Great Moments in Financial Economics: IV. The Fundamental Theorem (Part I)

Journal of Investment Management, Vol. 3, No. 4, Fourth Quarter 2005

Posted: 12 Oct 2005

See all articles by Mark Rubinstein

Mark Rubinstein

University of California, Berkeley - Haas School of Business

Abstract

This is the fourth in a series of articles in this Journal examining the historical origins of key ideas in the history of financial economics. The fundamental theorem asserts: there are no arbitrage opportunities if and only if state-prices exist. Like Newton's laws of motion, though highly abstract, it underlies the most important results in financial economics. The paper starts with some necessary background, explaining the related trio of ideas, subjective probabilities, risk-neutral probabilities and state-prices. Our search for the origins of the concept of state-prices will take us back several centuries to some work of Edmund Halley and Christiaan Huygens, who were financial economists on the side. In a Great Moment in the history of financial economics in 1953, the first clear and general application of state-prices to economics appears in the work of Kenneth Arrow. Less well known is some early important commentary by the economist Jacques Dreze. In the middle 1970's Mark Rubinstein and Stephen Ross may have been the first financial economists to appreciate the link between arbitrage and state-prices in incomplete markets, with the first completely clear statement and proof of the theorem provided by Ross. I then show how starting with the theorem, the important results of asset price theory (in particular, the CAPM) can be derived.

An extension of the fundamental theorem which anticipates modern option pricing will be discussed in Part II of this article which will appear in the next issue of the Journal.

Keywords: Probability, state-prices, arbitrage, complete markets

JEL Classification: G00

Suggested Citation

Rubinstein, Mark E., Great Moments in Financial Economics: IV. The Fundamental Theorem (Part I). Journal of Investment Management, Vol. 3, No. 4, Fourth Quarter 2005, Available at SSRN: https://ssrn.com/abstract=555403

Mark E. Rubinstein (Contact Author)

University of California, Berkeley - Haas School of Business ( email )

545 Student Services Building, #1900
2220 Piedmont Avenue
Berkeley, CA 94720
United States
510-642-3580 (Phone)
510-643-1420 (Fax)

HOME PAGE: http://www.haas.berkeley.edu/finance/rubinste.html

Do you have a job opening that you would like to promote on SSRN?

Paper statistics

Abstract Views
1,327
PlumX Metrics