The Basic Tools of Finance

Nội dung text: The Basic Tools of Finance

1. 2.3 The Basic Tools of Finance ▪ The financial system coordinates saving and investment. ▪ Participants in the financial system make decisions regarding the allocation of resources over time and the handling of risk. ▪ Finance is the field that studies such decision making. Institute of International Education
2. Finance: Questions ▪ Q: Which would you rather have: $100 today or $100 ten years later? ▪ Q: Would you rather have $100 today or $115 a year from today? ▪ Q: Would you rather have $100 or a lottery ticket that has a 60% chance of winning nothing and a 40% chance of winning $150? Institute of International Education
3. Present Value: The Time Value of Money ▪ To compare a sums from different times, we use the concept of present value. ▪ The present value of a future sum: is the amount today that would be needed, at current interest rates, to produce that future sum. ▪ The future value of a sum: the amount of money in the future that an amount of money today will yield, given current interest rates Institute of International Education
4. EXAMPLE 1: A Simple Deposit ▪ Deposit $100 in the bank at 5% interest per year. What is the future value (FV) of this amount? • Interest rate = r = 0.05 • Suppose that interest is paid annually and that it remains in the bank account to earn more interest - a process called compounding. Institute of International Education
5. EXAMPLE 1: A Simple Deposit ▪ Future value = • After 1 year: (1+0.05) ˣ $100 = $105 • After 2 years: (1+0.05) ˣ (1+0.05) ˣ $100 = (1+0.05)2 ˣ $100 = $110.25 • After 3 years: (1+0.05)3 ˣ $100 = $115.76 ➔ After N years: (1+0.05)N ˣ $100 Institute of International Education
6. EXAMPLE 1: A Simple Deposit Deposit $100 in the bank at 5% interest. What is the future value (FV) of this amount? ▪ In N years, FV = $100(1 + 0.05)N In this example, $100 is the present value (PV). N ▪ In general, FV = PV(1 + r ) where r denotes the interest rate (in decimal form). ▪ Solve for PV to get: PV = FV/(1 + r )N Institute of International Education
7. EXAMPLE 1: A Simple Deposit If the interest rate is 5%, the present value of $200 to be paid in 10 years is PV = 200/(1 + 0.05 )10 = $123 ➔This means that $123 deposited today in a bank account that earned 5% would produce $200 after 10 years. ➔This process is called discounting Discount factor: 1/(1 + r )N Institute of International Education
8. EXAMPLE 2: Investment Decision Present value formula: PV = FV/(1 + r )N ▪ Suppose r = 0.06 Should Ford spend $100 million to build a factory that will yield $200 million in ten years? Solution: Institute of International Education
9. EXAMPLE 2: Investment Decision ▪ Instead, suppose r = 0.09. Should Ford spend $100 million to build a factory that will yield $200 million in ten years? Solution: PV helps explain why investment falls - hence, Qd of loanable fund fall - when the interest rate rises. Institute of International Education
10. The Rule of 70 ▪ The Rule of 70: If a variable grows at a rate of x percent per year, that variable will double in about 70/x years. ▪ Example: ▪ If interest rate is 5%, a deposit will double in about 14 years. ▪ If interest rate is 7%, a deposit will double in about 10 years. Institute of International Education
11. Risk Aversion ▪ Most people are risk averse - they dislike uncertainty. ▪ Example: You are offered the following gamble. Toss a coin. ▪ If heads, you win $1000. ▪ If tails, you lose $1000. Should you take this gamble? ▪ If you are risk averse, the pain of losing $1000 would exceed the pleasure of winning $1000, so you should not take this gamble. Institute of International Education
12. The Utility Function Utility Utility which is a person’s subjective Current measure of well- utility being or satisfaction As wealth rises, the curve becomes flatter due to diminishing marginal utility: The more wealth a person Wealth has, the less extra utility he would get from an extra dollar. Current wealth Institute of International Education
13. The Utility Function and Risk Aversion Utility Utility gain from winning $1000 Utility loss from losing $1000 Because of diminishing marginal utility, a $1000 loss reduces Wealth utility more than a $1000 –1000 +1000 gain increases it. Institute of International Education
14. Managing risk ▪ Individuals can reduce risk by choosing to do any of the following: • Buy insurance • Diversify the assets they own • Accept a lower return on their investments Institute of International Education
