The Basic Tools of Finance
What are the three ways to manage risk?
1. Buy Insurance 2. Diversify 3. Accept a lower return
How is the price of a stock determined?
By supply and demand.
Present Value of perpetuity
C/i
Value of a share of stock
D1/ 1+i + D2/ 1+i^2 + D3/1+i^3
What does it mean diversify?
Don't put all your eggs in one basket.
Future Value Formula
FV=PVx(1 x i)^n
What diversification reduce?
Firm-specific risk, but will not affect market risk.
FV
Future Value
When stock prices changes what else changes?
Information
Present Value Formula
PV= FV/ (1+i)^n
PV
Present Value
Example of risk-aversion
The pain of losing $1,000 would exceed the gain from winning $1,000.
Why would one buy insurance?
To share risk ( not eliminating risks but spreading)
Risk
Uncertainty
How does news affect the price of a stock?
When good or bad news about a company becomes public, the price of the stock will rise or fall.
Perpetuity
an annuity with no maturity
Annuity
constant cash flow
Risk averse
disliking uncertainty
i
nominal annual interest rate
N
number of years
Market risk (aggregate risk)
risk that affects all economic actors at once.
Firm specific risk (idiosyncratic risk)
risk that affects only a single economic actor.
Future Value
the amount of money in the future that an amount of money today will yield, given prevailing interest rates, to produce a given future amount of money.
Present Value
the amount of money today that would be needed, using prevailing interest rates, to produce a given future amount of money.
Random Walk
the path of a variable whose changes are hard to predict.
Undervalued
the price of stock is less than the value.
Overvalued
the price of the stock is said to be greater than its value.
Fairly Valued
the price of the stock is the same the value.
Fundamental Analysis
the study of a company's acounting statements and future prospects to determine its value.
Efficient Market Hypothesis
the theory according to which asset prices reflect all publicly available information about the value of an asset.
Fundamental Analysis determines
the value of a stock based on dividends, the expected final sale price, the ability of the corporation to earn profits.
What doe it mean to accept a lower return?
tradeoff between return and risk.