chp 27

Chapter 27 introduces some tools that help understand the decisions that people make as they participate in financial markets. Finance is the field that studies how people make decisions regarding the allocation of resources over time and the handling of risk.The first section of the chapter discusses how to compare sums of money at different points in time. Money today is more valuable than the same amount of money in the future. The present value of any future sum of money is the amount today that would be needed at current interest rates to produce that future sum. Future value is the amount of money in the future that an amount of money today will yield, given prevailing interest rates. r denotes interest rate. Compounding is the accumulation of a sum of money in, say, a bank account, where the interest earned remains in the account to earn additional interest in the future. If r is the interest rate, then an amount X to be received in N years has a present value of X/(1+r)^N. Because the possibility of earning interest reduces the present value below the amount X, the process of finding a present value of a future sum of money is called discounting. The higher the interest rate the more money can be earned by depositing the money at the bank. The concept of present value helps explain why investment- and thus the quantity of loanable funds demanded-declines when the interest rate rises. Risk aversion is a dislike of uncertainty.