Danthine / Donaldson Intermediate Financial Theory

3. Auflage 2014
ISBN: 978-0-12-386871-8
Verlag: Elsevier Science & Techn.
Format: EPUB
Kopierschutz: Adobe DRM (»Systemvoraussetzungen)

E-Book, Englisch, 580 Seiten

Targeting readers with backgrounds in economics, Intermediate Financial Theory, Third Edition includes new material on the asset pricing implications of behavioral finance perspectives, recent developments in portfolio choice, derivatives-risk neutral pricing research, and implications of the 2008 financial crisis. Each chapter concludes with questions, and for the first time a freely accessible website presents complementary and supplementary material for every chapter. Known for its rigor and intuition, Intermediate Financial Theory is perfect for those who need basic training in financial theory and those looking for a user-friendly introduction to advanced theory. - Completely updated edition of classic textbook that fills a gap between MBA- and PhD-level texts - Focuses on clear explanations of key concepts and requires limited mathematical prerequisites - Online solutions manual available - Updates include new structure emphasizing the distinction between the equilibrium and the arbitrage perspectives on valuation and pricing, and a new chapter on asset management for the long-term investor

Jean-Pierre Danthine is professor of economics and finance at the University of Lausanne Switzerland), director of the International Center for Financial Asset Management and Engineering Lausanne & Geneva) and CEPR Research Fellow. The holder of a Ph.D. in economics from Carnegie-Mellon University and a M.S. in Economics from the University of Louvain, Professor DanthineI previously taught at at Columbia University and held visiting appointments at CUNY Graduate Center, University of Southern California (Los Angeles), Universit‚ d'Aix-Marseille, Universit‚ Laval (Qu‚bec), as well as Universities of Toulon and Dijon.He is an Associate Editor of Macroeconomic Dynamics and Finance Research Letters; Chairman of the Scientific Council of the TCIP (Training Center for Investment Professionals); member of the Council of the European Economic Association, of the Scientific Councils of CEPREMAP (Paris), CREST (Paris), CREI (U. Pompeu Fabra, Barcelona) as well as the Fonds national de la recherche scientifique (Economics Commission - Belgium). He was also a member of the Executive Committee of the ICMB (Geneva).

Autoren/Hrsg.

Danthine, Jean-Pierre

Donaldson, John B.

Inhaltsverzeichnis

1;Front Cover;1
2;Intermediate Financial Theory;4
3;Copyright Page;5
4;Contents;6
5;Preface;16
6;Dedication;22
7;I. Introduction;24
7.1;1 On the Role of Financial Markets and Institutions;26
7.1.1;1.1 Finance: The Time Dimension;26
7.1.2;1.2 Desynchronization: The Risk Dimension;29
7.1.3;1.3 The Screening and Monitoring Functions of the Financial System;30
7.1.4;1.4 The Financial System and Economic Growth;31
7.1.5;1.5 Financial Markets and Social Welfare;35
7.1.6;1.6 Financial Intermediation and the Business Cycle;41
7.1.7;1.7 Financial Crises;42
7.1.8;1.8 Conclusion;45
7.1.9;References;46
7.1.10;Complementary Readings;47
7.1.11;Appendix: Introduction to General Equilibrium Theory;47
7.1.11.1;Pareto Optimal Allocations;48
7.1.11.2;Competitive Equilibrium;50
7.2;2 The Challenges of Asset Pricing: A Road Map;54
7.2.1;2.1 The Main Question of Financial Theory;54
7.2.2;2.2 Discounting Risky Cash Flows: Various Lines of Attack;56
7.2.3;2.3 Two Main Perspectives: Equilibrium versus Arbitrage;58
7.2.4;2.4 Decomposing Risk Premia;60
7.2.5;2.5 Models and Stylized Facts;62
7.2.5.1;2.5.1 The Equity Premium;63
7.2.5.2;2.5.2 The Value Premium;65
7.2.5.3;2.5.3 The Term Structure;66
7.2.6;2.6 Asset Pricing Is Not All of Finance!;67
7.2.6.1;2.6.1 Corporate Finance;67
7.2.6.2;2.6.2 Capital Structure;68
