Financial Management

Answer 1: Modern World

Three pillars are at the basis of the modern theory of finance: optimality, arbitrage, and equilibrium. Optimality refers to the notion that rational investors aim at optimal returns. Arbitrage implies that the same asset has the same price in each single period in the absence of restrictions. Equilibrium means that markets are cleared by price adjustment through arbitrage at each moment in time. In the neoclassical model of a perfect market, e.g. the perfect market for capital, or the Arrow-Debreu world, the following criteria usually must be met:

no individual party on the market can influence prices;

conditions for borrowing/lending are equal for all parties under equal circumstances;

there are no discriminatory taxes;

absence of scale and scope economies;

all financial titles are homogeneous, divisible and tradable;

there are no information costs, no transaction costs and no insolvency costs;

all market parties have ex ante and ex post immediate and full information on all factors and events relevant for the (future) value of the traded financial instruments. The Arrow-Debreu world is based on the paradigm of complete markets. In the case of complete markets, present value prices of investment projects are well defined. Savers and investors find each other because they have perfect information on each others preferences at no cost in order to exchange savings against readily available financial instruments. These instruments are constructed and traded costlessly and they fully and simultaneously meet the needs of both savers and investors. Thus, each possible future state of the world is fully covered by a so-called Arrow-Debreu security (state contingent claim). Also important is that the supply of capital instruments is sufficiently diversified as to provide the possibility of full risk diversification and, thanks to complete information, market parties have homogenous expectations and act rationally. In so far as this does not occur naturally, intermediaries are useful to bring savers and investors together and to create instruments that meet their needs. They do so with reimbursement of costs, but costs are by definition an element - or, rather, characteristic - of market imperfection. Therefore, intermediaries are at best tolerated and would be eliminated in a move towards market perfection, with all intermediaries becoming redundant: the perfect state of disintermediation. This model is the starting point in the present theory of financial intermediation. All deviations from this model which exist in the real world and which cause intermediation by the specialized financial intermediaries are seen as market imperfections. This wording suggests that intermediation is something which exploits a situation which is not perfect, therefore is undesirable and should or will be temporary. The perfect market is like heaven, it is a teleological perspective, an ideal standard according to which reality is judged. As soon as we are in heaven, intermediaries are superfluous. There is no room for them in that magnificent place.

Answer 2

Mutual funds give people the opportunity to save money through the stock market. They are an ideal way to avoid the complications of picking ...