The Basic Tools Of Finance

Sometime in your life, you will have to deal with the economy’s financial system. You will deposit’ your savings in a bank: account, or you will take out a mortgage to buy a house. After you take a job, you will decide whether to invest your retirement account in stocks, bonds, or other financial instruments. You may try to put together your own stock portfolio, and then you will have to decide between betting on established companies such as General Electric or newer ones such as Google. And whenever you watch the evening news, you will hear reports about whether the stock market is up or down, together with the often feeble attempts to explain why the market behaves as it does If you reflect for a moment on the many financial decisions you will make during your life, you, will see two related elements in almost all of them: time and risk. As we saw in the preceding chapter the financial system coordinates the economy’s saving and investment. Thus, it concerns decisions we make today that will affect our lives in the future. But the future is unknown. When a person decides to allocate some saving, or a firm decides to undertake investment, the decision is based on a guess about the likely future result, but the actual result could end up being very different. This chapter introduces some tools that help us understand the decisions that people make as’ they participate in financial markets. The field of finance develops these tools ‘in great detail, and you may choose to take courses that focus on this topic. But because the financial system is so important to the functioning of the economy, many of the basic insights of finance are central to understanding how the economy works. The tools of fiance may also help you think through some of the decisions that you will make in your own life. This chapter takes up three topics. First” we disclose how to compare sums of money at different points in time. Second, we discuss how to manage risk. Third, we build on our analysis of time and risk to
examine what determines the value of an asset, such as ‘a share of stock.

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