1

FINANCIAL ECONOMICS:
Amnon Levys Lecture Notes






Spring 2013

















University of Wollongong
2

Table of Content

Part 1. Investment Theory

Week 1 The discrete-time discount factor: a derivation
Evaluation of investment projects:
Tobins q criterion
Net present value criterion
Internal rate of return criterion
Tutorial questions
The dynamics of capital stock
Tutorial questions

Week 2 The Dale J orgensons user cost approach to computing the desired
capital stock
Net investment and the Baumols partial adjustment model
Tutorial questions

Week 3 The role of interest rate in the optimal choice of saving and
consumption: a two-period analysis
Tutorial questions
Saving with fixed income, consumption and interest rate: an analysis in
continuous time
The continuous-time discount factor
Tutorial questions

Week 4 Intertemporal analysis of efficient investment in production capital
with costs of adjustment:
The models building blocks
The optimal control problem and the sufficient and
necessary conditions
The singular control and the no-arbitrage rule

Week 5 Intertemporal analysis of efficient investment in production capital
with costs of adjustment (cont.):
The phase-plane diagram of capital stock and gross
investment

Week 6 Intertemporal analysis of efficient investment in production capital
with costs of adjustment (cont.):
The steady state capital stock and investment and
comparative statics
Specific Appendix: Identification of the local
asymptotic stability nature of the models steady state
General Appendix: Identification of the local
asymptotic stability nature of a steady state of an
infinite horizon optimal control problem
3
Tutorial questions
Extension: efficient investment and borrowing with adjustment and
transaction cost and with tax considerations
The New Theory: irreversibility, uncertainty and the delay option

Week 7 In-Session Examination

Week 8 Modigliani-Miller approach to valuation of firms, leverage and cost of
capital
Houses values and prices and the cobeweb phenomenon
Tutorial questions


Part 2. Uncertainty, Risk, Insurance and Portfolio

Week 9 Risk, expected utility and optimal insurance
The Von Neuman-Morgenstern utility function
Optimal insurance (coverage) level
Supply side and the actuarially fair premium rate
Moral hazard
Tutorial questions

Week 10 Uncertainty, Risky Assets (Activities) and Portfolio: Basic concepts
Efficient Portfolios: Mean-Variance Approaches
The Markowitz Efficient Portfolio Set
Tobins Capital Market Line (CML)
William Sharpes Capital Asset Pricing Model (CAPM)
Tutorial: Construction of the CML

Week 11 Expected utility maximizing approach to choice of portfolio
Tutorial questions


Part 3. Financial Crises

Week 12 Evolution of a firms debt burden
Developing countries external sovereign debts:
Structure
Causes and evolution
The David Howards model
Implication for exchange rate policy
Tutorial questions

Week 13 Developing countries external sovereign debts (cont.):
External debt and economic growth
The Debt Laffer Curve and discount
Repudiation and debts secondary market price
Tutorial questions
The Global Financial Crisis, 2007-present

4
Lecture 1
(Week 1)
Discrete Time Discount Factor
The discount factor transforms future nominal values to present-time ones. The
following procedure generates an agents discount factor in discrete time with time-
invariant (fixed) interest rate. The analogue in continuous time will be developed in
lecture 3. Suppose that the best alternative activity/asset for an agent is a saving
account with flat, time-invariant interest rate r. A sum of
o
m is deposited in this
account and no further deposits, nor withdrawals, are made. The motion equation of
the account is therefore:
1
(1 )
t t
m r m

= + . (1)
It can be expressed as a homogeneous, first order, linear difference equation:
1
(1 ) 0
t t
m r m

+ = . (1)
Let
t
t
m c = (3)
be a solution, then by substituting into (1):
1
[ (1 )] 0
t
c r

+ = (4)
The non-trivial solution for is:
1 r = + (5)
and consequently
(1 )
t
t
m c r = + (6)
Substituting 0 t = and recalling the initial condition, ( 0)
o
m t m = = , then
o
c m = .
Hence, the solution to the initial-value problem is:
(1 )
t
t o
m m r = + . (7)
This implies that the present value of
t
m available in that account at some future date
t is:
1
1
| |
=
|
+
\ .
t
t o
m m
r
. (8)
The term on the left-hand side that multiplies
t
m can be interpreted as the discount
factor of the said agent, 1/ (1 ) +
t
r . Note that if the interest rate is variable, the
discount factor of
t
m in discrete time can be proven to be
5
1
1 2 3
1
1 (1 )
(1 )(1 )(1 )...(1 )
/
=
= +
+ + + +

t
t
r
r r r r

. (9)


Evaluation of Investment Projects:
Tobins q, Net Present Value, Internal Rate of Return

The Tobins q criterion
' 1
cos
market value of the investment project
Tobin s q
replacement t of the investment project
>
<
= .
If the investment projects Tobins q is smaller than 1, the project should be rejected.

The Net Present Value Criterion
0
1 1
( )
1 1
=
| | | |
= +
| |
+ +
\ . \ .

t T
T
t t t T
t
NPV R C I S
r r

where,
r is a time-invariant discount rate considered by the planner,
1,..., t T = and T the life expectancy of the project,
t
I is the expected cost of the investment in the project in period t,
t
R is the expected revenue generated by the project in period t,
t
C is the expected operational costs of the project in period t, and
T
S is the expected salvage (or resale) value of the project.
The components of investment projects NPV formula are tabulated below.

Year
Investment
Costs
Revenues
Operational
Costs
Salvage
Value
0
0
I
0
R
0
C
1
1
I
1
R
1
C
2
2
I
2
R
2
C
3
3
I
3
R
3
C



T
T
I
T
R
T
S
= NPV
0
1
1
=
| |

|
+
\ .

t
T
t
t
I
r

0
1
1
=
| |
+
|
+
\ .

t
T
t
t
R
r

0
1
1
=
| |

|
+
\ .

t
T
t
t
C
r

1
1
| |
+
|
+
\ .
T
T
S
r

6
If the projects expected 0 NPV < , the project should be rejected. Note that an
expected 0 NPV does not necessarily imply that the proposed project has to be
taken. Obstacles in computing the expected NPV stem from the uncertainty about T, I,
R, C and
T
S .

The Internal Rate of Return (IRR) Criterion
Investment projects vary in size and the development budget (say, of a ministry) is
limited. It is useful to calculate the IRR of each the proposed competing investment
projects and to use the IRRs for ranking in descending order. The internal rate of
return on an investment project is defined as the discount rate for which
( ) 0 NPV = . It is found by solving
0
1 1
( ) 0
1 1
t T
T
t t t T
t
NPV R C I S

=
| | | |
= + =
| |
+ +
\ . \ .

for . If r < , the project should be rejected.

Tutorial questions
1. Develop the formula of IRR ( ) for the case where T=1.
2. Develop the formula of IRR ( ) for the case where T=2.

The Dynamics of Capital Stock
Assuming linear depreciation, the capital stock evolution (or net investment) from an
initial value
o
K can be displayed as:
1 1 t t t t t
NI K K I K

= , (1)
where 0 1 < < is, for simplicity, a time-invariant (fixed) depreciation rate.
The evolution of the capital stock can be portrayed as a first order linear difference
equation:
1
(1 )
t t t
K K I

= (1)
Let us solve the initial-value problem and demonstrate the evolution of capital stock
for the special case of a time-invariant gross investment, 1,2,3,...
t
I I t = =
Step 1: the stationary capital stock (
ss
K )
In steady state,
7
1 t t ss
K K K

= = .
Hence,
ss
K I =
and
/
ss
K I = . (2)
Step 2: the solution to the homogeneous part
The homogeneous part of (1) is:
1
(1 ) 0
h h
t t
K K

= (3)
Assuming that
h t
t
K = , then
1
{ [ (1 )] 0} { 1 }
t

= = (4)
and hence
(1 )
h t
t
K = . (5)
Step 3: the general solution
/ (1 )
h t
t ss t
K K cK I c = + = + (6)
Step 4: Finding c
At 0 t = ,
0
/ (1 )
o
K I c = + and hence
0
/ c K I = . (7)
Step 5: the solution to the initial value problem
/ ( / )(1 )
t
t o ss
K I K I = + . (8)

Property: Recalling that 0 1 < < , lim(1 ) 0
t
t

= and hence lim /

t ss
t
K I K

= = .
That is, in this particular case, the stationary capital stock is asymptotically stableit
is attainable from any initial level, as depicted in the figure below.

ss
K

K

t 0
8
Lecture 2
(Week 2)

The Dale Jorgensons User-Cost Approach to Computing the
Desired Capital Stock

The user (or rental) cost of capital (
c
i )
The cost of a dollar directed to hiring production capital for a period of time (e.g., a
year) is the foregone periodical (e.g., annual) real interest rate [i.e.,
( ) / (1 ) r i = + , where i is the periodical nominal interest rate and the expected
periodical inflation rate
1
] plus the periodical (e.g., annual) depreciation rate ( ) of
that capital; namely,
+ = r i
c
.

The firm
The firm employs only two inputs: capital (K) and labor (L). Its production process is
represented by a concave function ) , ( L K F displaying positive, but diminishing,
marginal products of capital and labor (i.e., positive first partial derivatives,
0 , >
L K
F F , and negative second non-cross derivatives, 0 , <
LL KK
F F ). The firm is a
small player (i.e., has no monopsonistic power) in the markets of capital and labor.
Being a price-taker in these markets, its user cost (
c
i ) and workers wage (w) are
positive scalars.

The Firms objective
Finding the combination of inputs that minimizes the cost of producing a
predetermined output level.

Isocost
The locus of all the combinations of capital and labor that generate the same level cost
(C ) for the firm. That is, the set of all (K,L) for which

C wL K i
c
= + .

1
{1 (1 )(1 )} { } { (1 ) } { ( ) / (1 )} i r i r r i r r i + = + + = + + = + = + .
9
A total differentiation of the above expression while holding the level of cost
unchanged can help finding the slope of the isocost curve in the plane spanned by L
and K. Namely,

0 = = + dC wdL dK i
c


and by rearranging terms,

c
i
w
dL
dK
= .

The slope of any isocost is the negative of the labor-capital price ratio and as the firm
is a price-taker in these inputs markets, this ratio does not vary with the combination
of capital and labor employed by the firm but is fixed. Thus, an isocost is negatively
sloped and linear in the plane spanned by L and K and the greater is distance from the
origin the higher the associated input-hiring cost.

L
K
0
w/ic


For countries where labor is relatively scarce (e.g., North-Western Europe, Australia,
Canada and USA) the isocosts are steeper than for countries where labor is relatively
abundant (e.g., Bangladesh, India and China).

10
Isoquant
The locus of all the combinations of capital and labor producing the same level of
output. That is, the set of all (K,L) for which

y L K F = ) , ( .
By total differentiation, while holding the output level constant,
0 ) , ( ) , ( = = + dy dL L K F dK L K F
L k
.
Consequently,
) , (
) , (
L K F
L K F
dL
dK
K
L
= .
As 0 , >
L K
F F and 0 , <
LL KK
F F the slope of an isoquant in the L-K plane is negative
and diminishing as displayed in the following figure (excluding the special cases
where labor and capital are prefect substitutes or perfect complements).
L
K
0

The Production-Input Choice
The Dale J orgensons user-cost approach for determining a firms desired capital
stock suggests that the firm chooses its mix of inputs, capital and labor for simplicity,
efficiently so as to minimize the costs of producing a predetermined quantity of
output during a given period. The decision problem of the firm, in the J orgensons
context, can be formally displayed as:
) ( min
,
wL K i
c
L K
+
subject to y L K F = ) , ( .
11
Graphical solution
The graphical presentation of the problem and its solution is based on isocosts and
isoquants. The solution (
* *
,L K ) of the firms problem is found at the tangency point
between an isocost and the isoquant associated with the production level y.

