Introduction to Financial Economics

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

Asymmetric Information in Fin. Markets

Capital Structure Theory

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Financial Market A financial market is a market where financial assets are exchanged or traded. Examples include: 1. Primary vs. Secondary markets 2.
3.

Debt and equity markets vs. derivative markets

Centralized exchanges vs. over-the-counter markets

Role of Financial Markets

Price discovery - The interactions of buyers and sellers in a financial market determine the price of the traded asset.
Liquidity - A financial market offers liquidity. A buyer of an asset must be assured that if one needs to sell the asset in future one will manage to do so without any problems. The market facilitates this. Reduction of transaction costs - A financial market helps in the reduction of transaction costs. The two costs associated with transacting are search costs and information costs. Search costs include such costs incurred as one advertises his intention to sell or purchase an asset as well as the value of time spent locating a counterparty to the impending transaction. Information costs are costs associated with assessing the investment merits of a financial asset, i.e., the likelihood of the cash flow expected to be generated. 5

Classification of Financial Markets

Financial markets can be classified by the type of financial claim such as debt markets or equity market. Examples would include stock exchanges where ordinary shares are traded.

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.
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Financial Markets and the Real Economy

The real economy and financial markets are not unrelated. We begin by distinguishing between real assets and financial assets. Real Assets Real assets: represent a societys wealth. Real assets produce output consumed by economy. They determine the productive capacity of the economy. Examples include: land, buildings, machinery & equipment, knowledge, etc.

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.

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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.

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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.

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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.
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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.

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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.

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Risks faced by Mgt vs. Risk faced by Shareholders

Mgt. and shareholders may be exposed to different risks associated with the firm. If shareholders are fully diversified then they are exposed just to the systematic or firm-specific risk. If one particular firm doesnt do so well there may be others doing well, gains and losses may cancel out, reducing risk. But if the managements income is largely from their compensation then they may be exposed to the firms total risk. Therefore management tends to take action to reduce the firms total risk, even if such action may not be in the shareholders 17 interests.

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

Schemes used by Mgt. to reduce exposure to firm risk

 4. Transfer of funds from surplus to deficit units

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Risks associated with investing in financial assets

Purchasing Power risk- this is the risk that is due to the uncertainty of the buying power of the cash flow you may receive from the financial assets. Default or credit risk the issuer of the financial asset may fail to pay the lender i.e. the borrower may default on the obligation. Foreign exchange risk for assets whose cash flow is not denominated in SA Rands there is the risk that the exchange rate will change adversely resulting in losses in SA Rands.

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Users of the Financial System The needs of the users of the financial system will determine what financial assets are available. 3 main groups:

The Household Sector The Business Sector The Government Sector

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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.

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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.
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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.
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The Role of Capital Markets:

An Illustration using Inter-temporal Consumption Choice

Back to Basics: Economics 101

In ECO101 we assume a unique happiness function for every individual (utility function). We call such a function the individuals subjective preference. Every economic agent is trying to maximize his/her happiness subject to some constraints. Maximise utility subject to some constraints: E.g., U(x, y) subject to PxX + PyY W
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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
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Economics 101
The constraint of PxX + PyY W can be shown as the budget line.
y

W/Py

Feasible Consumption Set

Budget line (Slope = Px/Py)

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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

W/Py C* (with consumption of x* and y*) y* U1 U0

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U2

x*

W/Px

Inter-temporal Consumption Choice

For inter-temporal consumption choice, we employ the same rationale. Now, x becomes current consumption (C0) and y becomes future consumption (C1). That means, our happiness depends on two things: current and future consumption.

C1

U2 U1 U0
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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)

MU > 0 (U / C0) > 0 MU is diminishing i.e., (2U / C2) < 0 U = U(C0,C1=constant)

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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
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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
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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

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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
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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
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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
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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(1+r) + Y1 Capital market line with Slope = -(1+r) Y1

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Y0

W0

C0

Capital Market Line

Looking at points A and B: Point A: You consume your current and future endowments now. So, C0 = current endowment + PV of future endowment, i.e., C0 = Y0+Y1/(1+r) Point B: You consume nothing now and everything in future. So C1 = Y0(1+r)+Y1 Slope of capital line = C1/C0=[Y0(1+r)+Y1 ]/[Y0+Y1/(1+r)] = -(1+r)
Therefore, equation of capital market line: C1=Y0(1+r)+Y1 - (1+r)C0 Thus: C1=W1- (1+r)C0
C1

W1=Y0(1+r) + Y1

B
Capital market line with Slope = -(1+r)

Y1

A
Y0 W0 C0

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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
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C*0 Y0

