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Chapter 3: Interest Rates and Rates of Return
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Terms in this set (26)
The interest rate on a loan should cover the opportunity cost supplying credit for
- Compensation for inflation: if prices rise, the payment received will buy few goods and services
- Compensation for default risk: the borrower might default on the loan.
- Compensation for waiting to spend the money.
Future Value
is the value at some future time of an investment made today.
Principle x ( 1+ i ) = Fv
Compounding
is the process of earning interest on interest, as saving accumulate over time.
Principle x ( 1 + i )^n = FVn
Present Value
is the value today of funds that will be received in the future
also known as "present discounted value"
Discounting
is the process of finding the present value of funds that will be received in the future (i.e. the opposite of compounding).
Present Value = FV / ( 1 + i)^n
True or False: The further in the future a payment is to be received, the smaller its present value
True
Debit Instruments
are methods of financing debt, and include simple loans, discount bonds, coupon bonds, and fixed payment loans.
also known as credit market instruments or fixed income assets
Equity
is a claim to part ownership of a firm
example: common stocks issued by a corporation.
Simple Loan (Debt Instruments)
is a debt instrument in which the BORROWER RECEIVES from the lender an amount called the principal and agrees to repay the lender the principal plus interest on a specific date when the loan matures
Discount Bond (Debt Instrument)
is a debt instrument in which the BORROWER repays the amount of the loan in a single payment at maturity but receives less than the face value of the bond initially
example: Student loans?
P= $1000 i= 10%
The LEND RECEIVES interest of $10,000= $9,091 = $909 for the year
Coupon Bonds (Debt Instrument)
A Coupon Bond is a debt instrument that requires multiple payments of interest on a regular basis, and a payment of the face value at maturity
Face Value (or Par Value)
the amount to be repaid by the bond issuer (the borrower) at maturity
Coupon
the annual fixed dollar amount of interest paid by the issuer of the bond to the buyer
Maturity
is the length of time of before the bond expires and the issuer makes the face value payment to the buyer.
Fixed-Payment Loan
is a debt instrument that requires the borrower to make regular periodic payments of principal and interest to the lender.
Example: You are repaying a $10,000 10-year student loan with a 9% interest rate, so your monthly payment is approx. $127
Yield to maturity
is the interest rate that makes the present value of the payments from an asset equal to the asset's price today.
Example: For a $10,000 loan required to pay $11,000 in one year
Capital Gain
occurs when the market price of an asset increases.
Capital Loss
occurs when the market price of an asset declines.
Financial Arbitrage
is the process of buying and selling securities to profit from price changes over a brief period of time
Law of One Price
Identical products should sell for same price everywhere
The Rate of Return (R)
is the return on a security as a % of the initial price. For a bond, R equals the coupon payment plus the change in the price of a bond divided by the initial price.
example: A bond with $1,000 face value and coupon rate of 8%.
end-of-year price is $1,271.81, then, the rate of return fro the year is:
R= Coupon + Coupon Gain / Purchase Price
Interest-rate risk
is the risk that the price of a financial asset flutuate in response to changes in market interest rates
Nominal Interest Rates
are interest rates that are not adjusted for changes in purchasing power. Nominal interest rate is the interest rate on three-month U.S. Treasury bills
Real Interest Rate
are interest rates that are adjusted for changes in purchasing power.
The expected real interest rate (r) equals the nominal interest rate (i) minus the expected rate of inflation (pie^e)
...
Deflation
is a sustained decline in the price level.
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