TCHE341:
FINANCIAL ECONOMICS
CHAPTER 1: Introduction: capital markets,
consumption and investment
Đỗ Khánh Hiền
ABOUT ME
❖ Email: dokhanhhien@ftu.edu.vn
Please include TCHE341 in the subject line!
❖ Office hours: by appointment
❖ Education:
➢ BCom - The University of Melbourne, Australia
➢ MSc - LSE, UK
SUBJECT AIM & ASSESSMENT
❖ Overall Aim
➢ The purpose of this course is to acquaint the student with basic
principles of finance theory emphasizing the theory of the firm's
investment and financing decisions.
❖ Assessment
Task
%
Participation
10%
Midterm test
30%
Final exam
60%
COURSE MATERIAL
❖ Reading:
➢ Required: Copeland, T.E. và Weston, J.F. 2005. Financial Theory
and Corporate Policy. 4th edition, Addison-Wesley Publishing
Company.
➢ Recommended: consult the syllabus
➢ Read daily (financial) news!!!
WHAT IS FINANCE?
Major areas of finance
❖ Investment analysis and management
❖ Corporate finance
❖ Capital markets and financial institutions
❖ International finance
❖ Personal finance
❖ Real estate finance
❖ Public finance
TOPICS COVERED
❖ Investment: Background and Issues (L1-2)
❖ Investment decisions: the certainty case (L3-4)
❖ Theory of choice: utility theory given uncertainty
(L5-6)
❖ State preference theory (L7-9)
❖ Object of choice: Mean – variance portfolio theory
(L10-12)
❖ Market equilibrium: CAPM and APT (L13-15)
Introduction: capital markets, consumption and investment
CHAPTER 1: OUTLINE
❖ Course information
❖ Consumption and investment without capital market
❖ Consumption and investment with capital markets
❖ Marketplaces and transaction costs
❖ Transaction costs and the breakdown of separation
Introduction: capital markets, consumption and investment
LECTURE 1: OUTLINE
❖ Course information
❖ Consumption and investment without capital market
❖ Consumption and investment with capital markets
❖ Objectives: roles of capital markets; consumption
decisions of individuals and corporations; the role of
interest rate in consumption and investment decisions.
Introduction: capital markets, consumption and investment
Modern Finance Theory
1958
Introduction: capital markets, consumption and investment
The 6 theories upon which modern finance
is founded
➢ Utility Theory
➢ State-preference Theory
➢ Mean-Variance Portfolio Theory
➢ CAPM & APT
➢ Option pricing Theory
➢ Modigliani -Miller Theorems
Introduction: capital markets, consumption and investment
Introduction: capital markets, consumption and investment
Now
Future
Introduction: capital markets, consumption and investment
Introduction: capital markets, consumption and investment
In order to decide, Robinson Crusoe needs to:
➢ understand his own subjective trade-offs between consumption now
and consumption in the future, embodied in the utility and
indifference curves
➢ know the feasible trade-offs between present and future consumption
that are technologically possible
➢ From the analysis of a Robinson Crusoe economy we will find that
the optimal consumption/investment decision establishes a subjective
interest rate for him, representing his (unique) optimal rate of
exchange between consumption now and in the future
➢ The interest rate: the price of deferred consumption or the rate of
return on investment.
Introduction: capital markets, consumption and investment
Consumption and investment without capital
market
Do capital markets benefit society?
➢ compare a world without capital markets to one with them
➢ show that no one is worse off and that at least one individual is
better off in a world with capital markets
Introduction: capital markets, consumption and investment
Consumption and investment without capital
market
Assume that all outcomes from investment are known with certainty,
that there are no transactions costs or taxes, and that decisions are
made in a one-period context.
➢ Individuals are endowed with income y0 at the beginning of the
period, and y1 at the end of the period
➢ They must decide how much to actually consume now C0 and
how much to invest in productive opportunities in order to
provide end-of-period consumption C1
➢ Assume that every individual prefers more consumption to less,
or the marginal utility of consumption is positive and decreasing
Introduction: capital markets, consumption and investment
Subjective Trade-offs between beginning and
end-of-period consumption
Introduction: capital markets, consumption and investment
Subjective Trade-offs between beginning and
end-of-period consumption
Introduction: capital markets, consumption and investment
Subjective Trade-offs between beginning and
end-of-period consumption
Introduction: capital markets, consumption and investment
Subjective Trade-offs between beginning and
end-of-period consumption
The slope of the straight line just tangent to the
indifference curve at point B measures the rate of
trade-off between C0 & C1 at point B.
➢ This trade-off is called the marginal rate of
substitution (Marginal Rate of Substitution)
between consumption today and consumption
tomorrow; MRS = -(1+ri)
➢ The subjective rate of time preference is an interest
rate, measuring the rate of substitution between
consumption bundles over time and revealing how
many extra units of consumption tomorrow must
be received in order to give up one unit of
consumption today and still have the same total
utility
Introduction: capital markets, consumption and investment
Productive investment opportunities
Productive opportunities allow a unit of
current savings/investment to be turned into
more than one unit of future consumption.
➢ Each individual has a schedule of productive
investment opportunities that can be arranged
from the highest rate of return down to the
lowest (not just a straight line, any decreasing
function would do)
➢ Diminishing marginal returns to investment
(the more an individual invests, the lower the
rate of return on the marginal investment).
