Professional Documents
Culture Documents
Third Year Financial Economics 2012 Topic1a1
Third Year Financial Economics 2012 Topic1a1
February 2012
Financial economics applies the techniques of economic analysis to understand the savings and investment decisions of individuals, the investment, financing and payout decisions of firms, the level and properties of interest rates and prices of financial derivatives and the economic role of financial intermediaries.
To be covered:
Financial Markets/Financial Development and Economic Growth Decision making given uncertainty risk Financial Instruments Interest Rates
Derivatives
Financial Intermediation
Financial Market A financial market is a market where financial assets are exchanged or traded. Examples include: 1. Primary vs. Secondary markets 2.
3.
They can be classified by maturity of the claim money market vs. capital markets. Money markets are markets where short-term instruments are traded. Capital markets deals with long-term debt instruments.
They can also be classified as those dealing with newly issued instruments (primary markets) or those dealing with already existing assets (secondary markets).
So an IPO would take place in a primary market while a seasoned offering would occur in a secondary market.
6
Financial Assets Financial assets are claims to the income generated by the real assets. They are just pieces of paper, or computer entries. They contribute to the productive capacity indirectly. Examples include: stocks, bonds, etc.
Financial assets: Allow for the separation of ownership and management Facilitate the transfer of funds to enterprises with attractive investment opportunities. They are claims to the income generated by real assets. Their value depends on the value of the underlying real assets.
The Relationship between Financial Assets and Real Assets Real assets produce goods and services. Financial assets determine the allocation of wealth among investors.
Money firms receive when they issue securities (financial assets) is used to purchase real assets.
The return on a financial asset comes from the income produced by a real asset. Financial assets are destroyed in the course of doing business (e.g. loan). Real assets are only destroyed by accident or through wearing out over time.
10
Financial Markets and the Economy -Financial assets and the markets in which they are traded do play an important role in the economy. -Financial assets allow us to make optimal use of the economys real assets. -These assets play 4 main roles: Consumption Timing Allocation of Risk Separation of Ownership and Management Transfer of funds from surplus to deficit units.
11
1. Consumption Timing Some individuals in the economy earn more than they want to spend. Others spend more than they earn Financial assets allow us to time our consumption. They make it possible for us to store our purchasing power. Invest in high earning periods and spend in low earning periods. Can allocate consumption to periods that provide greatest satisfaction. Individuals can separate decisions concerning current consumption from constraints imposed by current earnings.
12
2. Allocation of Risk All real assets involve some risk. Cash flows are not certain but can be assigned probabilities depending on different scenarios. Investors with different risk profiles are catered for: risk averse, risk neutral, risk loving. Different financial assets cater for this e.g. equities and bonds. There is generally a positive relationship between risk and return. This allows firms to optimally price assets depending on the risk-return characteristics of investors. Facilitates process of building stock of real assets.
13
3. Separation of Ownership and Management In todays business environment characterized by large corporations owners do not necessarily manage firms. Financial markets allow this separation of ownership and management. Holders of equity are the owners, they appoint a management team to run the firm on their behalf. This brings about the principal-agent problem.
14
Principal-agent problem
Agency problems: empire building, risk avoidance to protect jobs, excessive consumption of luxuries.
Different ways used by mgt. to increase their welfare at the expense of shareholders
1. Excessive consumption of perquisites they use firm resources to make expenditures that provide them with personal benefits (private jets, holding meeting in exotic resorts doubling as vacation spots). 2. Maximizing firm size rather than its value in the labor market for the mgt. compensation is highly related with firm size. Mgt has an incentive to maximize the size of the firm and not firm value. This is known as overinvestment and mgt. that overinvest is said to be engaging in empire building. 3. Siphoning corporate assets - E.g., mgt. can establish a separate shell firm which they own and then direct cash flow from the 15 main firm to the shell.
4. Risk-avoidance to protect jobs mgt. may be so self-serving as to be biased against more risky projects and favouring less risky ones.
Solutions: 1. Tie compensation to performance (stock options); 2. Outside monitors (security analysts). 3. Etc.
