Chapter 14 Flashcards
Compounding
Earning interest annually in a bank account
Discounting
The process of finding a present value of a future sum of money
*The higher the interest rate the more you can earn by depositing your money in the bank
Risk-averse
Disliking bad things more than liking comparable good things
Utility
A person’s subjective measure of well-being or satisfaction
The property of diminishing marginal utility
The more wealthy person has the last utility she gets from an additional dollar
Transfer of risk
Insurance
Role of insurance
Not to eliminate risks but to spread them around more efficiently
Insurance companies count on the fact that most people will not make claims on their policies to pay out claims to the few who make them
Adverse selection
A high-risk person is more likely to purchase insurance going to low-risk person because they benefit more from insurance protection
Moral hazard
People with insurance have less of an incentive to be careful
Diversification
Reducing risk by placing a large number of small but rather than a small number of large ones
Firm specific risk
Uncertainty associated with specific companies
Eliminated by diversification
Market risk
Uncertainty associated with the entire economy, affecting all companies traded on the stock market
Not in the made it by diversification
Undervalued/overvalued stock
Undervalued: if the price of the stock is less than its value
Overvalued: if the price of a stock is more than its value
Fairly valued: when price and value of a stock are equal
Fundamental analysis
The detailed analysis of a company to estimate it’s value
Random walk
Changes in stock prices are impossible to predict from available information
Speculative bubble
When the price of an asset rises above its fundamental value
Present value
(Of a future sum of money) is the amount today that would be needed at current interest rates to produce that future sum
