Financial Theory Foundations

Financial theory seeks to explain how buyers and sellers in financial markets price contracts to exchange money across time and across risk profiles. Using rules of agent behavior, theory generates financial models that attempt to predict the fair prices of the securities in financial markets. To make the models simple enough to be used in practice, theorists make simplifying assumptions about the characteristics of markets and market participants. The simplifying assumptions used to model agent behavior are hotly debated among theorists and practitioners. The argument is made that the practical use of the models only proves helpful to the extent that the simplifying assumptions upon which the models are built represent close approximations of market reality. This note reviews the simplifying assumptions that form the basis of classical finance models.