Chapter- One:

Introduction

Kawser Ahmed Shiblu

Lecturer
Department of Finance
Jagannath University
Elton, Gruber, Brown & Goetzmann

Introduction
Almost everyone owns a portfolio (group) of assets
containing real assets as well as financial assets.
The composition of the portfolio may be the result of a
series of
haphazard and unrelated decisions or
deliberate planning.

When an investor is faced with a choice from among an

enormous number of assets, she or he considers
the number of possible assets and
the various possible proportions in which each can be held

Here we analyze how decision makers can structure their

problems so that they are left with a manageable number
of alternatives.
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The economic theory of choice:

under certainty
All decision problems
steps/elements:

have

certain

i. the delineation of alternatives,

ii. the selection of criteria for choosing among those
alternatives and
iii. finally the solution of the problem.

Furthermore, individual solutions can often

be aggregated to describe equilibrium
conditions that prevail in the marketplace.
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Illustration: The steps/elements of an

economic decision problem
Consider an investor who will receive with
certainty an income of $10000 in each of two
years. Assume that the only investment
available is a savings account yielding 5% per
year. In addition, the investor can borrow
money at a 5% rate.
How much should the investor save and how
much should he or she consume each year?
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Illustration: The steps/elements of an

economic decision problem
The economic theory of choice proposes to
solve this by splitting the analysis into three
parts.
I.

First, specify those options that are available to

the investor called Opportunity Set.
II. Second, specify how to choose among these
options called Indifference Curve
i. Third, the solution of the problem

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Illustration : The steps/elements of an

economic decision problem
Step-1: Opportunity Set:
a representation of the choices available to the investor

Here available three extreme choices are :

i.
ii.

save nothing and consume $ 10000 in each period, point B

save all income in the first period and consume everything in the
second, point A
iii. consume everything now and not worry about tomorrow, point C

Note that point A, B and C lie along a straight line.

does this happen by accident!!!!
No. In fact, all of the enormous possible patterns of consumption in
period 1 and 2 will lie along this straight line. But why????????
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Illustration : The steps/elements of an

economic decision problem

FIGURE 1-1 The investors opportunity set.

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Illustration : The steps/elements of an

economic decision problem
The amount the investor consumes in the two
periods is constrained by the amount of income
the investor has available in two periods.
Let C1 be the consumption in period 1 and C2 be
the consumption in period 2. So,
Period 2 consumption = Period 2 Income + Amount Saved
in period 1 * (1+ Return on investment)
C2= $ 20500 1.05C1

This is the equation for straight line. So all of the

enormous possible patterns of consumption in
period 1 and 2 will lie along this straight line.
Elton, Gruber, Brown & Goetzmann

Illustration : The steps/elements of an

economic decision problem
Here,
intercept is $20500 if C1=0
Slope is minus one plus interest rate

Why is the line negatively sloped?

As slope reflects that each dollar the investor consumes in period 1
reduces period 2 consumption by $1.05 as investment opportunity
forgone

Can the value of period 1 savings be negative?

Yes. For those investors who has dissavings (borrowing).
Amount Saved in period 1= Period 1 income ($10000) C1
Amount Saved in period 1= -$5000 if C1 is $150000.
This negative figure indicates borrowing or dissavings.
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Understanding Capacity Test

a. Assume you can lend and borrow at 5% and have
$20,000 in income in each of two periods.
Further assume you have current wealth of
$50,000.
a.
b.

What is your opportunity set?

What is the straight line equation?

b. An individual has two employment opportunities

involving the same work conditions but different
incomes. Job-1 yields Y1 = 50, Y2 = 30. Job-2 yields
Y1 = 40, Y2 = 40. Given the markets are perfect
and bonds yield 5%, which should be selected?
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Illustration : The steps/elements of an

economic decision problem
Step-2: Indifference Curves
A representation of the investors tastes or preferences
An investor chooses among the opportunities by
specifying a series of curves called utility functions or
indifference curves
The name indifference curves is used because the
curves are constructed so that everywhere along the
same curve the investor is assumed to be equally happy.
In other words, the investor does not care whether he
obtains point A, B, or C along curve I1.
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Illustration : The steps/elements of an

economic decision problem

FIGURE 1-2 Indifference curves.

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Illustration of the steps/elements of an

economic decision problem
Which IC will you prefer most and why?
curve I1 . Because investor always prefers more
to less.

Why ICs are in curved shaped?

For an assumption that each additional dollar of
consumption foregone in period 1 requires
greater consumption in period 2

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Understanding Capacity Test

Assume your utility function is,
U(C1, C2)= 1 + C1 + C2 + (C1C2 /50),
Map your indifference curve if U(C1, C2)= 50 and
you have income equal to $20 in each of two
periods.

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Illustration : The steps/elements of an

economic decision problem
Step-3: The Solution
The optimum consumption pattern for the
investor is determined by the point at which a
number of the set of indifference curves is
tangent to the opportunity set.

Why only the tangent point?

Among the ICs, some are not feasible and some
are feasible but dont make better off.
Along the IC, Points except tangent cant be
feasible.
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Illustration of the steps/elements of an

economic decision problem

FIGURE 1-3 Investor equilibrium.

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Determining Equilibrium Interest Rate

The optimum decision could occur in three sections of
opportunity set in Figure 1.3.
A to B:
If the optimum occurs in the segment AB, then the investor lends
money at the 5% rate

Point B :
If the optimum occurs at Point B, then the investor is neither a
borrower nor a lender.

B to C:
Finally, if the optimum occurs in the segment BC then the investor
borrows against future income at the 5% rate.

At a 5% interest rate the investor wishes to lend $2,000,

the difference between $10,000 in income and $8,000 in
consumption.

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Determining Equilibrium Interest Rate

At 5% interest rate, summing across all investors
who wish to lend is gives one point on the supply
curve and who wish to borrow also gives one point
on the demand curve.
By varying the interest rate, the supply and demand
curve can be traced out and the equilibrium interest
rate determined.
The equilibrium interest rate:
rate at which the amount investors wish to borrow is
equal to the amount investors wish to lend.
often called a market clearing condition.
determined by Investors tastes and investors income.
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Understanding Capacity Test

Assume you can lend and borrow at 10%

and have $5,000 in income in each of two
periods.
i.
ii.

What is your opportunity set?

What is the preferred choice if the preference
function is, P= C1 + C2 + C1C2.

Using the previous example in slide no. 14 and

assuming lending & borrowing interest rate
10%, What is the preferred choice.
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Multiple Assets and Risk

Let, a second asset existed that yielded 10%,
then
intercept on the vertical axis would be $21,000
the slope would be (1.10).
the investor would surely prefer it if lending and
prefer the 5% asset if borrowing.
The preferred opportunity set would be knicked

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Multiple Assets and Risk

FIGURE 1-4 Investors opportunity set with several alternatives.

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Understanding Capacity Test

Assume you have income of $5000 in each
of two periods and can lend at 10% but pay
20% on borrowing. What is your
opportunity set?

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Multiple Assets and Risk

Is this situation stable?
Two assets yielding different certain returns cannot
both be available since everyone will want to invest
in the higher-yielding one and no one will purchase
the lower-yielding one.
We are left with two possibilities; either there is
only one interest rate available in the marketplace
or returns are not certain.
Since we observe many different rates, uncertainty
must play an important role in the determination of
market rates of return. To deal with uncertainty, we
need to develop a more complex opportunity set.
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