7.2.6.3;2.6.3 Taxes and Capital Structure;69
7.2.6.4;2.6.4 Capital Structure and Agency Costs;71
7.2.6.5;2.6.5 The Pecking Order Theory of Investment Financing;72
7.2.7;2.7 Banks;72
7.2.8;2.8 Conclusions;74
7.2.9;References;74
8;II. The Demand for Financial Assets;76
8.1;3 Making Choices in Risky Situations;78
8.1.1;3.1 Introduction;78
8.1.2;3.2 Choosing Among Risky Prospects: Preliminaries;79
8.1.3;3.3 A Prerequisite: Choice Theory Under Certainty;84
8.1.4;3.4 Choice Theory Under Uncertainty: An Introduction;86
8.1.5;3.5 The Expected Utility Theorem;89
8.1.6;3.6 How Restrictive Is Expected Utility Theory? The Allais Paradox;95
8.1.7;3.7 Behavioral Finance;98
8.1.7.1;3.7.1 Framing;99
8.1.7.2;3.7.2 Prospect Theory;101
8.1.7.2.1;3.7.2.1 Preference Orderings with Connections to Prospect Theory;106
8.1.7.3;3.7.3 Overconfidence;107
8.1.8;3.8 Conclusions;108
8.1.9;References;108
8.2;4 Measuring Risk and Risk Aversion;110
8.2.1;4.1 Introduction;110
8.2.2;4.2 Measuring Risk Aversion;110
8.2.3;4.3 Interpreting the Measures of Risk Aversion;113
8.2.3.1;4.3.1 Absolute Risk Aversion and the Odds of a Bet;113
8.2.3.2;4.3.2 Relative Risk Aversion in Relation to the Odds of a Bet;115
8.2.3.3;4.3.3 Risk Neutral Investors;116
8.2.4;4.4 Risk Premium and Certainty Equivalence;117
8.2.5;4.5 Assessing the Degree of Relative Risk Aversion;120
8.2.6;4.6 The Concept of Stochastic Dominance;121
8.2.7;4.7 Mean Preserving Spreads;125
8.2.8;4.8 An Unsettling Observation About Expected Utility;128
8.2.9;4.9 Applications: Leverage and Risk;129
8.2.9.1;4.9.1 An Example;131
8.2.9.2;4.9.2 Is Leverage a Good Thing?;132
8.2.9.3;4.9.3 An Application to Executive Compensation;134
8.2.10;4.10 Conclusions;135
8.2.11;References;136
8.2.12;Appendix: Proof of Theorem 4.2;136
8.3;5 Risk Aversion and Investment Decisions, Part 1;138
8.3.1;5.1 Introduction;138
8.3.2;5.2 Risk Aversion and Portfolio Allocation: Risk-Free Versus Risky Assets;139
8.3.2.1;5.2.1 The Canonical Portfolio Problem;139
8.3.2.2;5.2.2 Illustration and Examples;140
8.3.3;5.3 Portfolio Composition, Risk Aversion, and Wealth;141
8.3.4;5.4 Special Case of Risk-Neutral Investors;144
8.3.5;5.5 Risk Aversion and Risky Portfolio Composition;145
8.3.6;5.6 Risk Aversion and Savings Behavior;147
8.3.6.1;5.6.1 Savings and the Riskiness of Returns;147
8.3.6.2;5.6.2 Illustrating Prudence;151
8.3.6.3;5.6.3 The Joint Saving–Portfolio Problem;152
8.3.7;5.7 Generalizing the VNM-Expected Utility Representation;153
8.3.7.1;5.7.1 Preferences for the Timing of Uncertainty Resolution;154
8.3.7.2;5.7.2 Preferences That Guarantee Time-Consistent Planning;156
8.3.7.2.1;5.7.2.1 Quasi-Hyperbolic Discounting;158
8.3.7.3;5.7.3 Separating Risk and Time Preferences;160
8.3.8;5.8 Conclusions;162
8.3.9;References;163
8.4;6 Risk Aversion and Investment Decisions, Part II: Modern Portfolio Theory;166
8.4.1;6.1 Introduction;167
8.4.2;6.2 More About Utility Functions and Return Distributions;167
8.4.3;6.3 Refining the Normality-of-Returns Assumption;172
8.4.4;6.4 Description of the Opportunity Set in the Mean–Variance Space: The Gains from Diversification and the Efficient Frontier;175
8.4.5;6.5 The Optimal Portfolio: A Separation Theorem;181
8.4.6;6.6 Stochastic Dominance and Diversification;182
8.4.7;6.7 Conclusions;188
8.4.8;References;189
8.4.9;Appendix 6.1: Indifference Curves Under Quadratic Utility or Normally Distributed Returns;189
8.4.9.1;Part I;189
8.4.9.2;Part II;190
8.4.9.2.1;U Is Quadratic;191
8.4.9.2.2;The Distribution if R Is Normal;191
8.4.9.3;Proof of the Convexity of Indifference Curves;193
8.4.10;Appendix 6.2: The Shape of the Efficient Frontier; Two Assets; Alternative Hypotheses;194
8.4.10.1;Perfect Positive Correlation;194
8.4.10.2;Imperfectly Correlated Assets;194
8.4.10.3;Perfect Negative Correlation;195
8.4.10.4;One Riskless and One Risky Asset;195
