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Principles of Economics, Ninth Edition N. Gregory Mankiw
N. Gregory Mankiw, Principles of Economics, 9th Edition © 2021 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
PowerPoint Slides prepared by:
V. Andreea CHIRITESCU
Eastern Illinois University
N. Gregory Mankiw Principles Of Economics Ninth Edition
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Chapter 27
The Basic Tools of Finance
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N. Gregory Mankiw, Principles of Economics, 9th Edition © 2021 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Present Value, Part 1
Finance
Studies how people make decisions:
Allocation of resources over time
Handling of risk
Present value
Amount of money today that would be needed
Using prevailing interest rates
To produce a given future amount of money
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N. Gregory Mankiw, Principles of Economics, 9th Edition © 2021 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Present Value, Part 2
Future value
Amount of money in the future
That an amount of money today will yield
Given prevailing interest rates
Compounding
Accumulation of a sum of money
Interest earned remains in the account
To earn additional interest in the future
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N. Gregory Mankiw, Principles of Economics, 9th Edition © 2021 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Present Value, Part 3
If you put $100 in a bank account today, how much will it be worth in N years?
Present value = $100
Interest rate = r
Future value = …
(1+r) ˣ $100 after 1 year,
(1+r) ˣ (1+r) ˣ $100 = (1+r)2 ˣ $100 after 2 years,
(1+r)3 ˣ $100 after 3 years, …
(1+r)N ˣ $100 after N years,
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N. Gregory Mankiw, Principles of Economics, 9th Edition © 2021 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Present Value, Part 4
How much would you have to deposit in a bank right now to yield $200 in N years?
Future value = $200 in N years
Interest rate = r
Present value = $200/(1+r)N
Discounting
Find present value for a future sum of money
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N. Gregory Mankiw, Principles of Economics, 9th Edition © 2021 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Present Value, Part 5
General formula for discounting:
r, interest rate
X, amount to be received in N years (future value)
Present value = X / (1+r)N
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N. Gregory Mankiw, Principles of Economics, 9th Edition © 2021 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Managing Risk, Part 1
Rational response to risk
Not necessarily to avoid it at any cost
Take it into account in your decision making
Risk aversion
Dislike of uncertainty
Utility
A person’s subjective measure of well-being/satisfaction
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N. Gregory Mankiw, Principles of Economics, 9th Edition © 2021 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Managing Risk, Part 2
Utility function
Every level of wealth provides a certain amount of utility
Exhibits diminishing marginal utility
The more wealth a person has
The less utility he gets from an additional dollar
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N. Gregory Mankiw, Principles of Economics, 9th Edition © 2021 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Figure 1 The Utility Function
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N. Gregory Mankiw, Principles of Economics, 9th Edition © 2021 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Markets for Insurance, Part 1
The markets for insurance
Person facing a risk
Pays a fee to insurance company
Insurance company
Accepts all or a part of risk
Insurance contract – gamble
You may not face the risk
Pay the insurance premium
Receive: peace of mind
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N. Gregory Mankiw, Principles of Economics, 9th Edition © 2021 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Role of insurance
Not to eliminate the risks, but to spread the risks around more efficiently
Problems:
Adverse selection
High-risk person – more likely to apply for insurance
Moral hazard
After people buy insurance – less incentive to be careful
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Markets for Insurance, Part 2
N. Gregory Mankiw, Principles of Economics, 9th Edition © 2021 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
An insurance company
Cannot perfectly distinguish between high-risk and low-risk customers
Cannot monitor all of its customers’ risky behavior
Price of insurance
Reflects the actual risks that the insurance company will face after the insurance is bought
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Markets for Insurance, Part 3
N. Gregory Mankiw, Principles of Economics, 9th Edition © 2021 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Diversification of Firm-Specific Risk, Part 1
Diversification
Reduction of risk
By replacing a single risk with a large number of smaller, unrelated risks
“Don’t put all your eggs in one basket”
Risk
Standard deviation – measures the volatility of a variable
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N. Gregory Mankiw, Principles of Economics, 9th Edition © 2021 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Diversification of Firm-Specific Risk, Part 2
Risk of a portfolio of stocks
Depends on number of stocks in the portfolio
The higher the standard deviation
The riskier the portfolio
