Chapter 11 Capital market theory and the pricing of financial securities The core of financial economic theory is the study of individual behavior of households in the intertemporal allocation of their resources in an environment of uncertainty and of the role of economic organizations in facilitating these allocations. The intersection between this specialized branch of microeconomics and macroeconomic monetary theory is most apparent in the theory of capital markets. The complexity of the interaction of time and uncertainty provides intrinsic excitement to study the subject. The mathematics of capital market theory contains some of the most interesting applications of probability and optimization theory. This chapter discusses necessary conditions for static financial equilibrium that are used to determine restrictions on equilibrium security prices. The combined consumptionportfolio selection problem is formulated in a more realistic and more complex dynamic setting. The chapter examines intertemporal equilibrium pricing of securities and discusses the conditions under which allocations in the continuous trading model are Pareto efficient.