Lecture 11 basic tools of finance

Macroeconomics

Lecture 11

Basic Tools of Finance

Questions

1. What is an Index Fund?

2. What is the basic equation for finance?

3. What is the Future Value of $100 invested at a 13% growth rate for 7 years?

4. What is the Present Value of $800 in 12 years at 4%?

5. What is the Future Value of $700 invested at a 7% growth rate for 13 years?

6. What is the Present Value of $500 in 4 years at 12%?

7. What does insurance allow you do do?

8. What is the difference between an index fund and a mutual fund?

9. What is compounding?

10. What is discounting?

A stock that consists of stocks from a stock market group

(1 + r)N

$100 x (1 + r)N = $100 x (1 +.13)7 = $100 x 2.353 = $235.30

$800 ÷ (1 + r)N = $800 ÷ (1 +.04)12 = $800 ÷ 1.60 = $500.00

$1,686.89

$317.75

Take more risks

management, fees, diversity

multiplying to find a future value

dividing to find a present value

Intellectual

Financial Physical

Human

Culture

Entrepreneur

trust knowledge skills personality health relationships

natural resources time buildings equipmentthings than make things

money and risksavers and borrowers time is money

(1+r)n

insurance   limited liability corporations

ideas technologymethods

Cultural Capital

EthicsInstitutions

EthicsHow people treat each other

Beliefs, Values, & Preferences

Informed by Worldview

Institutions

Organizations that people create to implement their

ethics.

Common Propertyvs.

Private Property

Different IncentivesDifferent Behaviors

Common Property

If everybody owns it, no one takes care of it.

Private Property

If one party owns it, they will tend to care for it

because they receive the value

Insurance Problems

Asymmetric InformationAdverse Selection

Moral Hazard

Asymmetric Information

Parties to a trade do not have the same

information

Not Equal

Asymmetric Information

0

25

50

75

100

Salesman Buyer

Asymmetric Information

How to make the information equal on

both sides

Asymmetric Information

Asymmetric Information

0

25

50

75

100

Salesman Buyer

Asymmetric Information

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