Jean-Pierre Danthine is professor of economics and finance at the University of Lausanne Switzerland), director of the International Center for Financial Asset Management and Engineering Lausanne & Geneva) and CEPR Research Fellow. The holder of a Ph.D. in economics from Carnegie-Mellon University and a M.S. in Economics from the University of Louvain, Professor DanthineI previously taught at at Columbia University and held visiting appointments at CUNY Graduate Center, University of Southern California (Los Angeles), Université d'Aix-Marseille, Université Laval (Québec), as well as Universities of Toulon and Dijon.

He is an Associate Editor of Macroeconomic Dynamics and Finance Research Letters; Chairman of the Scientific Council of the TCIP (Training Center for Investment Professionals); member of the Council of the European Economic Association, of the Scientific Councils of CEPREMAP (Paris), CREST (Paris), CREI (U. Pompeu Fabra, Barcelona) as well as the Fonds national de la recherche scientifique (Economics Commission - Belgium). He was also a member of the Executive Committee of the ICMB (Geneva).

He was formerly Vice-Rector of the University of Lausanne, chairman of its Departement d'Econométrie et d'Economie Politique (DEEP) and director of its Institute for Banking and Financial Management, member of the Executive Committee of CEPR (Center for Economic Policy research - London), of the CEPS Macroeconomic Policy Group (Brussels), of the Scientific Council of the European Science Foundation Network in Financial Markets. He was also an Associate Editor of the European Economic Review, of the Journal of Empirical Finance and of the Revue Finance.

His publications have appeared in Econometrica, the Journal of Political Economy, the Review of Economic Studies, the Journal of Finance, the Journal of Economic Theory, the Journal of Public Economics, the European Economic Review, and many other journals.

Why do we need financial markets and institutions? We chose to address this question as our introduction to this text on financial theory. In doing so, we touch on some of the most difficult issues in finance and introduce concepts that will eventually require extensive development. Our purpose here is to phrase this question as an appropriate background for the study of the more technical issues that will occupy us at length. We also want to introduce some important elements of the necessary terminology. We ask the reader's patience as most of the sometimes difficult material introduced here will be taken up in more detail in the following chapters.

A financial system is a set of institutions and markets permitting the exchange of contracts and the provision of services for the purpose of allowing the income and consumption streams of economic agents to be desynchronized-that is, made less similar. It can, in fact, be argued that indeed the primary function of the financial system is to permit such desynchronization. There are two dimensions to this function: the time dimension and the risk dimension. Let us start with time. Why is it useful to dissociate consumption and income across time? Two reasons come immediately to mind. First, and somewhat trivially, income is typically received at discrete dates, say monthly, while it is customary to wish to consume continuously (i.e., every day).

Second, and more importantly, consumption spending defines a standard of living, and most individuals find it difficult to alter their standard of living from month to month or even from year to year. There is a general, if not universal, desire for a smooth consumption stream. Because it deeply affects everyone, the most important manifestation of this desire is the need to save (consumption smaller than income) for retirement so as to permit a consumption stream in excess of income (dissaving) after retirement begins. The life-cycle patterns of income generation and consumption spending are not identical, and the latter must be created from the former. The same considerations apply to shorter horizons. Seasonal patterns of consumption and income, for example, need not be identical. Certain individuals (car salespersons, department store salespersons) may experience variations in income arising from seasonal events (e.g., most new cars are purchased in the spring and summer), which they do not like to see transmitted to their ability to consume. There is also the problem created by temporary layoffs due to business cycle fluctuations. While they are temporarily laid off and without substantial income, workers do not want their family's consumption to be severely reduced.

Box 1.1

Representing Preference for Smoothness

The preference for a smooth consumption stream has a natural counterpart in the form of the utility function, U( ), which is typically used to represent the relative benefit a consumer receives from a specific consumption bundle. Suppose the representative individual consumes a single consumption good (or a basket of goods) in each of two periods, now and tomorrow. Let c1 denote today's consumption level and c2 tomorrow's, and let U(c1)+U(c2) represent the level of utility (benefit) obtained from a given consumption stream (c1, c2).

Preference for consumption smoothness must mean, for instance, that the consumption stream (c1, c2) = (4, 4) is preferred to the alternative (c1, c2) = (3, 5), or

4+U4>U3+U5,

Dividing both sides of the inequality by 2, this implies

4>12U3+12U5.

As shown in F

PART I : INTRODUCTION
Chapter 1: On the Role of Financial Markets and Institutions
Chapter 2: The Challenges of Asset Pricing: A Roadmap
PART II: THE DEMAND FOR FINANCIAL ASSETS
Chapter 3: Making Choices in Risky Situations
Chapter 4: Measuring Risk and Risk Aversion
Chapter 5: Risk Aversion and Investment Decisions, Part I
Chapter 6: Risk Aversion and Investment Decisions, Part II: Modern Portfolio Theory
PART III: EQUILIBRIUM PRICING
Chapter 7: The Capital Asset Pricing Model: Another View about Risk
Chapter 8: Arrow-Debreu Pricing I
Chapter 9: The Consumption Capital Asset Pricing Model (…