L
K
0
w/ic
K*
L*
y


In the cost-minimizing combination of capital and labor ( *, *) K L the following
optimality conditions prevail:

1.
* *
* *
( , )
( , )
L
K c
F K L w
F K L i
=

2. y L K F = ) , (
* *


These optimality conditions constitute a system of two equations with two unknowns
whose solution is the firms demand for production inputs:
the desired capital stock
) , , (
*
y i w f K
c
=
and the desired labor level
) , , (
*
y i w g L
c
= .
12
Lagrange-method solution
The optimality conditions can also be obtained by applying the Lagrange method to
) ( min
,
wL K i
c
L K
+ subject to y L K F = ) , ( . The Lagrange function (L ) associated with
this problem is:
[ ( , )] = + +
c
i K wL y F K L L
where is the Lagrange multiplier and is interpreted as the marginal cost of
production.
Since ( , ) F K L is jointly concave and ( )
c
i K wL + is linear in K and L, then L is
jointly convex in K and L, the second-order conditions for minimum are satisfied and
an interior solution exists. The first order conditions (FOCs) for minimum are:

{ } ( *, *) 0 ( *, *)

= = =
`

)
L L
w F K L F K L w
L

L

{ } ( *, *) 0 ( *, *)

= = =
`

)
c K K c
i F K L F K L i
K

L

{ } ( *, *) 0 ( *, *)

= = =
`

)
y F K L F K L y

L

The division of the first condition by the second implies the first optimality condition:
( *, *)
( *, *)
L
K c
F K L w
F K L i

= .
Illustration: The desired capital stocks for two countries endowed with the same
technology but with different input-price ratio,
B
c
A
c
i
w
i
w
|
|
.
|

\
|
>
|
|
.
|

\
|
.
L
K
0
K*A
L*A
y
A
B
K*B
L*B

13
Example
Consider the case where the firms production function is Cobb-Douglas and
displaying constant return to scale, i.e., 1 0 , 0 ,
1
< < > =

A L AK F . The positive
parameter A represents the firms technological level and the parameters and 1
are the elasticities of the firms production with respect to capital and labor,
respectively (i.e., =

=
K
F
K
F
k
/ and =

= 1 /
L
F
L
F
L
).
In this case, the optimality condition of equality between the ratio of the marginal
products of labor and capital (
K L
F F / ) and the input price ratio (
c
i w/ ) is
c
i
w
L AK
L AK
=

1 1
* *
* * ) 1 (
.
By rearranging terms,
* * c
c c
i (1 )K * w K * w 1
( )( ) L ( )( )K
L* i L* 1 i w

= = =
` ` `

)
) )
.
By substituting this expression into the second optimality condition for
*
L ,
y K
w
i
AK
c
= |
.
|

\
|

1
* *
) )(
1
(
By rearranging terms, the desired capital stock is

|
.
|

\
|
=
1
*
) )(
1
(
w
i
A
y
K
c
.
This expression proposes that the desired capital stock:
1. proportionally increases with the output level to be produced,
2. decreases with the firms technological level,
3. increases with the capital production elasticity,
4. decreases with the labor production elasticity,
5. increases with the wage rate, and
6. decreases with the user cost.

14
Net Investment and the Baumols Partial Adjustment Model
Due to various possible constraints (e.g., funds, floor space, training complementary
labor, and/or objection of trade union to labor-replacing capital) there might not be an
immediate adjustment of the capital stock to the desired level. William Baumols
partial adjustment model reflects that at every period the net investment in capital is
proportional to the difference between the desired stock and the actual stock of capital
at the end of the previous period:
1 0 ), (
1
*
1
< < = =


t t t t
K K K K NI .
By collecting term, Baumols model can be rendered as a first-order, linear difference
equation
*
1
) 1 ( K K K
t t
=


whose solution is obtained by using the following five-step method.
Step 1: The stationary capital stock,
ss
K
In steady state,
1 t t
K K

= and hence
*
(1 )
ss ss
K K K =
which in turn implies:
*
ss
K K = .
Step 2: The solution to the homogeneous part
1
(1 ) 0
h h
t t
K K

=
Suppose
h t
t
K = .
Then
1
1
h t
t
K

= .
By substitution into the homogeneous part:
1
(1 ) 0
t t


= .
In turn,
1
{ [ (1 )] 0} { (1 )}
t

= = .
Hence,
(1 )
h t
t
K = .
Step 3: the general solution
* (1 )
h t
t ss t
K K cK K c = + = + , where c is a scalar.
15
Step 4: the value of c
Recalling the
0
( 0) K t K = = , and substituting 0 t = into the general solution:
0
0
* (1 ) * K K c K c = + = +
and hence
0
* c K K = .
Step 5: the solution to the initial value problem
By substituting
0
* c K K = into the general solution,
t
t
K K K K ) 1 )( (
*
0
*
+ = .
Since
t
t
K K K K ) 1 )( (
*
0
*
+ = and
t
) 1 ( diminishes over time (i.e., as t ),
the actual capital stock asymptotically converges to the desired capital stock from any
possible initial level that is different from the desired one, as displayed by the
trajectories in the following figure.




*
K

K

t 0
16
Exercise 1
(To be handed to the lecturer at the beginning of the lecture in week 3)

Firm A invest every year 1,000,000 dollars in on premises production capital. Its
production capital depreciates at a rate of 0.1 per annum. Its present production
capital stock is 5,000,000 dollars. Use
1 1 t t t t t
NI K K I K

= to compute
1. firm As steady-state capital stock; and
2. the first three years levels of this stock.

Consider a firm whose production process can be depicted by the following function
0.6 0.4
4000 Y K L = . The annual salary of any worker employed by the factory is $
30,000. The annual nominal interest rate is 0.07. There is no inflation expected by the
firms manager. The annual capital-depreciation rate is 0.03. The value of the initial
capital stock in the factory is $ 10,000,000. The manager adjusts the capital stock in
the factory to the desired level by 50 per cent of the discrepancy in any given year.
The objective of the firms manager is to minimize the costs of producing $
120,000,000 value of goods in any given year. Use the J orgenson and Baumol models
to answer the following questions.

3. What is the firms user cost?
4. What is the firms desired capital stock (measured in dollars)?
5. What is the firms net investment in the first year?
6. What is the firms net investment in the second year?



17
Lecture 3
(Week 3)

The Role of Interest Rate in the Optimal Choice of Saving and Consumption:
A Two-Period Analysis

Consider a person who:
1. lives two periods: present (0) and future (1);
2. has certain incomes:
0
y at present and
1
y in the future;
3. can transfer financial resources from one period to another in a fixed interest
rate ) (r : saving in the case of a transfer from period 0 to period 1, or
borrowing in the case of a transfer from period 1 to period 0;
4. leaves neither bequest nor debt at death;
5. who derives utility from consumption at present and in the future in
accordance to a concave lifetime utility function ) , (
1 0
C C u ; and
6. who simultaneously chooses consumption in period 0 (
0
C in nominal values)
and consumption in period 1 (
1
C in nominal values) at the beginning of period
0 so as to maximize his/her utility subject to his/her inter-temporal budget
constraint.

Formally, the decision problem of this person is:
0 1
max ( , ) u C C
subject to the intertemporal budget constraint
_
0
0 0 1 1
) ( ) 1 (
S
C y r y C + + = .
As displayed by the intertemporal budget constraint, the price of present consumption
comprises the purchasing price ($1) and the forgone interest on that dollar (i.e., 1 r + ).
Due to the concavity of the utility function and linearity of the budget constraint, the
corresponding Lagrange function
0 1 1 0 0 1
( , ) [ (1 )( ) ] = + + + u C C y r y C C L
is concave in
0
C and
1
C and hence there exists an interior solution (
* *
1
*
0
, , C C ).
The Lagrange multiplier ( ) can be interpreted in the present case as the shadow
value of the budget available for the second period consumption. It is expressed in
utility terms. It is the marginal lifetime utility of funds available in the second period.
18
The interior solution satisfies the following necessary conditions:

* *
* 0 1
0 0
( , )
(1 ) 0

= + =

u C C
r
C C

L
(1)

* *
* 0 1
1 1
( , )
0

= =

u C C
C C

L
(2)

* *
1 0 0 1
(1 )( ) 0

= + + =

y r y C C

L
. (3)

From equations (1) and (2) [i.e., dividing both sides of equation (1) by
*
while
noting that
* * *
0 1 1
( , )/ u C C C = ], the marginal rate of substitution of future
consumption for present consumption is equal to the price ratio of present and future
consumption:

r
C C C u
C C C u
+ =


1
/ ) , (
/ ) , (
1
*
1
*
0
0
*
1
*
0
(4)

From equation (3)

) )( 1 (
*
0 0 1
*
1
C y r y C + + = . (5)

The system comprising equations (4) and (5) determines
*
0
C and
*
1
C and subsequently
the individuals level of saving (when
*
0 0
0 y C > ), or borrowing (when
0
*
0 0
< C y ).














19
Illustration: Two-period consumption and saving for two different interest rates
(r r > )

























Extension: Two period consumption and saving with
borrower lender
r r >

0
C

1
C
0
y
1
y


1
C

0
y

1
y
1 r + 1 r +
0
C
20
Tutorial questions
1. Let,

5 . 0
1
5 . 0
0
9 . 0 C C u + =

0 1
$60,000 y y = =

0.08 r = .

1. Prove that the optimality condition leads to:

2
* *
1 0
0.45
(1 )
0.5
C r C
(
= +
(



2. Substitute the above expression into the budget constraint and show that

* 1 0
0
2
(1 )
0.45
(1 ) (1 )
0.5
y r y
C
r r
+ +
=

(
+ + +
`
(


)


3. Compute
0 1 0
, , S C C .

4. Suppose, instead, that 10 . 0 = r and all other things remain the same. Re-compute
0 1 0
, , S C C and draw a conclusion on the relationship between saving (or borrowing)
and interest rate.

21
Saving (m) with Fixed Income (y), Consumption (c) and Interest Rate (r):
An Analysis in Continuous Time

The change in the individuals saving account is given by:

( ) ( ) ( )
dm
m t rm t y c
dt
= + `

It can be expressed as a first order linear differential equation (FOLDE):

( ) ( ) ( ) m t rm t c y = `

whose solution, as explained by the five steps below, is

0
( )
rt
c y c y
m t m e
r r
| |
= +
|
\ .

where
0
( 0) m t m = = .

Step 1: The stationary level of the saving account
In steady state, 0 m = ` . The substitution of this property in the FOLDE implies:
( )
ss
rm c y =
Hence,
ss
c y
m
r

= .
Step 2: The solution to the homogeneous part ( ) ( ) 0
h h
m t rm t = `
Assume that
( )
t
h
m t e

= .
Then,
( )
t
h
m t e

= ` .
By substitution into the homogeneous part:
0
t t
e re

=
which implies:
r = .
Hence,
( )
rt
h
m t e = .


22
Step 3: the general solution
( ) ( )
rt
ss h
c y
m t m m t e
r

= + = +
Step 4: The value of
By substituting 0 t = into the general solution:
0
0
( 0)
ss h
r
m m m t
c y c y
e
r r

= + =

= + = +

Hence,
0 0 ss
c y
m m m
r

= = .
Step 5: the solution to the initial value problem
By substituting the value of into the general solution:
0
( )
rt
c y c y
m t m e
r r
| |
= +
|
\ .
.

The continuous-time discount factor (
rt
e

)
Assuming no withdrawals and deposits, the level of the saving account can be
obtained by substituting 0
t t
c y = = for every instance t into the above solution to the
initial value problem:
0
( )
rt
m t m e = .
Dividing both sides by
rt
e ,
0
( )
rt
m e m t

= .
The term
rt
e

can be interpreted as the continuous-time discount factor.

