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Evolved in1950s, still dominating paradigm, portfolio theory, option price model.
Assumptions about people: logical, autonomous economic agents characterized by
· expected utility maximization over time, risk aversion... and Assumptions about markets:
· perfect, no transaction cost or taxes, no constraining regulations,perfect competition
· information is costless and received simultaneously by all individuals is also complete and liquid . As a result, market values are the relevant signals for consumption and investment decisions.
As a result, asset pricing (AP) and corporate finance (CF) theorems emerged:
· AP: all agents reach their maximum
· AP: portfolios are mean-variance efficient (Markowitz)
· AP: only systematic non-diversifiable risk is priced (CAPM founded by Sharpe)
· AP: no opportunities left for arbitrage
· AP: price equals value
· CF: irrelevance of capital structure (Modgliani & Miller)
· CF: irrelevance of dividend structure (Miller & Modgliani)
Conclusion: Divergence between theory and reality is unsatisfactorily large
· theory predicts direct relation between surplus and deficit economic units
· theory leaves no space for financial intermediaries, regulations etc. (this is part of institutional economic-based finance)
· behaviour of individuals and resulting aggregate (= market) outcomes: irrational behaviour of individuals can be observed, anomalies of financial market prices (this is part of behavioural finance)
