Introduction

The analytical framework in the classical finance models discussed in this book is largely the same as in general equilibrium theory: agents, acting as price-takers, exchange claims on consumption to maximize their respective utilities. Because the focus in financial economics is somewhat different from that in mainstream economics, we will ask for greater generality in some directions while sacrificing generality in favor of simplification in other directions.

As an example of greater generality, it will be assumed that markets are incomplete: the Arrow–Debreu assumption of complete markets is an important special case, but in general it will not be assumed that agents can purchase any imaginable payoff pattern on securities markets. Another example is that uncertainty will always be explicitly incorporated in the analysis. It is not asserted that there is any special merit in doing so; the point is simply that the area of economics that deals with the same concerns as finance but concentrates on production rather than uncertainty has a different name (capital theory).

As an example of simplification, it will generally be assumed in this book that only one good is consumed and that there is no production. Again, the specialization to a single-good exchange economy is adopted only to focus attention on the concerns that are distinctive to finance rather than microeconomics, in which it is assumed that there are many goods (some produced), or capital theory, in which production economies are analyzed in an intertemporal setting.