Chapter 19 Flashcards
(24 cards)
Present value
the amount of money today that would be needed to produce a future amount of money, given prevailing interest rates
Future Value
the amount of money in the future than an amount of money today will yield, given prevailing interest rates
Formula for future value
(1+r) x $100=after 1 year
(1+r) x (1+r) x $100=after 2 years
(1+r) x (1+r) x (1+r) x100=after 3 years
(1+r) ^n x $100= after N years
Formula for present value
Ex: X/(1+r)^n
Discounting
the process of finding a present value of a future sum of money
The rule of 70
if some amount grows at a rate of x percent per year, then that amount doubles in approximately 70/x years
Risk adverse
People who dislike bad things more than they like comparable good things
Utility
A person’s subjective measure of well-being or satisfaction
Annuity
A regular income every year until you die
Markets for insurance suffer for two reasons
- Adverse selection
2. Moral hazard
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
Standard deviation
How risk is measured. It measures the volatility of a variable. That is, how much the variable is likely to fluctuate. (the higher 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 they expected.
Firm-specific risk
the uncertainty associated with a specific company
Market risk
the uncertainty associated with the entire economy, which affects all companies traded on the stock market
Dividends
cash payments that a company makes to its shareholders
Fundamental analysis
the study of a company’s accounting statements and future prospects to determine its value
When following stock of a company, you should look keep an eye on these three things
- Price
- Dividend
- Price-earnings ratio
Price earnings ratio (P/E)
the price of one share of a corporation’s stock divided by the corporation’s earnings per share over the past year
Efficient markets hypothesis
The theory that asset prices reflect all publicly available information about the value of an asset
Informational efficiency
the description of asset prices that rationally reflect all available information
Random walk
the path a variable whose changes are impossible to predict
Index fund
An index fund is a mutual fund that buys all the stocks in a given stock index.
Because of diminishing marginal utility, most people are risk averse. Risk averse people can reduce risk by doing three things
- buying insurance
- diversifying their holdings
- choosing a portfolio with lower risk and lower return
