Background Financial The-ory

• Philosophers have been against interest for thousands of years.

• That is because they didn't understand what causes interest.

• Irving Fisher concluded that the real rate of interest is determined by market participants' preferences and endowments

Present Value and interest rates

• Nominal Interest Rate – Inflation• US Government bonds have an “Inflation

protected” rate allowing us to calculate the real interest rate roughly.

• http://www.bloomberg.com/markets/rates-bonds/government-bonds/us

Real Interest Rate

• We can not be sure about the future.• Generally some assets such as US govern-

ment bonds are classified as risk free and other assets have ratings against this asset.

• This uncertainty is classified.• Rating agencies• Risk and Return

Uncertainty

• There is a diversification benefit which re-duces risk.

• This is possible to quantify in a mathematical equation but has been understood for thou-sands of years.

• Don’t put all your eggs into one basket.

Diversification

• The market functioning by itself without inter-ference from the outside, in other words a situation of laissez-faire, leads to allocations that are Pareto efficient. At least if there are no externalities and there's no monopoly. So government shouldn’t interfere.

Efficient markets

• Price is determined by marginal utility, water and diamonds

• Some people have more money and prefer certain things.

• Supply and demand

Marginal Utility