Tutorial questions
On her retirement at 65 years of age Rosemary received from her superannuation
(pension) fund a sum of 400,000 dollars, which she deposited in a saving account with
a fixed 6 percent annual interest rate. Rosemary expects her annual spending to be
30,000 dollars.

1. Denote by

t the date (instance) in which Rosemarys saving account is exhausted

and substitute this date into the solution to the saving account FOLDE and prove that
0
1 /

ln
/
| |
=
|

\ .
c r
t
r c r m
.
2. To which age (

65 t + ) Rosemarys saving will be sufficient?

23
Lecture 4
(Week 4)

Intertemporal Analysis of Efficient Investment in Production Capital
with Costs of Adjustment


1. The models building blocks
Consider a firm with the following characteristics.

1.1 Production: The firm produces a single product with capital and, for simplicity,
with a fixed quantity of labour in a time-invariant technology that can be depicted by
the following concave production function:
( ( ), )
t
y F K t L =
where 0
K
F > and 0
KK
F < .

1.2 Markets: The firm operates in perfectly competitive markets of its product and
inputs (i.e., it is a price taker). The price of its product (P), wage rate (w) and
purchasing price of capital (q) may change over time due to changes in demand and
supply in the respective markets.

1.3 Adjustment Costs: The instantaneous costs of adjustment (e.g., instalment costs)
associated with new capital are depicted by a convex function ( )
t
C I with ( ) 0
t
C I >
and ( ) 0
t
C I > .

1.4 Capital motion equation: The firms initial capital stock is
0
K and, despite
having a stock with a variety of vintages, the rate of depreciation of the firms capital
is taken, for simplicity, to be a scalar 0 1 < < . Consequently,
( ) ( ) ( ) K t I t K t =
`
.

1.5 Planning Horizon and Time Preferences: The firm is infinitely lived and has a
time-invariant (fixed) rate of time preference (discount), 0 > .

1.6 Objective: The firm chooses its gross investment path { } I so as to maximize the
sum of its discounted instantaneous net cash-flows subject to the motion equation of
its capital stock. This postulate is consistent with maximising the value of the firm in
an efficient stock market (i.e., in a stock market where all agentsbuyers and sellers
of stocksare rational and informed).
24
2. The optimal control problem and the sufficient and necessary conditions
The firms objective can be formally expressed as:

{ }
0
max [ ( ) ( ( ), ) ( ) ( ) ( ( )) ( ) ]
t
I
e P t F K t L q t I t C I t w t L dt

subject to the firms capitals motion equation:

( ) ( ) ( ) K t I t K t =
`


and the initial condition:

0
(0) K K = .

The (present value) Hamiltonian associated with this optimal control problem is:

( ) [ ( ) ( ( ), ) ( ) ( ) ( ( )) ( ) ] ( )[ ( ) ( )]

= +
t
t e P t F K t L q t I t C I t w t L t I t K t

H

where ( ) t is the co-state variable. It converts physical units of net capital investment
into nominal units. Hence, it can be interpreted as the shadow value (expressed in
present value) of capital.
The second-order (curvature) conditions require that the present value Hamiltonian is
jointly concave in the state variable and the control variable. That is, the 2 2
Hessian matrix of H with respect to (K,I) must be negative semidefinite. Noting
that the Hessian matrix of H is

( , ) 0
0 ( )
t
KK
t
e PF K L
H
e C I

(
=
(

and recalling assumptions 1 and 3, the principal minors of H are negative (i.e.,
( , ) 0
t
KK
e PF K L

<

and ( ) 0
t
e C I

<

) and det ( , )[ ( )] 0
t t
KK
H e PF K L e C I

= >

,
as required. Hence, the following necessary conditions for maximum are also
sufficient:
2


( )
( ) ( ) ( ( ), ) ( )

= = +

`
t
K
t
t e P t F K t L t
K

H
(the adjoint equation)

( )
[ ( ) ( ( ))] ( ) 0

= + + =

t
t
e q t C I t t
I

H
(the optimality condition)

2
The maximum principle was developed by Pontriagin, L.S., Boltyanskii, V.G., Gamkrelidze, R.V. and
Mishchenko, E.F. (The Mathematical Theory of Optimal Process, Wiley, New York, 1962). It shows
that if the control function [I*(t)] and the corresponding path of the state variable [K*(t)] maximize the
objective function subject to the constraints, there exists a continuously differentiable function ( ) t
such that I*, K* and simultaneously satisfy the necessary conditions. Mangasarian (1966) provided
the basic sufficiency theorem for the maximum principle (Mangasarian, O.L, Sufficient Conditions for
the Optimal Control of Nonlinear Systems, SIAM Journal Control 4, 1966: 139-152).
25

( ) ( ) ( ) K t I t K t =
`
(the state equation)

lim ( ) ( ) 0
t
t K t

= (the tranversality condition).

In an infinite horizon dynamic optimization, the transversality condition requires the
present value of the state variables, capital stock in the present case, to converge to
zero as time goes to infinity. It is the boundary condition in an infinite horizon
dynamic optimization. Combined with the initial condition,
0
( 0) K t K = = , it
determines a solution to the problem's first-order conditions. The first-order and
transversality conditions are sufficient to identify an optimum in a concave
optimization problem. Given an optimal path, the necessity of the transversality
condition reflects the impossibility of finding an alternative feasible path for which
each state variable deviates from the optimum at each time and increases discounted
utility (i.e., value of the firm in the case under consideration, A. Levy). (Robert A.
Becker, Transversality Condition, The New Palgrave Dictionary of Economics,
Second Edition, 2008, Edited by Steven N. Durlauf and Lawrence E. Blume)

The optimality condition implies that along the profit maximizing path of investment
the shadow value of capital is equal to the cost of acquiring an additional unit of
capitalthe purchasing price and the marginal adjustment cost:

( ) [ ( ) ( ( ))]
t
t e q t C I t

= + .

Dividing both sides of the adjoint equation by ( ) t , while noting that
( ) [ ( ) ( ( ))]
t
t e q t C I t

= + , the rate of change of the shadow value of capital is given
by:

( ) ( ( ), ) ( )
( ) [ ( ) ( ( ))]
K
P t F K t L t
t q t C I t

=
+
`
.

Compatible with the association of value with scarcity, the first term on the right-hand
side (RHS) of the above equality implies that higher the capitals depreciation rate,
the greater the firms appreciation of its remaining capital. The second term on the
RHS indicates the potential accumulation of capital generated by the last unit of
capital added to the firms stockthe market value of the firms capitals marginal
product divided by the cost of acquiring additional capital. The larger this potential
accumulation of capital, the lower the scarcity of capital in the firm and, in turn, the
firms rate of appreciation of its capital.

3. The singular control and the no-arbitrage rule
While the firms decision problem is intertemporal, the Hamiltonian and, in turn, the
first order condition for maximum are constructed for a point in time t. The optimality
condition can be perpetuated by differentiation with respect to time and setting the
resultant derivative to be equal to zero:

26
( )
0 0
| |
= =
|

\ .
d t
dt I
H
(singular control).

More specifically,
{ [ ( ) ( ( ))] ( ) 0} 0
t
d
e q t C I t t
dt

+ + = =

which implies that the singular control equation is:

[ ( ) ( ( ))] [ ( ) ( ( )) ( )] ( ) 0
t t
e q t C I t e q t C I t I t t



+ + + =
` `
`
.

The substitution of the adjoint equation, ( ) ( ) ( ( ), ) ( )
t
K
t e P t F K t L t

= +
`
, into the
singular control equation implies:

[ ( ) ( ( ))] [ ( ) ( ( )) ( )] ( ) ( ( ), ) ( ) 0
t t t
K
e q t C I t e q t C I t I t e P t F K t L t



+ + + =
`
`

The substitution of ( ) [ ( ) ( ( ))]
t
t e q t C I t

= + implies further:

[ ( ) ( ( ))] [ ( ) ( ( )) ( )] ( ) ( ( ), )
[ ( ) ( ( ))] 0
t t t
K
t
e q t C I t e q t C I t I t e P t F K t L
e q t C I t

+ +
+ + =
`
`


which can be rendered as:

( )[ ( ) ( ( ))] [ ( ) ( ( )) ( )] ( ) ( ( ), ) 0
K
q t C I t q t C I t I t P t F K t L + + + =
`
` .

Consequently, the firms gross investment evolution is:

( )[ ( ) ( ( ))] [ ( ) ( ( ), ) ( )]
( )
( ( ))
K
q t C I t P t F K t L q t
I t
C I t
+ + +
=

`
`
. (No arbitrage rule)

The change in the level of gross investment from one instance to the following should
be equal to the difference between the opportunity cost of (i.e., the foregone return on
distributed revenues due to) investment in an additional unit of capital (namely, the
product of the user cost of capital and the full price of the additional unit of capital)
and the marginal return on the additional unit of capital (namely, the market value of
the firms capitals marginal product plus capital gain), divided by the associated rise
in the marginal adjustment cost.

If ( )[ ( ) ( ( ))] ( ) ( ( ), ) ( )
K
q t C I t P t F K t L q t + + > + ` gross investment is accelerated over
time.

If ( )[ ( ) ( ( ))] ( ) ( ( ), ) ( )
K
q t C I t P t F K t L q t + + < + ` gross investment is decelerated over
time.

27
Lecture 5
(Week 5)

Intertemporal Analysis of Efficient Investment in Production Capital
with Costs of Adjustment (cont.)

4. The phase-plane diagram of capital stock and gross investment
The solution to the firms optimal control problem is given by the capital motion
equation:

( ) ( ) ( ) K t I t K t =
`


and the no-arbitrage rule:

( )[ ( ) ( ( ))] [ ( ) ( ( ), ) ( )]
( )
( ( ))
K
q t C I t P t F K t L q t
I t
C I t
+ + +
=

`
`
.

This system of two differential equations articulates the possible joint trajectories of
capital stock and investment. The system, the possible trajectories and the stationary
levels of investment and capital stock can be portrayed in a phase-plane spanned by
the state variable K and the control variable I. The phase-plane is divided into several
phases (or regions) by two imaginary curves called isoclines. Along one of this
isoclines 0 K =
`
, and along the other 0 I =
`
. Each phase has its own dynamic
characteristics. The intersection point(s) of the isoclines is a steady state(s).

To facilitate the construction of the phase-plane diagram we assume that the firm
takes (expects) the purchasing price of capital (q) and the price of its product (P) to be
time-invariant (fixed): 0 q P = =
`
` .

4.1 The isoclines
The formula of the isocline 0 K =
`
is obtained by setting the left hand side of the state
equation ( ) ( ) ( ) K t I t K t =
`
to be equal to zero:

I K = .

Recalling that 0 1 < < , the isocline 0 K =
`
is depicted by a positively sloped line in
the plane spanned by K and I as displayed by the green line in Figure 1 below.

Theisocline 0 I =
`
is the locus of all the combinations of K and I for which the right
hand side of the no-arbitrage rule is equal to zero. In turn, each of these combinations
of K and I satisfy the following equality:

( )[ ( )] ( , ) 0
K
q C I PF K L + + = .

By total differentiation:

28
( ) ( ) ( , ) 0
KK
C I dI PF K L dK + = .

Hence, the slope of the isocline 0 I =
`
is given by:

( , )
( ) ( )
KK
PF K L dI
dK C I
=
+
.

Recalling the assumptions 0
KK
F < and 0 C > :

( , )
0
( ) ( )
KK
PF K L dI
dK C I
= <
+


That is, the isocline 0 I =
`
is negatively slopped in the plane (K,I) as depicted by the
brown line in Figure 1 below for the case where 0
KKK
F C = = .

