N.

Gregory Mankiw

Principles of
Economics Sixth Edition

27
The Basic Tools of
Finance Premium
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 Introduction

 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 is the field that studies such
decision making.

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 Present Value: The Time Value of
Money
 To compare sums from different times, we use the
concept of present value.
 The present value of a future sum: the amount
that would be needed today to yield that future
sum at prevailing interest rates
 Related concept:
The future value of a sum: the amount the sum
will be worth at a given future date, when allowed
to earn interest at the prevailing rate

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 EXAMPLE 1: A Simple Deposit
 Deposit $100 in the bank at 5% interest.
What is the future value (FV) of this amount?
 In N years, FV = $100(1 + 0.05)N
 In three years, FV = $100(1 + 0.05) 3 = $115.76
 In two years, FV = $100(1 + 0.05)2 = $110.25
 In one year, FV = $100(1 + 0.05) = $105.00

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 EXAMPLE 1: A Simple Deposit
 Deposit $100 in the bank at 5% interest.
What is the future value (FV) of this amount?
 In N years, FV = $100(1 + 0.05)N
 In this example, $100 is the present value (PV).

 In general, FV = PV(1 + r )N
where r denotes the interest rate (in decimal
form).
PV = FV/(1 + r )N
 Solve for PV to get:

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 EXAMPLE 2: Investment
Decision
Present value formula: PV = FV/(1 + r )N
 Suppose r = 0.06.
Should General Motors spend $100 million to build
a factory that will yield $200 million in ten years?
Solution:
Find present value of $200 million in 10 years:
PV = ($200 million)/(1.06)10 = $112 million
Since PV > cost of factory, GM should build it.

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 EXAMPLE 2: Investment
Decision
 Instead, suppose r = 0.09.
Should General Motors spend $100 million to build
a factory that will yield $200 million in ten years?
Solution:
Find present value of $200 million in 10 years:
PV = ($200 million)/(1.09)10 = $84 million
Since PV < cost of factory, GM should not build it.

Present value helps explain why

investment falls when the interest rate rises.

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 ACTIVE LEARNING 1
Present value

You are thinking of buying a six-acre lot for $70,000.

The lot will be worth $100,000 in five years.
A. Should you buy the lot if r = 0.05?

B. Should you buy it if r = 0.10?

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 ACTIVE LEARNING 1
Answers

You are thinking of buying a six-acre lot for $70,000.

The lot will be worth $100,000 in five years.
A. Should you buy the lot if r = 0.05?
PV = $100,000/(1.05)5 = $78,350.
PV of lot > price of lot.
Yes, buy it.
B. Should you buy it if r = 0.10?
PV = $100,000/(1.1)5 = $62,090.
PV of lot < price of lot.
No, do not buy it.
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 Compounding
 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.
 Example: Buy $1000 worth of Microsoft stock,
hold for 30 years.
If rate of return = 0.08, FV = $10,063
If rate of return = 0.10, FV = $17,450

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 The Rule of 70
 The Rule of 70:
If a variable grows at a rate of x percent per year,
that variable will double in about 70/x years.
 Example:
 If interest rate is 5%, a deposit will double in
about 14 years.
 If interest rate is 7%, a deposit will double in
about 10 years.

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 Risk Aversion
 Most people are risk averse—they dislike
uncertainty.
 Example: You are offered the following gamble.
Toss a fair coin.
 If heads, you win $1000.
 If tails, you lose $1000.
Should you take this gamble?
 If you are risk averse, the pain of losing $1000
would exceed the pleasure of winning $1000,
and both outcomes are equally likely,
so you should not take this gamble.
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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 accepts
part or all of the risk.
 Insurance allows risks to be pooled,
and can make risk averse people better off:
E.g., it is easier for 10,000 people to each bear
1/10,000 of the risk of a house burning down
than for one person to bear the entire risk alone.

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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.
2. Moral hazard:
People with insurance have less incentive to
avoid risky behavior.
Insurance companies cannot fully guard against
these problems, so they must charge higher prices.
As a result, low-risk people sometimes forego
insurance and lose the benefits of risk-pooling.

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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. Joe begins smoking in bed after buying fire

insurance.

B. Both of Susan’s parents lost their teeth to gum

disease, so Susan buys dental insurance.

C. When Gertrude 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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 ACTIVE LEARNING 2
Answers

A. Joe begins smoking in bed after buying fire

insurance.
moral hazard
B. Both of Susan’s parents lost their teeth to gum
disease, so Susan buys dental insurance.
adverse selection
C. When Gertrude parks her Corvette convertible,
she doesn’t bother putting the top up, because her
insurance covers theft of any items left in the car.
moral hazard
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 Measuring Risk
 We can measure risk of an asset with the
standard deviation, a statistic that measures a
variable’s volatility—how likely it is to fluctuate.
 The higher the standard deviation of the asset’s
return, the greater the risk.

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 Reducing Risk Through Diversification

 Diversification reduces risk by replacing a

single risk with a large number of smaller,
unrelated risks.
 A diversified portfolio contains assets whose
returns are not strongly related:
 Some assets will realize high returns,
others low returns.
 The high and low returns average out,
so the portfolio is likely to earn
an intermediate return more consistently
than any of the assets it contains.
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 Reducing Risk Through Diversification

 Diversification can reduce firm-specific risk,

which affects only a single company.
 Diversification cannot reduce market risk,
which affects all companies in the stock market.

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 Reducing Risk Through Diversification

50 Increasing the number

of stocks reduces firm-
Standard dev of
portfolio return

40
specific risk.
30

20 But
market
10
risk
remains.
0
0 10 20 30 40
# of stocks in portfolio
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 The Tradeoff Between Risk and Return

 Tradeoff:
Riskier assets pay a higher return, on average,
to compensate for the extra risk of holding them.
 E.g., over past 200 years, average real return on
stocks, 8%. On short-term govt bonds, 3%.

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 The Tradeoff Between Risk and Return

 Example:
Suppose you are dividing your portfolio between
two asset classes.
 A diversified group of risky stocks:
average return = 8%, standard dev. = 20%
 A safe asset:
return = 3%, standard dev. = 0%
 The risk and return on the portfolio depends on
the percentage of each asset class in the
portfolio…

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 The Tradeoff Between Risk and Return
Increasing
the share of
stocks in the
portfolio
increases
the average
return but
also the risk.

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