Basic Concepts and General Theory

11 Março 2021, 14:30 • Jacco Thijssen

This week we first looked at the role of the corporate manager in the investment process. Once we realized that the manager takes decisions on behalf of investors it became clear that we needed to study how investors make decision about their investments. Closely related to that is the more general question what determines "value" and prices for assets in financial markets. This led us to conduct a whistle-stop tour of the theory of general equilibrium in a two-period setting. We found that if there are no redundant assets in the economy and if investors' preferences are "well-behaved", then investors' demand and supply of assets is well-defined if, and only if, prices do not admit arbitrage opportunities. We also found that equilibrium prices exist. In finance we will use these results by assuming that observed prices reflect equilibrium and, thus, that prices do not admit arbitrage opportunities. In addition, if markets are complete (i.e. if all income streams can be generated by trading in financial assets), then any new asset introduced in the economy is redundant. That means that we can find its value by computing the market value of the unique replicating portfolio of the new asset. This is referred to as the TFMV (True Financial Market Value) of the asset. So, throughout this module we will invoke the following axioms:

1. market prices do not admit arbitrage;
2. markets are complete.

If we are willing to make some additional assumptions, then we can derive the CAPM (Capital Asset Pricing Model) and link the (equilibrium) excess return to any (portfolio of) asset(s) to the (equilibrium) excess return on the market portfolio (i.e. the unique portfolio generating aggrgate income in the economy) through the asset's beta.       

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