Chapter 1

Fisher Separation Theorem

A.Consumption and investment
without capital markets
1. Assumptions
1) All outcomes from investment are known
with certainty, i.e R
i
=a
1
u
1
+a
2
u
2
++a
n
u
n
2) No transaction costs, no exchange
3) No taxes
4) Two-period model

A.Consumption and investment
without capital markets
2. Optimal consumption without capital markets
1) Consumption
A.Consumption and investment
without capital markets
) 1 (
) (
) (
0
1
01
i
B u
i
i
i
r
C u
C u
MRS
+ =
c
c
=
=
B A
B A
r r
MRS MRS
>
>
01 01
MRS: MRS decreasing:
A.Consumption and investment
without capital markets
2) Production
A.Consumption and investment
without capital markets
B A
B A
r r
MRT MRT
<
<
01 01
) 1 (
)] ( [
)] ( [
0
1
01
i
B
i
i
i
r
I W u
I W u
MRT
+ =
c
c
=
MRT: MRT increasing:
A.Consumption and investment
without capital markets
3) Optimal consumption
) , (
) , ( ) , ( ) , (
: ), ! (
), , ( ) , ( :
), , ( ) , ( : ?
:
: ?
1 0
1 0 1 0 1 0
2
1 0 1 0
1 0 1 0 1
0
C C
C C
B B D D C C
D D
E E D D
B B
A A B B
E E
A A
C C at n consumptio Optimal
MRT MRS
C C u C C u C C u
n consumptio Optimal C t Poin Yes u
less invest MRT MRS
but C C u C C u D t Poin
more invest MRT MRS
but C C u C C u B t Poin u
less invest MRS MRT E t Poin
more invest MRS MRT A t Poin u

=
= >

>
>
<
>
<
>
A.Consumption and investment
without capital markets
1) Optimal consumption for different investors
2
01
2
01
1
01
1
01
MRT MRS MRT MRS = < =
Individual 1 prefers consuming more at C1
Individual 2 prefers consuming more at C0

B.Consumption and investment
with capital markets
1. Assumptions
1) All outcomes from investment are known
with certainty.
2) Inter-temporal exchange rate of consumption
bundles, r>0 is known. No transaction costs.
3) No taxes.
4) Two-period model
B.Consumption and investment
with capital markets
2. Optimal consumption with capital markets
1) consumption
B.Consumption and investment
with capital markets
A. Initial endowment, A:


B. Capital market line (CML)





C. Slope of u
0
at A=-(1+r
i
)
Slope of CML=-(1+r)
, Invest more consume less at C
0



r
y
y w
+
+ =
1
1
0 0
0 1
u u
B A r r
i
> =>
=> >
B.Consumption and investment
with capital markets





intercept slope

w (unchanged), u:u
0
u
1
()

) 1 (
) 1 ( ) 1 (
1 1
*
0 1
*
0 0
*
1
*
1
*
0
1
0 0
r c w
r c r w c
r
c
c
r
y
y w
+ =
+ + = =>
+
+ =
+
+ =
B.Consumption and investment
with capital markets
2) Production
) 1 (
01 01 i
i i
r MRT MRS + = =
A: Personal

B: Market
-(1+r)
B.Consumption and investment
with capital markets
3) Optimal consumption
B.Consumption and investment
with capital markets
A. Initial endowment, A(c
0
,c
1
)

Invest more at t=0
(or consume less at t=0)
AB,

i i
MRT MRS
01 01
<
?)
unchanged , ,
) , ( ) , (
) , ( ) , (
1 0
*
1
*
0 1 0
1 0
*
1
*
0
why
w c c where
c c c c
c c u c c u
| +

>
B.Consumption and investment
with capital markets
B. Optimal consumption without capital markets,
ri>r
markets offer cheaper funds
invest less at t=0
consume more at t=0
borrow more to consume
BC,



C. Optimal consumption with capital markets,

) , (
*
1
*
0
c c B
?) , ,
) , ( ) , (
) , ( ) , (
1 0
* *
1
* *
0
*
1
*
0
*
1
*
0
* *
1
* *
0
why w c c where
c c c c
c c u c c u
| + |

>
) , (
* *
1
* *
0
c c C
C.Implications
1.


2.


3. Fisher separation theorem
Given perfect and complete markets, the production is
governed by an objective market criterion without regard
to individuals subjective preferences that enter into their
consumption decision.
) (
) (
2 1
3 2
1 2 3
adjustment self adjustment Portf olio u u
Leverage f unction market Capital u u
u u u

> >

) (
1 1
1
0
* *
1
* *
0
Leverage increases wealth C B
changes wealth No B A
r
c
c
r
c
c

+
+ >
+
+
C.Implications
1) Complete market
Basis Span, linear combination
Linear independent
2) Perfect market
A. No transaction costs, No taxes(Market frictionless)
B. No short sell restriction
C. Perfect competition, price takers
D. Perfect information, no information cost,
asymmetric.
C.Implications
3) Optimal production,
MRR=r
i
Optimal consumption,
r
i
= r

C.Implications
4. Unanimity principle
Same production opportunity set, same investment portfolio,C




MRT r MRS MRS ium Inequilibr c
I I
t at more invest
r r
r MRT MRS Investor b
I I
consume to t at more borrow
r r
r MRT MRS Investor a
= + = =
>
=
<
+ > =
>
=
>
+ < =
) 1 ( , .
0
) 1 ( , 2 .
0
) 1 ( , 1 .
2
01
1
01
2
'
2
2
1
02
1
02
1
'
1
1
1
01
1
01
C.Implications
d.Individual delegates investment decision to managers(No individuals
utility functions involved)
Investors required rate of return
=Market required rate of return
Maximization of investors wealth
Investors borrowing or lending according to their utility function






Managers made production decision without regard to the utility of the
individual investor
Rf.DeAngelo[1981], Makowski[1983]