15. Managing Risk With Insurance ▪ How insurance works: A person facing a risk pays a fee to the insurance company, which in return accepts part or all of the risk. ▪ Role of insurance - Not to eliminate the risks - Spread the risks around more efficiently Institute of International Education
16. Two Problems in Insurance Markets 1. Adverse selection: A high-risk person benefits more from insurance, so is more likely to purchase it. 2. 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 Institute of International Education
17. Reducing Risk Through Diversification ▪ Diversification reduces risk by replacing a single risk with a large number of smaller, unrelated risks. ▪ A diversified portfolio contains assets whose returns are not strongly related: ▪ Some assets 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. Institute of International Education
18. Measuring Risk ▪ Risk of a portfolio of stocks - Depends on number of stocks in the portfolio ▪ We can measure risk of an asset with the standard deviation, a statistic that measures a variable’s volatility – how likely it is to fluctuate. ▪ The higher the standard deviation of the asset’s return, the greater the risk. Institute of International Education
19. Reducing Risk Through Diversification ▪ Market risk and specific risk are two different forms of risk that affect assets. • Diversification can reduce firm-specific risk, which affects only an industry or a single company. • Diversification cannot reduce market risk, which affects all asset classes or companies in the stock market. Institute of International Education
20. Reducing Risk Through Diversification Risk (standard deviation of 1. Increasing the number of stocks portfolio return) in a portfolio reduces firm-specific (More risk) risk through diversification . . . 49 20 2. . . . but market risk remains. (Less risk) 0 1 4 6 8 10 20 30 40 Number of Stocks in Portfolio ➔ Increasing the number of stocks reduces the amount of risk in a stock portfolio, but cannot eliminate all risk. Institute of International Education
21. The Tradeoff Between Risk and Return ▪ Tradeoff: Riskier assets pay a higher return, on average, to compensate for the extra risk of holding them. ▪ E.g., Stocks have offered much higher rates of return than alternative financial assets, such as bonds and bank savings accounts Institute of International Education
22. The Tradeoff Between Risk and Return Return (percent 100% per year) stocks 75% stocks 50% 8.3 stocks 25% stocks Increasing the share No of stocks in the stocks portfolio increases the average return 3.1 but also the risk. Risk (Sd) 0 5 10 15 20 Institute of International Education
23. Asset Valuation ▪ When deciding whether to buy a company’s stock, you compare the price of the shares to the value of the company. ▪ If share price > value, the stock is overvalued. ▪ If price < value, the stock is undervalued. ▪ If price = value, the stock is fairly valued. ▪ Value of a share = PV of any dividends the stock will pay + PV of the price you get when you sell the share Institute of International Education
24. A C T I V E L E A R N I N G Valuing a share of stock If you buy a share of Dell stock today, ▪ you will be able to sell it in 3 years for $30. ▪ you will receive a $1 dividend at the end of each of those 3 years. If the current interest rate is 10%, what is the value of a share of Dell stock today? Institute of International Education
25. Asset Valuation Fundamental Technical Analysis Analysis ▪ Refers to the detailed ▪ Refers to the analysis of a company to understanding patterns in estimate its value company’s share price ▪ Long-term investing ▪ Short-term trading ▪ Focus on things like ▪ Using historic price charts company’s management to forecast future pricing structure, industry position, and volume trends growth rate, competitors Institute of International Education
26. The Efficient Markets Hypothesis ▪ Efficient Markets Hypothesis (EMH): the theory that each asset price reflects all publicly available information about the value of the asset ▪ E.g.: Those companies that are likely to earn higher profits will have shares that sell at a higher price. Institute of International Education
27. Implications of EMH 1. Stock market is informationally efficient: Each stock price reflects all available information about the value of the company. Stock prices change when information changes 2. Stock prices follow a random walk: Changes in stock prices are impossible to predict from available information 3. If markets are efficient, the only wise thing an investor can do is buy a diversified portfolio Institute of International Education