16
1. Excessive diversification Mgt can diversify the firms operations across industries, even though this may be of little value to the already diversified shareholders. This excessive diversification serves to reduce the probability of the firms failure and thus reduces the probability that the mgt would be out of a job. 2. Bias toward investment with near-term payoffs if mgt compensation is tied to the firms earnings, then mgt has an incentive to bias their selection of capital projects toward investments that payoff well in a short period of time. This can happen even when the investments may not maximize shareholder value in the long-run. 3. Mgt. Entrenchment the CEO can steer the firm towards investments that reflect his/her unique talents. Overtime, this policy will make it difficult for shareholders to fire the CEO even if he/she is not optimally performing. 18
19
20
Users of the Financial System The needs of the users of the financial system will determine what financial assets are available. 3 main groups:
21
The Household Sector The consumption timing function of financial assets is most relevant to households 2 factors have a significant effect on the financial needs of households: taxes and risk preferences.
Taxes: high-tax bracket investors will seek tax-free securities. Financial services providers will endeavor to offer such assets.
Risk preference: differences in risk preference lead to demand for a diverse set of investment alternatives. Also leads to demand for easy portfolio diversification.
22
The Business Sector Businesses need to raise money to finance investment in real assets. 2 ways for businesses to raise money: -borrow from banks or households (issuing bonds) this is referred to as debt. -issuing stocks (allowing new owners) this is referred to as equity. - firms issue to get best possible price, to minimize cost of issuing. To achieve this they use of investment banks. Low cost implies simplicity of securities. But households want variety. Intermediaries address this mismatch.
23
The Government Sector Government requires money for investment, social services, salaries etc. When revenue < expenditure governments need to borrow. The government cannot sell shares to raise capital. It can:
- print money (inflationary pressure) - issue treasury bills and other fixed income securities. These are highly liquid: quickly converted to cash with low transaction costs. Because of governments taxing power it is very credit worthy. Can therefore borrow at lowest interest rates.
24
Economics 101
We can represent an individuals preference, U(x, y), by indifference curves on the x-y diagram.
y
Represent higher levels of utility U0 < U1 < U2
U2 U1 U0
27
Economics 101
The constraint of PxX + PyY W can be shown as the budget line.
y
W/Py
W/Px
Maximizing utility means picking the best feasible consumption point (C*). The equilibrium condition is:
(slope of indifference curve) MRS = Px/Py (Slope of budget line) Where MRS = MUx/MUy
y
U2
x*
W/Px
C1
U2 U1 U0
30
C0
In order to have the indifference curves (ICs) as described with nice concave shapes, we assume that: More is better than less. Diminishing marginal utility of consumption for a single period.
U(C0,C1)
31
C0
With the assumptions, we have the following diagram. The slope of the IC represents the individuals subjective rate of time preference (SRTP). We call the slope the marginal rate of substitution between current consumption and future consumption. The math expression is: MRS = MU(C0)/MU(C1)= (U / C0) / (U / C1)
C1
U0
32
C0
The Constraint
Recall that an individual maximizes his happiness subject to constraints. What are the constraints? It depends on the options available for the individual to allocate his wealth across different time periods. We study two options: [1] Production opportunity and [2] participation in the capital market. We assume the individual has endowment of Y0 and Y1 in the current and future periods, respectively. So, we can plot the endowment point on the diagram. Constraint A: With no wealth allocation across periods, his utility is U0.
C1
You basically consume what you get each period, C*0=Y0, C*1=Y1
Y1 U0
33
Y0
C0
Production Opportunity
Constraint B: The individual can only invest in production opportunities to allocate wealth across periods Now, we introduce production opportunities that allow a unit of current savings/investment to be turned into more than one unit of future consumption. Assume the individual faces a schedule of productive investment opportunities. We line them up from the highest return to the lowest and plot them as follows: Such decreasing marginal rate of return means diminishing marginal returns to investment because the more an individual invests, the lower the rate of return on the MARGINAL investment.
Marginal rate of return
34
Total investment
Total investment in the current period is equal to current period endowment minus current consumption (i.e., Investment = Y0-C0) With this in mind, we can plot the constraint on the C0-C1 space. We call this constraint the production opportunity set (POS). The slope of the POS is now called the Marginal Rate of Transformation (MRT) offered by the production/investment opportunity set. Investment means the individual can move its consumption point along POS.C1
Y1
35
Y0
C0
Production Opportunity
At the endowment point, the individual is not maximizing his utility subject to Constraint B. He can do better by investing more (i.e., move north-west along the POS) because at the endowment point, the return offered by investing is higher than his SRTP needed to make him feel indifferent. The equilibrium is when he invests until the return offered by the marginal investment is just equal to its SRTP. We have: (slope of POS) MRT = MRS (slope of indifference curve).
