© 2009 South-Western, a part of Cengage Learning, all rights reserved C H A P T E R The Basic Tools of Finance E conomics P R I N C I P L E S O F N. Gregory Mankiw Premium PowerPoint Slides by Ron Cronovich 27

In this chapter, look for the answers to these questions:  What is “present value”? How can we use it to compare sums of money from different times? 현재가치란 ? 다른 시기의 금액을 비교하기 위해 이를 어떻게 활용 ?  Why are people risk averse? 사람들은 왜 위험을 회피하나 ? How can risk-averse people use insurance and diversification to manage risk ? 위험회피자는 위험을 관리하기 위해 보험과 분산투자를 어떻게 활용할 수 있나 ?  What determines the value of an asset? 무엇이 자산의 가치를 결정 ? What is the “efficient markets hypothesis”? 효율적 시장가설이란 ? Why is beating the market nearly impossible? 시장을 무시할 수 없는 이유 1

THE BASIC TOOLS OF FINANCE 2 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. 금융제도의 참가자들은 시간에 걸친 자원의 배분과 위험관리를 고려하여 의사결정을 한다.  Finance is the field that studies such decision making. 재무관리는 이러한 의사결정을 연구하는 분야다.

THE BASIC TOOLS OF FINANCE 3 Present Value: The Time Value of Money  To compare a sums from different times, we use the concept of present value. 서로 다른 시기의 금액을 비교하기 위해 현재가치라는 개념을 사용  The present value of a future sum: the amount that would be needed today to yield that future sum at prevailing interest rates 미래금액의 현재가치는 현재 이자율을 적용하여 일정액의 미래금액을 얻기 위해 지금 필요한 금액  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 금액의 미래가치는 현재 이자율에서 오늘 주어진 금액으로 미래에 얻을 수 있는 금액

THE BASIC TOOLS OF FINANCE 4 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( ) N  In three years, FV = $100( ) 3 = $  In two years, FV = $100( ) 2 = $  In one year, FV = $100( ) = $105.00

THE BASIC TOOLS OF FINANCE 5  Deposit $100 in the bank at 5% interest. What is the future value (FV) of this amount?  In N years, FV = $100( ) 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).  Solve for PV to get: EXAMPLE 1: A Simple Deposit PV = FV/(1 + r ) N

THE BASIC TOOLS OF FINANCE 6 EXAMPLE 2: Investment Decision  Suppose r = 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. Present value formula: PV = FV/(1 + r ) N

THE BASIC TOOLS OF FINANCE 7 EXAMPLE 2: Investment Decision  Instead, suppose r = 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.

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? A C T I V E L E A R N I N G 1 Present value 8

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. A C T I V E L E A R N I N G 1 Answers 9

THE BASIC TOOLS OF FINANCE 10 Compounding 복리계산  Compounding: the accumulation of a sum of money where the interest earned on the sum earns additional interest 은행 예금의 이자가 그 계좌에 예치되어 거기에 다시 이자가 붙는 방식으로 원리금이 축적되는 것  Because of compounding, small differences in interest rates lead to big differences over time. 복리계산 때문에 이자율의 작은 차이가 시간이 흐름에 따라 큰 차이를 가져온다.  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

THE BASIC TOOLS OF FINANCE 11 The Rule of 의 법칙  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. 어떤 변수가 매년 x 퍼센트 성장하면 그 변수가 두 배가 되는데 70/x 년이 걸린다.  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.

THE BASIC TOOLS OF FINANCE 12 Risk Aversion  Most people are risk averse – they dislike uncertainty. 대부분의 사람들은 위험회피적이다 - 불확실성을 싫어함  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. 만약 당신이 위험회피적이라면 1000 달러를 잃는 고통이 1000 달러를 따는 즐거움보다 크고, 두 가지 결과가 나올 확률이 같으므로 당신은 이 도박에 응하지 않을 것이다.

THE BASIC TOOLS OF FINANCE 13 The Utility Function Wealth Utility Current wealth Current utility Utility is a subjective measure of well-being that depends on wealth. 효용은 만족에 대한 주관적 척도이며 재산의 크기에 의존한다. As wealth rises, the curve becomes flatter due to diminishing marginal utility: the more wealth a person has, the less extra utility he would get from an extra dollar. 재산이 증가하면 한계효용체감 때문에 곡선이 완만해진다. 더 많은 재산을 가진 사람일수록 추가적인 1 달러에 대한 추가적인 만족이 작다. As wealth rises, the curve becomes flatter due to diminishing marginal utility: the more wealth a person has, the less extra utility he would get from an extra dollar. 재산이 증가하면 한계효용체감 때문에 곡선이 완만해진다. 더 많은 재산을 가진 사람일수록 추가적인 1 달러에 대한 추가적인 만족이 작다.

