Chapter 27: The Basic Tools of Finance

Chapter 27: The Basic Tools of Finance

• Finance: the field that studies how people make decisions regarding the allocation of resources over time and the handling of risk

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Chapter 27.1: Present Value: Measuring the TIme Value of Money

• Present value: the amount of money today needed to produce a future amount of money, given prevailing interest rates

• Future value: the amount of money in the future that an amount of money today will yield, given prevailing interest rates

• Compounding: the accumulation of a sum of money, where the interest earned remains in the account to earn additional interest in the future

• (1+r)^N * $x,where r=rate of interest, N=number of years, and x=original total $

• Discounting: the process of finding a present value of a future sum of money

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Chapter 27.2: Managing Risk

• 27.2a: Risk Aversion

  • Risk averse: a dislike of uncertainty
  • Utility: a person’s subjective measure of well-being or satisfaction
  • The more money someone has, the less utility earned from the next dollar earned

• 27.2b: The Markets for Insurance

  • Buying insurance deals with risk
  • Insurance is bought for a peace of mind
  • Adverse selection: a high risk person is more likely to apply for insurance than a low risk person
  • Moral hazard: after insurance is bought, there is less incentive to be careful about risky behaviors

• 27.2c: Diversification of Firm-Specific Risk

  • Diversification: the reduction of risk achieved by replacing a single risk with a large number of smaller, unrelated risk
  • Bought stock bets on the future profitability of that company, which is risky because not all information is known
  • Standard deviation: risk measured by the volatility of variable
  • The higher the standard deviation, the more volatile it is, and the riskier it is 
  • Firm-specific risk: risk that affects only a single company
  • Market risk: risk that affects all companies in the stock market

• 27.2d: The Trade-Off between Risk and Return

  • People face trade-offs
  • Historically, stocks have offered much higher rates of return than bonds, bank savings accounts, and other financial assets

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Chapter 27.3: Asset Valuation

• 27.3a: Fundamental Analysis
  • Overvalued: a stock whose price is more than its value
  • Fairly valued: a stock whose price is equivalent to its value
  • Undervalued: a stock whoswhose price is less than its value
  • Fundamental analysis: the detailed analysis of a company in order to estimate its value
  • Stock analysts are hired by firms to conduct a fundamental analysis and give advice on stocks to buy
  • Dividends: cash payments a company makes to its shareholders
  • A company’s ability to pay dividends depends on the company’s ability to earn profits
• 27.3b: The Efficient Markets Hypothesis
  • Efficient markets hypothesis: the theory that asset prices reflect all publicly available information about the value of an asset
  • Money managers watch new stories and conduct fundamental analysis to try and determine a stock’s value. Stocks are bought ideally when a price falls below its fundamental value, and sold when the price is above the fundamental value
  • At market price, number of shares being sold = number of shares being bought
  • Informational efficiency: the description of asset prices that rationally reflect all available information
  • Stock prices change when information changes. When good news appears about a company, the price rises, and if bad news appears, the price falls
  • Random walk: the path of a variable whose changes are impossible to predict
• 27.3c: Market Irrationality
  • Speculative bubble: whenever the price of an asset rises above what appears to be its fundamental value
  • Speculative bubbles may happen because the value of a stock to a stockholder is decided by the stream of dividend payments but also on the final sale price
  • You need to estimate not only the value of the business, but what other people will think of the business’s worth in the future
  • If the market were irrational, a rational person would be able to beat the market
  • Beating the market is nearly impossible

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