FINANCIAL ECONOMICS

Lecturer ： Do Duy Kien, PhD

Foreign Trade University, HCM Campus

Email ： doduykien.cs2@ftu.edu.vn

Copyright (ppt slides): Quyen Do Nguyen, PhD

Faculty of Banking and Finance
Foreign Trade University
 Financial Economics
2

 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

 Reference
3

 Copeland, Thomas E., Weston, J.

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

Exams Scale

Participation Attendance 10%

Mid-term exam Close-book written test 30%

Final exam Close-book written test 60%

 CHAPTER 1:
INTRODUCTION: CAPITAL
MARKETS, CONSUMPTION
AND INVESTMENT
 Objectives
6

 Examine consumption and investment of individuals and

businesses

 Understand the role of interest rate in consumption and

investment decision making
 Consumption and investment without capital markets
7

 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
8


 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 at the beginning of the period and 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.
(;
 Problem for optimal consumption and investment
 How much should an individual decide to consume and invest today in order to
consume at the end of the period?
 The economy WITHOUT capital markets
9

 
The utility curve of individuals for consumption at present
 Assume that consumption at the end of
U(Co
)
  ;

Co
 The economy WITHOUT capital markets
10

 Utility
  curve at both
 Represents trade-offs between
consumption at the beginning of
and at the end of the period (at
present and in the future).
 Any combinations of provide the
same total utility to consumers.
 AB curve is called indifference
curve.
 The economy WITHOUT capital markets
11

 
S in the space .
Utility function:
Consumers’ utility = U(Utility)

Mathematica DEMO
 The economy WITHOUT capital markets
12

 
The tangent line at point A measures the utility trade-offs.
 If there is a small change in utility while remaining the total
utility , there must be an equivalent change in This trade-off
is called the marginal rate of substitution – MRS.
 Mathematically, it is expressed as:

 Since an individual prefers more utility, he only has less consumption today
and will therefore demand relatively more future consumption
 The economy WITHOUT capital markets
13

  
 because the slope of the tangent line at point A is greater
than that at point B
 WHY?
 The economy WITHOUT capital markets
14

 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.
WITHOUT capital markets but WITH investment
15

 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
16

  The benefit of investment

 An individual endowed with a resource
bundle at 0 and 1 that has utility
 Due to investment, this individual can
move along the production opportunity
set to point B by investing .
 The total utility increases from to
 Will this individual move over point B?
 Only move to the point at which
 At this point and
 WHY?
WITHOUT capital markets but WITH investment
17

 In
  the world without capital
markets, each individual with the
same endowment 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
with capital markets
18

 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 .
 is a market-determined rate of interest
 Assume that is positive and certain
 Consumption and investment
with capital markets
19

 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 markets (Without
production)
20

  Capital market exists with a constant 

borrowed at the beginning of the period will be
at the end of the period  Capital market line is a
straight line with the slope of
 Individual can change utility by moving along the
capital market line.
 At point A (MRS<r) utility  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 has the present value:

 Q: After engaging in the capital market, does the

value of the endowment change?
 Scenario 1: Consumption and capital markets (Without
production)
21

  The equation for the capital market line:

S
thus, A, B have the same  (Wealth)
does not change when borrowing/ lending
on the capital market line but utility (U)
change  Can increase utility through the
capital market.
 Scenario 2: Consumption and capital markets (With production)
22


 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  Move to B
 Capital market exists  Individuals can

freely move along the capital market line to

achieve the optimal utility (At point C, )
 We are better off when capital markets
exist.
 Fisher’s Separation Theorem
23

 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 Theorem for
corporations
24

 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.
 Implications of Fisher’s Separation Theorem for
corporations
25

  With the established assumptions

 In the long run, investors can adjust
production and investment so that
marginal return is equal to market
return

 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
26

 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.
 Figure 1.10: A primitive exchange economy with no central marketplace. Figure 1.11: The
productivity of a central marketplace.
27
 When Fisher’s Separation Theorem is WRONG?
28

 Transaction cost is large 

lending rate > borrowing rate
 Each individual will choose
different optimal production points.
 Exercises
29

 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 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, . 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, ; optimal
production/investment ; optimal consumption ; present value of final wealth .
Exercise 1
Project 1+ required Initial Accumulated
return investment investment
 Maximum investment= $7= Maximum
consumption @ t=0
 Optimal production point B, adjacent to the
capital market line with the slope of -1.1
 At production point D, invest $3 @ t=0 
$3.9 @ t=1
 At point B, consume $3, invest $4, $3 into
D and $1 into B  3.9+1.2 = 5.1 @ t=1
 The present value of this decision is:
Exersise 2 Figure 1

  
 Schedule of investment, all
of which have the same rate
of return (Figure 1)
 Investment opportunity set Figure 2
(Figure 2)
Exercise 3