C1
C*1 Y1 U0
36
U1 C*0 Y0 C0
Production Opportunity
Points to Note: This individual can achieve a higher utility (U1>U0) by investing in production opportunities (i.e. reallocating consumption over time). His feasible consumption set expands with the introduction of production opportunities. With constraint A, he can only consume at the endowment point. With the introduction of production opportunity (a less restrictive constraint B), his feasible consumption set becomes all the points along the POS. This gives the rationale for inter-temporal consumption choice which also explains investment. If exposed to various investment opportunities, individuals want to take some of them in order to allocate wealth. Doing so would allow them to achieve higher utility level. C1
C*1 Y1 U0
37
U1 C*0 Y0 C0
Capital Market
Now, instead of one individual, lets assume there are many individuals in the economy. Some are lenders, while others are borrowers. We now have opportunities to borrow and lend at the market-determined interest rate (r). Constraint C: No production opportunity. But individuals can lend/borrow at r. We can graph the borrowing and lending opportunities along the capital market line. Now, we introduce the concept of wealth. Wealth of an individual is the present value of his current and future endowment. Thus: W0 = Y0 + Y1/(1+r) and W1 = (1+r)Y0 + Y1 C1
Y0
W0
C0
W1=Y0(1+r) + Y1
B
Capital market line with Slope = -(1+r)
Y1
A
Y0 W0 C0
39
Capital Market
The feasible consumption set is now all the points along the capital market line. Moving north-west along the capital market line, the individual can achieve a higher utility (U2>U0).
This individual is now lending (Y0-C*0) amount of money, and will get back (1+r)(Y0-C*0) in the next period so that he can consume a total of C*1= Y1+(1+r)(Y0-C*0).
C1
Y0(1+r) + Y1
NB: One should be able to determine C*0 and C*1 (i.e., optimal consumption path)
C*1 Y1
U2 U0
40
C*0 Y0
W0
C0
C1
P*1
(C*0, C*1)
D
Y1 P*0
U3 U1 U0
41
Y0
W*0
C0
We call this the FISHER SEPARATION THEOREM. The important point is the production point is governed solely by objective criteria, namely, the set of opportunities available and the market interest rate. This is independent of individuals subjective rate of time preferences. C1
P*1
(C*0, C*1)
A
Y1 P*0
U3 U1 U0
42
Y0
W*0
C0
Y1 P*0 Y0
W*0
C0
Implication 2: Consider two investors investing all their money on the stocks of a single firm. Their well-being is thus tied to the well-being of the firm. Consider the firm is making a decision on what to produce. Fisher Separation Theorem implies that even though the two investors differ in their subjective perception of how to consume between now and future, they both has one unified objective, i.e, to maximize their current wealth. Doing so means the firm can maximize its value. This is the same as investing until the return on the marginal investment is just equal to the cost of capital, i.e, the market interest rate. And the firm knows that its shareholders will unanimously agree on what it does.
C1
Y1 P*0 Y0
W*0
C0
Implication 2: MRT = (1 + r) is the point where both of the two individuals would agree for the firm to produce. This is exactly the famous project selection rule, the positive Net Present Value rule. The firm value is maximized by taking all projects that have positive NPV. NPV = -initial investment + present value of future payout discounted by cost of capital. Cost of capital = r
C1
Y1 P*0 Y0
W*0
C0
Is exactly the same as the positive net present value rule: Net Present Value Rule Calculate the NPV for all available (independent) projects. Those with positive NPV are taken.
At the optimum: NPV of the least favourable project ~= zero
This is a rule of selecting projects of a firm that no matter how individual investors of that firm differ in their own opinion (preferences), such rule is still what they are willing to direct the manager to follow.
46
48
An Exercise
C1 C0 = C1 As C0 MU As C1 MU
45
U0 C0
[U'(C0)/ U'(C1)] = 1 To the right of the 450 line, the slope is less than 1 as [U'(C0)/ U'(C1)] < 1 To the left of the 450 line, the slope is greater than 1 as [U'(C0)/ U'(C1)] > 1
49
The individuals wealth is given by the equation W = y0 + [1/(1+R)]y1 where R is the rate of interest and is the subjective rate of time preference If an individual is to maximize utility, then we know that the present value of consumption must equal wealth: W = y0 + [1/(1+R)]y1
Derive the optimal consumption paths, assuming
a) W=100, R=10%, =10% b) W=100, R=5%, =10% c) W=100, R=10%, =5%
C1
If = R C0* = C1* If > R C0* > C1* If < R C0* < C1* C1*
U
C0
*
C0
51
52