8/5/2019

FINANCIAL ECONOMICS
Lecturer： Quyen Do Nguyen, PhD
Corporate Finance Department
Faculty of Banking and Finance
Foreign Trade University
Email： quyendn@ftu.edu.vn

Course Materials: https://www.dropbox.com/sh/bhbsaz4t8ehyk50/AADaldsAfM

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Financial Economics
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 Chapter 1: Introduction: capital markets, consumption and investment

 Chapter 2: Investment decisions: the certainty case

 Chapter 3: Theory of choice: utility theory given uncertainty

 Chapter 4: State preference theory

 Chapter 5: Object of choice: Mean – variance portfolio theory

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Reference
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 Copeland, Thomas E., Weston, J.

Fred and Shastri, K. (2005)
Financial Theory and Corporate
Policy. Pearson Education, Inc.,
4th Edition.

Exams Scale

Participation Attendance 10%

Mid-term exam Close-book written test 30%

Final exam Close-book written test 60%

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CHAPTER 1: INTRODUCTION:
CAPITAL MARKETS,
CONSUMPTION AND
INVESTMENT

Objectives
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 Examine consumption and investment of individuals and

businesses

 Understand the role of interest rate in consumption and

investment decision making

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Consumption and investment without

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capital markets
 What benefits do capital markets bring about to the economy?

 Prove that: Capital markets increase the utility of at least one

individual without forgoing any other individuals’ utility.
 Methods:

 The economy WITHOUT capital markets vs. the economy WITH capital
markets

The economy WITHOUT capital markets

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 Assumptions
 All outcomes from investment are know with certainty
 No transaction costs and taxes = 0
 Decisions are made in a one-period context
 Individuals are endowed with income 𝑦 at the beginning of the period
and 𝑦 at the end of the period.
(Mana from heaven)
 Every individual is assumed to prefer more consumption to less.  The
marginal utility of consumption is always positive but decreasing.
( > 0; < 0)
 Problem for optimal consumption and investment
 How much 𝐶 should an individual decide to consume and invest today in
order to consume 𝐶 at the end of the period?

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The economy WITHOUT capital markets

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 The utility curve of individuals for consumption at present 𝐶

 Assume that consumption at the end of 𝐶 is constant.
U(Co)

> 0; <0

Co

The economy WITHOUT capital markets

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 Utility curve at both 𝑪𝟎 𝒂𝒏𝒅 𝑪𝟏

 Represents trade-offs between
consumption at the beginning of
𝑪𝟎 and at the end of the period
𝑪𝟏 (at present and in the future).
 Any combinations of 𝑪𝟎 𝒂𝒏𝒅 𝑪𝟏
provide the same total utility to
consumers.
 AB curve is called indifference
curve.

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The economy WITHOUT capital markets

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Simulat𝑖𝑛𝑔 𝑡ℎ𝑒 𝑟𝑒𝑙𝑎𝑡𝑖𝑜𝑛𝑠ℎ𝑖𝑝 𝑜𝑓 𝑈(𝐶 ) 𝑣à 𝑈(𝐶 )

in the space 0𝐶 𝐶 .
Utility function: U = 𝐿𝑛[𝐶]
Consumers’ utility = U(Utility)
 𝑈 𝐴 =𝑈 𝐵 <𝑈 𝐷
 𝑈 𝐴 =𝑈 𝐶 +𝑈 𝐶
 𝑈 𝐵 =𝑈 𝐶 +𝑈 𝐶
 𝑈 𝐶 >𝑈 𝐶
 𝑈 𝐶 <𝑈 𝐶
Mathematica DEMO

The economy WITHOUT capital markets

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 The tangent line at point A measures the utility trade-offs.

 If there is a small change in utility 𝑑𝑈𝐶 while remaining the
total utility 𝑈 , there must be an equivalent change in 𝑑𝑈𝐶 .
This trade-off is called the marginal rate of substitution – MRS.
 Mathematically, it is expressed as:
 𝑀𝑅𝑆 = U Constant = − 1 + 𝑟
 Since an individual prefers more utility, he only has less consumption today
and will therefore demand relatively more future consumption 𝜕𝐶 > 𝜕𝐶

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The economy WITHOUT capital markets

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 𝑀𝑅𝑆 = U Constant = − 1 + 𝑟

𝑟 > 𝑟 because the slope of the tangent line at point A is

greater than that at point B

 WHY?

The economy WITHOUT capital markets

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 E.g. If we only consider consumption without

investment  How will the relationship
between consumption and saving will change
if investment is involved?
 Saving 1 unit of consumption will create >1 unit
of utility at the end of the period.
 New assumption: Each individual will have a
bundle of investment opportunities, however,
the more an individual invests, the lower the
rate of return on the marginal investment. 
Diminishing marginal investment
 All investment are assumed to be independent
of one another and perfectly divisible.

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WITHOUT capital markets but WITH investment

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 Integrate investment into consumption and

saving
 The curve ABX represent diminishing
marginal investment rate of return
 The slope of a line tangent to curve ABX
is the rate at which $1 of consumption
forgone today is transformed by
productive investment into a dollar of
consumption tomorrow (Marginal Rate of
Transformation – MRT).
 The line tangent to point A has the highest
slope representing the highest rate of
return at point A.

