Eco 202 ch 27 basic tools of finance

Chapter 27 !

Basic Tools of

Finance

Key Termsfinance present value future value compounding discounting risk aversion diversification

firm-specific risk market risk fundamental analysis efficient market hypothesis information efficiency random walk

SurveyQuestion 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.

SurveyQuestion 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

Trading paper for paper

I.O. U.

10 SAR Dr. Gale

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 ValueThe amount of money in the future, using an interest rate, that a present amount will

produce

Key Formula 1

(1+r)N

r = rate N = number of periods

Future Value or FV

(1+r)N

r = 7% FV =?

1 1.070 2 1.145 3 1.225

N FV

(1+r)N

r = 10% FV =?

1 1.100 2 1.210 3 1.331 4 1.464 5 1.611

N FV

(1+r)N

r = 15% FV =?

1 1.150 2 1.323 3 1.521

N FV

(1+r)N

r = 15% N = 3 FV =?

1 1.150 2 1.323 3 1.521

N FV

Present ValueThe amount of money need today, using an

interest rate, to produce a future

amount

Key Formula 2

(1+r)N

r = rate N = number of periods

Present Value or PV1 Reciprocal

of the FV formula

(1+r)N

r = 7% N = 3 PV =?

1 .935 2 .873 3 .816

N PV

1

(1+r)N

r = 10% N = 5 PV =?

1 .909 2 .826 3 .751 4 .683 5 .621

N PV

1

Insurance

Sharing risk !

Does not eliminate risk Spread around risk

Risk Aversion

A dislike of uncertainty

ScenarioCost: 1000

Risk: 1 in 100 Expected cost =

cost x risk = 1000 x .01

=10

ScenarioExpected 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