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'
< +
otherwise
W W for W W W r
r W K W h
0
,
,
~
*
1 0 1
*
0 0
( )
( ) ( ) ( ) ( )
'
+ +
otherwise
W W A for A W W r
r W K
0
*
0 0
*
0
Objective function:
( ) ( ) ,
0 max
0
W h E
W
( ) ( ) ( ) ( )( ) ( ) A dF r A W W r W K W h E
W W
+ +
*
0
0
*
0 0
,
with ( ) A F as the distribution function of ( ) A
( )
( ) ( ) ( )
1
1
]
1
*
0
0
*
0 0
W W
A dF A W W
W
r r
W
h E
To evaluate the expression above we use Leibnitz:
( )
( )
( )
( )
( )
( )
( )
( ) ( )
( )
( ) ( )
functions able differenti continous g and v u with
u g
u
v g
v
dx x g dx x g
v
u
v
u
da
d
,
, , , ,
( ) ( ) ( ) ( )
1
1
]
1
+ + +
*
0
*
0 0
*
1 0 1
W W
W W W W A dF r r
( ) ( ) ( ) ( ) 0 1 1
*
0
+ W W F r r
( )
*
0
1 W W F
r
r
+
( )
*
0
1
1
W W F
r
r
+
then
*
0
1
1
1
W W F
r
,
_
or
*
0
1
1
1
W W F
r
,
_
,
_
+
+
r
F W W
1
1
1 * *
0
That means the optimal level of cash is the critical level
*
W plus a risk mark up
,
_
r
F RM
1
1
1
0 <
r
RM
0 >
RM
0
*
0
<
r
W
0
*
0
>
RM
W
How does a distribution function that tends to result in higher ( ) A affect RM.
( )
( )
( )
( )
( ) ( )
0 0 0 0
1 1
0 0
A A prob A A prob A A prob A A prob
G F
A G
G
A F
F
( ) ( )
0 0
A A prob A A prob
G F
The probability to pay out A
0
with G is at least as high as with F.
Intuitively we say, with G we hold at least as much cash as F.
This means G is stochastic dominant to F:
( ) ( ) G F G A A F A G
1 1
has greater RM and
*
, 0
*
, 0 F G
W W
Critique: model static (to change that see Miller Model next week)
model does not reflect economic realities here in Germany
(in Germany businesses usually negotiate a line of credit (LC) where the bank
charges a commitment fee independent of the actual usage of the LC, only after
the LC is exhausted the cost of borrowing increase.)
Model extension:
-
0
W
remains in a interest bearing account (i.e. money market account) that earns interest
M
r -
-
0
W K
is invested in a CD (i.e. time account) interest
CD
r
-a LC in the volume of L is available interest
LC
r
-if we exceed L the cost of borrowing increase to
+
LC
r
-commitment fee in % for the LC is
CF
r
The return of the policy
0
W
is as follows:
( ) ( )
( )
'
+ +
+
L W for W L W r
W L for W r
W for W r
Lr r W K L W h
LC
LC
M
CF CD
1 1 1
1 1
1 1
0 0
0
0
,
Objective function:
( ) ( )
max
,
0
0
,
L W
L W h E O
With:
( ) ( ) ( ) ( ) ( ) ( ) ( )
( ( ) ( ) ) ( ) A dF A W L A W r
A dF A W r A dF A W r Lr r W K L W h E
W L
LC
W L
W
LC
W
M CF CD
+
+
+ + +
+ +
0
0
0
0
0 0
0 0
0
0 0
,
W L F r W F r r r
W L F r W F W L F r W F r r
W
L W h E
LC LC M CD
LC LC M CD
and
( ) ( )
( ) ( ) 0 1
,
0
0
+ +
W L F r
L
L W h E
CF
with
( ) ( )
0
,
2
0
2
L
L W h E
and
( ) ( )
0
,
0
2
0
2
W
L W h E
Solution:
,
_
M LC
CD CF LC
r r
r r r
F W
1
0
( )
,
_
+
M LC
CD CF LC r
r r
r r r
F F L
CF
1 1
1
with K W
*
0
0 and
*
0 L
'
< <
,
_
K W for K
W for
K W for
r r
r r r
F
W
M LC
CD CF LC
0
0
0
1
*
0
0 0
0
( )
'
>
,
_
otherwise
L for
r r
r r r
F F
L
M LC
CD CF LC
r
CF
0
0 1
1 1
*