Chapter 31 The theory of value in security markets

General equilibrium theory is applied wholesale to obtain a theory of value for security markets. The modern theory of value for security markets extends general equilibrium theory in various ways: (1) it explicitly treats general multiperiod trading opportunities under uncertainty and in incomplete markets; (2) it investigates, in remarkable depth, implications of the law of one pricethat is, of arbitrage-free prices; (3) to represent security returns in convenient and testable ways, it places strong restrictions on preferences and exploits a great deal of probability theory, especially the theories of Markov processes and stochastic integration, separately and together. The chapter discusses that as financial market theory grows, it laps over the boundaries of the general equilibrium paradigm to focus on the process of price formation. The microstructure of security markets has come under increasing scrutiny; the theory of specialist market makers, for example, is gradually being filled out. The need to address asymmetric information, in particular, has led to strategic models of investment behavior. Despite the diverse aims of financial economic theory, the chapter summarizes the developments in finance that rest or build on general equilibrium theory, emphasizing the valuation of financial assets.