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Social Science
Economics
Finance
Ch. 14- The Basic Tools of Finance
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Terms in this set (15)
present value
the amount of money today that would be needed, using current 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 current interest rates
formula used to compute the future value
future value = present value x (1+ r)^n
formula used to compute the present value
present value = future value / (1+ r)^n
how does a change in the interest rate affect the present value of a future payment?
because the future payment doesn't change, a change in interest rate affects the present value of a payment; if the interest rate falls, the PV increases (because you're not discounting as much with the discount rate); if the interest rate rises, the PV decreases;
why is it that with a higher interest rate, the money you receive today is worth more?
with a higher interest rate, the money you receive today is worth more because you can earn a greater amount of interest on your money
rule of 70 formula
70/ (annual % growth rate)
risk-averse
dislike of uncertainty
what are two problems that insurance companies face?
1.) adverse selection: tendency for high-risk people to apply for insurance in greater numbers that low-risk people high-risk people would benefit more from insurance protection
2.) moral hazard: tendency for people to engage in riskier behavior because they have less incentive to be careful since the insurance company will cover much of the resulting losses
market risk
risk that affects all companies in the stock market
firm-specific risk
risk that affects only a single company
diversification
the reduction of risk achieved by replacing a single risk with a large number of smaller unrelated risks
increasing the number of stocks in a portfolio reduces what risk?
this reduces firm-specific risk, but does not eliminate market risk because market performance impacts all companies
efficient market hypothesis
states that markets quickly integrate all available information so that the price of a stock or other asset reflects all available information; according to the hypothesis, all stocks are fairly valued at all times; theory states it is impossible to "beat the market"
speculative bubble
occurs when asset prices rise above what appears to be their fundamental values. this can happen if people are willing to pay more than the fundamental value for an asset on the premise that another person will buy the asset for an even higher price in the near future
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