An Introduction to the Economics of

Financial Market

Saumitra Bhaduri
Introduction to Financial Market
Purpose of Financial System:

To enable individual to transfer wealth between states

via competitive (liquid) promise and enforce delivery
on those promises.

Individual wealth transfers do not directly change

social wealth. But individual will be able to engage in
different productive activities which do change social
wealth as a result of their individual wealth transfers.
Do Capital Markets Benefit Society?

To answer this we need to compare an economy without

capital market to one with them and show that no one is
worse off and that at least one individual is better off in a
world with Capital market.
General Equilibrium Model : An Example

U A 100 x 0.5 x 2 y ; (exA , e yA ) (4,5000)

U B 30 x 0.5 x 2 y ; (exB , e yB ) (80,1000)
Endogenous Variable : ( p x , p y , x A , y A , x B , y B )

Max U A 100 x 0.5 x 2 y

s.t p x x A p y y A p x exA p y e yA ;
Max U B 30 x 0.5 x 2 y
s.t p x x p y y p e p e ;
B B B
x x
B
y y
Eqm is defined as :
x x e e
A B A
x
B
x

y A y B e yA e yB
px x p y y px e p y e
A A A
x
A
y

p x x B p y y B p x exB p y e yB
A
MU px
x
A

MU y py
B
MU px
x
B

MU y py
Demand and Supply Eqn :
x A x B 4 80 84
y A y B 5000 1000 6000
Budget Equation :
p x x A p y y A p x 4 p y 5000
p x x B p y y B p x 80 p y 1000
MU xA 100 x A px

MU yA 1 py
MU xB 30 x B px

MU yB 1 py
Assume p y 1 (Walras ) :
x A 100 p x ; x B 30 p x and we have x A x B 84
p x 23 ; x A 77 ; x B 7
From budget set :
y A 3321 and y B 2679
General Equilibrium Model : An Example

Max U A (3 / 4) ln x (1 / 4) ln y ; (exA , e yA ) (2,1)

s.t p x x A p y y A p x exA p y e yA ;
Max U B (2 / 3) ln x (1 / 3) ln y ; (exB , e yB ) (1,2)
s.t p x x p y y p e p e ;
B B B
x x
B
y y
Demand and Supply Eqn :
x A xB 2 1 3
y A yB 1 2 3
BudgetEquation :
px x A p y y A px 2 p y1
px x B p y y B p x1 p y 2
MU xA 3 / 4 x A px 3/ 4 1/ 4

MU yA 1 / 4 y A py px x A py y A
MU xB 2 / 3x B px 2/3 1/ 3

MU yB 1 / 3 y B py px x B py y B
Assume p y 1 (Walras ) :
It is evident from MU condition that A will spend 3 / 4 of his income on X
while B will spend 2 / 3 of his income on X .
x A [3 / 4( 2 p x 1 p y )] / p x ; x B [ 2 / 3( p x 2 p y )] / p x
From D S
3 / 4( 2 p x 1 p y ) 2 / 3( p x 2 p y ) 2 1 3 p x 5 / 2
x A 9 / 5 ; xB 6 / 5
From budget set :
y A 3 / 2 and y B 3 / 2
In general :
Max U ( x, y ) ln x ln y ; (e , e ) A
x
A
y

s.t p x x p y y p e p e ;
A A A
x x
A
y y

x
1
(1 ) p x

p x exA p y e yA
y

(1 ) p y

p x exA p y e yA
Financial General Equilibrium Model:
Irving Fisher (18671947)
 The Fisher Model and the Foundations
of the Net Present Value Rule:
What are the factors that we need to add to
develop a Financial Model:

Time: Also captures Impatience : Think

of Y as the same good as X but one
period later.

Risk
The Fisher Model and the Foundations
of the Net Present Value Rule:
Assets : pay dividends in later time.
Assets: A real asset is defined by its payoff:

D ;D
x y

Since there is no risk the assets are defined by

their dividends.
Economy :

U , (e , e ), (D , D )
i i
x
i
y

x

y A , i
A i
Fishers Impatient Theory: Interest

Impatient is a fundament attribute of human

nature. As long as people like to have things
today rather than tomorrow their will be a rate
of interest. Interest is, at it were, impatient
crystallized into a market rate
Fishers Impatient Theory: Interest as Price

Instead of thinking of money today for money

tomorrow Fisher thought of goods given up today
for good tomorrow.

The real rate of interest is no more or less than the

relative price of good today Vs good tomorrow.

Thus the rate of interest rate is the most important

price in the economy.
Why Positive?

