Applications of the Contingent Claims Model

Arrow prices are a natural and an ingenious extension of the Arrow-Debreu general equilibrium model. The differentiation of commodities by the present and by states of nature in the future created an equivalency between the conventional certainty model to one of production and consumption with uncertainty. Arrow’s extension to futures markets and financial securities also extended the two fundamental theorems of welfare economics to finance: The first, that every competitive equilibrium is a Pareto optimum, and the second, that any Pareto optimal allocation can be supported by a competitive equilibrium, given some redistribution of income, were the impetus for generations of study in finance that continues to this day.