Ch 14 Basic Tools of Finance 1 Present Value Finance o Studies how people make decisions Allocation of resources over time Handling of risk Present Value o Amount of money today o That would be needed Using prevailing interest rates To produce a given future amount of money Future Value of 100 at 5 compounding interest rate 100 1 r years 163 o Amount of money in the future o Than an amount of money today will yield o Given prevailing interest rates Compounding o Accumulation at a sum of money Interest earned remains in the account To earn additional interest in the future Discounting o Find present value for a future sum of money General formula for discounting o R interest rate o X amount to be received in N years future value o Present value X 1 r N Managing Risk Rational response to risk o Not necessarily to avoid it at any cost o Take it into account in your decision making o Risk aversion Dislike of uncertainty Utility Utility function o A person s subjective measure of well being satisfaction o Every level of wealth provides a certain amount of utility o Exhibits diminishing marginal utility The more wealth a person has The less utility he gets from an additional dollar Ch 14 Basic Tools of Finance 2 The markets for insurance o Person facing a risk Pays a fee to insurance company Insurance company Accepts all or a part of risk Insurance contract gamble o You may not face the risk o Pay the insurance premium payments to compensation o Receive peace of mind Role of Insurance o Not to eliminate risks but to spread the risks around more efficiently Markets of insurance problems o Adverse selection profits higher losses o Moral hazard Diversification irresponsible behavior High risk person more likely to apply for insurance higher After people buy insurance less incentive to be careful triggers o Reduction of risk o By replacing a single risk with a large number of smaller unrelated risks o don t put all your eggs in one basket Risk o Std dev measures the volatility of a variable sq root of Vsub1 Avg 2 Vsub2 Avg 2 Vsub3 Avg 2 Risk of a Portfolio of Stocks o Depends on number of stocks in the portfolio o higher std dev riskier portfolio 3 Ch 14 Basic Tools of Finance 3 Diversification o Can eliminate firm specific risk o Cannot eliminate market risk Firm specific risk o Affects only a single company Market Risk o Affects all companies in the stock market The trade off between risk and return o Two types of assets Diversified group 8 return 20 std dev Safe alternative 3 return 0 std dev o The more a person puts into stocks The greater the risk and the return Ch 14 Basic Tools of Finance 4 o Study of a company s accounting statements and future prospects to Fundamental analysis Asset Valuation determine its value Undervalued stock Price Value Overvalued stock Price Value Fairly valued stock Price Value Use fundamental analysis to pick a stock o Do all the necessary research yourself o Rely on the advice of Wall Street analysts o Buy a mutual fund The Efficient Markets Hypothesis for you A manager conducts fundamental analysis and makes the decision o Theory about how financial markets work not completely true o Asset prices reflect all publicly available information about the value of an o Each company listed on a major stock exchange is followed closely by asset fair value many managers o Equilibrium of supply and demand sets the market price Stock Markets o Exhibit information efficiency Informational efficiency o Description of asset prices o Rationally reflect all available information Ch 14 Basic Tools of Finance 5 Implication of efficient markets hypothesis o Stock prices should follow a random walk Changes in stock prices are impossible to predict from available Efficient Markets Hypothesis information o Assumes that people buy selling stock are rational Process information about stock s underlying value Fluctuation in stock prices are partly psychological When the price of an asset is above its fundamental value the market experiences a speculative bubble Possibility of speculative bubbles o Value of the stock to a stockholder depends on Stream of dividend payments Final sale price Debate frequency and importance of departures from rational pricing o Market irrationality Movement in stock market News that alter a rational valuation o Efficient markets hypothesis Impossible to know the correct rational valuation of a company Evidence on stock prices Random Walks and Index Funds o Even if not exactly a random walk unpredictable are very close to it Index fund Active funds o Mutual fund that buys all stocks in a given stock index o Actively managed mutual funds Professional portfolio manager o Buy only the best stocks Performance of Index Funds o Better than active funds Active portfolio managers o Lower return than index funds o Trade more frequently o Incur more trading costs o Charge greater fees o Only 16 of managers beat the market