FIN4722 ADVANCED HOUSEHOLD FINANCE

Lecture 1: Introduction
 LESSON OUTLINE

1. Introduction

2. Functions

3. Interventions

4. Grading, Housekeeping, and Group Project

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 1. INTRODUCTION

• In this class, we take a household-oriented of Household Finance through 3

dimensions:
1 2 3

How organizations How firms, governments

How households make
provide goods and and other parties
financial decisions
services to satisfy these intervene in the
financial functions provision of financial
services.
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 1. INTRODUCTION
THREE-SECTOR ECONOMY

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 1. INTRODUCTION
UNDER-RATED FIELD
• The field of financial economics, or finance, focuses on
– Financial markets – asset pricing
– Intermediary – banking
– Firms – Corporate finance
• But it fails to address the other major circles in the system
– The household sector
• The household sector is a substantial element, but the related study is
somewhat neglected subfield within financial economics.
– “Household finance … has attracted much recent interest, but still lacks
definition and status within our profession”
– John Campell, 2006 Presidential Speech to AFA

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 1. INTRODUCTION
UNDER-RATED FIELD
• Every top MBA programs offer course on corporate finance or
investments, but few provides explicit courses on household finance.

• Intellectual division back to 1800s

– Business-related courses taught at urban universities for men to
manage business careers
– Consumer-related topics are taught at rural universities for women to
take care of household.

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 1. INTRODUCTION

• The English term ‘Economics’ is derived

from the Greek word ‘Oikonomia’.

• Its meaning is ‘household management’.

Economics was first read in ancient Greece.
Aristotle, the Greek Philosopher termed
Economics as a science of ‘household
management’.

• What is unique about Household Finance?

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 1. INTRODUCTION

HOUSEHOLD-SPECIFICS
• Many decisions taken by households are beyond the focus of either asset
pricing and corporate finance
Liability side
• 1. Financial products available to households
– Personal loans
• Credit card, consumer loan
– Collateralized loans
• Car loan, Mortgages (Fixed-rate Mortgage vs Adjusted-rate
Mortgage)
• 2. Limited access to credit restricts inter-temporal resource substitution
and consumption smoothing.
– High cost borrowing, i.e. payday loan
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 1. INTRODUCTION
HOUSEHOLD-SPECIFICS
Asset side
• Human capital
– It’s the main source of life-time income for the majority
– Can’t be traded or insured
– Slow to accumulate and hard to predict
• The rest of household wealth
– Illiquid assets (i.e. real estate) and liquid assets(i.e. deposit, stock)
– Barriers for households to efficiently management
• information asymmetry
• Transaction costs

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 1. INTRODUCTION
THE SCALE
• Total assets of Household vs Corporate

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 1. INTRODUCTION
THE SCALE
• Total financial assets of Household vs Corporate

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 1. INTRODUCTION

INSTITUTIONS

• Institutional Environment matters

– Mortgage rate as an example
– In United Kingdom, Canada, and Australia, Hong Kong, by contrast,
ARM is more prevalent, and most mortgages are tied to short-term
interest rates.
– In the United States FRMs are more commons make up less than 10
percent of recent residential mortgage originations

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 1. INTRODUCTION

INSTITUTIONS
• Challenges to households
– Unevenly distributed across households
– Limited understanding of financial instruments and thus poor financial
decisions
– Financial intermediaries cannot solve
• Dealing with financial advisors and money managers

• “Big Five” Q
– Developed by Annamaria Lusardi and Olivia Mitchell at Wharton
– Applied worldwide, including U.S. National Financial Capability Study
– https://gflec.org/education/financial-literacy-answers/#5

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 1. INTRODUCTION

MEASUREMENT OF FINANCIAL LITERACY

• 1) “Suppose you had $100 in a savings account and the interest rate was
2% per year. After 5 years, how much do you think you would have in the
account if you left the money to grow?”
– A) More than $102
– B) Exactly $102
– C) Less than $102
– D) Don’t know

• https://gflec.org/education/financial-literacy-answers/#5

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 1. INTRODUCTION
• 2) “Imagine that the interest rate on your savings account was 1% per year
and inflation was 2% per year. After 1 year, with the money in this
account, would you be able to buy…”
– A) More than today
– B) Exactly the same as today
– C) Less than today
– D) Don’t know

• 3) If interest rates rise, what will typically happen to bond prices?

