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# Eco 202 ch 27 basic tools of finance

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### Eco 202 ch 27 basic tools of finance

1. 1. Chapter 27 ! Basic Tools of Finance
2. 2. 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
3. 3. 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.
4. 4. 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.
5. 5. Payback? One year? Five years? Ten years?
6. 6. Promissory Note I.O. U. 10 SAR Dr. Gale Trading paper for paper
7. 7. Compounding The process of ﬁnding the future value of a present sum of money ! multiplying
8. 8. Discounting The process of ﬁnding the present value of a future sum of money ! dividing
9. 9. compounding is the inverse of discounting discounting is the inverse of compounding
10. 10. Finance Time and Risk
11. 11. Future Value The amount of money in the future, using an interest rate, that a present amount will produce
12. 12. Key Formula 1 Future Value or FV N (1+r) r = rate N = number of periods
13. 13. r = 7% FV =? N (1+r) N 1 2 3 FV 1.070 1.145 1.225
14. 14. r = 10% FV =? N (1+r) N 1 2 3 4 5 FV 1.100 1.210 1.331 1.464 1.611
15. 15. r = 15% FV =? N (1+r) N 1 2 3 FV 1.150 1.323 1.521
16. 16. r = 15% N = 3 FV =? N (1+r) N 1 2 3 FV 1.150 1.323 1.521
17. 17. Present Value The amount of money need today, using an interest rate, to produce a future amount
18. 18. Key Formula 2 Present Value or PV Reciprocal 1 of the N FV formula (1+r) r = rate N = number of periods
19. 19. r = 7% N = 3 PV =? 1 N (1+r) N 1 2 3 PV .935 .873 .816
20. 20. r = 10% N = 5 PV =? 1 N (1+r) N 1 2 3 4 5 PV .909 .826 .751 .683 .621
21. 21. Insurance Sharing risk ! Does not eliminate risk Spread around risk
22. 22. Risk Aversion A dislike of uncertainty
23. 23. Scenario Cost: 1000 Risk: 1 in 100 Expected cost = cost x risk = 1000 x .01 =10
24. 24. Scenario Expected cost =10 Total Cost = 1000 Get 100 people to give 10 each to fund the account 10 x 100 = 1000
25. 25. Insurance Problems Asymmetric Information Adverse Selection Moral Hazard
26. 26. Asymmetric Information Parties to a trade do not have the same information ! Not Equal
27. 27. Adverse Selection Making a bad choice due to asymmetric information
28. 28. Moral Hazard Changing behavior after an agreement ! Temptation to abuse the other party
29. 29. Diversiﬁcation Replace one large risk with lots of smaller unrelated risks
30. 30. Three Risks Firm Risk Industry Risk Market Risk
31. 31. Firm Risk Risk that affects only a single company
32. 32. Industry Risk Risk that affects all the companies in an industry
33. 33. Market Risk Risk that affects all the companies in the stock market
34. 34. Valuation What is it worth? ! Analyze ﬁnancial statements and future prospects
35. 35. Speculative Bubble Price is greater than fundamental value ! Buy because everyone else is buying