8.4.11;Appendix 6.3: Constructing the Efficient Frontier;196
8.4.11.1;The Basic Portfolio Problem;196
8.4.11.2;Generalizations;197
8.4.11.3;Nonnegativity Constraints;197
8.4.11.4;Composition Constraints;198
8.4.11.5;Adjusting the Data (Modifying the Means);199
8.4.11.6;Constraints on the Number of Securities in the Portfolio;200
8.5;7 Risk Aversion and Investment Decisions, Part III: Challenges to Implementation;204
8.5.1;7.1 Introduction;204
8.5.2;7.2 The Consequences of Parameter Uncertainty;206
8.5.3;7.3 Trends and Cycles in Stock Market Return Data;210
8.5.3.1;7.3.1 Trends in International Stock Market Cross-Correlations;211
8.5.3.2;7.3.2 Asset Correlations in Cyclical Periods of High Volatility;213
8.5.3.3;7.3.3 The Financial Crisis;214
8.5.4;7.4 Equally Weighted Portfolios;216
8.5.5;7.5 Are Stocks Less Risky for Long Investment Horizons?;218
8.5.5.1;7.5.1 Long- and Short-Run Equity Riskiness: Historical Patterns;218
8.5.5.2;7.5.2 Intertemporal Stock Return Behavior Through Time: The Random Walk Model;220
8.5.5.3;7.5.3 Are Stocks Less Risky in the Long Run? A Predictive Perspective;224
8.5.6;7.6 Conclusions;226
8.5.7;References;227
8.5.8;Appendix 7.1;228
9;III. Equilibrium Pricing;230
9.1;8 The Capital Asset Pricing Model;232
9.1.1;8.1 Introduction;232
9.1.2;8.2 The Traditional Approach to the CAPM;233
9.1.3;8.3 Valuing Risky Cash Flows with the CAPM;237
9.1.4;8.4 The Mathematics of the Portfolio Frontier: Many Risky Assets and No Risk-Free Asset;240
9.1.5;8.5 Characterizing Efficient Portfolios (No Risk-Free Assets);245
9.1.6;8.6 Background for Deriving the Zero-Beta CAPM: Notion of a Zero-Covariance Portfolio;247
9.1.7;8.7 The Zero-Beta CAPM;250
9.1.8;8.8 The Standard CAPM;252
9.1.9;8.9 An Empirical Assessment of the CAPM;254
9.1.9.1;8.9.1 Fama and MacBeth (1973);255
9.1.9.2;8.9.2 Banz (1981) and the “Size Effect”;257
9.1.9.3;8.9.3 Fama and French (1992);257
9.1.9.4;8.9.4 Volatility Anomalies;258
9.1.10;8.10 Conclusions;262
9.1.11;References;263
9.1.12;Appendix 8.1: Proof of the CAPM Relationship;264
9.1.13;Appendix 8.2: The Mathematics of the Portfolio Frontier: An Example;265
9.1.14;Appendix 8.3: Diagrammatic Representation of the Fama–MacBeth Two-Step Procedure;268
9.2;9 Arrow–Debreu Pricing, Part I;270
9.2.1;9.1 Introduction;270
9.2.2;9.2 Setting: An Arrow–Debreu Economy;271
9.2.3;9.3 Competitive Equilibrium and Pareto Optimality Illustrated;273
9.2.4;9.4 Pareto Optimality and Risk Sharing;280
9.2.5;9.5 Implementing PO Allocations: On the Possibility of Market Failure;283
9.2.6;9.6 Risk-Neutral Valuations;286
9.2.7;9.7 Conclusions;289
9.2.8;References;290
9.3;10 The Consumption Capital Asset Pricing Model;292
9.3.1;10.1 Introduction;293
9.3.2;10.2 The Representative Agent Hypothesis and its Notion of Equilibrium;293
9.3.2.1;10.2.1 An Infinitely Lived Representative Agent;293
9.3.2.2;10.2.2 On the Concept of a “No-Trade” Equilibrium;294
9.3.3;10.3 An Exchange (Endowment) Economy;298
9.3.3.1;10.3.1 The Model;298
9.3.3.2;10.3.2 Interpreting the Exchange Equilibrium;301
9.3.3.3;10.3.3 The Formal CCAPM;304
9.3.4;10.4 Pricing Arrow–Debreu State-Contingent Claims with the CCAPM;304
9.3.4.1;10.4.1 The CCAPM and Risk-Neutral Valuation;308
9.3.5;10.5 Testing the CCAPM: The Equity Premium Puzzle;309
9.3.6;10.6 Testing the CCAPM: Hansen–Jagannathan Bounds;316
9.3.7;10.7 The SDF in Greater Generality;318
9.3.8;10.8 Some Extensions;320
9.3.8.1;10.8.1 Reviewing the Diagnosis;320
9.3.8.2;10.8.2 Adding a Disaster State;322
9.3.8.3;10.8.3 Habit Formation;325
9.3.8.4;10.8.4 The CCAPM with Epstein–Zin Utility;326
9.3.8.4.1;10.8.4.1 Bansal and Yaron (2004);329
9.3.8.4.2;10.8.4.2 Collin-Dufresne et al. (2013);331
9.3.8.5;10.8.5 Beyond a Representative Agent and Rational Expectations;336
9.3.8.5.1;10.8.5.1 Beyond a Representative Agent;336
