N.

GREGORY MANKIW NINTH EDITION

PRINCIPLES OF
ECONOMICS
CHAPTER
The Basic Tools of
Finance
Interactive PowerPoint Slides by:
V. Andreea Chiritescu
Eastern Illinois University
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 IN THIS CHAPTER
• What is “present value”? How can we use it
to compare sums of money from different
times?
• Why are people risk averse?
How can risk-averse people use insurance
and diversification to manage risk?
• What determines the value of an asset?
What is the “efficient markets hypothesis”?
Why is beating the market nearly impossible?

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 Finance
• The financial system
– Coordinates saving and investment
• Participants in the financial system
– Make decisions regarding the allocation of
resources over time and the handling of risk
• Finance
– Studies how people make decisions regarding
the allocation of resources over time and the
handling of risk

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 Present Value
• The present value of a future sum:
– The amount of money today (PV) needed
to produce a future amount of money
(FV), given prevailing interest rates
• The future value of a sum:
– The amount of money in the future (FV)
that an amount of money today (PV) will
yield, given prevailing interest rates

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 EXAMPLE 1: Grandma’s gift
Demarcus received $200 from grandma for
his birthday. He wants to deposit the money in
the bank at 5% interest.
What is the future value (FV) of this amount?
• In N years, future value FV = PV×(1 + r)N

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 EXAMPLE 2: How much to save?
Amaia inherited money from her aunt’s estate.
She wants to travel for now, but also to save
some of the money to pay for grad school in 4
years.
If the interest rate is 8%, how much does she
need to deposit today to have $20,000 in 4
years?
• We know FV = PV×(1 + r)N so, PV = FV / (1 + r)N

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 Compounding and the Rule of 70
• Compounding:
– The accumulation of a sum of money where the
interest earned on the sum earns additional
interest
• Because of compounding
– Small differences in interest rates lead to big
differences over time.
• The Rule of 70:
– If an amount grows at a rate of x % per year, that
amount will double in about 70/x years.
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 EXAMPLE 3: Compounding and the rule of 70
You buy $1,000 worth of Microsoft stock, and hold it
for 30 years.
• 2% increase in the rate of return (from 8% to 10%)
leads to over $7,000 of additional interest earned
over the 30 years.

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 EXAMPLE 4: Investment decision
Pacific Gas & Electric wants to build a new power
plant that will generate $800 million in ten years.
The plant costs $400 million to build. Should PG&E
build the plant if:
a) Interest rate is 4%? Why?
b) Interest rate is 8%? Why?

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 Active Learning 1: Buying land to sell later
Makayla is thinking of purchasing a twelve-
acre lot for $70,000. The lot will be worth
$120,000 in ten years.
A. Should Makayla buy the lot if r = 0.03?
B. Should Makayla buy it if r = 0.07?

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 Risk Aversion
• Most people are risk averse: dislike
uncertainty.
– People dislike bad things happening to
them
• Utility
– A person’s subjective measure of well-
being or satisfaction.
– Diminishing marginal utility help explain
why most people are risk adverse
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 The utility function and risk aversion
Utility
Utility gain from
winning $1,000

Utility loss from

losing $1,000
Diminishing marginal
utility: the $1,000 loss
reduces utility more
than the $1,000 gain
increases it. –$1,000 +$1,000
Wealth
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 Managing Risk With Insurance
• How insurance works:
– A person facing a risk pays a fee to the
insurance company, which in return
agrees to accept all or part of the risk.
– Insurance allows risks to be pooled, and
can make risk averse people better off.

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 Two Problems in Insurance Markets
1. Adverse selection:
– A high-risk person benefits more from insurance,
so is more likely to purchase it.
– People with chronic illnesses have more
incentive to buy health insurance (provided it
covers their treatment) than other people
2. Moral hazard:
– People with insurance have less incentive to
avoid risky behavior.
– People with good fire insurance: less incentive to
replace the batteries in their smoke detectors.
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 Active Learning 2: Adverse selection or moral hazard?

Identify whether each of the following is an

example of adverse selection or moral hazard.
A. Jeremiah begins smoking in bed after buying
fire insurance.
B. Both of Chloe’s parents lost their teeth to gum
disease, so Chloe buys dental insurance.
C. When Aliyah parks her Corvette convertible,
she doesn’t bother putting the top up,
because her insurance covers theft of any
items left in the car.