➢ All investments are assumed independent of
one another and perfectly divisible.
Introduction: capital markets, consumption and investment
Marginal rate of transformation of a productive
investment opportunity set
MRS = MRT
MRT: The slope of a line
tangent to curve ABX is
the rate at which a dollar
of consumption foregone
today is transformed by
productive investment
into a dollar of
consumption tomorrow
Introduction: capital markets, consumption and investment
Consumption and investment without capital
market
Without the existence of capital markets, individuals with the same endowment
and the same investment opportunity set may choose completely different investments
because they have different indifference curves.
Introduction: capital markets, consumption and investment
Consumption and investment with capital
markets
Intertemporal exchange of consumption bundles will be represented by the
opportunity to borrow or lend unlimited amounts at a market-determined rate
of interest.
➢ Assuming that interest rates r > 0, any amount of funds lent today
will return interest plus principal at the end of the period
➢ With an initial endowment of (y0, y1) that has utility U1, we can reach
any point along the market line by borrowing or lending at the market
interest rate plus repaying the principal amount, X0
➢ With future value X1 then X1 = X0 + rX0 = (1+r)X0
➢ Similarly: the present value of our initial endowment, (y0, y1) is:
Introduction: capital markets, consumption and investment
Consumption and investment with capital
markets
Introduction: capital markets, consumption and investment
Consumption and investment with capital
markets
➢
➢
➢ Future value W1 = (1+r)W0, hence:
➢ PV(endowment) = PV(consumption) = W0
Moving along the capital market line does not change one's wealth, but
it does offer a pattern of consumption that has higher utility.
Introduction: capital markets, consumption and investment
Consumption and investment with capital
markets
Introduction: capital markets, consumption and investment
Consumption and investment with capital
markets
The decision process that takes place with production opportunities
and capital market exchange opportunities occurs in two separate and
distinct steps:
➢ choose the optimal production decision by taking on projects
until the marginal rate of return on investment equals the
objective market rate
➢ 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
Introduction: capital markets, consumption and investment
Fisher separation theorem
Given perfect and complete capital markets, the production decision is
governed solely by an objective market criterion (represented by
maximizing attained wealth) without regard to individuals' subjective
preferences that enter into their consumption decisions.
Introduction: capital markets, consumption and investment
Implication for corporate policy - Investment
decision delegated to managers
Introduction: capital markets, consumption and investment
Implication for corporate policy - Investment
decision delegated to managers
Both investor 1 and investor 2 will direct the manager of their firm to choose production
combination (P0, P1).
They can then take the output of the firm and adapt it to their own subjective time
preferences by borrowing or lending in the capital market. Investor 1 will choose to
consume more than his or her share of current production (point A) by borrowing today in
the capital market and repaying out of his or her share of future production. Alternately,
investor 2 will lend because he or she consumes less than his or her share of current
production. Either way, they are both better off with a capital market.
The optimal production decision is separated from individual utility preferences. Without
capital market opportunities to borrow or lend, investor 1 would choose to produce at point
Y, which has lower utility. Similarly, investor 2 would be worse off at point X
Thus all individuals use the same time value of money (i.e., the same market-determined
objective interest rate) in making their production/investment decisions.
Introduction: capital markets, consumption and investment
Exercises
Suppose your production opportunity set in a world with perfect certainty
consists of the following possibilities:
a) Graph the production opportunity set in a C0, C1 framework.
b) If the market rate of return is 10%, draw in the capital market line for the
optimal investment decision.
Introduction: capital markets, consumption and investment
LECTURE 2: OUTLINE
❖ Marketplaces and transaction costs
❖ Transaction costs and the breakdown of separation
❖ Objectives: Roles of financial markets; Transaction
costs
Introduction: capital markets, consumption and investment
Marketplaces and transaction costs
Assume that we have a primitive economy with N producers, each
making a specialized product and consuming a bundle of all N
consumption goods.
Given no marketplace, bilateral exchange is necessary with the cost of
each leg of such an exchange trip being $T.
Altogether, for 5 producers, there are [N(N — 1)]/2 = 10 trips, at a
total cost of $10T.
Introduction: capital markets, consumption and investment
Marketplaces and transaction costs
If a central marketplace is established, t the total number of trips can
be reduced to 5, with a total cost of $5T.
If the total cost (including the cost of living) is < $ (10T - 5T), it is
profitable to establish a marketplace and everyone will be better off
Introduction: capital markets, consumption and investment
Marketplaces and transaction costs
Marketplaces serve to efficiently reduce transactions costs (the
operational efficiency of capital markets).
The lower the transactions costs are, the more operationally efficient a
market can be.
Introduction: capital markets, consumption and investment
Transaction costs and the breakdown of
separation
If transactions costs are nontrivial:
➢ Financial intermediaries and marketplaces will provide a useful
service
➢ Borrowing rate > lending rate
➢ The difference between the borrowing and lending rates
represents their (competitively determined) fee for the economic
service provided, invalidating the Fisher separation principle!
➢ Consider major imperfections: the impact of corporate and
personal taxes and information asymmetries.
Introduction: capital markets, consumption and investment
Transaction costs and the breakdown of
separation