Eco 202 ch 27 the basic tools of finance part 2
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Transcript of Eco 202 ch 27 the basic tools of finance part 2
Chapter 27
The Basic Tools of Finance
Part 2
FinanceDecisions about
money, time, and risk
Present ValueThe amount of money need today, using an
interest rate, to produce a future
amount
Future ValueThe amount of money in the future, using an interest rate, that a present amount will
produce
CompoundingFormula
(1+r)N
Discounting
The process of finding the present value of a future sum of money
Risk Aversion
A dislike of uncertainty
Insurance
Sharing risk
Does not eliminate riskSpread around risk
ScenarioCost: 1000
Risk: 1 in 100Expected cost =
cost x risk = 1000 x .01
=10
ScenarioExpected cost =10Total Cost = 1000
Get 100 people to give 10 each to fund the
account10 x 100 = 1000
Insurance Problems
Asymmetric InformationAdverse Selection
Moral Hazard
Asymmetric Information
Parties to a trade do not have the same
information
Not Equal
Adverse Selection
Making a bad choice due to asymmetric
information
Moral Hazard
Changing behavior after an agreement
Temptation to abuse the other party
Diversification
Replace one large risk with lots of smaller
unrelated risks
Three Risks
Firm RiskIndustry RiskMarket Risk
Firm Risk
Risk that affects only a single company
Industry Risk
Risk that affects all the companies in an
industry
Market Risk
Risk that affects all the companies in the stock
market
Valuation
What is it worth?
Analyze financial statements and future
prospects
Speculative Bubble
Price is greater than fundamental value
Buy because everyone else is buying