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 Diversification of Firm-Specific Risk
• Standard deviation
– Measures the volatility of a variable
• Diversification
– The reduction of risk achieved by replacing a
single risk with a large number of smaller,
unrelated risks.
– Can eliminate firm-specific risk (affecting a
single company), but not market risk
(affecting all companies in the stock market)

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 Reducing risk through diversification
More risk Increasing the number of stocks
50 reduces firm-specific risk
RISK: Standard dev. of

40
portfolio return

30

20 But
market
10
risk
0 remains.
0 10 20 30 40
Less risk
# of stocks in portfolio
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 Trade-Off Between Risk and Return
• Trade-off:
– Riskier assets pay a higher return, on
average, to compensate for the extra risk
of holding them.
– Over the past 200 years, average real
return:
• On stocks, 8% (riskier asserts)
• On short-term government bonds, 3%.

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 EXAMPLE 4: The risk-return trade-off
Return Portfolio with two asset
(percent
per year)
classes:
• A diversified group of
75%
risky stocks with an
8 stocks average return = 8%,
100%
25% stocks standard dev. = 20%
stocks 50% • A safe asset with a
3
stocks return = 3%, standard
No
stocks dev. = 0%
Increasing the share of
0 5 10 15 20 stocks in the portfolio
Risk (standard deviation) increases the average
return but also the risk.
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 Asset Valuation – 1
• When deciding whether to buy a
company’s stock:
– You compare the price of the shares to
the value of the company.
• Stocks are:
– Undervalued if Price < Value
– Overvalued if Price > Value
– Fairly valued if Price = Value

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 Active Learning 3: Valuing a share of stock
If you buy a share of AT&T stock today (r = 0.1), you
will be able to sell it in 3 years for $30. You will receive
a $1 dividend at the end of each of those 3 years.
• What is the value of a share of AT&T stock today?

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 Asset Valuation – 2
• Value of a share
= PV of any dividends the stock will pay
+ PV of the price you get when you sell the share
• Problem:
– When you buy the share, you don’t know what
future dividends or prices will be.
• Fundamental analysis (one way to value a stock)
– The study of a company’s accounting
statements and future prospects to determine
its value
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 Active Learning 4: Show of hands survey
You have a brokerage account with Merrill
Lynch Wealth Management. Your broker calls
you with a hot tip about a stock: new
information suggests that the company will be
highly profitable.
Should you buy stock in the company?
A. Yes
B. No
C. Not until you read the prospectus.
D. What’s a prospectus?
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 Efficient Markets Hypothesis – 1
• Efficient Markets Hypothesis (EMH):
– The theory that asset prices reflect all
publicly available information about the
value of an asset
– Each company listed on a major stock
exchange is followed closely by many
money managers
– The equilibrium of supply and demand
sets the market price

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 Efficient Markets Hypothesis – 2
• Stock market exhibits informational
efficiency:
– Each stock price reflects all available
information about the value of the company.
• Stock prices should follow a random walk:
– The path of a variable whose changes are
impossible to predict.
• If prices reflect all available information
– No stock is a better buy than any other. The
best you can do is to buy a diversified portfolio
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 ASK THE EXPERTS
Diversification
“In general, absent any inside information, an
equity investor can expect to do better by
holding a well-diversified, low-fee, passive
index fund than by holding a few stocks.”

Source: IGM Economic Experts Panel, January 28, 2019.

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 Market Irrationality – 1
• Many believe that stock price movements
are partly psychological:
– J.M. Keynes, 1930s: stock prices are
driven by “animal spirits” of investors;
irrational waves of pessimism and
optimism
– Alan Greenspan: 1990s stock market
boom due to “irrational exuberance”

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 Market Irrationality – 2
• Speculative bubbles
– The price of an asset rises above what
appears to be its fundamental value
• Possibility of speculative bubbles
– Value of the stock to a stockholder
depends on:
• Stream of dividend payments
• Final sale price

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 Market Irrationality – 3
• Debate: frequency and importance of
departures from rational pricing
– Market irrationality
• Movement in stock market is hard to explain -
news that alter a rational valuation
– Efficient markets hypothesis
• Impossible to know the correct/rational
valuation of a company

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 CHAPTER IN A NUTSHELL
• Because savings can earn interest, a sum of
money today is more valuable than the same sum
of money in the future. The present value of any
future sum is the amount that would be needed
today, given prevailing interest rates, to produce
that future sum.
• Because of diminishing marginal utility, most
people are risk averse. Risk-averse people can
reduce risk by buying insurance, diversifying their
holdings, and choosing a portfolio with lower risk
and lower return.

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 CHAPTER IN A NUTSHELL
• The value of an asset equals the present value of
the cash flows the owner will receive. For a share
of stock, these cash flows include the stream of
dividends and the final sale price.
• According to the efficient markets hypothesis,
financial markets process available information
rationally, so a stock price always equals the best
estimate of the value of the underlying business.
Some economists question the efficient markets
hypothesis, however, and believe that irrational
psychological factors also influence asset prices.

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