9.3.8.5.2;10.8.5.2 Beyond Rational Expectations;339
9.3.9;10.9 Conclusions;340
9.3.10;References;340
9.3.11;Appendix 10.1: Solving the CCAPM with Growth;342
9.3.12;Appendix 10.2: Some Properties of the Lognormal Distribution;343
10;IV. Arbitrage Pricing;346
10.1;11 Arrow–Debreu Pricing, Part II;348
10.1.1;11.1 Introduction;348
10.1.2;11.2 Market Completeness and Complex Securities;349
10.1.3;11.3 Constructing State-Contingent Claims Prices in a Risk-Free World: Deriving the Term Structure;353
10.1.4;11.4 The Value Additivity Theorem;358
10.1.5;11.5 Using Options to Complete the Market: An Abstract Setting;360
10.1.6;11.6 Synthesizing State-Contingent Claims: A First Approximation;366
10.1.7;11.7 Recovering Arrow–Debreu Prices from Options Prices: A Generalization;368
10.1.8;11.8 Arrow–Debreu Pricing in a Multiperiod Setting;375
10.1.9;11.9 Conclusions;380
10.1.10;References;381
10.1.11;Appendix 11.1: Forward Prices and Forward Rates;381
10.2;12 The Martingale Measure: Part I;384
10.2.1;12.1 Introduction;384
10.2.2;12.2 The Setting and the Intuition;385
10.2.3;12.3 Notation, Definitions, and Basic Results;387
10.2.4;12.4 Uniqueness;392
10.2.5;12.5 Incompleteness;395
10.2.6;12.6 Equilibrium and No Arbitrage Opportunities;398
10.2.7;12.7 Application: Maximizing the Expected Utility of Terminal Wealth;400
10.2.7.1;12.7.1 Portfolio Investment and Risk-Neutral Probabilities;400
10.2.7.2;12.7.2 Solving the Portfolio Problem;403
10.2.7.3;12.7.3 A Numerical Example;404
10.2.8;12.8 Conclusions;406
10.2.9;References;407
10.2.10;Appendix 12.1 Finding the Stock and Bond Economy That Is Directly Analogous to the Arrow–Debreu Economy in Which Only State...;407
10.2.11;Appendix 12.2 Proof of the Second Part of Proposition 12.6;409
10.3;13 The Martingale Measure: Part II;410
10.3.1;13.1 Introduction;410
10.3.2;13.2 Discrete Time Infinite Horizon Economies: A CCAPM Setting;411
10.3.3;13.3 Risk-Neutral Pricing in the CCAPM;413
10.3.4;13.4 The Binomial Model of Derivatives Valuation;420
10.3.5;13.5 Continuous Time: An Introduction to the Black–Scholes Formula;430
10.3.6;13.6 Dybvig’s Evaluation of Dynamic Trading Strategies;433
10.3.7;13.7 Conclusions;437
10.3.8;References;437
10.3.9;Appendix 13.1: Risk-Neutral Valuation When Discounting at the Term Structure of Multiperiod Discount Bond;437
10.4;14 The Arbitrage Pricing Theory;440
10.4.1;14.1 Introduction;440
10.4.2;14.2 Factor Models: A First Illustration;442
10.4.2.1;14.2.1 Using the Market Model;443
10.4.3;14.3 A Second Illustration: Multifactor Models, and the CAPM;444
10.4.4;14.4 The APT: A Formal Statement;447
10.4.5;14.5 Macroeconomic Factor Models;449
10.4.6;14.6 Models with Factor-Mimicking Portfolios;451
10.4.6.1;14.6.1 The Size and Value Factors of Fama and French (1993);451
10.4.6.2;14.6.2 Momentum Portfolios;457
10.4.7;14.7 Advantage of the APT for Stock or Portfolio Selection;459
10.4.8;14.8 Conclusions;460
10.4.9;References;460
10.4.10;Appendix A.14.1: A Graphical Interpretation of the APT;461
10.4.10.1;Statement and Proof of the APT;462
10.4.10.2;The CAPM and the APT;464
10.4.11;Appendix 14.2: Capital Budgeting;464
10.5;15 An Intuitive Overview of Continuous Time Finance;466
10.5.1;15.1 Introduction;466
10.5.2;15.2 Random Walks and Brownian Motion;467
10.5.3;15.3 More General Continuous Time Processes;471
10.5.4;15.4 A Continuous Time Model of Stock Price Behavior;472
10.5.5;15.5 Simulation and European Call Pricing;474
10.5.5.1;15.5.1 Ito processes;474
10.5.5.2;15.5.2 Binomial Model;476
10.5.6;15.6 Solving Stochastic Differential Equations: A First Approach;477
10.5.6.1;15.6.1 The Behavior of Stochastic Differentials;477
10.5.6.2;15.6.2 Ito’s Lemma;479
10.5.6.3;15.6.3 The Black–Scholes Formula;480
10.5.7;15.7 A Second Approach: Martingale Methods;482
10.5.8;15.8 Applications;483
10.5.8.1;15.8.1 The Consumption–Savings Problem;483
