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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. 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