Capital Markets 2 Flashcards
Present Value
1) present value = amount of money that given current interest rates needed to produce future sum
Present Value Formulas
X/(1+r)^n:
Finding present value of a future sum (how much is X in n years worth today with a r% interest)
2) X * (1+r)^n
Finding future value of present sum (how much X worth at r% interest in n years)
Risk Aversion
1) people dislike bad things happening to them
2) economists use utility to measure it
Utility Function
1) Wealth (x-axis) + Utility (y-axis)
2) gets flatter with increasing wealth (diminishing marginal utility –> wealthier a person –> less winning that amount means)
Market for Insurance
1) Role = spread risks out efficiently
2) Fire insurance won’t reduce risk of house burning down but it means you won’t have to shell out the entire price to rebuild
Problems with market for insurance
1) Adverse Selection = High risk ppl benefit more from insurance than low risk people
2) Moral hazard = once people have insurance –> less careful about risky behaviors bc they are insured
Diversification
1) Don’t put all eggs in one basket
2) Reduce risk by placing many small, imperfectly correlated bets rather than a small number of large bets
How is risk measured
1) Standard deviation
2) Large standard deviation of portfolio –> volatile return w. high risk
What type of risk does diversification eliminate
1) Eliminates firm-specific risk NOT market risk
2) Firm specific = uncertainty with specific company
3) Market risk = uncertainty of entire stock market (in event of recession –> diversification will not help much)
What to consider when buying stocks
1) Value of share of business (hard to measure)
2) Price being sold
If both equal: fairly valued
if price < value: undervalued
if price > value: overvalued
Fundamental Analysis
1) Determining value of a company through accounting statements + future prospects
How can you do fundamental analysis to pick stocks?
1) Do research yourself
2) Rely on advice of Wall Street analysts
3) Buy shares in mutual fund –> manager makes decisions for you
What is efficient markets hypothesis
1) Changes to stock prices impossible to predict bc follow a random walk
2) Just buy a diversified portfolio and call it a day
Assumptions of efficient market hypothesis
1) Based on idea that news about a company is what changes stock values BUT news is inherently impossible to predict
2) Every company is managed by rational portfolio managers
3) Equilibrium of supply + demand sets market price
Market Irrationality
1) Says that may partly increase due to psychological reasons
2) speculative bubbles –> people buying more than stock is worth today because they expect people to pay more for it tomorrow (artificially raises stock price well above fundamental value)
Feud btwn market irrationality + efficient market hypothesis
1) Essentially irrational market –> everyone is irrational + therefore hard to predict BUT efficient market says everyone is rational but it’s news that is difficult to predict
2) Efficient market = hard to know true valuation of a company so jumping to a specific valuation is irrational AND if markets rly were irrational then a rational person could beat it but that’s not the case
3) Irrationality = stock market moves in ways that difficult to guess