10.5.8.2;15.8.2 An Application to Portfolio Analysis;484
10.5.8.2.1;15.8.2.1 Digression to Discrete Time;485
10.5.8.2.2;15.8.2.2 Return to Continuous Time;487
10.5.8.3;15.8.3 The Consumption CAPM in Continuous Time;489
10.5.9;15.9 Final Comments;490
10.5.10;References;490
10.6;16 Portfolio Management in the Long Run;492
10.6.1;16.1 Introduction;492
10.6.2;16.2 The Myopic Solution;495
10.6.3;16.3 Variations in the Risk-Free Rate;501
10.6.3.1;16.3.1 The Budget Constraint;502
10.6.3.2;16.3.2 The Optimality Equation;504
10.6.3.3;16.3.3 Optimal Portfolio Allocations;505
10.6.3.4;16.3.4 The Nature of the Risk-Free Asset;507
10.6.3.5;16.3.5 The Role of Bonds in Investor Portfolios;508
10.6.4;16.4 The Long-Run Behavior of Stock Returns;509
10.6.4.1;16.4.1 Solving for Optimal Portfolio Proportions in a Mean Reversion Environment;512
10.6.4.2;16.4.2 Strategic Asset Allocation;514
10.6.4.3;16.4.3 The Role of Stocks in Investor Portfolios;515
10.6.5;16.5 Background Risk: The Implications of Labor Income for Portfolio Choice;515
10.6.6;16.6 An Important Caveat;524
10.6.7;16.7 Another Background Risk: Real Estate;524
10.6.8;16.8 Conclusions;527
10.6.9;References;528
10.7;17 Financial Structure and Firm Valuation in Incomplete Markets;530
10.7.1;17.1 Introduction;530
10.7.1.1;17.1.1 What Securities Should a Firm Issue if the Value of the Firm is to be Maximized?;531
10.7.1.2;17.1.2 What Securities Should a Firm Issue if it is to Grow as Rapidly as Possible?;531
10.7.2;17.2 Financial Structure and Firm Valuation;531
10.7.2.1;17.2.1 Financial Structure F1;533
10.7.2.2;17.2.2 Financial Structure F2;535
10.7.3;17.3 Arrow–Debreu and Modigliani–Miller;537
10.7.4;17.4 On the Role of Short Selling;539
10.7.5;17.5 Financing and Growth;541
10.7.5.1;17.5.1 No Contingent Claims Markets;542
10.7.5.2;17.5.2 Contingent Claims Trading;542
10.7.5.3;17.5.3 Incomplete Markets;544
10.7.5.4;17.5.4 Complete Contingent Claims;545
10.7.6;17.6 Conclusions;547
10.7.7;References;547
10.7.8;Appendix: Details of the Solution of the Contingent Claims Trade Case of Section 17.5;548
10.8;18 Financial Equilibrium with Differential Information;550
10.8.1;18.1 Introduction;550
10.8.2;18.2 On the Possibility of an Upward-Sloping Demand Curve;552
10.8.3;18.3 An Illustration of the Concept of REE: Homogeneous Information;553
10.8.4;18.4 Fully Revealing REE: An Example;558
10.8.5;18.5 The Efficient Market Hypothesis;562
10.8.6;References;565
10.8.7;Appendix: Bayesian Updating with the Normal Distribution;565
11;Index;568
12;List of Frequently Used Symbols and Notation;578
12.1;Roman Alphabet;578
12.2;Greek Alphabet;579
12.3;Numerals and Other Terms;580

Leseproben

Chapter 1 On the Role of Financial Markets and Institutions
Chapter 1 considers the role played by the financial system in the economic life of a society. In general terms, a financial system allows for the income and consumption (or, in the case of firms, investment) streams of economic agents to be desynchronized; that is, made less similar, across both time periods and states of nature (uncertain events). We consider how the functioning of the financial system can have substantial consequences of the growth of an economy and for its business cycle properties. Keywords
Arrow–Debreu securities; Great Recession case; Edgeworth–Bowley box; Pareto optimal; complete financial markets; competitive equilibrium Chapter Outline 1.1 Finance: The Time Dimension 3 1.2 Desynchronization: The Risk Dimension 6 1.3 The Screening and Monitoring Functions of the Financial System 7 1.4 The Financial System and Economic Growth 8 1.5 Financial Markets and Social Welfare 12 1.6 Financial Intermediation and the Business Cycle 18 1.7 Financial Crises 19 1.8 Conclusion 22 References 23 Complementary Readings 24 Appendix: Introduction to General Equilibrium Theory 24 Pareto Optimal Allocations 25 Competitive Equilibrium 27 1.1 Finance: The Time Dimension
