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Finance I summary
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This is a summary of the course Finance I. The summary contains all the theory and formulas necessary for the exam.
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Lecture 1.2Hirshleifer model
• Allocation decision: the financial economic decision for each individual is how much to:
o Consume
o Invest in the financial markets
o Invest in real markets
Hirshleifer model without financial and without real market
• Assumptions:
1. A certain world is assumed: the individual knows all the decision alternatives and the
corresponding outcomes.
2. There is a one-period model where only two moments are important: the start of the
period (now, t = 0) and the end of the period (later, t = 1).
3. The individual has a current income of 𝐶𝐹0 and a future income of 𝐶𝐹1 .
• At t = 0 you receive 𝐶𝐹0 and at t = 1 𝐶𝐹1 (income at t = 0 and t = 1 respectively)
• What do you do?
o At t = 0 you can consume 𝐶𝐹0 completely, partly or nothing.
o If there is money left at t = 0, you put this amount under your pillow and you
consume it including the 𝐶𝐹1 at t = 1.
Hirshleifer model with financial and without real market
• Assumption
1. Each participant can borrow or lend unlimitedly against the risk-free market interest rate
rf
,• Optimal consumption combination
o If we assume that the individual is able to rank his preferences consistently for the
different consumption combinations (C0,C1) and value these combinations by means
of his utility function, then we can derive indifference curves.
o An indifference curve in this case contains the collection of consumption
combinations to which the individual assigns an equal utility value.
o The slope of an indifference curve therefore is called the marginal rate of
substitution between the present and future consumption
• With financial markets it is possible to reallocate cash flows in time >> consumption
possibility line.
• The optimal consumption combination (C0,C1) of the individual can be determined as the
point where the indifference curve is tangent to the consumption possibilities line.
, Lecture 1.3
Hirshleifer model with financial and real market
• Invest until the marginal return = interest rate
• The existence of financial and real markets makes people “happier”, i.e. gives them higher
utility.
o Without financial markets people have to consume in the same period as they have
income.
o Without real markets profitable projects will be unused.
o The existence of both markets makes it possible for people to achieve at higher
indifference curves.
• Fisher separation theorem
o Theorem: The real investment decision is taken independently from the consumption
decision.
o Step 1, optimal investments: Marginal return = interest rate (opportunity cost of
capital*)
o Step 2, optimal consumption Marginal utility of consumption now and later =
interest rate
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