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N. Gregory Mankiw, Principles of Economics, 9th Edition © 2021 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Figure 2 Diversification Reduces Risk
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N. Gregory Mankiw, Principles of Economics, 9th Edition © 2021 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Diversification of Firm-Specific Risk
Diversification
Can eliminate firm-specific risk
Cannot eliminate market risk
Firm-specific risk
Affects only a single company
Market risk
Affects all companies in the stock market
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N. Gregory Mankiw, Principles of Economics, 9th Edition © 2021 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Trade-Off between Risk and Return
Example, two types of assets
Diversified group
8% return and 20% standard deviation
Safe alternative
3% return and 0% standard deviation
The trade-off
The more a person puts into stocks, the greater the risk and the return
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N. Gregory Mankiw, Principles of Economics, 9th Edition © 2021 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Figure 3 The Trade-Off between Risk and Return
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N. Gregory Mankiw, Principles of Economics, 9th Edition © 2021 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Asset Valuation, Part 1
Fundamental analysis
Study of a company’s accounting statements and future prospects
To determine its value
Stocks are:
Undervalued if Price < Value
Overvalued if Price > Value
Fairly valued if Price = Value
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N. Gregory Mankiw, Principles of Economics, 9th Edition © 2021 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Use fundamental analysis to pick a stock
Do all the necessary research yourself
Rely on the advice of Wall Street analysts
Buy a mutual fund
A manager conducts fundamental analysis and makes the decision for you
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Asset Valuation, Part 2
N. Gregory Mankiw, Principles of Economics, 9th Edition © 2021 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
The efficient markets hypothesis
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
Equilibrium of supply and demand sets the market price
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Asset Valuation, Part 3
N. Gregory Mankiw, Principles of Economics, 9th Edition © 2021 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Stock markets
Exhibit informational efficiency
Informational efficiency
Description of asset prices
Rationally reflect all available information
Implication of efficient markets hypothesis
Stock prices should follow a random walk
Changes in stock prices are impossible to predict from available information
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Asset Valuation, Part 4
N. Gregory Mankiw, Principles of Economics, 9th Edition © 2021 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
ASK THE EXPERTS
Diversification
“In general, absent any inside information, an equity investor can expect to do better by choosing a well-diversified, low-fee, passive index fund than by holding a few stocks.”
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N. Gregory Mankiw, Principles of Economics, 9th Edition © 2021 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Random Walks and Index Funds, Part 1
The efficient markets hypothesis
Theory about how financial markets work
Probably not completely true
Evidence on stock prices
Even if not exactly a random walk, are very close to it
Index fund
Mutual fund that buys all stocks in a given stock index
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N. Gregory Mankiw, Principles of Economics, 9th Edition © 2021 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Random Walks and Index Funds, Part 2
Active funds
Actively managed mutual funds
Professional portfolio manager
Buy only the best stocks
Performance of index funds
Better than active funds
Broadly-based index funds beat 86 percent of stock mutual funds, 2005–2019
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N. Gregory Mankiw, Principles of Economics, 9th Edition © 2021 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Random Walks and Index Funds, Part 3
Active portfolio managers
Lower return than index funds
Trade more frequently
Incur more trading costs
Charge greater fees
Only 14% of managers beat the market
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N. Gregory Mankiw, Principles of Economics, 9th Edition © 2021 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Market Irrationality, Part 1
Efficient markets hypothesis
Assumes that people buying and selling stock are rational
Process information about stock’s underlying value
Fluctuations in stock prices
Partly psychological
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N. Gregory Mankiw, Principles of Economics, 9th Edition © 2021 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
When price of an asset
Above its fundamental value
Market – experiencing a speculative bubble
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, Part 2
N. Gregory Mankiw, Principles of Economics, 9th Edition © 2021 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
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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Market Irrationality, Part 3
N. Gregory Mankiw, Principles of Economics, 9th Edition © 2021 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
