Microeconomics - Chapter 9 - The Basic Tools of Finance
TESTING POINTS
Questions for Review
Quick Quiz
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
Question 2
Describe three ways that a risk-averse person might reduce the risk she faces
Question 1
The interst Rate is 7 percent.What is the present value of $150 to be recievedin 10 years?
MODELS
The Trade off Between Risk and Return - F9.3
Diversification Reduces Risk - F9.2
Subtopic
The Utility Function - F9.1
LEARNING OBJECTIVES
Examine what determines the value of an asset
Learn how to manage risk
Measure the value of money at different points in time
EXTRA READING
In the News
Some Lessons From Enron
Investors Behaviour Clouds the Wisdom of Offering Wider Choice in 401(k)'s
CASE STUDY
RANDOM WALKS AND INDEX FUNDS
FYI
The Magic of Compoundingand the Rule of 70
FORUMALS
rule of 70
Where:r = interest raten= yearsP = starting
( 1 + r )^n x P
SUMMARY
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.
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.
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.
ASSET VALUATION
Market Irrationality
The Efficient Marktes Hypothesis
Fundamental Analysis
dividends
fairly valued
overvalued
undervalued
MANAGING RISK
The Tradeoff between Risk and Return
Diversification of Idiosyncratic Risk
standard deviation
The Markets for Insurance
moral hazard
adverse selection
annuity
Risk Aversion
PRESENT VALUE: MEASING THE TIME VALUE OF MONEY
If r is the interst rate, then an amount X to be recieved in N years has present value of X / ( 1 + r )^N
Questions
Second Example
First Example
A: Assume 10 years at 5%
( 1.05 )^10 x 100
$163
Q: What is the Future value of $100in N years
KEY TERMS
random walk
the path of a variable whose changes are impossibleto predict
informationally efficient
reflecting all available information in a rational way
efficent markets hypothesis
the theory that asset prices reflect all publicly availableinformation about the value of an asset
fundamental analysis
the study of a company's accounting statementsand future prospects to determine its value
aggregate risk
risk that affects all economic actors at once
idiosyncratic risk
risk that affects only a single economic actor
diversification
the reduction of risk achieved by replacing a single riskwith a large number of smaller unrelated risks
risk averse
exhibiting a dislike of uncertainty
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
future value
the amount of money in the future that anamount of money today will yield, given prevailing interest rates
present value
the amount of money today that would be needed to produce, using prevailing interest rates, a given future amount of money
finance
the field that studies how people make decisions regarding the allocation of resources over time and the handling of risk
Introduction
