Chapter 1

Fisher Separation Theorem

 A.Consumption and investment
without capital markets
1. Assumptions
1) All outcomes from investment are known
with certainty, i.e Ri=a1u1+a2u2+…+anun
2) No transaction costs, no exchange
3) No taxes
4) Two-period model
 A.Consumption and investment
without capital markets
2. Optimal consumption without capital markets
1) Consumption
 A.Consumption and investment
without capital markets
MRS: MRS decreasing:

ui (C1 )
MRS i
MRS 01A  MRS 01B
ui (C0 ) u  B
01
rA  rB
 (1  ri )
 A.Consumption and investment
without capital markets
2) Production
 A.Consumption and investment
without capital markets
MRT: MRT increasing:

ui [W ( I1 )]
MRT01i  MRT01A  MRT01B
ui [W ( I 0 )] B
 (1  ri ) rA  rB
 A.Consumption and investment
without capital markets
3) Optimal consumption
u0 ?  Point A : MRT A  MRS A  invest more
Point E : MRT E  MRS E  invest less
u1 ?  Point B : u (C0 B , C1B )  u (C0 A , C1 A ), but
MRS B  MRT B  invest more
Point D : u (C0 D , C1D )  u (C0 E , C1E ), but
MRS D  MRT D  invest less
u2 (Yes!),  Point C : Optimal consumption
u (C0C , C1C )  u (C0 D , C1D )  u (C0 B , C1B )
MRS C  MRTC
 Optimal consumption at (C0C , C1C )
A.Consumption and investment
without capital markets
1) Optimal consumption for different investors

1
MRS 01  MRT011  MRS 01
2
 MRT012
Individual 1 prefers consuming more at C1
Individual 2 prefers consuming more at C0
 B.Consumption and investment
with capital markets
1. Assumptions
1) All outcomes from investment are known
with certainty.
2) Inter-temporal exchange rate of consumption
bundles, r>0 is known. No transaction costs.
3) No taxes.
4) Two-period model
 B.Consumption and investment
with capital markets
2. Optimal consumption with capital markets
1) consumption
B.Consumption and investment
with capital markets
A. Initial endowment, A:
y1
w0  y0 
1 r
B. Capital market line (CML)

C. Slope of u0 at A=-(1+ri)
Slope of CML=-(1+r)
r  ri  A  B , Invest more consume less at C0

 u1  u0
B.Consumption and investment
with capital markets
*
y1 c
w0  y0   c0*  1
1 r 1 r
 c1*  w0 (1  r )  c0* (1  r )
 w1  c0* (1  r )

intercept slope

w (unchanged), u:u0→u1(↑)
 B.Consumption and investment
with capital markets
2) Production

A: Personal
i
MRS 01  MRT01i  (1  ri )
B: Market
-(1+r)
 B.Consumption and investment
with capital markets
3) Optimal consumption
B.Consumption and investment
with capital markets
A. Initial endowment, A(c0,c1)
MRS 01 i
 MRT01i
Invest more at t=0
(or consume less at t=0)
A→B,
u (c0* , c1* )  u (c0 , c1 )
(c0 , c1 )  (c0* , c1* )
where c0 , c1 , w unchanged
（why ?)
 B.Consumption and investment
with capital markets
B. Optimal consumption without capital markets, B ( c0* , c1* )
ri>r
markets offer cheaper funds
invest less at t=0
consume more at t=0
borrow more to consume
B→C, u( c** , c** )  u( c* , c* )
0 1 0 1

(c0* , c1* )  (c0** , c1** )

where c0 , c1 , w （why ?)
C. Optimal consumption with capital markets, C ( c0** , c1** )
 C.Implications
1. u3  u2  u1
u2  u3  Capital market function ( Leverage)
u1  u2  Portfolio adjustment ( self  adjustment)
**
c
2. c0**  1  c0  c1
1 r 1 r
A  B No wealth changes
B  C wealth increases ( Leverage)
3. Fisher separation theorem
“Given perfect and complete markets, the production is
governed by an objective market criterion without regard
to individual’s subjective preferences that enter into their
consumption decision.”
 C.Implications
1) Complete market
Basis Span, linear combination
Linear independent
2) Perfect market
A. No transaction costs, No taxes(Market frictionless)
B. No short sell restriction
C. Perfect competition, price takers
D. Perfect information, no information cost,
asymmetric.
 C.Implications
3) Optimal production,
MRR=ri
Optimal consumption,
r i= r
 C.Implications
4. Unanimity principle
Same production opportunity set, same investment portfolio,C
1
a.Investor1, MRS 01  MRT011  (1  r )
 r1  r
 borrow more at t  0 to consume
 I1'  I1
1
b.Investor2, MRS 02  MRT021  (1  r )
 r2  r
 invest more at t  0
 I 2'  I 2
1
c.Inequilibr ium , MRS 01  MRS 01
2
 (1  r )  MRT
 C.Implications
d.Individual delegates investment decision to managers(No individuals’
utility functions involved)
Investors’ required rate of return
=Market required rate of return
Maximization of investors’ wealth
Investors’ borrowing or lending according to their utility function

Managers made production decision without regard to the utility of the

individual investor
Rf.DeAngelo[1981], Makowski[1983]