Financial decision making is typically concerned with the amount of investment capital to allocate to various assets or asset classes in various financial markets. The opportunity set can be very complex, with sets of equities, bonds, commodities, derivatives, futures, and currencies changing stochastically and dynamically over time.To consider decisions in a complex market, it is necessary to impose structure. In the abstract, the assets and the participants buying and selling them are parts of a system with underlying economic states. The system’s dynamics and the factors defining the states within it have been studied extensively in finance and economics. The dynamics of the market and the behavior of participants determine the trading prices of the various assets in the opportunity set. A simplifying assumption is that the financial market is perfectly competitive. There are conditions which must be present for a perfectly competitive market structure to exist. There must be many participants in the market, none of which is large enough to affect prices. Individuals should be able to buy and sell without restriction. All participants in the market have complete information about prices. In
the competitive market, investors are price takers. These assumptions are strong, and in actual financial markets they are not exactly satisfied. However, with the assumed structure, an idealized market can be characterized and that provides a standard by which existing practice can be measured.
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