Chapter 27: The Basic Tools of Finance

Chapter 27 studies the basic tools of finance, defined as the field that studies how people make decisions regarding the allocation of resources over time and the handling of risk. The time value of money has two values: present and future value. Present value is the amount of money needed to produce another amount of money in the future. Future value is the amount of money that an amount of money today would yield, if interest rates remain constant. This can be calculated through compounding, which is the accumulation of a sum in money where the interest earned remains in the account to accumulate more interest.

Risks are other tools of finance, which explains insurance, diversification, and the risk-return trade-off, especially when risk aversion is involved, which is a dislike of uncertainty. Insurance is based off of risk, when people decide whether or not to take the risk of paying for insurance when it is possible nothing would happen, but the insurance market spreads risks. However, adverse selection and moral hazard prevent the risk from being properly spread because people would behave more carelessly and would not consider insurance if they are low risk.

Diversification is the reduction of risk by replacing a single risk with a large number of unrelated risks. An example is a stock portfolio, where savers would spend money on multiple unrelated stocks rather than a single stock. Diversification eliminated firm-specific risk which is a risk that affects only a single company, but cannot avoid market risk, which is a risk that affects all companies.

Asset valuation is the last basic tool of finance, a big part of it being fundamental analysis. People would study a company’s accounting statements and future prospects to determine its value, and if the price is less than the value, the stock is undervalued, where as if the price is more than the value, the stock is overvalued.

The efficient markets hypothesis is the theory that asset prices reflect all publicly available information about the value of an asset. Information efficiency is the description of asset prices that rationally reflect all available information, and random walks are the paths of a variable whose changes cannot be predicted.