wants to change the equilibrium situation, it would mean worsening their own situation. From this concept, numerous economists, among which John von Neumann emphasizes, were developing this theory.

The Game Theory was developed with the simple interrelation between individuals. All games, children and adults, board games or sports games, are models of conflict situations and cooperatives in which we can recognize situations and patterns that are repeated frequently in the real world.

How can we apply this theory to the present?

Today, people face this theory on a daily basis. In fact, at any time we are exposed to it. For example: when the board makes the decision about the amount that will be invested, when we enrol in the university, the distribution of costs etc. For men, the importance of the Game Theory is evident, because every day they face multiple situations that are games.

The study of games has inspired scientists of all times to develop theories and mathematical models that help us in decision making. Statistics is a branch of mathematics that arose precisely from calculations to design winning strategies in games of chance, as well as in making decisions for investments.

Currently, the Game Theory is concerned above all with what happens when men relate rationally. That is when individuals interrelate using reasoning. That is why in investments, which is the focus of this work, criteria of optimal allocation and decision under risk and profitability of an investment portfolio are established.

Applications of Game Theory in economics and finance

Like almost everything in this life, the application of Game Theory and Nash equilibrium has a double point of view: from the business point of view we will seek to achieve that balance to maximize benefits and minimize risks, while from the institutions that avoid the creation of monopolies and oligopolies the objective will be to create laws to prevent this balance from occurring, in order to promote free trade and competition. This article takes as a reference the business prism.

From this perspective, the applications are endless and cover all types of companies. From a small ice cream stand that is thinking about lowering the prices of its products and must think how the opposite will act, a large automotive multinational that is thinking of investing hundreds of millions of euros to create an electric vehicle and needs to know what will be the return on your investment and the risk associated with the project according to what your competition can do.

Complication of the decisions

Many times these decisions, especially when we are in the field of a small company (think of the example of the ice cream man), we take them based on intuition and experience, trusting that our decision will be the best. But the decisions will always be more accurate and reliable if we make them based on statistics and other mathematical concepts, as we have already seen in the prisoner’s dilemma. At least, if it finally goes wrong, we will know that we had the odds on our side and we have acted correctly, being other exogenous factors those that have failed our strategy.

In large companies, which have entire departments of risk analysis, these types of decisions are never random and are based on analysis of competition, market studies and risk analysis. But we can also extrapolate this type of strategy to small and medium enterprises, according to our economic possibilities and available means.

If you found this post interesting, we recommend you to continue researching more about game theory. There are very curious developed problems that will awaken your true passion for finances. If you already have it clear and want to study Financial Risk Management, request information on our website. We will wait for you!

 

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