ECON 205 1st Edition Lecture 11 Outline of Last Lecture Role of financial institutions Savings and investment How government policies affect saving investment an interest rate Outline of Current Lecture Finance studies how participants in financial system make decisions in allocation of resources Present vs future values Risk Asset valuation Current Lecture Present Value The time value of money To compare money from different times use concept of present value Present Value of a future sum amount that would be needed today to yield the future sum at prevailing interest rates o PV FV 1 r N Future Value amount needed in future to yield present sum at future interest rates o FV PV 1 r N o FV future value PV Present value r interest rate N number of years Present value helps explain why investment falls when the interest rate rises Compounding Compounding accumulation of money when interest is earned on the sum earns additional interest o Small different in interest rate will lead to big differences over time Rule of 70 if a variable grows at rate of x percent per year that variable will double in about 70 x years Risk Aversion Risk Averse don t like uncertainty o Most people are risk averse Insurance works when a person facing a risk pays a fee to the insurance company which in return accepts part or all of the risk Insurance allows risks to be pooled and can make risk averse people better off Problems with Risk Aversion o Adverse Selection a high risk person benefits more from insurance so is more likely to purchase it o Moral Hazard people with insurance have less incentive to avoid risky behavior Companies do not fully guard against these problems so they charge higher premium rates Some low risk people forego insurance and skip getting low benefits of insurance pooling Measuring Risk Risk of financial asset measured by standard deviation and or volatility of that asset o Volatility ability to fluctuate in terms of dollar returns Diversification decreases the risk by replacing a single risk with a large number of smaller unrelated risks o Decrease firm specific risk o Cannot decrease market risk Market risk affects ALL firms The Tradeoff Between Risk and Return Tradeoff riskier assets pay a higher return on average to compensate for the extra risk of holding them How risky a portfolio is to hold depends on a person s risk aversion For example if you are dividing a portfolio between 2 asset classes o Diversified group of risky stocks Average return 8 Standard Deviation risk 20 o Safe Asset Average return 3 Standard deviation 0 o Risk and return on a portfolio depends on the percentage of each asset class in the portfolio Increasing the share of stocks in the portfolio increase the average return AND the risk Asset Valuation Asset valuation comparing the price of the shares to the value of the company when deciding whether or not to buy stocks o Overvalued when Share Price Value o Undervalued when Share Price Value o Fairly Valued when Share Price Value Value of a share o PV of any dividends the stock will pay o PV of the price you get when you sell the stock Problem you never know what the future dividends of prices will be Fundamental Analysis study of a company s accounting statements and future prospects to determine its value o Only way to value a stock Efficient Markets Hypothesis Efficient Markets Hypothesis EMH theory that each asset price reflects all publicly available information about the value of the asset Informationally Efficient each stock price reflects all the available information regarding a company s value Random Walk stock price only changes in response to new info about a company s value Impossible to systematically beat the market Index Funds vs Managed Funds Index fund mutual fund that buys all the stocks in a given stock index Managed Fund aims to buy only the best stocks o Have higher expenses than index funds EMH implies that returns on actively managed funds should not consistently exceed the returns on index funds Market Irrationality Many believe stock price movements are partly psychological o J M Keynes stock prices are driven by waves of pessimism and optimism o Alan Greenspan 1990s stock market boom due to irrational exuberance Bubbles when speculators buy overvalued assets expecting prices to rise further