The steady state (SS) is in the intersection of the two isoclines. It is unique and
interior.



Figure 1: The isoclines and steady state


0 K =
`
K
I
0 I =
`
SS
0
29
4.2 The motions of K and I in the phases and the nature of the steady state
The isoclines 0 K =
`
and 0 I =
`
divide the plane spanned by K and I into four phases.
Each phase has its own dynamic characteristics. The following procedure is made to
identify the dynamic characteristics of the various phases.

By differentiating K I K =
`
with respect to I:

1 0
dK
dI
= >
`


Consequently, 0 K >
`
in the region above the isocline 0 K =
`
(since moving to that
region from any point is made by increasing I) and 0 K <
`
in the region below the
isocline 0 K =
`
(since moving to that region from any point is made by decreasing I)
as depicted by the horizontal arrows.


Figure 2: The horizontal forces above and below the isocline 0 K =
`



By differentiating the no-arbitrage rule
( )[ ( )] [ ( , ) ]
( )
K
q C I PF K L q
I
C I
+ + +
=

`
`
with
respect to K and recalling that 0
KK
F < and 0 C > :

( , )
0
( )
KK
PF K L dI
dK C I

= >

`
.

Consequently, 0 I >
`
in the region to the right of the isocline 0 I =
`
(since moving
rightward from any point on the isocline 0 I =
`
is facilitated by a larger K) and 0 I <
`

in the region to the left of the isocline 0 I =
`
(since moving leftward from any point on
the isocline 0 I =
`
is facilitated by a smaller K) as displayed by the vertical arrows.


0 K =
`
K
I
0 K <
`
0
0 K >
`
30

Figure 3: The vertical forces on the right and left hand sides of the isocline 0 I =
`



Figure 4 is constructed by combining Figure 2 and Figure 3. The two isoclines divide
the plane into four phases. The motion in each phase is indicated by the combination
of the horizontal and vertical arrows. As depicted in this phase-plane diagram, there
are only two trajectories leading to steady state. They are called the convergent arms
(or branches) of the stable manifold. All other possible trajectories do not converge to
the steady state. In such a case, the steady state is not asymptotically stable and can be
classified as a saddle point. (See Appendix for mathematical proof.) It can be reached
from any initial level of capital by adjusting the gross investment level so as to
embark on the relevant arm of the stable manifold.


Figure 4: The phase-plane diagram of capital stock and gross investment
0 I >
`
K
I
0 I =
`
0
0 I <
`
0 K =
`
K
I
0 I =
`
SS
0
K
0
I
0
31
Tutorial questions
Suppose that:
2
, 0 C cI c = >
, 0 F aLK a = >
0
( ) P t P =
0
( ) q t q = .
1. Ignoring the curvature condition on the Hamiltonian, prove that the no-arbitrage
rule for this case is


0 0
( )[ 2 ( )]
( )
2
q cI t PaL
I t
c
+ +
=
`
.

2. Show that the steady state levels of K is
0 0
( )
2 ( )
ss
PaL q
I
c


+
=
+


1. Show that the solution to the no-arbitrage rule is

( )
0
( ) ( )
t
ss ss
I t I I I e
+
= + .
32
Lecture 6
(Week 6)

Intertemporal Analysis of Efficient Investment in Production Capital
with Costs of Adjustment (cont.)

5. The steady state capital stock and investment and comparative statics

5.1 The steady state values of K and I
In steady state, 0 I =
`
. By substituting these steady state properties into the no-
arbitrage rule:

( )[ ( )] ( , ) 0
ss K ss
q C I PF K L + + =


That is, the foregone distributed revenue due to investment in an additional unit of
capital (i.e., the marginal opportunity cost of capital investment) is equal to the market
value of the marginal product of capital.

Furthermore, in steady state 0 K =
`
and by substituting this condition into the state
equation:

/
ss ss
K I = .

Thus, the stationary investment level should satisfy the following equality:

( )[ ( )] ( / , ) 0
ss K ss
q C I PF I L + + =
.

This equality might not yield a close form solution for
ss
I . Numerical simulations of
this equation with assumptions about the explicit functional forms of C and F and
values of the model parameters can generate the value of
ss
I .

5.2 Comparative statics: the effects of the model parameters on steady state
The total differentiation of ( )[ ( )] ( / , ) 0
ss K ss
q C I PF I L + + = and the
assumptions about the firms production and costs of adjustment functions gives the
effects of changes in the firms product price, time-preference rate, depreciation rate
and capital purchasing price on the steady-state levels of gross investment and capital
stock. The effect of the planners rate of time preference on the steady-state level of
gross investment is developed in detail. By total differentiation,

[( ) ( ) ( / ) ( / , )] [ ( )] 0
ss KK SS ss ss
C I P F I L dI q C I d + + + =

implying,

[( ) ( ) ( / ) ( / , )] [ ( )]
ss KK SS ss ss
C I P F I L dI q C I d + = +

and, consequently,
33
[ ( )]
0
( ) ( ) ( / ) ( / , )
ss ss
ss KK SS
dI q C I
d C I P F I L
+
= <
+
.

The following effects of the rest of the models parameters on the steady-state level of
gross investment are obtained in a similar manner:

2
{[ ( )] ( / ) ( / , )}
0
( ) ( ) ( / ) ( / , )
ss ss ss KK ss
ss KK SS
dI q C I P I F I L
d C I P F I L


+ +
= <
+


( )
0
( ) ( ) ( / ) ( / , )
ss
ss KK SS
dI
dq C I P F I L


+
= <
+


( / , )
0
( ) ( ) ( / ) ( / , )
ss K ss
ss KK SS
dI F I L
dP C I P F I L

= >
+


As /
ss ss
K I = , then 0
ss
dK
d
< , 0
ss
dK
d
< , 0
ss
dK
dq
< , 0
ss
dK
dP
> .

The effects of these parameters on the steady state can be illustrated by shifts in the
isoclines. Note that while changes in , , q P shift only the isocline 0 I =
`
, a change in
shifts both isoclines.

Specific Appendix: Identification of the local asymptotic stability nature of
steady state of the aforesaid firms optimal control problem
Let us linearise the no-arbitrage rule

( )[ ( ) ( ( ))] [ ( ) ( ( ), ) ( )]
( )
( ( ))
K
q t C I t P t F K t L q t
I t
C I t
+ + +
=

`
`


in the vicinity of steady state under the assumption that 0 C = (i.e., C is a scalar):

1
{[( )/ ][ ( )] ( / ) ( , )}
[( )/ ] ( ) ( / ) ( )
( ) ( / )
ss K ss
ss KK ss
KK
I C q C I P C F K L
C C I I P C F K K
I P C F K b



= + +
+ +
= + +
`


where

1
( )[ / ] ( / )
SS KK ss
b q C I P C F K + + .

Consequently, the linearised no-arbitrage rule

1
( ) ( / )
KK
I I P C F K b = + +
`


and the state-equation:
34

( ) K t I K =
`

constitute a system of first order linear differential equations:

1
( ) ( / )
1 0
KK
P C F b I I
K
K

( + ( ( (
=
(
( ( (

`
`
.

A solution to the homogeneous part of this system is the form:

2 1
t
I
Ae
K

(
=
(



In which case,

2 1
t
I
Ae
K

(
=
(

`
`
.

By substituting into the homogeneous part:

2
{ 0} {( ) 0}
t t
Ae aAe a I A

= =

where

( ) ( / )
1
KK
P C F
a

+ (
=
(

(the state-transition matrix).

A non-trivial solution (i.e., 0 A ) to this equality requires the matrix
2
( ) a I to be
singular. Namely,

2
det( ) 0 a I = .

Consequently,
1
and
2
are the characteristic roots (eigenvalues) of the state-
transition matrix:

2
1,2
2
0.5{ ( ) [ ( )] 4det( )}
0.5{ 4[ ( ) ( / ) ]}
KK
tr a tr a a
P C F

=
= + +


and the general solution of the differential equation system is:

1 2
1 1 2 2
( (
= + +
( (

t ss t t
t ss
I I
c Ae c A e
K K

.
35

Since 0 C > and 0
KK
F < , then
2
4[ ( ) ( / ) ]
KK
P C F + + > and, in turn,
1
0 > and
2
0 < . In which case, the steady state is a saddle point. That is, it is not
locally asymptotic stable, yet there are two converging arms (or branches) in the
vicinity of the steady state. These two converging arms comprise the stable manifold.

The corresponding characteristic vectors can be found, up to an arbitrary constant, by
a consecutive substitution of the characteristic roots into the general solution at 0 t =
and while taking into account the initial condition.

General Appendix: Identification of the local asymptotic stability nature of a
steady state of an infinite horizon optimal control problem
A solution to a general infinite planning horizon optimal control problem with one
state variable and one control variable is a set of two differential equations: one for
the state variable (the state equation, i.e., the motion equation of the stock variable)
and the other for the control variable (the Euler equation). Following a linearization in
the steady state combination, this system can be displayed as

( ) ( ) X t aX t b =
`


where a is a 2x2 J acobian (or state-transition) matrix and b a 2x1 column vector. The
solution to this system is found as follow.

Step 1. In steady state 0 X =
`
and hence
1
ss
X a b

= .

Step 2. Let ( )
t
X t Ae

= be a solution to the homogeneous part is ( ) ( ) 0 X t aX t =

`
.
Then,
0
t t
Ae aAe

=
Hence,
( ) 0
t
a I Ae

=
The non-trivial solution to this equation implies that ( ) a I is a singular matrix and
hence det( ) 0 a I = . Namely,
{ }
11 12 2
11 22 11 22 21 12
21 22
( )
0 ( ) ( ) 0
( )
a a
a a a a a a
a a


= + + =
`

Consequently,
2
1,2
0.5[ ( ) 4det ] tra tra a =

Step 3. The general solution is
1 2
1 2
( )
t t
ss
X t X Ae A e

= + + .

Consequently,
1 2
1 2
lim ( ) lim( )
t t
ss
t t
X t X Ae A e


= + .
Conclusions:
36
If
1 2
, 0 < ,
ss
X is locally asymptotically stable (node).
If
1 2
, 0 > ,
ss
X is not locally asymptotically stable.
If
1 2
0& 0 > < ,
ss
X is a saddle point there exists a singular stable manifold
comprising two convergent branches (arms).
If ( 4det ) 0 tra a < , then
1 2
& are complex (having a real part and an
imaginary part) and the trajectory of X oscillates around
ss
X (focus). The oscillations
are: explosive if 0 tra > (diverging spiral), damped if 0 tra < (converging spiral), or
orbiting if 0 tra = (centre).

Comment: For any exponentially discounted, infinite horizon, one control variable
and one state variable optimal control problem the eigenvalues of the pertinent
J acobian matrix sum to the discount rate. This implies that, as long as the discount
rate is positive, the steady state cannot be locally asymptotically stable. (See Michael
R. Caputo, 2005, Foundations of Dynamic Economics Analysis, chapter 18 for proof
and explanation.)

Tutorial: Discussion of Possible Extensions
1. Credit-financed investment with:
a. a flat interest rate (compatible with Modigliani-Miller Proposition 1 on the
independence of the firms value from its debt-equity structure)
b. an interest rate that rises with the firms leverage (incompatible with
Modigliani-Miller Proposition 1)

2. Uncertainty about revenues and costs and irreversibility of investment: the new
investment theory and the delay option

3. Uncertainty about the firms life-expectancy (duration)


Extension 1.a: Efficient Investment and Borrowing with Adjustment and
Transaction Cost and with Tax Considerations
The firms objective is postulated to be maximizing the sum of the discounted
instantaneous net cash-flows:
1 2
{ , }
0
max {(1 )[ ( ) ( ( ), ) ( ) ( ( )) ( ( )) ( ) ( )]
( ) ( ) ( ) ( )}
t
I B
e P t F K t L w t L C I t C B t r t D t
q t I t D t B t dt

subject to:

( ) ( ) ( ) K t I t K t =
`

( ) ( ) ( ) D t B t D t =
`


where,

( ) B t is borrowing at t,
( ) D t is debt at t,
is a flat time-invariant tax rate,
37
1
C is the adjustment cost function,
2
C is the transaction cost function,
( ) r t is the average contracted instantaneous interest rate, and
is the instantaneous debt-repayment rate.