WITHOUT capital markets but WITH investment

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 The benefit of investment

 An individual endowed with a resource
bundle [𝑦 , 𝑦 ] at 0 and 1 that has
utility 𝑈
 Due to investment, this individual can
move along the production opportunity
set to point B by investing 𝑦 − 𝐶 .
 The total utility increases from 𝑈 to 𝑈
 Will this individual move over point B?
 Only move to the point at which 𝑀𝑅𝑇 = 𝑀𝑅𝑆
 At this point 𝑃 = 𝐶 and 𝑃 = 𝐶
 WHY?

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WITHOUT capital markets but WITH investment

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 In the world without capital

markets, each individual with the
same endowment [𝑦 , 𝑦 ] and the
same investment opportunities set
may choose completely different
investments because they have
different indifferent curve.
 In the adjacent graph, individual 2
invests more or less than individual
1? WHY?

Consumption and investment

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with capital markets
 A Robinson Crusoe economy
 One person
 No opportunities to exchange intertemporal consumption among
individuals
 Extend the assumptions
 Many individuals in the economy
 Intertemporal exchange of consumption bundles will be presented
by the opportunity to borrow or lend unlimited amount at 𝑟.
 𝑟 is a market-determined rate of interest
 Assume that 𝑟 is positive and certain

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Consumption and investment

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with capital markets

 Capital markets = Individuals with savings, individuals who

are in need of funds.

 Scenario1: Ignore production

 Scenario 2: Production is considered

 Question: Will individuals’ utility increase or not with capital

markets?

Scenario 1: Consumption and capital

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markets (Without production)
 Capital market exists with a constant 𝑟  𝑋
borrowed at the beginning of the period will be
𝑋 = 𝑋 1 + 𝑟 at the end of the period 
Capital market line is a straight line with the slope
of −(1 + 𝑟)
 Individual can change utility 𝑈 by moving along
the capital market line.
 At point A (MRS<r) utility 𝑈  Moving towards
B by moving along the capital market line  MRS
= - (1+r)
 From point A to point B, individual borrows or lends?
 The initial endowment [𝑦 , 𝑦 ] has the present
value:
𝑊 =𝑦 +
 Q: After engaging in the capital market, does the
value of the endowment change?

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Scenario 1: Consumption and capital

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markets (Without production)

Scenario 2: Consumption and capital markets

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(With production)
 From point A
 If there is production but no
borrowing/lending  increasing utility by
moving along production line to point D
(MRS = MRT)
 At point D, marginal return on investment >
cost of borrowed funds (steeper slope at D
than B)  Continue to invest by limiting
consumption on 𝑦  Move to B
 Capital market exists  Individuals can
freely move along the capital market line to
achieve the optimal utility 𝑈 (At point C,
𝑊∗ > 𝑊 )
 We are better off when capital markets exist.

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Fisher’s Separation Theorem

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 The decision process in production and exchange world occurs in 2 separate and distinct
steps:
 Step 1: choose the optimal production decision by taking on projects until the marginal rate
of return on investment equals the objective market rates,

 Step 2: then choose the optimal consumption pattern by borrowing or lending along the
capital market line to equate your subjective time preference with the market rate of return

 The separation of the investment (step 1) and consumption (step 2) decisions is known as the
Fisher separation Theorem.

Implications of Fisher’s Separation

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Theorem for corporations
 With the above-said assumptions
 Investors can authorize corporate
managers to make decisions related to
investment and production decisions
 Individual 1 and 2 both have optimal
production at point D D
 Each investor can optimize his utility
by borrowing/lending on the capital
markets and adjusting consumption
to maximize each utility.

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Implications of Fisher’s Separation

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Theorem for corporations
 With the established assumptions
 In the long run, investors can adjust
production and investment so that
marginal return is equal to market
return
𝑀𝑅𝑆 = 𝑀𝑅𝑆 = 𝑀𝑅𝑇 = −(1 + 𝑟)
 In the long run, all investors require
the same rate of return on investment
 Investors require the same
discount rate (equal to the market
return).

The function of the capital market

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 Individuals with more investment

opportunities that bring about
higher return can take advantage of
the capital markets by borrowing.
 The capital markets transfer funds
from individual with fewer
opportunities but with fund surplus to
individuals with more opportunities
but with fund deficit.
 Everyone is better off with the
existence of the capital markets.

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Figure 1.10: A primitive exchange economy with no central marketplace.

Figure 1.11: The productivity of a central marketplace.
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When Fisher’s Separation Theorem is WRONG?

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 Transaction cost is large 

lending rate > borrowing rate
 Each individual will choose
different optimal production points.

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Exercises
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1. Suppose your production opportunity set in a world of perfect certainty consists of the following
possibilities.
(a) Graph the production opportunity set in a 𝐶 , 𝐶 framework.
(b) If the market rate of return is 10%, draw in the capital market line for the optimal investment decision.
Project Investment Outlay Rate of return
A $1,000,000 0.08
B 1,000,000 0.2
C 2,000,000 0.04
D 3,000,000 0.3
2. Suppose that the investment opportunity set has N projects, all of which have the same rate of
return, 𝑅 ∗ . Graph the investment opportunity set.
3. Graphically demonstrate the Fisher separation theorem for the case where an individual ends up
lending in financial markets. Label the following points on the graph: initial wealth, 𝑊 ; optimal
production/investment 𝑃 𝑃 ; optimal consumption 𝐶 ∗ 𝐶 ∗ ; present value of final wealth 𝑊 ∗ .

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