The rate of interest is determined the same way the

relative price of apples and oranges is determined,
by supply and demand.
The rate of interest is positive because impatient
people prefer goods today to good tomorrow and
because there will probably be more good
tomorrow than today.
Determinants of Impatience:
The rate of impatience depends principally upon two
circumstances, the character of the individual and
character of the income of which he finds himself the
owner.

Among the individual characteristics:

Foresight
Self-control
Habit
Expectation of life
Love for posterity
 Patience and Wealth
The patient will accumulate wealth!

By waiting they make possible more

production, i.e., they allow society to
produce wealth.

Their patience earns them their returns.

Consumption & Investment Decision
- Robinson Crusoe Economy
A Simple Story .
A simple world:

1. All outcome from the investment are known with

certainty ~ NON RANDOM. All investment decision are
assumed to be independent.
2. No Distortion ~ No Taxes & Transaction Costs
3. Decisions are made in a one-period context.
4. Individual are endowed with resources (coconuts) Y0 and
Y1.
Y0 Time line Y1
5. Mr. Crusoe needs to decide how much to consume now C0
and how much to invest to get end of period consumption
C1 .
A simple world:

6. Every individual is assumed to prefer more consumption

to less.
7. Diminishing Marginal Utility of consumption.
U(C0)

Observations:
Marginal Utility >0
DMUs

Total Utility of Consumption C0

 U(C0,C1)

U(C1)
Indifference Curves:
Provides various
combinations of C0 and A
C1 such that utility is
same.
B
C1

U(C0)

Trade offs between C0 & C1

C0
 SRTP
Slope of the line: Subjective Rate
of Time Preference ~ How many
extra units of consumption
tomorrow must be received to give
C1 up one unit C0. Point A has a higher
Change in C1 SRTP than B.

Change in C1
B

C0
1 unit 1 unit
 SRTP is higher at
C1 A than B Slope at B is MRS between C0 & C1

A D
Slope of the line: Subjective Rate
B of Time Preference ~ How many
extra units of consumption
tomorrow must be received to give
up one unit C0. Point A has a higher
SRTP than B.
C0

Indifference curves representing the time preference of

consumption.
Mr. Crusoe, therefore makes his decision by using a simple
rule:

MRS(C0,C1) = SRTP = - (1+ri)*

U const

* Note : C1=C0(1+ri)
Simple Investment Opportunities

Invest opportunities
A are arranged from the
highest to lowest rate
of return.

B Observation: DMR
ri

X
I0 Total Investment

Mr. Crusoes schedule of investment. He will

select all investments that have rates of return
higher than SRTP
 Project Investment Rate of Return
A 1,000,000 8%
B 1,000,000 20%
C 2,000,000 4%
D 3,000,000 30%

Graph the production opportunity set in a Co & C1

framework.
Project ROA (1+r) Investment Cum Sum Output
D 1.3 3 3 3.9
B 1.2 1 4 1.2
A 1.08 1 5 1.08
C 1.04 2 7 2.08

Total 8.26
 C1 Slope: Rate at which one unit
Slope= -(1+ri) of consumption foregone
today is transformed by
productive investment into
future consumption (MRT).
B
P1= C1
U2

y1 U1
A
P0= C0 y0 C0
 Mr. Crusoe, therefore makes his decision by using a simple
rule:

MRS = MRT = SRTP = -(1+ri)

Process: Mr. Crusoe starts with an initial endowment and

compares his SRTP with the MRT. If the rate on investment is
higher he gains by making investment (Y0-C0). He finally gets
to B, where MRT=SRTP.
A few important observations:

1. At B, Mr.Crusoes consumption in each time period is

exactly equal to the output from production.

2. Individuals with same endowment and the same

investment opportunity set may end up with different
investments as they have different Indifference Curves.
 Individual B Individual B has lower
C1 SRTP

y1 Individual A

C0
y0
The Fisher Model and the Foundations of the Net
Present Value Rule:
What are the factors that we need to add to develop a Financial Model:

Time: Also captures Impatient

Risk
Assets : pay dividends in later time.

Time: Think of Y as the same good as X but one period later

Assets: An real asset is defined by its payoff: Dx ; D y
Since there is no risk the assets are defined by their dividends.

Economy :
U , (e , e ), ( D
i i
x
i
y

x , Dy )A , iA
Fishers Model: An Example

Two agents (A, B) and two goods model : (X 1, X2) Coconuts today
and coconuts tomorrow or next year i.e, 1 and 2 are the times

A is impatient : UA(X1,X2)=lnX1+ 0.5lnX2 with eA = (1, 1)

B is patient : UB(X1,X2)=lnX1+ lnX2 with eB = (1, 0)

Assets: Stock and Stock with future dividends of X2 as:

D2=1 and D 2=2
(A , A ) (1, 0.5) ;
Original ownership of assets: (B , B ) (0, 0.5)
Fishers Model: An Example

Financial Equilibrium :

(q , q ), ( X
1 2 1
A
, X 2A ), ( X 1B , X 2B ), ( , ), (A , A ), (B , B )
In equilibrium i chooses (X1 and X2) and (,) to maximize Ui subject to the
budget set.

