• Finance: the field that studies how people make decisions regarding the allocation of resources over time and the handling of risk

27-1 Present Value: Measuring the Time Value of Money

• Present value: the amount of money today needed to produce a future amount of money, given prevailing interest rates

• Future value: the amount of money in the future that an amount of money today will yield, given prevailing interest rates

• Compounding: the accumulation of a sum of money, where the interest earned remains in the account to earn additional interest in the future

• (1+r)^N * $x,where r=rate of interest, N=number of years, and x=original total $

• Discounting: the process of finding a present value of a future sum of money

27-2 Managing Risk

Risk Aversion

• Risk-averse: a dislike of uncertainty

• Utility: a person’s subjective measure of well-being or satisfaction

• The more money someone has, the less utility earned from the next dollar earned

The Markets for Insurance

• Buying insurance deals with risk

• Insurance is bought for peace of mind

• Adverse selection: a high-risk person is more likely to apply for insurance than a low-risk person

• Moral hazard: after insurance is bought, there is less incentive to be careful about risky behaviors

Diversification of Firm-Specific Risk

• Diversification: the reduction of risk achieved by replacing a single risk with a large number of smaller, unrelated risk

• Bought stock bets on the future profitability of that company, which is risky because not all information is known

• Standard deviation: risk measured by the volatility of variable

• The higher the standard deviation, the more volatile it is, and the riskier it is

• Firm-specific risk: the risk that affects only a single company

• Market risk: the risk that affects all companies in the stock market

The Trade-Off Between Risk and Return

• People face trade-offs

• Historically, stocks have offered much higher rates of return than bonds, bank savings accounts, and other financial assets

27-3 Asset Valuation

Fundamental Analysis

• Overvalued: a stock whose price is more than its value

• Fairly valued: a stock whose price is equivalent to its value

• Undervalued: a stock whose price is less than its value

• Fundamental analysis: the detailed analysis of a company in order to estimate its value

• Stock analysts are hired by firms to conduct fundamental analysis and give advice on stocks to buy

• Dividends: cash payments a company makes to its shareholders

• A company’s ability to pay dividends depends on the company’s ability to earn profits

The Efficient Markets Hypothesis

• Efficient markets hypothesis: the theory that asset prices reflect all publicly available information about the value of an asset

• Money managers watch new stories and conduct fundamental analyses to try and determine a stock’s value. Stocks are bought ideally when a price falls below its fundamental value and sold when the price is above the fundamental value

• At market price, number of shares being sold = number of shares being bought

• Informational efficiency: the description of asset prices that rationally reflect all available information

• Stock prices change when information changes. When good news appears about a company, the price rises, and if bad news appears, the price falls

• Random walk: the path of a variable whose changes are impossible to predict

Market Irrationality

• Speculative bubble: whenever the price of an asset rises above what appears to be its fundamental value

• Speculative bubbles may happen because the value of a stock to a stockholder is decided by the stream of dividend payments but also on the final sale price

• You need to estimate not only the value of the business but what other people will think of the business’s worth in the future

• If the market were irrational, a rational person would be able to beat the market

• Beating the market is nearly impossible