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 rateOutline of Current Lecture - Finance- studies how participants in financial system make decisions in allocation of resources- Present vs. future values- Risk- Asset valuationCurrent LecturePresent 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 rateso PV= (FV) / ((1+r)N) - Future Value- amount needed in future to yield present sum at future interest rateso 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 risesCompounding- Compounding- accumulation of money when interest is earned on the sum earns additional interesto 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 yearsRisk Aversion- Risk Averse- don’t like uncertaintyo 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 Aversiono Adverse Selection- a high-risk person benefits more from insurance, so is more likely to purchase ito 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 poolingMeasuring Risk- Risk of financial asset measured by standard deviation and/or volatility of that asseto 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 riskso Decrease firm-specific risko Cannot decrease market risk Market risk affects ALL firmsThe 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 classeso 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 riskAsset Valuation- Asset valuation- comparing the price of the shares to the value of the company when deciding whether or not to buy stockso Overvalued when Share Price > Valueo Undervalued when Share Price < Valueo Fairly Valued when Share Price = Value- Value of a share…o =PV of any dividends the stock will payo +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 valueo Only way to value a stockEfficient 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 marketIndex 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 stockso Have higher expenses than index funds- EMH implies that returns on actively managed funds should not consistently exceed the returns on index fundsMarket Irrationality- Many believe stock price movements are partly psychologicalo 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