Chapter 11 - Time and uncertainty. After studying this chapter you will be able to understand: Why money is worth more now than in the future? How compounding works over time? How to calculate the present value of a future sum? What the costs and benefits are of a choice using expected value? How risk aversion makes a market for insurance possible?. | Chapter 11 Time and Uncertainty © 2014 by McGraw-Hill Education 1 What will you learn in this chapter? Why money is worth more now than in the future. How compounding works over time. How to calculate the present value of a future sum. What the costs and benefits are of a choice using expected value. • How risk aversion makes a market for insurance possible. • What the importance is of pooling and diversification for managing risk. • What challenges adverse selection and moral hazard pose for insurance. • • • • © 2014 by McGraw-Hill Education 2 Value over time • When a decision requires weighing uncertain future costs and benefits, two complications are faced: – The value of money changes over time, causing an inaccurate direct comparison of current costs and benefits to future costs and benefits. – The future is uncertain, causing future benefits and costs to be only approximate estimates. © 2014 by McGraw-Hill Education 3 1 Timing matters • When costs and benefits of a choice occur at different times, this profoundly affects the choice. • Consider the following scenario: You have won a competition and can choose one of the following prizes: Option A: $100,000 now. Option B: $105,000 ten years from now. • Which would you choose and why? © 2014 by McGraw-Hill Education 4 Interest rates • When considering money today versus future money, individuals consider the opportunity cost of waiting until the future to receive the money. – The interest rate tells how much today’s money is worth in the future. – Depositing $100,000 in a bank at a 5% annual interest rate is worth in one year: $100,000 + ($100,000*5%) = $105,000 • Future money can be equated to the present. In the above example, $105,000 in one year is worth $100,000 today. © 2014 by McGraw-Hill Education 5 Compounding • When analyzing the value of money over a time period longer than one year, compounding the interest payments is necessary. – This causes a process of accumulation, as interest .