THE BASIC TOOLS OF FINANCE 14 The Utility Function and Risk Aversion Because of diminishing marginal utility, a $1000 loss reduces utility more than a $1000 gain increases it. 한계효용체감 때문에 천달러 상실은 천달러 획득시의 효용증가분보다 큰 효용감소를 초래한다. Wealth Utility – Utility loss from losing $1000 Utility gain from winning $1000

THE BASIC TOOLS OF FINANCE 15 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. 위험에 직면한 어떤 사람이 보험회사에 보험료를 지불하고, 보험회사는 ( 보험료를 대가로 ) 그 위험의 부분 또는 전부를 떠안는다.  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. 보험은 위험들을 공동 부담하게 함으로써 위험회피적인 사람들이 더 나은 삶을 살 수 있게 해준다. 예컨대 만 명의 사람이 집이 화재로 전소될 위험의 1/10,000 씩을 감당하는 것이 한 사람이 전체 위험을 혼자 감당하는 것보다 낫다.

16 Two Problems in Insurance Markets 1.Adverse selection: A high-risk person benefits more from insurance, so is more likely to purchase it. 역선택 : 위험이 높은 사람이 보험으로부터 더 많은 혜택을 받으므로 보험에 가입할 가능성이 높다 2.Moral hazard: People with insurance have less incentive to avoid risky behavior. 보험에 가입한 사람은 위험한 행동을 덜 조심한다 Insurance companies cannot fully guard against these problems, so they must charge higher prices. 보험회사는 이러한 문제를 완전히 차단할 수 없으며, 따라서 더 높은 보험료를 부과하여야 한다. As a result, low-risk people sometimes forego insurance and lose the benefits of risk-pooling. 결과적으로 위험이 낮은 사람들이 보험을 떠나서 위험의 공동부담의 혜택을 누리지 못하는 경우도 있다.

A C T I V E L E A R N I N G 2 Adverse selection or moral hazard? 17 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.

A C T I V E L E A R N I N G 2 Answers 18 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. 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

THE BASIC TOOLS OF FINANCE 19 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. 우리는 어떤 자산의 위험을 표준편차라는 통계량으로 측정할 수 있다. 표준편차는 한 변수의 휘발성 ( 변동성 )- 그것이 얼마나 변동할 것인가 - 를 측정한다.  The higher the standard deviation of the asset’s return, the greater the risk. 수익의 표준편차가 높은 자산일수록 위험이 더 큰 자산이다.

THE BASIC TOOLS OF FINANCE 20 Reducing Risk Through Diversification  Diversification reduces risk by replacing a single risk with a large number of smaller, unrelated risks. 분산투자는 하나의 위험을 서로 상관되지 않은 수많은 작은 위험으로 대체함으로써 위험을 줄이는 투자방법이다.  A diversified portfolio contains assets whose returns are not strongly related: 분산투자된 포트폴리오는 그 수익들의 상관성이 크지 않은 자산들로 구성된다.  Some assets will realize high returns, others low returns. 일부는 고수익, 일부는 저수익  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. 고수익과 저수익은 서로 상쇄되어 포트폴리오는 그것에 포함된 어떤 개별 자산보다도 안정적으로 중간정도의 수익을 벌어들일 수 있다.

THE BASIC TOOLS OF FINANCE 21 Reducing Risk Through Diversification  Diversification can reduce firm-specific risk, which affects only a single company. 분산투자는 기업특수적 위험은 줄일 수 있다  Diversification cannot reduce market risk, which affects all companies in the stock market. 분산투자는 시장위험은 줄일 수 없다.

THE BASIC TOOLS OF FINANCE 22 Reducing Risk Through Diversification Increasing the number of stocks reduces firm- specific risk. Standard dev of portfolio return # of stocks in portfolio But market risk remains.

THE BASIC TOOLS OF FINANCE 23 The Tradeoff Between Risk and Return  Tradeoff: Riskier assets pay a higher return, on average, to compensate for the extra risk of holding them. 위험자산일수록 높은 수익을 내어 평균적으로 그것을 보유하는 추가적인 위험을 상쇄한다.  E.g., over past 200 years, average real return on stocks, 8%. On short-term govt bonds, 3%. 예컨대 지난 200 년가 주식의 평균 실질 수익은 8% 였고 단기 국채 수익은 3% 였다.

THE BASIC TOOLS OF FINANCE 24 The Tradeoff Between Risk and Return  Example: Suppose you are dividing your portfolio between two asset classes. 당신의 포트폴리오를 두 종류의 자산으로 나눈다고 가정해보자  A diversified group of risky stocks: average return = 8%, standard dev. = 20% 위험 증권으로 분산된 그룹 : 평균 수익 8%, 표준편차 20%  A safe asset: return = 3%, standard dev. = 0% 안전 자산 : 수익률 3%, 표준편차 0%  The risk and return on the portfolio depends on the percentage of each asset class in the portfolio… 포트폴리오의 위험과 수익은 각 자산 종류의 비중에 의존한다.

THE BASIC TOOLS OF FINANCE 25 The Tradeoff Between Risk and Return Increasing the share of stocks in the portfolio increases the average return but also the risk.