Why do we need financial markets and institutions? We choose to address this question as our introduction to this text on financial theory. In doing so, we touch on some of the most difficult issues in finance and introduce concepts that will eventually require extensive development. Our purpose here is to phrase this question as an appropriate background for the study of the more technical issues that will occupy us at length. We also want to introduce some important elements of the necessary terminology. We ask the reader’s patience as most of the sometimes difficult material introduced here will be taken up in more detail in the following chapters. Fundamentally, a financial system is a set of institutions and markets permitting the exchange of contracts and the provision of services for the purpose of allowing the income and consumption streams of economic agents to be desynchronized—i.e., made less similar. It can, in fact, be argued that indeed the primary function of the financial system is to permit such desynchronization. There are two dimensions to this function: the time dimension and the risk dimension. Let us start with time. Why is it useful to disassociate consumption and income across time? Two reasons come immediately to mind. First, and somewhat trivially, income is typically received at discrete dates, say monthly, while it is customary to wish to consume continuously (i.e., every day). Second, and more importantly, consumption spending defines a standard of living, and most individuals find it difficult to alter their standard of living from month to month or even from year to year. There is a general, if not universal, desire for a smooth consumption stream. Because it deeply affects everyone, the most important manifestation of this desire is the need to save (consumption smaller than income) for retirement so as to permit a consumption stream in excess of income (dissaving) after retirement begins. The life-cycle patterns of income generation and consumption spending are not identical, and the latter must be created from the former. The same considerations apply to shorter horizons. Seasonal patterns of consumption and income, for example, need not be identical. Certain individuals (car salespersons, department store salespersons, construction workers) may experience variations in income arising from seasonal events (e.g., most new cars are purchased in the spring and summer; construction activity is much reduced in winter), which they do not like to see transmitted to their ability to consume. There is also the problem created by temporary layoffs due to variation in aggregate economic activity that we refer to as business cycle fluctuations. While they are temporarily laid off and without substantial income, workers do not want their family’s consumption to be severely reduced (Box 1.1). Box 1.1 Representing Preference for Smoothness The preference for a smooth consumption stream has a natural counterpart in the form of the utility function, U( ), which is typically used to represent the relative benefit a consumer receives from a specific consumption bundle. Suppose the representative individual consumes a single consumption good (or a basket of goods) in each of two periods, now and tomorrow. Let c1 denote today’s consumption level and c2 tomorrow’s, and let U(c1)+U(c2) represent the level of utility (benefit) obtained from a given consumption stream (c1, c2). Preference for consumption smoothness must mean, for instance, that the consumption stream (c1,c2)=(4,4) is preferred to the alternative (c1, c2)=(3, 5), or (4)+U(4)>U(3)+U(5) Dividing both sides of the inequality by 2, this implies (4)>12U(3)+12U(5) As shown in Figure 1.1, when generalized to all possible alternative consumption pairs, this property implies that the function U(·) has the rounded shape that we associate with the term strict concavity.
