Summary: Reader In Finance I

Read the summary and the most important questions on Reader in Finance I

• 1 Hirschleifer Model

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• Why do financial markets exist?

  • Allocation decision
  • Hirschleifer model without real market
  • Hirschleifer model with real market
  • Fischer separation theorem

• Allocation decision determines the financial economic decision for individual how much to?

  • Consume
  • Invest on financial markets
  • Invest on real markets

• Explain the Fisher Separation Theorem.

  Meaning of the separation theorem: 

  • Everybody wants the same level of investments (until the marginal return is smaller than the interest rate)
  • Managers can focus on real investment projects that add value
  • The financial market takes care of the individual choice with respect to consumption now and later 

   

  Theorem:

  • The real investment decision is taken independently from the consumption decision.
  • Step 1, optimal investments: marginal revenue = interest rate
  • Step 2, optimal consumption: marginal utility of consumption now and consumption later = interest rate

• Define two types of pension promises.

  (1) Defined-benefit pension:

  • The company promising you the pension (the benefit) and bears the risk of having not enoough capital to pay. Usually the benefit depends on career path (average wage). The company bears the risk.

  (2) Defined- contribution pension: 

  • The entity promises you the contribution, but depending on the investment returns the pension is higher or lower. The employee bears the risk.

• Explain two main types of financing systems. 

  (1) Pay-as-you-go 

  • Workers today pay for pensioners today
  • No accumulated savings
  • Higher pensions implies higher taxes

  (2) Capital financed or funded

  • Each generation saves for its own generation
  • Can be either collective in a group or individual

• Describe the optimal consumption combination. 

  Indifferences curves indicate the utility a person gets from consumption combinations C0 and C1

  The more top-right, the higher the utility: 

  • More consumption is better
  • Optimal tradeoff between consumption now and consumption later

  Optimal consumption combination

  • Tangency point of indifference curve and line that connects all possible consumption combinations

• Explain the Hirschleifer Model without real market with refer to the existence of financial markets.

  You receive income NOW (t=0) and LATER (t=1)

  (1) Without financial markets: 

  • Receive income now = consume now or put aside
  • Receive income later = consume later

  (2) With financial markets: 

  • Save if you want to consume your current income later
  • Borrow if you want to consume your future income now

  Still there is a perfect financial market because saving and borrowing at the same interest rate are possible.

• 2 Basic Concepts in Finance

• Explain equity holders and their position in the company.

  • Equity holders own the company and are entitled to receive dividends
  • The equity holders want to maximize the value of their claims
  • The CEO manages the company in the best interest of the equity holders

• Explain Arbitrage and Equilibrium in connection to financial markets.

  Time and risk are translated in a price by trading in financial markets through the mechanisms arbitrage and equilibrium. For equilibrium to exist, there should be no arbitrage opportunities. 

  Arbitrage opportunity: 

  • Never make a loss
  • Sometimes make a profit

• 3 Investment Decision Rules

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• What are the three investment questions regarding investment?

  1. When is an investment attractive?
  2. How to choose between two (mutually exclusive) investments?
  3. How to choose with a limited budget?