Globalization, Gating, and Risk Finance

3Global Finance: Utility, Financial Consumption, and Asset Pricing

Motivation

This chapter outlines the utility‐based and Arrow–Debreu approaches to financial risk and asset pricing as used in global financial models. While the utility‐based approach to pricing is founded on agents’ preferences, the Arrow–Debreu approach is preference free. To put it another way, it is based on a number of specific conditions; for example, no arbitrage, unique equilibrium prices, and the predictability of all future state preferences. In this chapter, we extend conventional single‐agent utility pricing to a multi‐agent model and construct an approach to the “financialization” of utility decisions. In this context, prices are unique and defined by aggregate (global) demand for consumption, rather than by what each agent is willing to pay for consumption, as well as by the aggregate supply and its price. The multi‐agent framework is applied to the study of several problems; for example, the multi‐agent consumption‐based capital asset pricing model (CCAPM), as well as to a variety of challenging problems in global finance, including investment in competing markets, credit pricing, and foreign exchange (FX) pricing. The Arrow–Debreu framework and its rationale, which underlies complete markets finance, is developed and applied to investment pricing using simple models. These are extended to continuous‐time models in Chapters 7 and 8.

3.1 Introduction: Financial Models and Pricing

Adam Smith’s ...