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. 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.
  3. 3. 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.
  4. 4. Survey Most people avoid risk on gains ! but prefer to take risks to avoid loss
  5. 5. 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
  6. 6. Key Formulas r = rate N = number of periods Compounding Discounting Future Value or FV multiplying Present Value or PV dividing N (1+r) 1 N (1+r)
  7. 7. Finance Time and Risk
  8. 8. Tomorrow One Year Ten Years
  9. 9. Discount the future ! Today is worth more than tomorrow
  10. 10. Today One year Ten Years Grow in the Future
  11. 11. Promissory Note I.O. U. 10 SAR Dr. Gale Trading paper for paper
  12. 12. Rates and Compounding Linear versus Exponential
  13. 13. Linear versus Exponential Adding versus Compounding 64 64 ^ 56 48 40 32 32 24 16 16 8 0 2 1 + 4 2 8 6 8 3 4 10 5 12 6
  14. 14. Fixed Amount N Start Add End 0 100.00 7.00 107.00 1 107.00 7.00 114.00 2 114.00 7.00 121.00 3 121.00 7.00 128.00 4 128.00 7.00 135.00 5 135.00 7.00 142.00
  15. 15. Compounding Grow by a percentage each year, not a fixed amount
  16. 16. Compounding The process of finding the future value of a present sum of money ! multiplying
  17. 17. Discounting The process of finding the present value of a future sum of money ! dividing
  18. 18. compounding is the inverse of discounting discounting is the inverse of compounding
  19. 19. Compounding 7% N Start Add End 0 100.00 7.00 107.00 1 107.00 7.49 114.49 2 114.49 8.01 122.50 3 122.50 8.58 131.08 4 131.08 9.18 140.26 5 140.26 9.82 150.07
  20. 20. Fixed vs. Compounding Fixed 7% N Start Add End Start Add End 0 100.00 7.00 107.00 100.00 7.00 107.00 1 107.00 7.00 114.00 107.00 7.49 114.49 2 114.00 7.00 121.00 114.49 8.01 122.50 3 121.00 7.00 128.00 122.50 8.58 131.08 4 128.00 7.00 135.00 131.08 9.18 140.26 5 135.00 7.00 142.00 140.26 9.82 150.07
  21. 21. amount Compounding 8% 4% 2% time
  22. 22. Rate Amount in 30 years 1% 136.13 2% 184.76 4% 337.31 8% 1,086.77 16% 9,958.59 32% 546,753.87
  23. 23. Future Value The amount of money in the future, using an interest rate, that a present amount will produce
  24. 24. Key Formula 1 Future Value or FV N (1+r) r = rate N = number of periods
  25. 25. r = 10% FV =? N (1+r) N 1 2 3 4 5 FV 1.100 1.210 1.331 1.464 1.611
  26. 26. Present Value The amount of money need today, using an interest rate, to produce a future amount
  27. 27. Key Formula 2 Present Value or PV Reciprocal 1 of the N FV formula (1+r) r = rate N = number of periods
  28. 28. r = 10% N = 5 PV =? 1 N (1+r) N 1 2 3 4 5 PV .909 .826 .751 .683 .621 3.791
  29. 29. 7% discount 1 0.935 2 0.873 3 0.816 4 0.763 5 0.713 6 0.666 7 0.623 8 0.582 9 10 0.544 0.508 Worth less and less due to time and risk
  30. 30. Insurance Sharing risk ! Does not eliminate risk Spread around risk
  31. 31. Risk Aversion A dislike of uncertainty
  32. 32. Scenario Cost: 1000 Risk: 1 in 100 Expected cost = cost x risk = 1000 x .01 =10
  33. 33. Scenario Expected cost =10 Total Cost = 1000 Get 100 people to give 10 each to fund the account 10 x 100 = 1000
  34. 34. Insurance Problems Asymmetric Information Adverse Selection Moral Hazard
  35. 35. Asymmetric Information Parties to a trade do not have the same information ! Not Equal
  36. 36. Adverse Selection Making a bad choice due to asymmetric information
  37. 37. Moral Hazard Changing behavior after an agreement ! Temptation to abuse the other party
  38. 38. Diversification Replace one large risk with lots of smaller unrelated risks
  39. 39. Three Risks Firm Risk Industry Risk Market Risk
  40. 40. Firm Risk Risk that affects only a single company
  41. 41. Industry Risk Risk that affects all the companies in an industry
  42. 42. Market Risk Risk that affects all the companies in the stock market
  43. 43. Valuation What is it worth? ! Analyze financial statements and future prospects
  44. 44. Speculative Bubble Price is greater than fundamental value ! Buy because everyone else is buying

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