The necessary conditions for maximum and the singular control equations imply that
the no-arbitrage rules of investment and borrowing are:

1
1
( )[ ( ) (1 ) ( ( ))] [(1 ) ( ) ( ( ), ) ( )]
( )
(1 ) ( ( ))
K
q t C I t P t F K t L q t
I t
C I t

+ + +
=

`
`


2
2
[(1 ) ( ) ] ( )[1 (1 ) ( ( ))]
( )
(1 ) ( ( ))
r t C B t
B t
C B t

+ +
=

`
.

Comment: In this setting where the firms contracted interest rate is flat, the efficient
investment and borrowing trajectories are independent. In contrast, the firms efficient
investment and borrowing trajectories are interdependent if the firms contracted
interest rate rises with the firms current financial leverage (cf. Stiglitz, 1972, 1975;
Levy et al., 1989)
3
:

( ) ( ( )), 0 r t r l t r = >
where
( )
( )
( ) ( )
D t
l t
K t D t

.

Steady state
By setting 0 K =
`
and 0 D =
`
the following steady state levels are obtained:

/
ss ss
K I = (stationary capital stock)

/
ss ss
D B = (stationary debt)

/
/ /
ss ss
ss
ss ss ss ss
D B
l
K D I B

=

(stationary leverage)

where
ss
I and
ss
B are found by setting ( ) 0 I t =
`
and ( ) 0 B t =
`
in the no-arbitrage rules
and assuming that the prices and interest rate are time-invariant.

For example, suppose that:

2
1 1 1
, 0 C c I c = >

3
Stiglitz, J .E. (1972), Some aspects of pure theory and corporate finance: bankruptcy and turnovers
The Bell Journal of Economics 3, pp. 458-483. (See also Reply in Bell vol. 6, 1975, pp. 711-714.)
Levy, A. J ustman, M. and Hochman, E. (1989),The implications of financial cooperation in Israels
semi-ccoperative villages, Journal of Development Economics 30, pp. 24-46.
38
2
2 2 2
, 0 C c B c = >
, 0 F aLK a = >
0
( ) P t P =
0
( ) q t q =
0 t
r r = .
Then (as was shown earlier):
0 0
1
( )
2 ( )
ss
PaL q
I
c


+
=
+
.
By setting ( ) 0 B t =
`
in the borrowings no-arbitrage rule:
0 2
[(1 ) ] ( )[1 2 (1 ) ] 0
ss
r c B + + =

and hence:

0
2
1 {[(1 ) ]/( )}
2 (1 )
ss
r
B
c

+ +
=

.

39
Lecture 7
(Week 8)

Modigliani-Miller Approach to Valuation of Firms, Leverage and
Cost of Capital
(American Economic Review Vol. XLVII, 1958, 261-297)

Suppose that firm j belongs to a homogeneous class k of firms in which the
capitalization (discount) rate is common and equal to a scalar
k
(which also may
reflect the category of risk associated with the uncertain returns on the firms
operation).
Also suppose that firm j is infinitely lived and has a time-invariant expected return,
j
x , on its activity every instance.

If information is perfect and all agents are rational, the price (value) of firm j is given
by:

| |
k
j
k k
k
j
j
t
k
k
j
t
k
j
x
e e
x
x e dt x e p


= = =

) (
1
0
0
0
.

In order to understand the following propositions it is helpful to consider the balance
sheet of the firm.

Firms j Balance Sheet

Assets Liabilities
Assets-in-place
and
growth opportunities
Stocks of Firm j ( )
j
S
Bonds of Firm j ( )
j
D
Value of Firm j (
j
V )



Modigliani-Miller First Proposition: If the market of capital is perfectly
competitive, then
j
k
j
j j j
p
x
D S V = +

.

(This equality is an equilibrium, no-arbitrage, condition.)

This proposition suggests that, as long as the capital market is perfectly competitive,
the value of firm j is not affected by the firms capital-financing method (composition
of equity and debt).

Suppose that the rate of interest on loans is a scalar r. That is, the rate of return on all
bonds is equal to r. In contrast, the (expected) return on stocks (shares) is uncertain.
That is, while bonds are taken to be risk-free stocks are risky. Since stocks are risky
40
assets, their rate of return (i) should compensate rational, risk averse holders for the
cost of risk bearing. Namely,

r i
j
>
for every firm j.


Modigliani-Miller Second Proposition: The (expected) rate of return on firms j
stocks is

j
j
k k j
S
D
r i ) ( + = . ( r
k
> )
That is,
j
i exceeds the capitalization rate
k
by the difference between the
capitalization rate and the interest rate, compounded by the firms leverage.

Proof: By definition,
j
j j
j
S
rD x
i

= . From M-M first proposition (
j j
k
j
D S
x
+ =

),
) (
j j k j
D S x + = . Hence,
( )
( )
k j j j j
j k k
j j
S D rD D
i r
S S

+
= = + .

Comment: M-M second proposition implies that the firm cannot gain from
substituting cheap securities (bonds bearing a certain rate of return r for holders) for
expensive securities (stocks whose expected rate of return is larger than r). As can be
seen from M-M second proposition
j
i rises with the firms leverage (
j j
S D / )
proportionally to ) ( r
k
.

By rearranging terms in M-M second proposition and recalling that
j j j
V D S = + :
( ) ( )
j j j
j k k j j j j k j k j
j j j
j
V
D S D
i r i S S D rD i r
S V V


| | | |

= + = + = + | | ` ` `
| |
) \ . \ . )
)
_
.
Hence,
k
can also be interpreted as the Weighted Average Cost of Capital (WACC).



Tutorial questions
Suppose that the current interest rate is 0.06 per annum, the current market values of
the bonds and stocks of firm A are $ 40,000,000 and $ 60,000,000, respectively, and
the expected rate of return on firm As stocks is 0.10 per annum.

1. Compute firm As leverage.
2. Compute firm As WACC.
3. Are the M-M propositions 1 and 2 valid when the market of credit is not perfectly
competitive? Can the firms leverage affect the firms value?


41
Houses Values and Prices and the Cobeweb Phenomenon

Value of a House
Houses constitute a major part of most individuals portfolios. The value of a house is
the sum of its discounted net returns over its remaining life expectancy (0,T):

0
[Re ]
T
rt
t t t
V e nt Capital Gains Depreciaion dt

= +

.

As in Modigliani-Millers (1958) formulation of the firm price, let us assume that the
house is infinitely lived and that the discounting (interest) rate and the annual rent,
capital gains, and depreciation of the house are time-invariant (fixed), the value of the
house is given by:


0
(Re )
Re
rt
V e nt Capital Gains Depreciaion dt
nt Capital Gains Depreciation
r

= +
+
=

Example: Consider a house whose full-tenancy rent is estimated to be $ 600 per week
(i.e., $ 31,200 per annum), capital gain is estimated to be $ 35,000 per annum and
depreciation (or maintenance cost) is estimated to be $ 20,000 per annum. The annual
interest rate is 0.06. The present value of this house is:

000 , 770
06 . 0
000 , 20 000 , 35 200 , 31
=
+
= V dollars.

If the market of houses is efficient, the price of a house should be equal to V.


Market Price of a House under Perfect Foresight
Let the market of houses be perfectly competitive and agents be endowed with perfect
foresight.

Demand:
0 1 2 3 4
d
t t t t t t t
Q a a LOC a POP a Y a i P = + + + +

where, t is a time index, LOC is an index of how thought after (reputable) is the
location (due to physical, environmental, social and commercial characteristics of the
neighbourhood), POP denotes population, Y aggregate income, i interest rate, P price
and random disturbance, and where all the parameters are positive scalars.

Supply:
0 1
s
t t t t
Q b b w P = + +

where, w is an aggregate index of construction-input price, is a random disturbance
and the parameters are all positive.

42
The equilibrium condition is:

0 1 2 3 4 0 1 t t t t t t t t t
a a LOC a POP a Y a i P b b w P + + + + = + +

implying that the market price of a house is given by:

* 0 0 1 2 3 1 4
( ) [ ]
t t t t t t t
t
a b a LOC a POP a Y b w a i
P


+ + + + +
=
+
.


Market Price of a House under Nave Expectation: A Cobweb Phenomenon
There is usually a lag between listing a house for sale and actual sale. Vendors listing
their houses for sale have expectations about the price of houses. Suppose that the
vendors price expectations are nave:

1
exp

=
t
t
P P .

That is, vendors expect the sale price to be equal to the price observed at the time of
listing their properties for sale.

In this case, the supply schedule is given by:

t t t
t
s
P w b b Q + + =
1 1 0
.

The equilibrium condition is:

t t t t t t t t t
P w b b P i a Y a POP a LOC a a + + = + + + +
1 1 0 4 3 2 1 0


or, equivalently,


| | ] [ ) (
1
4 1 3 2 1 0 0 1 t t t t t t t t t
i a w b Y a POP a LOC a b a P P

+ + + + +
|
.
|

\
|
=
|
.
|

\
|
+

.


This first-order linear difference equation can be solved for the case where all
variables, except price, are time invariant:

| | ] [ ) (
1
4 1 3 2 1 0 0 1

+ + + + +
|
.
|

\
|
=
|
.
|

\
|
+

i a w b Y a POP a LOC a b a P P
t t
.

In this case, the stationary (long-run) price of a house is given by:



+
+ + + + +
=
) ( ) (
4 1 3 2 1 0 0
i a w b Y a POP a LOC a b a
P
ss
.
The deviation of the market price from the stationary level is given by

43
t
ss ss t
P P P P
|
.
|

\
|
=

) (
0
.
which displays damped oscillations when < (i.e., when the supply curve is
steeper than the demand curve), explosive oscillations when > (i.e., when the
demand curve is steeper than the supply curve), and constant oscillations when =
(i.e., when the demand curve is as steep as the supply curve). The following figures
display the possibilities of damped and explosive price fluctuations for a market that
used to be in equilibrium, but following a hike in the interest rate (represented by a
downward shift of the demand curve) is not in equilibrium due to the vendors nave
(sticky rather than perfect, or rational) price expectations.



Explosive oscillations ( > ) following a hike in the interest rate (
1 0
i i > )




Damped oscillations ( < ) following a hike in the interest rate (
1 0
i i > )

flate
S
1
( )
steep
D i
Q
P
0
( )
steep
D i
0
Q
0
P
steep
S
1
( )
flate
D i
Q
P
0
( )
flate
D i
44
Lecture 8
(Week 9)


Risk, Expected Utility and Optimal Insurance

Von Neuman-Morgenstern utility function: When facing uncertainty (e.g., about
income) a rational consumer maximizes expected utility (e.g., from income). Let u be
the consumers utility, then E(u) is the consumers expected utility (or the Von
Neuman-Morgenstern utility.

Suppose that:

1. the consumer derives utility from x [i.e., ) (x u ],
2. x is random variable (e.g., income and hence consumption level),
3. there can be S mutually exclusive realizations of x (depending on the state of his
worldcombination of circumstances such as weather, political crisis, employment,
personal health ), each with a probability 1 0 < <
s
p , 1
1
=
=
S
s
s
p .
In this case, the expected utility (Von Neuman-Morgenstern utility) of the consumer
is given by:

1
( )
S
s s
s
Eu p u x
=
=

.

