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# Eco 202 ch 27 basic tools of finance

## on Feb 25, 2014

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## Eco 202 ch 27 basic tools of financePresentation Transcript

• Chapter 27 ! Basic Tools of Finance
• Key Terms ﬁnance present value future value compounding discounting risk aversion diversiﬁcation ﬁrm-speciﬁc risk market risk fundamental analysis efﬁcient market hypothesis information efﬁciency random walk
• Survey Question 1 What would you prefer? ! A. Win 1,000 riyals ! B. Flip a coin: 50 percent chance you win 2,000 riyals 50 percent chance you win nothing.
• Survey Question 2 What would you prefer? ! A. Lose 1,000 riyals ! B. Flip a coin: 50 percent chance you lose 2,000 riyals 50 percent chance you lose nothing.
• Payback? One year? Five years? Ten years?
• Promissory Note I.O. U. 10 SAR Dr. Gale Trading paper for paper
• Compounding The process of ﬁnding the future value of a present sum of money ! multiplying
• Discounting The process of ﬁnding the present value of a future sum of money ! dividing
• compounding is the inverse of discounting discounting is the inverse of compounding
• Finance Time and Risk
• Future Value The amount of money in the future, using an interest rate, that a present amount will produce
• Key Formula 1 Future Value or FV N (1+r) r = rate N = number of periods
• r = 7% FV =? N (1+r) N 1 2 3 FV 1.070 1.145 1.225
• r = 10% FV =? N (1+r) N 1 2 3 4 5 FV 1.100 1.210 1.331 1.464 1.611
• r = 15% FV =? N (1+r) N 1 2 3 FV 1.150 1.323 1.521
• r = 15% N = 3 FV =? N (1+r) N 1 2 3 FV 1.150 1.323 1.521
• Present Value The amount of money need today, using an interest rate, to produce a future amount
• Key Formula 2 Present Value or PV Reciprocal 1 of the N FV formula (1+r) r = rate N = number of periods
• r = 7% N = 3 PV =? 1 N (1+r) N 1 2 3 PV .935 .873 .816
• r = 10% N = 5 PV =? 1 N (1+r) N 1 2 3 4 5 PV .909 .826 .751 .683 .621
• Insurance Sharing risk ! Does not eliminate risk Spread around risk
• Risk Aversion A dislike of uncertainty
• Scenario Cost: 1000 Risk: 1 in 100 Expected cost = cost x risk = 1000 x .01 =10
• Scenario Expected cost =10 Total Cost = 1000 Get 100 people to give 10 each to fund the account 10 x 100 = 1000
• Insurance Problems Asymmetric Information Adverse Selection Moral Hazard
• Asymmetric Information Parties to a trade do not have the same information ! Not Equal
• Adverse Selection Making a bad choice due to asymmetric information
• Moral Hazard Changing behavior after an agreement ! Temptation to abuse the other party
• Diversiﬁcation Replace one large risk with lots of smaller unrelated risks
• Three Risks Firm Risk Industry Risk Market Risk
• Firm Risk Risk that affects only a single company
• Industry Risk Risk that affects all the companies in an industry
• Market Risk Risk that affects all the companies in the stock market
• Valuation What is it worth? ! Analyze ﬁnancial statements and future prospects
• Speculative Bubble Price is greater than fundamental value ! Buy because everyone else is buying