– A) They will rise
– B) They will fall
– C) They will stay the same
– D) There is no relationship between bond prices and the interest rate
– E) Don’t know 15
 1. INTRODUCTION

• 4) A 15-year mortgage typically requires higher monthly payments than a

30-year mortgage, but the total interest paid over the life of the loan will
be less
– A) True
– B) False
– C) Don’t know

• 5) Buying a single company’s stock usually provides a safer return than a

stock mutual fund.
– A) True
– B) False
– C) Don’t know

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1. INTRODUCTION

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 1. INTRODUCTION

• The Growing Financial Literacy Problem

• As financial products continue to increase in complexity, the road ahead is

not an easy one

• Increased financial literacy translates into real world benefits for

individuals, including better job planning, saving decision, and achieving
financial independence.

• In household finance, we are concerned with the choice of the median

consumer rather than wealthy individual and corporate executives

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 1. INTRODUCTION

THE EMERGENCE OF HF

• The field starts to thrive and attract substantial attention in recent years
• 1. Households are more and more involved in financial decisions, due to
– Financial literalization
– Credit expansion
– Financial technology (FinTech) increase the set of financing
instruments

• In household finance, we are concerned with the choice of the median

consumer rather than wealthy individual and corporate executives

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 1. INTRODUCTION

THE EMERGENCE OF HF

• 2. Availability of Big Data

– Household micro-data was only observed through surveys
– Limitation of survey data
• Low quality – misreporting
• Lack of details
– Efforts to collect administrative data
• Private sectors, like banks and brokerage house
• Public institutions, government and regulatory

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 2. FUNCTIONS

MULTIDISCIPLINARY
• Household finance spans across disciplines, beyond finance and economics to
include:
– Industrial organization. For example, automatic enrolment in workplace saving
plan.
– Law. For example, regulation of retail financial transactions
– Psychology. For example, decisions affected by framing and cognitive biases
– Sociology. For example, decisions shaped by social networks

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 2. FUNCTIONS

Definition
• “Household Finance asks how households use financial instruments to attain their
objectives”
---Cambell
• A more expansive approach
– Provision of goods and services to satisfy the financial needs of households
– How consumers make financial decisions
– What is the role of government intervention

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 2. FUNCTIONS

• Household finance can help to improve household decision making through:

– Better financial products

– Better Regulation

– Avoiding problems such as inadequate retirement planning, over-leveraging,

uninformative sales tactics and poorly designed products

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 2. FUNCTIONS

• In this module, we study household finance through financial functions of:

Saving Consumption Investment Housing

Financial
Risk
Payment Borrowing Inclusion and
Management
Fintech

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 2. FUNCTIONS
2.1 SAVING
• Saving enables households to:
– Smooth their consumption
– Achieve a reasonable standard of living during retirement
– Accumulate funds to get through tough times
– and leave bequests if they so desire.
• The decision to save is determined by intertemporal substitution motive,
life cycle motive, precautionary saving and bequest motive.
• In practice, governments use incentives such as tax deferral, tax
exemptions and long term saving plans to encourage saving to reduce
reliance on social support
• Governments also leverage from literature from demographic and socio-
economic predictors of saving such as age, income, education and financial
literacy.
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 2. FUNCTIONS
2.2 CONSUMPTION
• We examine how consumption is affected by anticipated and unanticipated
changes in income
• Standard consumption models of consumption include the Keynesian
model, permanent income model and life cycle model.
• These models have also been augmented to include
– Market imperfections such as liquidity constraints, income uncertainty
and lifetime risks
– Behavioral factors such as mental accounting, present bias, hyperbolic
preferences
• As before, we also explore how consumption changes in the lifetime and
factors which affect consumption such as accessibility to loans, social
security systems etc.