(The Savage theorem provides an extension to this expected utility theorem.) As long
as ) (x u concave, the consumer expected utility is lower than her/his utility from the
expected value of x (i.e., a risk averse prefers having the expected value of a gamble
to taking the gamble). For illustration, consider the case where there are only two
mutually exclusive states of the world (S=2):

=
p x
p x
x
1
2
1


In this case,

) ( ) 1 ( ) ( )) ( (
2 1
x u p x pu x u E + =

and

) ) 1 ( ( )) ( (
2 1
x p px u x E u + =
45

x1 x2 E(x)
u(E(x))
E(u(x))
u


The more concave the utility curve the larger the difference between )) ( ( x E u and
)) ( ( x u E . A measure of the concavity of the utility curve is the Arrow-Pratt degree of
absolute risk aversion: ) ( / ) ( x u x u . Note that, by itself, u is not a good measure
of the concavity of the utility curve. The reason is that any affine transformation of u
is also represents the utility of the consumer. Thus, if, for instance, u is multiplied by
2, also u is multiplied by 2. But deflated by u , the concavity of the curve is
unchanged. Thus, the measure proposed by Arrow and Pratt is a standardized one. It
is positive for a risk-averse and negative for a risk-lover.

Optimal Insurance (Coverage) Level
Let the value of a property, W, be a random variable due to uncertainty of the state of
the world and assume for simplicity that there are only two mutually exclusive states
of world heavy storm with a probability p, or calm weather with a probability 1-p.
In the event of a heavy storm, the property damage/loss is L dollars. Let be the
insurance premium rate and q the level of insurance. The distribution of the property
owner wealth is given by:

+
=
p q W
p q L W
W
1
) 1 (
0
0

The property owners optimal level of insurance is found by:

) ( ) 1 ( ) ) 1 ( ( max )) ( ( max
0 0
q W u p q L W pu W u E
q q
+ +

The necessary condition for maximum expected utility is:

} 0 ) ( ) 1 ( ) ) 1 ( ( ) 1 ( { } 0
)) ( (
{
0 0
= + = q W u p q L W u p
dq
W u dE


46
) 1 (
) 1 (
*) (
*) ) 1 ( (
0
0

=

+
p
p
q W u
q L W u
.

To facilitate a close-form solution, let

W u = with 1 0 < < , then:

*] ) 1 ( [
) 1 (
) 1 (
*
0
1
1
0
q L W
p
p
q W

+
(

=

.

Subsequently, the property owners demand for insurance is given by:

+
(

) 1 (
) 1 (
) 1 (
) (
) 1 (
) 1 (
*
1
1
0
1
1
0
p
p
L W
p
p
W
q .

Supply Side and the Actuarially Fair Premium Rate
Considering the supply side, note that the profit of an insurance company is random:

=
p q
p q
1
) 1 (

If the competition in the insurance market is strong, the expected profit can be driven
to zero:
)} 1 ( ) 1 {( } 0 ) 1 ( ) 1 {( = = p p q p q p
which implies:
p = .
That is, the actuarially fair premium rate is equal to the probability of the property
being damaged. Substituting this rate into the insurance demand function:

L
p p
p p
p p
L W
p p
p p
W
q =
+
(

) 1 (
) 1 (
) 1 (
) (
) 1 (
) 1 (
*
1
1
0
1
1
0

.

When the actuarially premium rate is fair, a policy with full coverage is sought and
contracted.

Appendix
Let us now consider instead the polar case where the insurance industry is a monopoly
or stable cartel. For simplicity, let us assume that this monopoly is profit oriented and
risk neutral. In which case, it sets the insurance premium rate so as to maximize its
expected profit, while taking into account the adverse effect of the insurance premium
rate on the aggregate demand for insurance:
47
*
1
( ) ( )
N
D
i
i
Q q
=
=

where N is the number of clients. The monopoly expected profit is:
* * *
1 1 1
( ) (1 ) ( ) (1 ) ( ) ( ) ( )
N N N
m
i i i
i i i
E p q p q p q
= = =
= =


The premium rate that maximizes the monopoly expected profit should satisfy the
following necessary condition:
*
*
1 1
( ) ( )
( ) ( ) 0
m m N N
m m i
i
i i
dq dE
q p
d d

= =

= + =

.
To simplify matters even further, let us consider the case where the clients are
identical. In this case,
* *
1,2,3,...,
i
q q i N = = and the necessary condition is:
*
*
( )
( ) ( ) 0
m
m m
dq
Nq p N
d

+ =
or, alternatively:
*
*
( )
( ) ( ) 0
m
m m
dq
q p
d

+ = .
Recalling that
1
1
0 0
1
1
(1 )
( )
(1 )
*
(1 )
(1 )
(1 )
m
m
m
m m
m
p
W W L
p
q
p
p

(

=
(

+
(

(



m
and its comparative static properties can be found by numerical simulations.

Moral Hazard: This term reserved to the case where the probability of the bad event
(e.g., fire, accident, break in, hospitalisation) is affected by ones negligence (or free-
riding), which eventually raises the premium rate to all. This can be eliminated by
monitoring the individuals behaviour by the insurer.

Tutorial questions
J ohn derives utility from the market value (W) of his prime asset - a bungalow in
Paradise Beach - separately from his other utility-generating assets. His utility from
the market value of the bungalow is given by:
u W = .
J ohn assesses the value of the market to be 1,000,000 dollars. Alas, the bungalow is
threatened by the Haloa Tsunami. It is common knowledge that the Haloa Tsunami
hits Paradise Beach at random once in fifty years and inflicts total property loss. J ohn
is aware of that risk.
1. Calculate J ohns expected-utility maximising annual level of insurance when:
1a. The per annum premium rate is 0.05.
1b. The per annum premium rate is 0.02.
2. Can the premium rate be 0.015?
48
Lecture 9
(Week 10)

Uncertainty, Risky Assets (Activities) and Portfolio Choice

1. Basic Concepts

1.1 Portfolio
A portfolio is the composition of ones wealth. If there are N assets in ones world,
ones portfolio is:

1 2 3
( , , ,..., )
N
P A A A A =

where


1 2 3
1
... 1
N
N i
i
A A A A A
=
+ + + + = =

and

0 1
i
A is the fraction of ones wealth held in asset i.

1.2 Rate of return on asset i
The rate of return on asset i in period t is given by:

1
1
it it it
it
it
P P d
r
P

+
=
where
it
P is the price of asset i at the end of period t , and
it
d is dividend on asset i received by the owner (holder) during period t.

At the beginning of period t the price of asset i at the end of the period and the
dividend on asset i during the period are unknown. Hence, at the beginning of period t
the rate of return on asset i in period t (
it
r ) is random and asset i is risky. The expected
rate of return on asset i is:

( )
i i
E r .

The variance of the rate of return on asset i is:

2 2
var( ) ( )
i i i i
r E r = .

The covariances of the rate of return on asset i and the rate of return on any other asset
j is:

cov( , ) ( )( )
ij i j i i j j
r r E r r = .
49
1.3 Rate of return on a portfolio (
p
r )
In view of the definition of portfolio, the rate of return on a portfolio is a weighted
average of the rates of return on the various assets with the weights being equal to the
fractions of ones wealth held in these assets:

1 1 2 2 3 3
1
...
N
p N N i i
i
r Ar A r A r A r Ar
=
= + + + + =

Since the rates of return on the various assets are random,
p
r is random. The expected
rate of return on the portfolio is:

1 1 2 2 3 3
1 1 2 2 3 3
1
( ) ( ... )
( ) ( ) ( ) ... ( )
.
p p N N
N N
N
i i
i
E r E Ar A r A r A r
AE r A E r A E r A E r
A

=
= + + + +
= + + + +
=

The variance of
p
r is:

( )
2
1 1 2 2 3 3
2 2
1 1
var( ) var ...
.
p p N N
N N N
i i i j ij
i i j i
r Ar A r A r A r
A A A

= =
= + + + +
= +




2. Efficient Portfolios: Mean-Variance Approaches
Rational investors acquire information about assets (e.g., past performance and
market development and trend) for assessing the distribution of their rates of return. If
the distributions of the rates of return on all the assets are believed to be normal, it is
sufficient to consider the perceived means, variances and covariances of the rates of
return on the various assets for constructing efficient portfolios. This is known as the
mean-variance approach. Otherwise, efficiency can be gained by considering higher
moments of the joint distribution of the rates of return on the assets. Yitzhaki and
Shalit (Journal of Finance, 1984) proposed a Mean-Gini approach, as the Gini is a
distribution-free measure of disperssion.

2.1 The Markowitz Efficient Portfolio Set
Harry Markowitz (1952) has viewed the expected rate of return on a portfolio as the
benefits from holding the portfolio and the variance (hence the standard deviation) of
the rate of return on the portfolio as a measure of the level of the risk associated with
holding the portfolio. Therefore, he has argued:

a. that the combination (
1 2 3
, , ,...,
N
A A A A ) that minimizes the variance of the rate
of return on the portfolio for a predetermined expected rate of return on the
50
portfolio is an efficient portfolio (i.e.,
2
{ }
min
i
p
A
subject to
1
N
i i p
i
A
=
=

and
1
1
N
i
i
A
=
=

); and

b. that the set of all possible efficient portfolios can be found by repeating the
above procedure for every predetermined expected rate of return on a portfolio
and this set of efficient portfolios displays a trade-off between expected rate of
return and risk.



Fig. 1: The Markowitz curve

Investors with high degree of aversion toward risk would prefer portfolios on the
lower section of the Markowitz curve.

The Markowitzs approach can be displayed as a quadratic programming problem:

1
2 2
( ,..., )
1 1
min ( )
N
N N N
i i i j ij
A A
i i j i
A A A
= =
+



subject to:
1
N
i i p
i
A
=
=

1
1
N
i
i
A
=
=

.

The Lagrange function associated with this problem is:

p

0
The Markowitz
set of efficient
portfolios
-
-
Unattainable portfolio
Inefficient portfolio
-
51
2 2
1 2
1 1 1 1
( ) (1 )
= = = =
= + + +

N N N N N
i i i j ij p i i i
i i j i i i
A A A A A L .

Since the Lagrange function is convex in
1
( ,..., )
N
A A ,
4
the second order conditions for
minimum are satisfied and the efficient portfolio
* *
1
( ,..., )
N
A A is obtained by solving
the following set of 2 N + first order conditions:

2 * *
1 2
2 2 0 1,...,

= + = =

N
i i ij j i
j i
i
A A i N
A

L


*
1
1
0
=

= =

N
p i i
i
A

L


*
1
2
1 0
=

= =

N
i
i
A

L
.

From the solution of this set of first order conditions, the fraction of wealth that is
efficiently held in the form of asset i is some function of the model parameters:

*
1
( ,..., ,{ }, )
i i N ij p
A f = .

The first-order conditions imply that for every pair of assets k and l:


2 * * 2 * *
1 1
2 2 2 2
N N
k k kj j k l l lj j l
j k j l
A A A A

+ = +



or, equivalently:

2 * * 2 * *
1 1
(2/ )[ ] (2/ )[ ]
N N
k k k kj j l l l lj j
j k j l
A A A A

+ = +

.
That is, for any two assets included in a Markowitz efficient portfolio there should be
equality between the expected rates of return net of the marginal contributions to the
portfolios risk level.


