Microeconomics - Chapter 9 - The Basic Tools of Finance

finance

the field that studies how people make decisions regarding the allocation of resources over time and the handling of risk

present value

the amount of money today that would be needed to produce, using prevailing interest rates, a given future amount of money

future value

the amount of money in the future that anamount of money today will yield, given prevailing interest rates

compounding

the accumulation of a sume of money in, say, a bankaccount, where the interest earned remains in the accountto earn additional interest in the future

risk averse

exhibiting a dislike of uncertainty

diversification

the reduction of risk achieved by replacing a single riskwith a large number of smaller unrelated risks

idiosyncratic risk

risk that affects only a single economic actor

aggregate risk

risk that affects all economic actors at once

fundamental analysis

the study of a company's accounting statementsand future prospects to determine its value

efficent markets hypothesis

the theory that asset prices reflect all publicly availableinformation about the value of an asset

informationally efficient

reflecting all available information in a rational way

random walk

the path of a variable whose changes are impossibleto predict

present value

Questions

First Example

Q: What is the Future value of $100in N years

A: Assume 10 years at 5%

( 1.05 )^10 x 100

$163

Second Example

If r is the interst rate, then an amount X to be recieved in N years has present value of X / ( 1 + r )^N

Risk Aversion

The Markets for Insurance

annuity

adverse selection

moral hazard

Diversification of Idiosyncratic Risk

standard deviation

The Tradeoff between Risk and Return

Fundamental Analysis

undervalued

overvalued

fairly valued

dividends

The Efficient Marktes Hypothesis

Market Irrationality

Because savings can earn interst, a sum of moneytoday is more valuable than the same sum of moneyin the future. A person can compare sums from differenttimes using the concept of present value. The present value of an future sum is the amount it would be needed today,given prevailing interest rates, to produce that future sum.

Because of diminishing marginal utility, most people are riskaverse. Risk-averse people can reduce using insurance, throughdiversification, and by choosing a portfolio with lower risk andlower return.

The value of an asset, such as a share of stock, equals the presentvalue of the cash flows the owner of the share will recieve, includingthe stream of dividends, and the final sale price. According to the efficientmarkets hypothesis, financial markets process available information rationally,so a stock price always equals the best estimate of the value of the underlyingbusiness. Some economists equestion the efficient markets hypothesis, however,and beleive that irrational psychologyical factors also influence asset prices.

compounding

( 1 + r )^n x 100

rule of 70

FYI

The Magic of Compoundingand the Rule of 70

CASE STUDY

RANDOM WALKS AND INDEX FUNDS

In the News

Some Lessons From Enron

Investors Behaviour Clouds the Wisdom of Offering Wider Choice in 401(k)'s

Measure the value of money at different points in time

Learn how to manage risk

Examine what determines the value of an asset

The Utility Function - F9.1

Diversification Reduces Risk - F9.2

Subtopic

The Trade off Between Risk and Return - F9.3

Quick Quiz

Question 1

The interst Rate is 7 percent.What is the present value of $150 to be recievedin 10 years?

Question 2

Describe three ways that a risk-averse person might reduce the risk she faces

Question 3

Fortune magazine regularly publishes a list sof the "most respected"companies. According to the efficient markets hypothesis, if you restrict yourstock portfolio to these companies, would you earn a better then average return?

explain

Questions for Review

Question 1

the interest rate is 7%. Use the concept ofpresent value to compare $200 to be recieved in 10years and $300 to be recieved in 20 years.

Question 2

What beneifit do people get from the market insurance?

What two problems impede the insurance company from working perfectly?

Question 3

What is diversification?

Does a stockholder get more diversification going from:1 to 10 stocks or going from 100 to 120 stocks?

Question 4

Comparing stocks and government bonds

Which has more risk?

Which pays a higher average return?

Question 5

What factors should a stock analyst think aboutin determining the value of a share of stock?

Question 6

Describe the efficient marekt hypothesis, and give a piece of evidence consitentwith this theory.

Question 7

Explain the view of those economists whoare skeptical of the efficient markets hypothesis.