Budget set for agent i (A,B):

q1 X 1 q1e1i
q2 X 2 q2 e2i q2 D2 q2 D2
 Fishers Model: An Example

X X e e
1
A
1
B
1
A B
1

A B A B
A B A B
X 2A X 2B e2A e2B (A B ) D2 ( A B ) D2
Features of the Economy

Inflation: q2/q1
Arbitrage: With perfect foresight
D2 1
( for the example )
D2 2

Suppose after finding the equilibrium we add a third asset that pays $1
in period 2

=(1/(1+i)) where i is the nominal interest rate

Also
Selling
0 short selling

No default
 Present Value Prices:
Fisher says though it looks complicated it is simple to
solve. He introduces the concept of present value
Prices.
Also recognize that buying a stock implies sacrificing
consumption today! Coconuts today Vs coconuts
tomorrow
Now the arbitrage ensures that no matter how we do it
through assets , or it should represent same trade-
off.
 Present Value Prices:
p1= price of a coconut today=q1
p2= price today of a coconut tomorrow or next year
(say =1/4 which implies p2 is 1/8)

p2
D2 D2

Furthermore, the stocks effectively just add to the

endowment of goods.
Converting FE model to a GE model :

Redefining the model:

A
U ( X 1 , X 2 ) U A ( X 1 , X 2 ) with (e1A , e2A ) (1, 3)
B
U ( X 1 , X 2 ) U B ( X 1 , X 2 ) with (e1B , e2B ) (1, 1)

Solve for p1 and p2 as before : Assume p1=1

2 / 3( p1 3 p2 ) 1 / 2( p1 p2 )
2
p1 p2

p2=1/3 and A consumes of X1 and X2 (4/3 and 2) and

B consumes of X1 and X2 (2/3 and 2)
Back to FE

Real rate of interest rate: (1+r)=p1/p2 = 3 => r is 200%

[ Note that if you give up one coconut today you can get 3 units tomorrow]

Stock Price : Assume q1=1

=1/3 [ Since Alpha assets gives one coconut as dividend
tomorrow]
=2/3 [ Since price of Alpha is half of Beta (No Arbitrage)]

Fishers theory does not explain how much of each stock investors holds.

Does not explain inflation (q1and q2 are indeterminate)

Does not explain nominal interest rate but real interest rate
Fundamental Theorem of Asset Prices

Real Price of stock Alpha

D2

(q1 p1 ) (1 r )

p2
Remember D2 D2
p1
(1 r )
p2
Some more insights into Fishers model:

1. No- Arbitrage: Note if =1/3 then No Arbitrage implies that =2/3

2. We introduce a nominal bond with payoff 1$ in period one. Suppose

q1=q2=1 . The price of the bond is (1/1+i) where i is the nominal
interest rate. By no arbitrage:
$1 today -> you can buy 3 units of stock alpha -> 3units of X2 as dividend
tomorrow -> $3 -> (1+i) = 3 or i is 200%

3. Define real rate of interest rate as (1+r)= number of goods today ->
number of goods tomorrow
One unit of X1 -> 3 units of stock alpha -> 3 units of X2 ->
(1+r)=3 -> r is 200%

4. Suppose we have started with q1=1 and q2=2 then inflation (1+g)=2 or
g is 200%
1. What will be the price of stock with inflation:

No change in price ! Remember fundamental theorem of asset price.

D2

(q1 p1 1) (1 r )
Note in terms of nominal interest rate the

D2 q2

(1 i )

Nominal Interest rate with inflation: $1 today -> 3 units of alpha -> 3 units of X2 -> $
6 -> 1+i= 6 implies i is 500%

Fishers equation:

(1+r)=(1+i)/(1+g)
Consumption Decision with Capital Market

1. Inter-temporal exchange of consumption bundles will be

represented by the opportunity to borrow or lend unlimited
amounts at r, a market determined rate of interest .
2. Capital market facilitate the transfer of funds between
lenders and borrowers.
3. Interest rate is positive: Any amount of funds lent today will
return interest plus principal at the end of the period.