THE BASIC TOOLS OF FINANCE 26 Asset Valuation  When deciding whether to buy a company’s stock, you compare the price of the shares to the value of the company. 어떤 회사의 주식을 살 것인가를 결정해야 할 때 그 회사의 지분의 가격을 그 가치와 비교해야  If share price > value, the stock is overvalued. 지분가격 > 가치라면 주식은 과대평가됨  If price < value, the stock is undervalued. 지분가격 < 가치라면 주식은 과소평가됨  If price = value, the stock is fairly valued. 지분가격 = 가치라면 주식은 정당하게 평가됨

If you buy a share of AT&T stock today,  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. If the prevailing interest rate is 10%, what is the value of a share of AT&T stock today? A C T I V E L E A R N I N G 3 Valuing a share of stock 27

A C T I V E L E A R N I N G 3 Answers 28 $30/(1.1) 3 = $22.54in 3 years$30 $1/(1.1) 3 = $.75in 3 years$1 $1/(1.1) 2 = $.83in 2 years$1 $1/(1.1) = $.91in 1 year$1 present value of the amount when you will receive it amount you will receive The value of a share of AT&T stock equals the sum of the numbers in the last column: $25.03

THE BASIC TOOLS OF FINANCE 29 Asset Valuation  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.  One way to value a stock: fundamental analysis, the study of a company’s accounting statements and future prospects to determine its value

You have a brokerage account with Merrill Lynch. 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? A C T I V E L E A R N I N G 4 Show-of-hands survey 30

THE BASIC TOOLS OF FINANCE 31 The Efficient Markets Hypothesis  Efficient Markets Hypothesis (EMH): the theory that each asset price reflects all publicly available information about the value of the asset 각 자산의 가격은 그 자산의 가치에 대하여 사람들이 활용할 수 있는 모든 정보를 반영하고 있다는 이론

32 Implications of EMH 1. Stock market is informationally efficient: Each stock price reflects all available information about the value of the company. 2.Stock prices follow a random walk: 주식가격은 랜덤워크 A stock price only changes in response to new information (“news”) about the company’s value. News cannot be predicted, so stock price movements should be impossible to predict. 주식가격은 오로지 그 회사에 대한 새로운 정보 ( 뉴스 ) 에 반응하여 변화하는데 뉴스는 예측될 수 없으므로 주식가격의 운동은 예측불허다. 3.It is impossible to systematically beat the market. By the time the news reaches you, mutual fund managers will have already acted on it. 시장을 체계적으로 이기는 것은 불가능. 뉴스가 당신에게 도달할 저음에는 뮤추얼 펀드 매니저들은 이미 행동을 개시했을 것이다..

THE BASIC TOOLS OF FINANCE 33 Index Funds vs. Managed Funds  An index fund is a mutual fund that buys all the stocks in a given stock index.  An actively managed mutual fund aims to buy only the best stocks.  Actively managed funds have higher expenses than index funds.  EMH implies that returns on actively managed funds should not consistently exceed the returns on index funds.

THE BASIC TOOLS OF FINANCE 34 Index Funds vs. Managed Funds S&P SmallCap 600 (index fund) Managed mid cap funds S&P MidCap 400 (index fund) Managed mid cap funds % 5.9 S&P 500 (index fund) Managed large cap funds 2006 expense ratio annualized return

THE BASIC TOOLS OF FINANCE 35 Market Irrationality 시장의 불합리성  Many believe that stock price movements are partly psychological: 많은 사람들은 주식 가격의 운동이 부분적으로 심리적이라고 믿고 있다.  J.M. Keynes: stock prices driven by “animal spirits,” “waves of pessimism and optimism”  Alan Greenspan: 1990s stock market boom due to “irrational exuberance( 이상 과열 )”  Bubbles occur when speculators buy overvalued assets expecting prices to rise further. 거품은 투기자들이 과대평가된 자산을 미래에 가격이 더 오를 것이라고 기대하면서 살 때 발생한다.

THE BASIC TOOLS OF FINANCE 36 CONCLUSION  This chapter has introduced some of the basic tools people use when they make financial decisions.  The efficient markets hypothesis teaches that a stock price should reflect the company’s expected future profitability.  Fluctuations in the stock market have important macroeconomic implications, which we will study later in this course.

CHAPTER SUMMARY  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 of wealth, most people are risk-averse. Risk-averse people can manage risk with insurance, through diversification, and by choosing a portfolio with a lower risk and lower return. 37

CHAPTER SUMMARY  The value of an asset equals the present value of all payments its owner will receive. For a share of stock, these payments include dividends plus the final sale price.  According to the efficient markets hypothesis, financial markets are informationally efficient, a stock price always equals the market’s best guess of the firm’s value, and stock prices follow a random walk as new information becomes available. 38

CHAPTER SUMMARY  Some economists question the efficient markets hypothesis, and believe that irrational psychological factors also influence asset prices. 39