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As we had promised, we will begin with a simple possible scenario. In the world of finance, we will assume that there are dealings with a perfect market. The features that are going to exist are:

  • There will be no taxes.
  • No transaction costs will be charged (i.e. costs in the dealing of goods).
  • No differences will exist in opinions or information among the investors.
  • There will be so many investors and firms, that any one absence or presence will not have any influence on the prices.

A perfect market will allow the general public to put concentrated focus on concepts that basic. The concepts are put forward without the indulgence of the practical real world factors which only complicate the exposition. This book will further use these factors and assumptions to sketch a modular structure of the working of financial markets. However, this is not necessarily stated as to the way a firm is expected to operate. You will further get a better understanding of how markets operate all around the real world (which is going to be a lot more complex) in chapter 10.

In this current chapter, we are going to put forward 3 additional options which are not associated with that of the perfect market. This will give a simplification like no other:

  • No risk or uncertainty is accompanist. You have a clear view of what is out to happen.
  • No inflation is involved.
  • The per period rate of interest is the same for all.

This sort of financial utter utopia is nothing but unreal. But, the tools that these chapters will provide in learning will also come in handy for later chapters. In the later lessons as the world will transform from theoretical to real, it will turn to be harsher as well as more difficult. If there is any tool that does not give correct answers to the un-realistic simple theoretical world, it will fail in the real practical world, that too surely.

Our Basic Scenario: Perfect Markets, Certainty, Constant Interest Rates 1