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Chapter 27

# Ch. 27- Basic Tools of Finance .docx

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Department
Economics
Course
ECON 20B
Professor
Mu- Chun Chen
Semester
Fall

Description
Ch. 27: Basic Tools of Finance I. Present Value: Measuring Time Value of Money - finance: field of study of how people make decisions regarding the allocation of resources over time and handling risk o money today is more valuable than same amount in future o Present value: amount of \$ today that would be needed, using prevailing interest rates to produce a given future amount of \$ o Future value: amount of \$ in future that an amount of \$ today will yield, given prevailing interest rates o Compounding: accumulation of a sum of \$ in bank account where interest earned remains in the account to earn additional interest in future o Formula: Future value = (1+r)^n x Present value  n= years, r= interest rate o Present value= (Future value)/(1+r)^n o Discounting= process of finding present value of future sum of \$ o The increase of interest rate, the more you can earn by depositing your money in a bank o Quantity of loanable funds demanded declines when interest rate rises II. Managing Risk A. Risk aversion o risk aversion: dislike of uncertainty o utility: person’s \$subjective measure of well being/satisfaction - t he more wealth the person has, the less utility he gets from each additional dollar o the flatter, the more wealth increases 1. Markets for insurance  insurance company will pay you annuity  insurance role is to spread risk around more efficiently  adverse selection: high risk person more likely to apply for insurance than low risk people b/c high risk would benefit from insurance
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