Chapter 14 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 Present Value: Measuring the Time Value 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 -Future value: the amount of money in the future that an amount of money will yield, given prevailing interest rates -Compounding: the accumulation of a sum of money, where the interest earned remains in the account to earn additional interest in the future *If r is the interest rate, then an amount X to be received in N years has a present value of X / (1 + r)^N *Money today is more valuable than the same amount of money in the future (inflation) Managing Risk -Risk averse: a dislike of uncertainty -Utility: a person?s subjective measure of well-being or satisfaction. The utility function gets flatter as wealth increases -Annuity: a regular income every year until you die paid by the insurance company just in case you live too long -Insurance is a gamble. -2 problems insurance companies face. Adverse selection: a high-risk person is more likely to apply for insurance than a low-risk person. Moral hazard: After people buy insurance, they have less incentive to careful -Most people who buy insurance will never receive any return except peace of mind -Diversification: the reduction of risk achieved by replacing a single risk with a large number of smaller, unrelated risks -By increasing the number of stocks in different companies, you eliminate firm-specific risk, which is the uncertainty associated with specific companies, but you cannot eliminate market risk, which is the uncertainty associated with the entire economy (recession) Asset Valuation -You should invest in undervalued stocks (price is less than value) -Determining the value of a stock is a difficult process -Fundamental analysis: the study of a company?s accounting statements and future prospects to determine its value -Efficient market hypothesis: the theory that asset prices reflect all publicly available information about the value of an asset -If prices reflect all available information, no stock is better to buy than any other. The equilibrium of supply and demand sets the market price for shares. The number of people who think the stock is overvalued equals the number who think it?s undervalued -Random walk: the path of a variable whose changes are impossible to predict -Informational efficiency: the description of asset prices that rationally reflect all available information -Correlation between how well stocks does one year and how well it does the following year is almost exactly zero -Index funds almost always do better than mutual funds -Speculative bubble: when the price of an asset rises above what appears to be its fundamental value (over exuberance with the market in the 1990s) *When you evaluate a stock, you have to estimate not only the value of the business but also what other people will think the business is worth in the future