## Synopsis

Since students often find the link between financial economics and equilibrium theory hard to grasp, less attention is given to purely financial topics, such as valuation of derivatives, and more emphasis is placed on making the connection with equilibrium theory explicit and clear. This book also provides a detailed study of two-date models because almost all of the key ideas in financial economics can be developed in the two-date setting. Substantial discussions and examples are included to make the ideas readily understandable. Several chapters in this new edition have been reordered and revised to deal with portfolio restrictions sequentially and more clearly, and an extended discussion on portfolio choice and optimal allocation of risk is available. The most important additions are new chapters on infinite-time security markets, exploring, among other topics, the possibility of price bubbles.

## Excerpt

Financial economics plays a far more prominent role in the training of economists than it did even a few years ago. This change is generally attributed to the parallel transformation in financial markets that has occurred in recent years. Assets worth trillions of dollars are traded daily in markets for derivative securities, such as options and futures, that hardly existed a decade ago. However, the importance of these changes is less obvious than the changes themselves. Insofar as derivative securities can be valued by arbitrage, such securities only duplicate primary securities. For example, to the extent that the assumptions underlying the Black– Scholes model of option pricing (or any of its more recent extensions) are accurate, the entire options market is redundant because by assumption the payoff of an option can be duplicated using stocks and bonds. The same argument applies to other derivative securities markets. Thus it is arguable that the variables that matter most – consumption allocations – are not greatly affected by the change in financial markets. Along these lines one would no more infer the importance of financial markets from their volume of trade than one would make a similar argument for supermarket clerks or bank tellers based on the fact that they handle large quantities of cash.

In questioning the appropriateness of correlating the expanding role of finance theory to the explosion in derivatives trading, we are in the same position as the physicist who demurs when journalists express the opinion that Einstein’s theories are important because they led to the development of television. Similarly, in his appraisal of John Nash’s contributions to economic theory, Myerson [13] protested the tendency of journalists to point to the FCC bandwidth auctions as indicating the importance of Nash’s work. At least to those curious about the physical and social sciences, Einstein’s and Nash’s work has a deeper importance than television and the FCC auctions! The same is true of finance theory: its increasing prominence has little to do with the expansion of derivatives markets, which, in any case, owes more to developments in telecommunications and computing than to finance theory.

In questioning the appropriateness of correlating the expanding role of finance theory to the explosion in derivatives trading, we are in the same position as the physicist who demurs when journalists express the opinion that Einstein’s theories are important because they led to the development of television. Similarly, in his appraisal of John Nash’s contributions to economic theory, Myerson [13] protested the tendency of journalists to point to the FCC bandwidth auctions as indicating the importance of Nash’s work. At least to those curious about the physical and social sciences, Einstein’s and Nash’s work has a deeper importance than television and the FCC auctions! The same is true of finance theory: its increasing prominence has little to do with the expansion of derivatives markets, which, in any case, owes more to developments in telecommunications and computing than to finance theory.