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 2. FUNCTIONS
2.3 INVESTMENT
• Investment function is embodied in financial products and services that
vary in terms of time horizon, risk, tax treatment, liquidity and other
factors.
• We explore what mistakes households make when investing, why they do
so, and how organizations try to reduce them
• These investing mistakes are also described as empirical puzzles:
• An example of these investment mistakes include:
– Non-participation in risky asset markets despite positive equity risk
premiums
– Under-diversification of risky portfolios despite the apparent benefits
of diversification
– Investment in financial products with high fees despite failure of active
funds to outperform passive funds 27
 2. FUNCTIONS
2.4 HOUSING
• Dual purpose of consumption and investment.
• The home is the largest component of net wealth for most households .
• We explore factors that incentivize/deter home ownership such as age,
price, volatility and market imperfections.
• There are other factors which complicate home purchase such as type of
mortgage instrument, decision to refinance, ability to repay for these
mortgages etc.
• Lastly, we also unpack reasons and interventions from the 2008 Financial
Crisis.

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 2. FUNCTIONS
2.5 PAYMENT
• Payment focuses on the transfer of money for the purchase of goods and
services.
• Popular payment modes include cash, debit card, check and credit card.
• Theories that influence payment include acquisition and transaction utility,
buffering hypothesis, payment transparency hypothesis and sunk cost
fallacy.
• The choice of payment mode depends on characteristics such as social
status, reward program, credit limit, speed, convenience and security
• Given that consumer inattention and forgetfulness can result in transaction
fee mistakes, we also study attempts to leverage technology to reduce
these mistakes.

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 2. FUNCTIONS
2.6 BORROWING
• Borrowing is facilitated through secured and unsecured instruments such
as mortgages and student loans respectively.
• Households borrow for various reasons to smooth temporary fluctuations
in income, finance investments or impatience waiting for savings to
accumulate.
• In addition, we evaluate whether households make good borrowing
decisions based on how they default, whether their welfare improves, and
minimize costs.
• Lastly, we unpack how household leverage has increased over the years
from demographic shifts and new technologies, and the interventions that
followed to protect consumer interests

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 2. FUNCTIONS
2.7 RISK MANAGEMENT
• Households manage their risk through various insurance products and
means such as precautionary saving, and government assistance schemes.
• We explore the various insurance products that span across life insurance,
general insurance and annuities to manage risks.
• In addition, we unpack the type and reasons households do not make
optimal insurance decisions

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 2. FUNCTIONS
2.8 FINANCIAL INCLUSION AND FINTECH
• Financial inclusion encompasses a wider definition of financial products,
beyond microfinancing to ensure the underbanked get access to financial
services.
• Banks have been reluctant to service the unbanked and underbanked
which creates opportunities for new contenders i.e. Fintech firms.
• We explore how these FinTech firms use new technologies to disrupt
banking, such as blockchain, smart contracting, cryptocurrency, peer-to-
peer lending and robo-advising to name a few.
• Lastly, we study digital revolution and financial inclusion that followed in a
countries such as China, India, Kenya and Rwanda.

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 3. INTERVENTIONS

• Within each of the functions, the impact of interventions are also addressed.

• We explore interventions in the form of education, peer and social influence,

product design, market design and fiscal stimulus

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 3. INTERVENTIONS
3.1 EDUCATION
• Behaviors that lead to poor financial outcomes are largely due to the lack of
financial knowledge. For example,
– Some take on payday loans at astronomical interest rates when cheaper forms
of credit are available (Agarwal, Skiba and Tobacman, 2009).
– Others fail to refinance mortgages (Agarwal, Rosen and Yao, 2012), or fail to
plan for retirement (Lusardi, Mitchell and Curto, 2010). Agarwal
• However, the efficacy of learning is also complicated by changes in cognitive ability
over the life cycle, and behavioral biases

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 3. INTERVENTIONS
3.2 PEER AND SOCIAL INFLUENCE
• Peer and social influences affect how households make financial decisions.

