Lecture Notes on Finance and Current Events

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Auction Example and Information Disclosure

• Auctioned Items: Two packages, one book (sold for $60) and an iPod (sold for $45).
  • Smaller package sold for less, possibly due to size.
• Lesson: Importance of information in determining value.

Key Takeaways from the Auction Example

• Information Asymmetry: Different knowledge levels can influence bidding outcomes.
• Private Information: Multiple packages helped reduce information spillover.
• Market Behavior: Even with limited information, bids were close to retail values.

Current Events in Finance: Government Intervention

• Federal Takeover: U.S. government seized control of Fannie Mae and Freddie Mac.
• Historical Context: Similar actions not seen since the Great Depression.
• Entities' Role: Supported housing, student loans, auto loans by purchasing mortgages from banks.
• Market Impact: Defaults could have severe repercussions throughout financial systems.

Understanding Fannie Mae and Freddie Mac

• Function: Bought mortgages to enable banks to lend more.
• Crisis Context: Decline in housing market affected their stability.
• Government Role: Ensuring financial stability by backing these entities.
• Global Impact: Relationships with international investors (India, China) necessitate honoring these obligations.

Analogy with Auction Example

• Uncertainty Value: Difficulty in valuing assets without clear information.
• Market Dislocation: Similar to market uncertainty for Fannie Mae and Freddie Mac assets.
• Government Intervention: Aimed at preventing larger financial fallout.

Market Reactions and Potential Risks

• Market Response: Short-term success in calming markets post-intervention.
• Long-term Concerns: Potential inflation if too much money is printed without backing.
• Taxpayer Burden: Future generations may bear financial consequences of these bailouts.

Valuing and Understanding Assets

• Types of Assets: Physical and intangible assets like patents and trade secrets.
• Asset Definition: A sequence of future cash flows at a specific point in time.
• Discount Factors: Adjusting future cash flows to present value using exchange rates or discount rates.
• Value Operator (V): Function that takes a sequence of cash flows and provides their value.

Key Concepts

• Time and Value: Cash flows at different times are like different currencies, needing conversion.
• Net Present Value (NPV): Sum of future cash flows discounted to present value.
• Impatience and Discounting: Preference for immediate consumption leads to lower present value of future cash.

Practical Application: Calculating NPV

• Example Calculation: Using discount rates to determine net present value of an investment project.
• Management Decisions: Use NPV to make informed investment decisions.

Introducing the Opportunity Cost of Capital

• Interest Rate (R): Represents the opportunity cost of investing capital now vs. future.
• Exchange Rates: Translate future dollar amounts into present value.
• Unified View: Using interest rates simplifies conversion between cash amounts at different times.

Going Forward

• Next Lecture: Special cash flows like annuities and perpetuities.
• Real-World Application: E.g., calculating mortgage payments.