eco 202 ch 27 the basic tools of finance part 2
TRANSCRIPT
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Chapter 27
The Basic Tools of Finance
Part 2
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FinanceDecisions about
money, time, and risk
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Present ValueThe amount of money need today, using an
interest rate, to produce a future
amount
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Future ValueThe amount of money in the future, using an interest rate, that a present amount will
produce
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CompoundingFormula
(1+r)N
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Discounting
The process of finding the present value of a future sum of money
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Risk Aversion
A dislike of uncertainty
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Insurance
Sharing risk
Does not eliminate riskSpread around risk
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ScenarioCost: 1000
Risk: 1 in 100Expected cost =
cost x risk = 1000 x .01
=10
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ScenarioExpected cost =10Total Cost = 1000
Get 100 people to give 10 each to fund the
account10 x 100 = 1000
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Insurance Problems
Asymmetric InformationAdverse Selection
Moral Hazard
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Asymmetric Information
Parties to a trade do not have the same
information
Not Equal
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Adverse Selection
Making a bad choice due to asymmetric
information
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Moral Hazard
Changing behavior after an agreement
Temptation to abuse the other party
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Diversification
Replace one large risk with lots of smaller
unrelated risks
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Three Risks
Firm RiskIndustry RiskMarket Risk
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Firm Risk
Risk that affects only a single company
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Industry Risk
Risk that affects all the companies in an
industry
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Market Risk
Risk that affects all the companies in the stock
market
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Valuation
What is it worth?
Analyze financial statements and future
prospects
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Speculative Bubble
Price is greater than fundamental value
Buy because everyone else is buying