Click to edit Master title style,Click to edit Master text styles,Second level,Third level,Fourth level,Fifth level,Copyright 2004 South-Western,27,The Basic Tools of Finance,Finance,is the field that studies how people make decisions regarding the allocation of resources over time and the handling of risk.,PRESENT VALUE:MEASURING THE TIME VALUE OF MONEY,Present value,refers to the amount of money,today,that would be needed to produce,using prevailing interest rates,a given future amount of money.,PRESENT VALUE:MEASURING THE TIME VALUE OF MONEY,The concept of,present value,demonstrates the following:,Receiving a given sum of money in the present is preferred to receiving the same sum in the future.,In order to compare values at different points in time,compare their present values.,Firms undertake investment projects if the present value of the project exceeds the cost.,PRESENT VALUE:MEASURING THE TIME VALUE OF MONEY,If,r,is the interest rate,then an amount,X,to be received in,N,years has present value of:,X/(1+r),N,PRESENT VALUE:MEASURING THE TIME VALUE OF MONEY,Future Value,The amount of money in the future that an amount of money today will yield,given prevailing interest rates,is called the,future value,.,FYI:Rule of 70,According to the,rule of 70,if some variable grows at a rate of x percent per year,then that variable doubles in approximately,70/x years,.,MANAGING RISK,A person is said to be,risk averse,if she exhibits a dislike of uncertainty.,MANAGING RISK,Individuals can reduce risk choosing any of the following:,Buy insurance,Diversify,Accept a lower return on their investments,Figure 1 Risk Aversion,Wealth,0,Utility,Current,wealth,$1,000,gain,$1,000,loss,Utility loss,from losing,$1,000,Utility gain,from winning,$1,000,Copyright2004 South-Western,The Markets for Insurance,One way to deal with risk is to buy,insurance,.,The general feature of insurance contracts is that a person facing a risk pays a fee to an insurance company,which in return agrees to accept all or part of the risk.,Diversification of Idiosyncratic Risk,Diversification,refers to the reduction of risk achieved by replacing a single risk with a large number of smaller unrelated risks.,Diversification of Idiosyncratic Risk,Idiosyncratic risk,is the risk that affects only a single person.The uncertainty associated with specific companies.,Diversification of Idiosyncratic Risk,Aggregate risk,is the risk that affects all economic actors at once,the uncertainty associated with the entire economy.,Diversification,cannot,remove aggregate risk.,Figure 2 Diversification,Number of,Stocks in,Portfolio,49,(More risk),(Less risk),20,0,1,4,6,8,10,20,40,Risk(standard,deviation of,portfolio return),Aggregate,risk,Idiosyncratic,risk,30,Copyright2004 South-Western,Diversification of Idiosyncratic Risk,People can reduce risk by accepting a lower rate of return.,Figure 3 The Tradeoff between Risk and Return,Risk,(standard,deviation),0,5,10,15,20,8.3,3.1,Return,(percent,per year),50%,stocks,25%,stocks,No,stocks,100%,stocks,75%,stocks,Copyright2004 South-Western,ASSET VALUATION,Fundamental analysis,is the study of a companys accounting statements and future prospects to determine its value.,ASSET VALUATION,People can employ fundamental analysis to try to determine if a stock is,undervalued,overvalued,or fairly valued.,The goal is to buy,undervalued stock,.,Efficient Markets Hypothesis,The,efficient markets hypothesis,is the theory that asset prices reflect all publicly available information about the value of an asset.,Efficient Markets Hypothesis,A market is,informationally,efficient,when it reflects all available information in a rational way.,If markets are efficient,the only thing an investor can do is to buy a diversified portfolio,CASE STUDY:,Random Walks and Index Funds,Random walk,refers to the path of a variable whose changes are impossible to predict.,If markets are efficient,all stocks are fairly valued and no stock is more likely to appreciate than another.Thus stock prices follow a random walk.,Summary,Because savings can earn interest,a sum of money today is more valuable than the same sum of money in the future.,A person can compare sums from different times using the concept of present value.,The present value of any future sum is the amount that would be needed today,given prevailing interest rates,to produce the future sum.,Summary,Because of diminishing marginal utility,most people are risk averse.,Risk-averse people can reduce risk using insurance,through diversification,and by choosing a portfolio with lower risk and lower returns.,The value of an asset,such as a share of stock,equals the present value of the cash flows the owner of the share will receive,including the stream of dividends and the final sale price.,Summary,According to the efficient markets hypothesis,financial markets process available information rationally,so a stock price always equals the best estimate of the value of the underlying business.,Some economists ques