X1 = X0 + r X0 = X0 (1+r)
Consumption Decision with Capital Market
C1
Market Line:Slope = - (1+r)
W1

y1

C0
y0 W0

W0 = Y0 + Y1/(1+r)
Consumption Decision with Capital Market

C1
Market Line:Slope = -(1+r)
W1

C* 1
U2
A U1
y1
SRTP= -(1+ri)

C0
C*0 y0 W0
Equation for the Capital market Line:

1. W0 = Y0 + Y1/(1+r)

2. W0 = C*0 + C*1/(1+r)

=> C*1 = W0 (1+r) - (1+r) C*0

C*1 = W1 - (1+r) C*0

Observation: Moving along the capital line does not change ones
wealth, but it does offer different pattern of consumption.
Consumption & Investment Decision with Capital Market

Step 1: Mr. Crusoes economy

B
P1= C1
U2

A
y1 U1

P0= C0 y0
Consumption & Investment Decision with Capital Market

Step 2: Mr. Crusoe with capital market

P1 C
D U3
C1 *
B
U2
Market Line
A
y1 U1

W0 W*0
P0 C*0 y0
Consumption & Investment Decision with Capital Market

1. Decision process takes place in two separate &

distinct steps.
2. Select the optimum production decision by taking
project until MRT equals the market rate r.
MRT = - (1+r)
3. Select the optimum consumption by borrowing or
lend along the capital market line to equate SRTP
with the market rate of return.
MRS = - (1+r)
Fishers Separation Theorem:

Given perfect and complete capital market, the production

decision is governed solely by an objective market criterion
(represented by max. wealth) without regard to individuals
subject time preferences that enter into their consumption
decision.

MRSi = MRSj = - (1+r) = MRT

Consumption & Investment Decision with Capital Market

Individual B Individual B has lower SRTP

C1
A

B
P1

C
Individual A

C0
P0
Overlapping Generation Model: An Extension

Time does not have a beginning or end ! It goes for

ever.

Gen 0
Gen 1
Gen 2
Gen 3
Gen 4
Gen 5
Gen 6
OLG model with Land:

Land gives a dividend of 1unit of apple forever. Generation

0 own the land. All lands are normalized to one.
When young people save and invest in land. However, when
they are old they sell the land .

Every Generation t has :

(ett , ett1 ) (3, 1)
U ( xt , xt 1 ) ln xt ln xt 1 t 1
t

U 0 ( x1 ) ln( x1 )
OLG model with Land:

Financial Equilibrium:
(qt , t , ( x , x ), x1 , t )
t
t
t 1
t

Budget Set:
t 1
qt xt t t qt ett
qt 1 xt 1 qt 1ett1 t 1 t qt 11 t
t 0
qt xt qt ett t 1 qt 1
Observations:

qt is on both the sides of the budget set and hence can

be normalized. So we can take qt =1
We can also renormalize all the nominal price in
terms of apple price
t 1
xt t t ett
xt 1 ett1 t 1 t
t 0
xt ett t 1 1
Where t price of land at time t in terms of apple
at time t.
Fishers lesson:
Forget about assets by putting their dividends into the
endowment.
Look at the present value price:
p1 p2 p3 .. Where pt = price at time 1 of an apple at time
t.
Observe that by symmetry we can hope to find an
equilibrium with:
(pt+1/pt)= p = constant

For each generation the only relevant price is the

trade off between pt and pt+1.
Observations:
Real rate of interest:
t 1 1 pt 1
(1 rt ) (1 r )
t pt 1 p

The equilibrium for t >0

1 / 2(3 1 p ) 1 / 2(3 1 p )
1 3 1 5
p 1
Old demand young demand total sup ply
p2 6 p 3 0
6 36 12
p 0.55
2
Solutions:
Consumption (young, old)= (1.775, 3.225)
Market clears as total supply at each period is 5.
Price of land:
t 1 p 1 p 2 1 p 3 .......
1
1.225
r
Re member
1
p 0.55; Note p 1 to get a finite land price
(1 r )
r 0.81
Also note :
t 1 1
1 r 1.81
t
Solutions:

Generation 0 :
Old Consumption (3.225 = 1 + 1 +1.225)
Assets Market clears as with = 1
(1.775+1.1.225 = 3)
Transactions Costs and Capital Market

Case 1: 5 individual with

2 5 different commodities.

1 3

4
N individual = N(N-1)/2

5
Transactions Costs and Capital Market

1. With nontrivial transaction cost, financial intermediaries

and market place will provide a useful service.

FIs
A C

2. Intermediaries will ask for a premium: Borrowing rate

will be typically higher than the lending rate.
Transactions Costs and Fishers Separation Theorem

C1 Individual B

A Lending rate

PB1 B

PA1 C

Borrowing rate
Individual A

C0
PB0 PA0