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Chapter 27

Chapter 27 Economics.docx

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Harvard University
Economics 10b
Gregory Mankiw

Chapter 27 Economics: The Basic Tools of Finance • Finance: the field that studies how people make decisions regarding the allocation of resources over time and the handling of risk • Money today is more valuable than the same amount of money in the future due to inflation and the possible accumulation of interest • Present value: the amount of money today that would be needed, using prevailing interest rates, to produce a given future amount of money • Future value: the amount of money in the future that an amount of money today will yield given prevailing interest rates • Compounding: the accumulation of a sum of money in, say, a bank account where the interest earned remains in the account to earn additional interest in the future Future value: where r = real interest Discounting: the process of finding a present value of a future sum of money • The higher the interest rate, the more you can earn by depositing your money in a bank • Rule of 70: if some variable grows at a rate of x percent per year, then that variable doubles in approximately 70/x years • Risk aversion: a dislike of uncertainty • Utility: a person’s subjective measure of well-being or satisfaction • Diminishing marginal utility: the more wealth a person has, the less utility he gets from an additional dollar • Insurance: a person facing risk pays a fee to an insurance company, which agrees to accept all or part of the risk • Annuity: a regular income every year until you die • An insurance company is counting on the fact that most people will not make claims on their policies; otherwise, it couldn’t pay out the large claims to the unlucky few and still stay in business • Insurance spreads around risks more efficiently • Adverse selection: a high-risk person is more likely to apply for insurance than a low-risk person because a high-risk person would benefit more from insurance protection • Moral hazard: after people buy insurance, they have less incentive to be careful about their risky behavior because the insurance company will cover much of the resulting losses • An insurance company cannot distinguish between high-risk and low-risk customers, and it cannot monitor all of its customers’risky behaviorThe price of insurance reflects the actual risks that the insurance company will face after the insurance is bought • The high price of insurance is why some people, especially those who know themselves to be low-risk, decide against buying it • Diversification: the reduction of risk achieved by replacing a single risk with a large number of smaller, unrelated risks (i.e. through insurance or diverse stock portfolios) • Risk can be reduced by placing a large number of small bets, rather than a small number of large onesincreasing the number of stocks in a portfolio reduces firm-specific risk through diversification, but the market risk remains • Standard deviation: a measurement of the volatility of the variable; how much the variable is likely to fluctuate o The higher the standard deviation of a portfolio’s return, the more volatile its return is likely to be, and the riskier it is that someone holding the portfolio will fail to get the return that he/she expected • Firm-specific risk: risk that affects only a single company • Market risk: risk that affects all companies in the stock market • Historically, stocks have offered much higher rates of return than alternative financial assets • FundamentalAnalysis: the study of a company’s accounting statements and future prospects to determine its value o If the price is less than the value, the stock is said to be undervaluedbuy this stock o If the price is more than the value, the stock is said to be overvalued o If the price and the value are equal, the stock is said to be fairly valued o The value of a stock to a stockholder is what he gets out of owning it, which includes
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