Exam 3 Review

The Basic Tools of Finance

Islamic Finance

Unemployment

FinanceTimeRisk

TimeFuture ValuePresent Value

Future ValueWhat something today

will be worth in the future

Compounding

Present ValueWhat something in the future is worth today

Discounting

(1+r)N

r = Rate of compounding

N = Number of Periods

Compounding Discounting

(1+r)N(1+r)N 1   

Future Value Present ValueMultiply Present Value

by factor to get Future Value

Multiply Future Valueby factor to get Present Value

Two ways to get Present Value

(1+r)N 1    PV = FV x

or

(1+r)N FV    PV =

FV = PV x Factor

Rewrite

Factor FactorFV = PV x Factor

FactorPV = FV

1. Calculate factor (1+r)N

2. Is the problem FV or PV?

3. If FV then multiply by PV

FV = PV x Factor

4. If PV then divide FV by

PV = FV ÷ Factor

Future Value

= Present Value x (1+r)N

Present Value = 500r = 5% or .05N = 4Future Value = ?

= PV x (1+.05)4

= PV x 1.2155= 500 x 1.2155= 607.75

Present Value

= Future Value ÷ (1+r)N

Future Value = 2000r = 8% or .08N = 5Present Value = ?

= FV ÷ (1+.08)5

= FV ÷ 1.4693= 2000 ÷ 1.4693= 1361.16

QuestionsAlways given r and N

If given PV, then solve for FV

If given FV then solve for PVPV

FV

FV ?=

PV ?=r and N

Risk

Don’t like RiskRisk Adverse

Cannot always avoidReduce exposure

DiversificationReplace one large risk

with lots of small unrelated risks

SmallRisk

SmallRisk

SmallRisk

SmallRisk

SmallRisk

SmallRisk

LargeRisk

Insurance

Sharing riskDoes not eliminate riskReduce your exposure

How to Fund an Insurance Pool

Estimate Loss

Estimate Probability

Premium = Loss x Probability

Members = Loss ÷ Premium

Loss = 100

Probability 1 in 20 or .05

Premium = 100 x .05 = 5

Members = 100 ÷ 5 = 20

How to Fund an Insurance Pool

Adverse Selection

Making a bad choice due to asymmetric

information

Moral Hazard

Changing behavior after an agreement

Temptation to abuse the other party

Three Risks

Firm RiskIndustry RiskMarket Risk

Speculative Bubble

Price is greater than fundamental value

Buy because everyone else is buying

Chapter 28

IslamicFinance

Islamic FinanceMust have an asset

involved in the exchange

No money for money

IslamicProfit and loss sharing system

Non Islamicinterest-based system

Shariah - Sacred LawRiba - Usury -InterestGharar - UncertaintyHaram - ProhibitiedHalal - PermittedZakat - Religious TaxHiba - Gift

Deposits Current Saving -Wadiah Investment - MudarabahEquity Financing Mudarabah - Risk Musharakah - Share RiskAsset Financing Murabahah - Resell Salem - Crop Loan Ijarah Leasing - ReturnSukuk - Bonds Takaful - Insurance

FutureDifferent views and interpretations

EvolvingNo uniform consensus

Five schools of thoughtShafi’i, Maliki, Hanafi,

Hanbali, and Shi’a

Chapter 29

Unemployment

Total Population 30 million

Non-Saudis 10 million

Saudis 20 million

Adult Population Age 15+ 11 million

Not in Labor Force 6 million

In Labor Force 5 million

Labor Force Participation Rate 45%

Employed 4.4 million

Unemployed 600 thousand

Unemployment Rate 12%

Source: General Statistics Department and Information

Saudi Labor Force Around

Employedpaid employees

work in own businessunpaid workers in family business

full-time and part-timejobs but temporary absence

Unemployednot employed

availabletried to find a job in the last four

weekswaiting to be recalled from layoff

Discouraged Workers

People who would like to work but have given

up looking for a job

Not in Labor Forcenot employed or unemployed

discouraged workersfull-time student

homemakerretiree

Unemployment Rate

The percentage of the labor force that is

unemployed

Employment Analysis Saudi U.S China

Unemployment Rate 12.2% 7.9% 4.1%

Participation Rate 45.0% 63.3% 74.2%

Natural Rate of Unemployment

The normal rate of unemployment around

which the unemployment rate fluctuates

CyclicalUnemployment

The deviation of unemployment from its

natural rate

ProblemsOverstate - Above actual

Cash workers

Understate - Below actualDiscouraged workers

Unemployment

FrictionalSeasonalStructural

Frictional

Time to find a new job

Seasonal

Demand changes with the season

Structural

Too many workers

Change in demand for skills

Structural

Creative Destruction

10% a Year

Unemployment Insurance

Government program to provide income when

workers become unemployed

Unemployment Insurance

Unintended ConsequenceMoral Hazard

May prolong unemployment

Why are wages too high?

Minimum wage lawsUnions

Efficiency Wages

Minimum Wage Laws

Government sets a minimum wage that can

legally be paid

0

1,000

2,000

3,000

4,000

0 10 20 30 40 50 60

Supply

Demand

Wage

Workers

Equilibrium Wage

30 workers30 jobs

no unemployment

Minimum Wage40 workers

20 jobs20 unemployed

workers

Minimum Wage20 workersget a raise10 workers

lose job10 new

unemployed workers

MinimumWage

Efficiency Wages

Higher wages make more productive

employees

Efficiency Wages

Employee Wage Pizzas ProductivityWage per Pizza

Ali 100 5 20.0

Abdullah 200 12 16.7

Efficiency Wages

More HealthyLower TurnoverHigher Quality

More Effort