THIS BOOK IS an introduction to the theory of portfolio choice and asset pricing in multiperiod settings under uncertainty. An alternate title might be Arbitrage, Optimality, and Equilibrium, because the book is built around the three basic constraints on asset prices: absence of arbitrage, singleagent optimality, and market equilibrium. The most important unifying principle is that any of these three conditions implies that there are “state prices,” meaning positive discount factors, one for each state and date, such that the price of any security is merely the state-price weighted sum of its future payoffs. This idea can be traced to the invention by Arrow (1953) of the general equilibrium model of security markets. Identifying the state prices is the major task at hand. Technicalities are given relatively little emphasis so as to simplify these concepts and to make plain the similarities between discrete- and continuous-time models.ricing model.
To someone who came out of graduate school in the mid-eighties, the decade spanning roughly 1969–79 seems like a golden age of dynamic asset pricing theory. Robert Merton started continuous-time financial modeling with his explicit dynamic programming solution for optimal portfolio and consumption policies. This set the stage for his 1973 general equilibrium model of security prices, another milestone. His next major contribution was his arbitrage-based proof of the option pricing formula introduced by Fisher Black and Myron Scholes in 1973, and his continual development of that approach to derivative pricing. The Black-Scholes model now seems to be, by far, the most important single breakthrough of this “golden decade,” and ranks alone with the Modigliani and Miller (1958) Theorem and the Capital Asset Pricing Model (CAPM) of Sharpe (1964) and Lintner (1965) in its overall importance for financial theory and practice. A tremendously influential simplification of the Black-Scholes model appeared in the “binomial” option pricing model of Cox, Ross, and Rubinstein (1979), who drew on an insight of Bill Sharpe.