Figure 1.1 A strictly concave utility representation. Furthermore, and this is quite crucial for the growth process, some people—entrepreneurs, in particular—are willing to accept a relatively small income (but not necessarily consumption!) for an initial period of time in exchange for the prospect of high returns (and presumably high income) in the future. They are operating a sort of arbitrage over time. This does not disprove their desire for smooth consumption; rather, they see opportunities that lead them to accept what is formally a low-income level initially against the prospect of a much higher income level later (followed by a zero income level when they retire). They are investors who, typically, do not have enough liquid assets to finance their projects and, as a result, need to raise capital by borrowing or by selling shares. Indeed, the first key element in finance is time. In a timeless world, there would be no assets, no financial transactions (although money would be used, it would have only a transaction function), and no financial markets or institutions. The very notion of a security (a financial contract) implies a time dimension. Asset holding permits the desynchronization of consumption and income streams. The peasant putting aside seeds, the miser burying his gold, or the grandmother putting a few hundred dollar bills under her mattress are all desynchronizing their consumption and income, and in doing so, presumably seeking a higher level of well-being for themselves. A fully developed financial system should also have the property of fulfilling this same function efficiently. By that we mean that the financial system should provide versatile and diverse instruments to accommodate the widely differing needs of savers and borrowers insofar as size (many small lenders, a few big borrowers), timing, and maturity of loans (how to finance long-term projects with short-term money), and the liquidity characteristics of instruments (precautionary saving cannot be tied up permanently). In other words, the elements composing the financial system should aim at matching the diverse financing needs of different economic agents as perfectly as possible. 1.2 Desynchronization: The Risk Dimension
We have argued that time is of the essence in finance. When we talk of the importance of time in economic decisions, we think in particular of the relevance of choices involving the present versus the future. But the future is, by its very nature, uncertain: financial decisions with implications (payouts) in the future are necessarily risky. Time and risk are inseparable. This is why risk is the second key word in finance. For the moment, let us compress the time dimension into the setting of a “Now and Then” (present versus future) economy. The typical individual is motivated by the desire to smooth consumption between “Now” and “Then.” This implies a desire to identify consumption opportunities that are as similar as possible among the different possibilities that may arise “Then.” In other words, ceteris paribus—most individuals would like to guarantee their family the same standard of living whatever events transpire tomorrow: whether they are sick or healthy, unemployed or working, confronted with bright or poor investment opportunities, fortunate or hit by unfavorable accidental events.1 This characteristic of preferences is generally described as “aversion to risk.” A productive way to start thinking about this issue is to introduce the notion of states of nature or states of the world. A state of nature is a complete description of a possible scenario for the future across all the dimensions relevant for the...