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

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