W0

C0

Production and Capital Market

Constraint D: Individuals can now borrow/lend at r & invest in production opportunities. -With only production opportunity, the individual achieves U1 only (see point D in diagram below). But if capital market is introduced, he can do better. -At D the borrowing rate is less than the rate of return on the marginal investment. Since further investment returns more than the cost of borrowed funds we increase investment. That is we move up the POS until when point B is reached (at which point return on investment is equal to the borrowing rate). -At point B we receive output from production (P0, P1) and the present value of wealth is W*. -At this point, his wealth is maximized. -Now his wealth is W*0 = P*0 + P*1/(1+r) which is larger than W0. -Once we are on the market line we can move along it as we search for a utility maximizing point (i.e. (C*0, C*1) ). With his wealth maximized, he chooses (C*0, C*1) to consume and yield him U3.

C1

P*1

(C*0, C*1)
D

Y1 P*0

U3 U1 U0
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Y0

W*0

C0

Fisher Separation Theorem

Points to note: The decisions of production and consumption involve 2 distinct steps.
1st Step: Choosing production point by moving along POS and produce at the point where the return on the marginal investment is just equal to market interest rate. 2nd Step: Choosing consumption point by moving along the capital market line and consume at the point where MRS (subjective rate of time preference) is equal to market interest rate.

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
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Y0

W*0

C0

Fisher Separation Theorem

Implication 1: As the graph below shows, with two different individuals that differ only in their subjective preferences, given the same opportunity set, both of them would choose the exact same point of production regardless of the difference of their preferences.
C1

Individual 2 P*1 Individual 1

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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

Individual 2 P*1 Individual 1

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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

Individual 2 P*1 Individual 1

45

Y1 P*0 Y0

W*0

C0

How to max shareholders wealth?

We again uses Fisher Separation Theorem Given perfect and complete capital markets, the owners of the firm (shareholders) will unanimously support the acceptance of all projects until the least favourable project has return the same as the cost of capital. In the presence of capital markets, the cost of capital is the market interest rate. The project selection rule, i.e., equate
marginal rate of return of investment = cost of capital (market interest rate)

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.

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Fisher Separation Theorem

The separation principle implies that the maximization of the shareholders wealth is identical to maximizing the present value of lifetime consumption Since borrowing and lending take place at the same rate of interest, then the individuals production optimum is independent of his resources and tastes If asked to vote on their preferred production decisions at a shareholders meeting, different shareholders will be unanimous in their decision unanimity principle Managers of the firm, as agents for shareholders, need not worry about making decisions that reconcile differences in opinion among shareholders i.e there is unanimity The rule is therefore take projects until the marginal rate of return equals the 47 market interest rate = taking all projects with +ve NPV

An exercise for self-study

Consider the following utility function: U= U(C0) + 1/(1+ )U(C1) We now take a total derivative: U'(C0)dC0 + [1/(1+ )]U'(C1)]dC1 = 0 Rearranging, dC1/dC0 = -(1- ) [U'(C0)/ U'(C1)] slope of indifference curve the slope of the indifference curve depends upon the relative marginal utilities as well as the subjective rate of time preference

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An Exercise
C1 C0 = C1 As C0 MU As C1 MU

Slope of the indifference curve

along the 45 is -(1+ ) as
0

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
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dC1/dC0 = -(1- ) [U'(C0)/ U'(C1)] slope of indifference curve

Therefore, even if > 0, the tradeoff between C0 and C1 can be < 1

if C0 is sufficiently high

Another Numerical Example

Assume individuals can borrow and lend, but no production Suppose that the utility function for consumption is U = log(C0) + [1/(1+ )] log(C1)

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%

We are ignoring production opportunities in this example

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The Optimization Problem

Set up the constrained optimization problem L = log(C0) + [1/(1+ )] log(C1) + [ W C0 C1/(1+R)] The first order conditions L/C0 = (1/C0) - = 0 = 1 / C0 L/C1 = (1/(1+ )) (1/C1) - /(1+R) = 0 = [(1+R)/(1+)] (1/ C1)] [1 / C0] = [(1+R)/(1+)] (1/ C1)] C0* = [(1+ )/(1+ R)] C1*

C1

If = R C0* = C1* If > R C0* > C1* If < R C0* < C1* C1*

U
C0
*

C0
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Optimal Consumption Paths

Solve for the following three cases
a) W=100, R=10%, =10% C0 = (1.10/1.10)C1 W = C0 + C1 /(1+R) = 100 C0* = C1* = C* = 52.38 b)W=100, R=5%, =10%

c)=100, R=10%, =5%

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