• For example,
– Consumers who interact with neighbors and attend church are more likely to
invest in stocks. (Hong, Kubik and Stein, 2004)
– Investors possess biases when promoting their personal investing strategies,
focusing on wins rather than losses, which spurs people around them to adopt
active investing strategies (Han, Walden and Hirshleifer (2018).

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 3. INTERVENTIONS
3.3 PRODUCT DESIGN
• Some financial products are also complex because of the way they are structured

• For example,
– Credit cards vary in rates and fee structures
– Optimizing Mortgages is difficult with information overload and changing
interest rates
– Loan Steering, where good credit quality customers are steered towards high
margin mortgage products (Agarwal, Amromin, Ben-David, Chomsisengphet
and Evanoff, 2014).

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 3. INTERVENTIONS
3.4 MARKET DESIGN
• Market design from the interaction of financial intermediaries and households can
also lead to sub-optimal outcomes.
– Financially constrained borrowers can influence the valuation process in order
to borrow more (Agarwal, Ben-David and Yao, 2013).
– Mortgages with inflated valuations are more likely to default although lenders
typically factor the valuation bias into their pricing.
– Borrowers may be misled by teaser rates and complex pricing structures
where lenders offer lower initial rates but shroud back-loaded pricing features
to earn more revenue. There tend to be more shrouding when there are more
naïve borrowers (Agarwal, Song and Yao, 2017).

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 3. INTERVENTIONS
3.5 FISCAL STIMULUS
• Governments use fiscal policies such as tax rebates, wage laws and sales tax hinges
to improve financial decision making
– In 2001, the Bush administration announced tax rebates for about two-thirds
of US tax-filers. In response, households paid down their debt and the
spending of those who were most likely to be constrained rose (Agarwal, Liu
and Souleles, 2007).
– Sales tax holidays (STH) in the US induce households to spend, with no inter-
temporal substitution either before or after the STH (Agarwal, Marwell and
McGranahan, 2017).
• However, the success of these policies hinge also on the responses of households.

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 4. GRADING, HOUSEKEEPING, GROUP PROJECT

• Lecturer: Associate Prof. FAN Yi, Department of Real Estate,

NUS Business School

• Specialize in household sustainability

• F2F Teaching method; all students are to attend f2f classes

unless you have extenuating reasons (e.g. MC)

• Random lecture attendance taking

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 4. GRADING, HOUSEKEEPING, GROUP PROJECT

• Textbook:
Household Finance: A Functional Approach, (Sumit Agarwal,
Wenlan Qian, and Ruth Tan), Palgrave Publishing, 2020

• Optional Reading Materials:

Kiasunomics2, (Sumit Agarwal, Swee Hoon Ang, and Tien
Foo Sing), World Scientific Publishing, 2020

Kiasunomics3, (Sumit Agarwal, Swee Hoon Ang, and Tien

Foo Sing), World Scientific Publishing, 2024

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4. GRADING, HOUSEKEEPING, GROUP PROJECT

Final Grade Computation:

Participation 20 pts
Mid-term Test (90 mins in class) 20 pts
Final Test (90 mins in class) 20 pts
Assignment (individual reflection) 10 pts
Group Project 30 pts
TOTAL 100 pts

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 4. GRADING, HOUSEKEEPING, GROUP PROJECT
• Key Dates
Week 3: Finalization of Group members and submission of name list,
26 Aug 10am – 30 Aug 11:59pm (Canvas → People → Groups)

Week 7: Mid-term Test in Class + Group Project Consultation

Week 12: Final Test in Class

Week 13: Group Project Presentation Slide + Report uploaded to Canvas

before class

Week 13: Group Project Presentation in Class; Individual Reflection & Peer
Evaluation (if any) due 15 Nov 11:59pm Friday
If you have difficulty forming a
group, please write Prof. Yi Fan
(yi.fan@nus.edu.sg) by 30 Aug (Fri)
12 noon and I will try to help you 42