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CHAPTER 14

Finance: the field of study that studies decision making regarding the
allocation of resources over time and handling of risk.
Present value: the amount that would be needed today to yield that future
sum at prevailing interest rates.
PV is used to compare sums from different times.
Future value: the amount the sum will be worth at a given future date, when
allowed to earn interest at the prevailing rate.
FV = PV (1 + r) N
N: number of years
r: interest rate
Present value formula: PV = FV / (1 + r)

Discounting: find present value for a future sum of money.


If PV > cost, invest. If PV < cost, dont invest.
When interest rates rise, PV falls, which reduces investment.
Compounding: the accumulation of a sum of money where the interest
earned on the sum earns additional interest.
Because of compounding, small differences in interest rates lead to big
differences over time.
Simple interest formula: FV = PV (1 + r*t)
The rule of 70: If the interest rate in x percent per year, the value will double
in about 70/x years.
Risk aversion: dislike of risk. The pain of losing an amount of money would
exceed the pleasure of winning the same amount.

Utility: a subjective measure of well-being that depends on wealth


Diminishing marginal utility: the more wealth a person has, the less extra
utility he would get from an extra dollar (slope decreases). Due to this
property, the same amount of money loss reduces more utility than the same
amount of gain increases utility. This makes people risk averse.
Insurance: a person facing risk pays a fee to the insurance company, which
in return accepts part or all of the risk. Allows risks to be pooled, making risk
averse people better off, e.g. it is easier for 10,000 people to each bear
1/10,000 of the risk of a house burning down than for one person to bear the
entire risk alone.
Problems in insurance markets:
Adverse selection: a high risk person benefits more from insurance, so
is more likely to purchase it.
Moral hazard: people with insurance have less incentive to avoid risky
behavior.
Insurance companies cannot fully guard against these problems, so they
must charge higher prices. As a result, low risk people sometimes forego
insurance and lose the benefits of risk pooling.
Standard deviation: a statistic that measures a variables volatility, how likely
it is to fluctuate. This can be used to measure risk of an asset. The higher the
standard deviation of the assets return, the greater the risk.

Diversification: reduces risk by replacing a single risk with a large number of


smaller, unrelated risk.
A diversified portfolio contains assets whose returns are not strongly related.
Some will realize high returns, others low returns. The high and low returns
average out, so the portfolio is likely to earn an intermediate return more
consistently than any of the assets it contains.
Firm specific risk: affects a single company. Can be reduced by
diversification.
Market risk: affects all companies in the stock market. Cannot be reduced
by diversification.

Tradeoff: riskier assets pay a higher return, on average, to compensate for


the extra risk of holding them. Therefore, increasing the share of stocks in
the portfolio increases the average return but also the risk (stocks are riskier
than bonds because returns fluctuate).
Asset valuation: to decide whether to buy a companys stock by comparing
the price of the shares to the value of the company.
Price > value, stock is overvalued
Price < value, stock is undervalued
Price = value, stock is fairly valued
Value of a share: depends on final sale price and stream of dividend
payments.
= PV of any dividends the stock will pay (calculate individually for each year
and total the PV) + PV of the price you get when you sell the share

Fundamental analysis: the study of a companys accounting statements and


future prospects to determine its value.
Efficient markets hypothesis (EMH): the theory that each asset price reflects
all publicly available information about the value of the asset.
Stock market is informationally efficient: each stock price reflects all
information about the value of the company.
Stock prices follow a random walk: a stock price only changes in
response to new information (news) about the companys value. News
cannot be predicted, so stock price movements should be impossible
to predict.
It is impossible to systematically beat the market: By the time news
reaches you, mutual fund managers will have already acted on it.
Index fund: a mutual fund that buys all the stocks in a given stock index.
Managed funds: a mutual fund that aims to buy only the best stocks. Have
higher expenses than index funds.
EMH implies that returns on managed funds should not consistently exceed
the returns on index funds.
Market irrationality: many believe that stock price movements are partly
psychological.
Bubbles occur when speculators buy overvalued assets expecting
prices to rise further. This is dangerous because the bubble might burst and
the value of the stock crashes.

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