EDEV 311: ECONOMIC
DEVELOPMENT
SESSION 5: THE BASIC TOOLS OF FINANCE
What is Finance?
Finance is the field that studies
how people make decisions
regarding the allocation of
resources over time and the
handling of risk.
PRESENT VALUE: MEASURING
THE TIME VALUE OF MONEY
Present value refers to the amount of money today that would be
needed to produce, using prevailing interest rates, a given future
amount of money.
The concept of present value demonstrates the following:
Receiving a given sum of money in the present is preferred to receiving the same
sum in the future.
In order to compare values at different points in time, compare their present
values.
Firms undertake investment projects if the present value of the project exceeds
the cost.
PRESENT VALUE: MEASURING
THE TIME VALUE OF MONEY
If r is the interest rate, then an amount X to be received in N years has
present value of:
X/(1 + r)N
Future Value
The amount of money in the future that an amount of money today will
yield, given prevailing interest rates, is called the future value.
FYI: Rule of 70
According to the rule of 70, if some variable grows at a rate of x percent
per year, then that variable doubles in approximately 70/x years.
MANAGING RISK
A person is said to be risk averse if she exhibits a dislike of
uncertainty.
Individuals can reduce risk choosing any of the following:
Buy insurance
Diversify
Accept a lower return on their investments
The Markets for Insurance
One way to deal with risk is to buy
insurance.
The general feature of insurance
contracts is that a person facing a risk
pays a fee to an insurance company,
which in return agrees to accept all or
part of the risk.
Diversification of Idiosyncratic Risk
Diversification refers to the reduction of risk achieved by replacing a
single risk with a large number of smaller unrelated risks.
Idiosyncratic risk is the risk that affects only a single person. The
uncertainty associated with specific companies.
Aggregate risk is the risk that affects all economic actors at once, the
uncertainty associated with the entire economy.
Diversification cannot remove aggregate risk.
Diversification of Idiosyncratic Risk
People can reduce risk by
accepting a lower rate
of return.
ASSET VALUATION
Fundamental analysis is the study of a company’s accounting
statements and future prospects to determine its value.
People can employ fundamental analysis to try to determine if a stock
is undervalued, overvalued, or fairly valued.
The goal is to buy undervalued stock.
Efficient Markets Hypothesis
The efficient markets hypothesis is the theory that asset prices
reflect all publicly available information about the value of an asset.
A market is informationally efficient when it reflects all available
information in a rational way.
If markets are efficient, the only thing an investor can do is buy a
diversified portfolio
CASE STUDY: Random Walks and Index
Funds
Random walk refers to the path of a variable whose changes are impossible to
predict.
If markets are efficient, all stocks are fairly valued and no stock is more likely
to appreciate than another. Thus stock prices follow a random walk.
Summary
Because savings can earn interest, a sum of money today is more valuable
than the same sum of money in the future.
A person can compare sums from different times using the concept of present
value.
The present value of any future sum is the amount that would be needed
today, given prevailing interest rates, to produce the future sum.
Because of diminishing marginal utility, most people are risk averse.
Risk-averse people can reduce risk using insurance, through diversification,
and by choosing a portfolio with lower risk and lower returns.
The value of an asset, such as a share of stock, equals the present value of
the cash flows the owner of the share will receive, including the stream of
dividends and the final sale price.
Summary
According to the efficient markets hypothesis, financial markets
process available information rationally, so a stock price always
equals the best estimate of the value of the underlying business.
Some economists question the efficient markets hypothesis, however,
and believe that irrational psychological factors also influence asset
prices.
THANK YOU !
-OLFU SUMMER 2020