4
Note that
2 2
1 1
'
N N N
i i i j ij
i i j i
A A A A A
= =
+ =

, where A is an 1 N column vector of the wealth
fractions held in the N assets and is an N N variance-covariance matrix of the rates of return on
the N assets and hence positive semi-definite. Therefore,
2 2
1 1
N N N
i i i j ij
i i j i
A A A
= =
+

is convex in
1
,...,
N
A A . Being a linear combination of a convex and a linear functions of
1
,...,
N
A A , L is convex
in
1
,...,
N
A A .
52
2.2 Tobins Capital Market Line (CML)
J ames Tobin (1958) suggested the existence of a risk-free asset. Denoting by
f
r the
rate of return on this risk-free asset, he has argued that the set of efficient portfolio is
given by a line in the
p p
plane with an intercept
f
r and that is tangent to the
Markowitz curve as displayed in the Figure 2. He called this line the capital market
line (CML). Investors with high degree of aversion toward risk would prefer
portfolios on the lower section of the CML.

53

Fig. 2: The capital market line

The tangency point between the CML and the Markowitz curve can be interpreted as
the market portfolio of risky assets. Its associated combination of risk and expected
rate of return is ( , )
m m
. The CML formula is:

m f
p f p
m
r
r

| |
= +
|
\ .
.

The term
m f
m
r

| |
|
\ .
can be interpreted as the market price of risk.

Tutorial: Construction of the CML
The CML can be analytically constructed by noting that any efficient portfolio
(represented by a point on the CML) is a linear combination of the risk-free asset and
the market portfolio. Let A denote the fraction invested in the risk-free asset and 1-A
the fraction invested in the market portfolio, then the expected rate of return on an
efficient portfolio is given by:

(1 )
p f m
Ar A = +

and the standard deviation of the rate of return on an efficient portfolio is given by:

(1 )
p m
A = .

Since,
p

0
Markowitz curve
CML
f
r
m

The market
portfolio
54
{ (1 ) } { }
p m
p f m
f m
Ar A A
r

= + =

and { (1 ) } { }
m p
p m
m
A A

= =
then

p m m p
f m m
r



=

.

By rearranging terms:
( )
m p m f
p m f m f m p
m m
r
r r



| |
= = +
|
\ .
.
Consequently, the CML formula is:

m f
p f p
m
r
r

| |
= +
|
\ .
.


3. William Sharpes Capital Asset Pricing Model (CAPM)
Let
i
denote the risk associated with a unit of risky asset i relative to the risk
associated with a unit of investment in the market portfolio of risky asset. That is,

i i m
/ = .

The market of assets is assumed to be in equilibrium. In which case, the risk adjusted
rate of return should be the same for all assets. The expected rate of return on any
risky asset i should be equal to the rate of return on the risk-free asset plus an
adequate compensation (premium) for bearing the risk associated with holding this
risky asset (
m i i
= ). Recalling that the market price for risk is
m f m
r / ) ( , the
compensation for bearing the risk of holding a unit of asset i should be:

) (
f m i
m
f m
m i
r
r
=
|
|
.
|

\
|

Thus, if the market of assets is in equilibrium, the expected rate of return on every
asset i is:

) (
f m i f i
r r + = .

This equality is the capital asset pricing model (CAPM). The CAPM suggests that the
expected rate of return on the entire market of risky assets positively affects the
expected rate of return on asset i and it does so proportionally to the relative risk
embedded in holding asset i.

Having time-series observations on the rates of return on risky asset i and on the
market portfolio, the relative risk associated with holding asset i can be estimated by
regressing the rate of return on asset i onto the rate of return on the market portfolio.
Using, for example, ordinary least squares (OLS) estimation method:
55

) var(
) , cov(

f m
f m i
i
r r
r r r

= .
56
Lecture 10
(Week 11)

Uncertainty, Risky Assets (Activities) and Portfolio Choice (cont.)


4. Expected Utility Maximizing Approach to Portfolio Choice
Economic theory suggests that a rational individual facing uncertainty makes a choice
that maximizes her/his expected utility. The following analysis applies this approach
to the choice of portfolio.

Postulate 1: The portfolio holder derives utility (u) from the rate of return on her/his
portfolio (
p
r ) and in view of the uncertainty about
p
r makes her/his portfolio choice
so as to maximize her/his expected utility subject to the wealth constraint. That is,


1
,...,
max [ ( )]
N
p
A A
E u r

subject to:

1
1
N
i
i
A
=
=

.


Postulate 2: The marginal utility from the rate of return on the portfolio is positive but
diminishing. That is,

0 >

p
r
u
and 0
2
2
<

p
r
u
.

Postulate 3: The individual utility from her/his rate of return is given by the following
negative exponential function

p
Rr
e u

=1


where u u R = / indicates her/his degree of absolute risk aversion. (The more
concave the utility function, the greater the premium that one is willing to pay for
avoiding risk.)


57


Figure: The negative exponential utility function

In view of Postulate 3:

( ) (1 ) 1 1 ( )
p p
Rr Rr
p p
Eu r E e Ee mgf r R

= = =


where ( )
p
mgf r R is the moment generating function of the random variable
p
r
assessed at R.

Assumption: The rate of return on every asset is normally distributed [i.e.,
2
( , ) 1,..., = ~
i i i
r i N N ].

Recalling that
1
N
p i i
i
r Ar
=
=

, this assumption implies:

2
( , ) ~
p p p
r N

The moment generating function of the normally distributed
p
r is:

2 2 2
( ) exp{ 0.5 (0.5 ) } exp{ 0.5 ( 0.5 )}
p p p p p
mgf r R R R R R = + = .

Consequently,

1 1
2
,..., ,...,
{max [ ( )]} {max( 0.5 )}
N N
p p p
A A A A
E u r R .
p
r
u
1
0
58
Recalling that
1
N
p i i
i
A
=
=

and
2 2 2
1 1
N N N
p i i i j ij
i i j i
A A A
= =
= +

, then the investor
decision problem can be displayed as:

1
2 2
,...,
1 1 1
max{ 0.5 [ ]}
N
N N N N
i i i i i j ij
A A
i i i j i
A R A A A
= = =
+



subject to:

1
1
N
i
i
A
=
=

.

The Lagrange function associated with this maximization problem is:
2 2
1 1 1 1
0.5 [ ] (1 )
= = = =
= + +

N N N N N
i i i i i j ij i
i i i j i i
A R A A A A L

where the Lagrange multiplier can be interpreted as the shadow value of wealth.

Recalling that the variance of
p
r is a quadratic form in
1
,...,
N
A A that is based on a
positive semi definite variance-covariance matrix
ij
(

,
2 2
1 1
N N N
i i i j ij
i i j i
A A A
= =
+

is
convex in
1
,...,
N
A A . Consequently, L is concave in
1
,...,
N
A A and the N+1 necessary
conditions:


* 2 * *
( ) 0 1,...,

= + = =

N
i i i j ij
j i
i
R A A i N
A

L


*
1
1 0
=

= =

N
i
i
A

L


lead to an interior solution:

*
1
( ,..., , , ) 1,...,
i i N ij
A f R i N = =


*
1
( ,..., , , )
N ij
g R = .

The necessary conditions imply equality between the risk-adjusted expected rates of
return on assets included in the portfolio. That is,

* 2 * * 2 *
( ) ( )
N N
k k k j kj l l l j lj
j k j l
R A A R A A

+ = +


59

for every pair of assets k and l. The second term on each side of this equality
represents the extra cost of risk bearing for the investor resulting from a slight rise in
the share of the wealth held by assets k and l, respectively. These extra costs of risk
bearing are equal to the asset marginal contribution to the variance of
p
r
compounded by the portfolio holders degree of absolute risk aversion.


Claim (N=2): If all assets are risky and the number of assets is qual to two, and if
2 2
1 2 12
2 0 + > , there exists an interior solution:

2
* 1 2 2 12
1 2 2
1 2 12
[( )/ ]
2
R
A


+
=
+
.


Proof: In such a case the investors decision problem is:

1
2 2 2 2
1 1 1 2 1 1 1 2 1 1 12
max{ (1 ) 0.5 [ (1 ) 2 (1 ) ]}
A
A A R A A A A + + +

The first order condition for maximum is:

2 2 * 2
1 2 1 2 12 1 2 12
[( 2 ) ] 0 R A + + =

The second order condition for maximum is:

2 2
1 2 12
( 2 ) 0 R + <

Consequently, if
2 2
1 2 12
2 0 + > , there exists an interior solution:

2
* 1 2 2 12
1 2 2
1 2 12
[( )/ ]
2
R
A


+
=
+
.

Tutorial
Use the expected utility approach to construct the optimal portfolio under the
assumption that
2 2
1 2 1 2 12
0.05, 0.1, 0.1, 0.15, 0.25, 1 R = = = = = = .
60
Exercise 2
To be handed at the beginning of the lecture at the beginning of week 12 lecture

The expected rate of return is 0.05 on asset 1 and 0.10 on asset 2 during the coming
year. The variance of the rate of return is 0.20 on asset 1 and 0.30 on asset 2 and the
covariance of their rates of return is -0.05 for the same year.

1. What will be the portfolio of an expected utility maximizing person who has such
expectations, preferences on rate of return that can be displayed by a negative
exponential utility function, and degree of absolute risk aversion equal to 1?

2. How will her/his portfolio change if her/his degree of absolute risk aversion has
doubled?

3. Suppose now that asset 1 is risk free with rate of return 0.05. All other things are as
in 1. What will be the portfolio?
61
Lecture 11
(Week 12)

FINANCIAL CRISES


Evolution of a Firms Debt Burden
The evolution of the firms debt (D) can be compactly displayed by the following
motion equation:

t t t t
D r D =
`


where
t
is the firms profit at t and
t
r is the interest rate on the firms liabilities at t .

A possible measure of the firms debt burden (d) is its debt-profit ratio:

t
t
t
D
d

= .

By differentiation with respect to time, the evolution of the firms debt burden is
expressed as:

2
t t t t t t t t t
t t
t t t t t t
D D D D D
d d

= = =
` ` `
` ` `
`


Consequently, the rate of change of the firms debt burden is given by:

( / )
t t t t t
t t t t t t t
d D D
d D D


= =
` ` `
` `


In recalling the first equation describing the evolution of the firms debt,

t t t t t
t t t
d r D
d D

=
`
`


and by rearranging terms:

t t t
t
t t t
d
r
d D

(
= +
(

`
`


Additional insight can be gained by considering that:

( ; )
t t t t t
p y C y w =
,


where
t
y is the firms output,
t
p its product-price and
t
w
,
its input-price vector at t.




62
Developing Countries External Sovereign Debts:

Structure
Causes and Evolution
Implication for Exchange Rate Policy
External Debt and Economic Growth
Debt Laffer Curve and Discount
Repudiation and Debts Secondary Market Price



Structure
Public and Publicly Guaranteed vs. Private
Commercial Creditors vs. Non-Profit International Crediting Institutions
Short Term vs. Long Term


Causes and Evolution

Collapse of market price system and inefficient allocation: During the 1950s and
1960s there were expectations that the prices of exported primary goods would
decline. Hence, tariff protected industrialization was recommended and pursued. It led
to an erosion of the role of the market prices in conveying proper signals for
producers and consumers and in turn to inefficient allocation of inputs.

Bad and populist economic management: Subsidies on goods consumed by pressure
groups (e.g., voters in the major cities) contributed further to the distortion of the
internal price system and hence to inefficiency in the allocation of inputs.

Initially cheap credit: The large increase in the oil revenues (petrodollars) led to a
rise in some major commercial banks reserves during the early and mid 1970s.
Developing countries were encouraged to take large loans in initially low, but
variable, interest rate.

Rising interest rate: The two oil crisis (1973/4 and 1978/9) and the grain crisis led to
a hike in the inflation (two digit inflation by the end of the decade) and, due to
contracted variable interest rate, to a rise in the cost of servicing the external debt.

The 1985/6 oil glut: Some heavily indebted oil-exporting developing countries such
as Mexico and Nigeria saw a decline in their oil revenues due to the 1985/6 glut that
led to a fall in the price of crude oil from about USD 32 to USD 10 per barrel and
hence experienced difficulties in servicing their external liabilities.






