Introduction: Definitions and Concepts

Abstract

Financial markets can be regarded from various points of view. First of all there are economic theories which make assertions about security pricing; different economic theories exist in different markets (currency, interest rates, stocks, derivatives, etc.). Well known examples include the purchasing power parity for exchange rates, interest rate term structure models, the capital asset pricing model (CAPM) and the Black-Scholes option pricing model. Most of these models are based on theoretical concepts which, for example, involve the formation of expectations, utility functions and risk preferences. Normally it is assumed that individuals in the economy act ‘rationally’, have rational expectations and are averse to risk. Under these circumstances prices and returns can be determined in equilibrium models (as, for example, the CAPM) which clear the markets, i.e., supply equals aggregate demand. A different Ansatz pursues the arbitrage theory (for example, the Black-Scholes model), which assumes that a riskless profit would be noticed immediately by market participants and be eliminated through adjustments in the price. Arbitrage theory and equilibrium theory are closely connected. The arbitrage theory can often get away with fewer assumptions, whereas the equilibrium theories reach more explicitly defined solutions for complex situations.