ABSTRACT
This chapter presents the preliminaries of the model. The frictionless markets assumption can be justified on two grounds. First, very large institutional traders approximate frictionless markets since their transaction costs are minimal. The second argument is that understanding frictionless markets is a necessary prelude to understanding friction-filled markets. Markets tend to quote bond prices using interest rates. This is because interest rates summarize very complex cash flow patterns into a single number that is comparable across different financial securities. A forward contract is a financial security obligating the purchaser to buy a commodity at a prespecified price and at a prespecified date. Futures contracts are a more development than are forward contracts, having been introduced to financial markets sometime during the late 19th and early 20th centuries. A call option of the European type is a financial security that gives its owner the right to purchase a commodity at a prespecified price and at a predetermined date.