63
The David Howards Model of the Evolution a Countrys External Debt Burden
The absolute level of a countrys external liabilities (D) increases with the
accumulated periodical interest (rD) and decreases with the countrys trade balance
(TB):

t t t t
D r D TB =
`
(1)

A measure of the external debt burden (d) is the debt-GNP ratio:

t
t
t
D
d
Y
= . (2)

The change in the external debt burden is given by differentiating (2) with respect to
time:

2
/
t t t t t t t
t t
t t t t
D DY Y D D Y
d t d
Y Y Y Y
| |
= = =
|
\ .
` ` ` `
`
(3)

The rate of change of the countys external debt burden is obtained by dividing both
sides of (3) by d:

( / )
t t t t t
t t t t t t t
d D Y D Y
d Y D Y Y D Y
= =
` ` ` ` `
. (4)

Substituting (5.1) into (5.4):

t t t t t
t t t
d r D TB Y
d D Y

=
` `
(5)

Consequently,

t t t
t
t t t
d Y TB
r
d Y D
(
= +
(

` `
. (6)



Tutorial question
Consider a country with a stagnant economy, 40 billion dollars external debt, and a 2
billion dollar current account deficit per annum. The current interest rate on the
countrys external liability is 10 percent per annum. What is the current rate of change
in the countrys external debt burden?





64
Implication for Exchange Rate Policy

( / ) ( / , ) ( / , )
for dom for dom for dom
t t t t t t t t t t t t
TB EX e P P IM e P P Y TB e P P Y = = (7)

where,

e is the domestic currency nominal exchange rate (the domestic price of the foreign
exchange),
dom
P is the domestic price level,
for
P is the foreign price level, and
0
( / )
for dom
t t
TB
eP P

>

and 0
TB
Y

<

.

Hence,

( / , )
for dom
t t t t t
t
t t t
d Y TB eP P Y
r
d Y D
(
= +
(

` `
. (8)

The sterility of devaluation (Rudiger Dornbusch): If a significant portion of the
countrys external debt is public and publicly guaranteed and the tax system is mull-
functioning, a devaluation of the local currency cannot improve the countrys balance
of payment and reduce the external debt burden.

A devaluation of the domestic currency (e ) increases the government costs of
servicing its external liabilities in domestic currency. Since the tax system is mull-
functioning, the government resolves to printing domestic currency in a higher rate
than before the devaluation for purchasing the external currency required for servicing
its external liabilities. A higher rate of money supply increases the domestic price
level (
dom
P ), which diminishes the improving effect of the devaluation on the real
exchange rate and, in turn, the countrys trade balance and external debt burden:

for
t
dom
t
e P
P

65
External Debt Burden and Economic Growth

Determinants/Sources of Economic Growth
Suppose that the aggregate output at period t is given by an aggregate production
function:

( , )
t t t t
Y AF K L =

where,

0
t
A > is a technology shift parameter,
t
K is the aggregate capital stock,
t
L is the aggregate labour force,
0, 0
K L
F F
F F
K L

> >

and
2 2
2 2
0, 0
KK LL
F F
F F
K L

< <

.

By differentiating with respect to time:

( , ) ( , ) ( , )
K L
Y AF K L AF K L K AF K L L = + +
` ` ` `


The growth rate of this economy is obtained by dividing both sides by ( ) Y t :

( , ) ( , ) ( , )
K L
Y AF K L AF K L K AF K L L = + +
` ` ` `


( , )/ ( , ) ( , ) / ( , ) ( , ) / ( , )
K L
Y
AF K L AF K L AF K L K AF K L AF K L L AF K L
Y
= + +
`
` ` `


Consequently,

[ / ] [ ( , )/ ( , )] [ ( , )/ ( , )]
K L
Y
A A F K L F K L K F K L F K L L
Y
= + +
`
` ` `


Recalling that production elasticities with respect to capital and labour are defined as:

( , )[ / ( , )]
K K
F K L K F K L

( , )[ / ( , )]
L L
F K L L F K L

then the growth rate of this economy can be expressed as:

( ) ( )
t t t t
K L
t t t t
Y A K L
t t
Y A K L
= + +
` ` ` `
.

66


The substitution of this growth formula into equation (8) implies:

( / , )
( ) ( )
for dom
t t t t t t t
t K L
t t t t t
d A K L TB eP P Y
r t t
d A K L D

(
= + + +
(

` ` ` `


Paul Krugman (1988) stressed that accumulation of public and publicly guaranteed
external debt have led to expectations for increasing tax, which intensified capital
flight and discouraged repatriation of capital flight and investment in new
technologies.

In some countries, sub Sahara African ones in particular, the HIV-AIDS, malaria and
other epidemics, as well as natural catastrophes and civil wars, have shrunk the labour
force and its technology absorptive capacity.

67
Lecture 12
(Week 13)

The Debt Laffer Curve (DLC) and Discount
Being inspired by Laffers hypothesis of an inverted U-shaped relationship between
tax payment and the tax rate, Paul Krugman (1988) suggested an inverted U-shaped
relationship between a countrys expected external debt repayment (EDR) and the
book-value of its external debt (D). The underlying rationale is that in the case of
many developing countries a large portion of the external debt is public and publicly
guaranteed. A sovereign state is unlikely to be declared bankrupt and its domestic
assets are unlikely to be liquidized when it fails to service its external liabilities. If
such an inverted U-shaped relationship between EDR and D exists and the indebted
country is on the negatively sloped section of the debt Laffer curve, it is also in the
interest of the creditor to write off part of the debt and give a debt relief of, say,
*
0
D D .


While Krugmans argument lends support for a debt relief Bullow and Rogoff (JEP
4.1, 1990) argue against giving a prise to governments that badly manage their
countries and economies.

Formal construction of the DLC: Consider the case where the entire external debt is
either repudiated or repaid and where the probability of (total) repudiation rises with
the sovereigns external debt level:

0 ( ) 1 p D < < with 0 p > and 0 p > .

In this case, the expected debt repayment is given by a quadratic form concave in D:

[1 ( )] ( ) EDR p D D D p D D = =

depicted by an inverted parabolathe debt Laffer curve. EDR peaks at
*
D . That is,
*
D is found by solving the equation obtained from setting the first derivative of EDR
to be equal to zero:

* * *
1 ( ) ( ) 0 p D D p D = .
D
EDR
0
D
*
D
68
Repudiation and Debts Secondary Market Price
Sovereign debt might be partially, or fully repudiated (e.g., Mexico 1982, Brazil
1985). A simple illustration is given by the following binomial distribution of a
countrys debt repayment.

1
(1 )
D p
DR
D p

=

where,

0 1 p < < is the probability of repudiation, and
0 1 < is the rate of repudiation.

Consequently, the expected debt repayment is

( ) (1 ) (1 ) (1 ) E DR p D p D p D = + = .

In which case, we may expect that price of recycling the countrys external debt in the
secondary market will be:

( ) (1 )
1
SM
E DR p D
P p
D D

= = = .



Tutorial question
The external debt of country A is 200 billion dollars. Agents in the secondary market
believe that there is a probability of 0.5 that country A will repudiate half of its
external liabilities. What is the highest price that they would be will to pay for a one
dollar external bond issued by country A?


Appendix: Gross National Product, Debt Burden, Probability of Default and the
Debt Laffer Curve
It has been argued by Krugman (1988) that a countrys financial liabilities act like a
high marginal tax rate which deters government from taking painful measures to
improve the countrys economic performance and discourage capital formation. Thus
when an indebted country is on the downwardly sloping side of the debt Laffer curve,
both the debtor and creditor can benefit from a debt-reduction. Following Levy
(Economic Analyses of Financial Crises, 1995), let us construct a debt Laffer curve
for the case where: 1. the debt burden affects the probability of repudiation, and 2. the
annual debt repayment affects the countrys gross national product.

Assumption 1: The indebted countrys probability of default (0 1 p < < ):

1. rises with the burden of servicing its (public and publicly guaranteed) external
debt, which is measured by the ratio of the annual debt repayment (M) to the
countrys gross national product (Y), due to public aversion to tax increase
and subsidy cuts; and
69
2. decreases with the creditors ability to retaliate by limiting the countrys
access to the international credit market, which is proportional to the countrys
creditors (or syndicate of creditors) market share (s)

This assumption is reflected by the following specification of the default probability:

, , 0
M
p s
Y

| |
= >
|
\ .
. (1)

Assumption 2: The indebted countrys gross national product is adversely affected by
the annual debt repayment.

This assumption is consistent with the debt-overhang hypothesis. Namely, the
indebted countrys capital stock is adversely affected by the decline in the government
development budget and by capital flight engendered by high tax rate.

This assumption can be formally represented by:

, 1 Y Y M = (2)

Where Y is the (highest) level of gross national product attainable had the annual
debt repayment been nil.

The substitution of equation (2) into equation (1) implies:

M
p s
Y M

| |
=
|

\ .
(3)

By differentiation,


2
0
( )
M
Y
p
Y M

= >

and

3
2
0
( )
MM
Y
p
Y M

= >

as long as 0 Y M > .


Recalling that 0 1 p < < and p rises with M, the annual debt repayment must be within
the interval
min max
M M M , where
min
( ) 0 p M = and
max
( ) 1 p M = . The substitution
of these boundary conditions into equation (3) implies:

70
min
min
min
{0 } { }
M s
s M Y
Y M s

| |
| |
= =
| |
+
\ .
\ .


max
max
max
1
{1 } { }
(1 )
M s
s M Y
Y M s

| | | | +
= =
| |
+ +
\ . \ .


The feasible interval of the annual debt repayment
min max
( , ) M M is shifted rightward
by an increase in either Y or s and by decrease in either or . This interval is
also enlarged by Y .

In view of the above, the countrys annual debt repayment (ADR) is perceived by a
rational creditor to be binomially distributed:

1 /( )
0 /( )
M M Y M s
ADSR
M Y M s


+

=

+

Consequently, the expected annual debt repayment is:

( )
{1 [ /( ) ]}
p M
EADR M Y M s M = +
_
.
By differentiation,

1 [ ( ) ( ) 0
M
dEADR
p M p M M as M M
dM
> <
< >
= + = =



where

1
(1 )
Y
M
s

(
=
(
+ +

An increase in the annual debt repayment reduces the probability of such payment and
hence the expected annual debt repayment can be depicted by an inverted U-shaped
curve. Beyond M

an increase in the payment causes the probability of default to rise

so much that the expected annual debt repayment falls.

71

Figure: Debt Laffer curve


The Global Financial Crisis, 2007-present
A review of the origin of the present Global Financial Crisis can be found by using
the following link:

http://en.wikipedia.org/wiki/Financial_crisis_of_2007%E2%80%9308

Recommended articles
Pol, Eduardo, The Preponderant Causes of the USA Banking Crisis 2007-08, The
Journal of Socio-Economics, 2012, 41, 519-528.

Tularam, Gurudeo Anand; Subramanian, Bhuvaneswari, Modeling of Financial
Crises: A Critical Analysis of Models Leading to the Global Financial Crisis, Global
Journal of Business Research, 2013, 7 (3), 101-124.

Bengtsson, Elias, Shadow Banking and Financial Stability: European Money Market
Funds in the Global Financial Crisis, Journal of International Money and Finance,
February 2013, 32(1), 579-94.

Arouri, Mohamed; J awadi, Fredj; Nguyen, Duc Khuong, What Can We Tell about
Monetary Policy Synchronization and Interdependence over the 2007-2009 Global
Financial Crisis? Journal of Macroeconomics, J une 2013, 36, 175-87.
min
M
M

max
M
EADR
45
o