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Social Science
Economics
Finance
Exam #2
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Terms in this set (51)
simple interest
interest is earned on the original principal
compound interest
Interest earned on both the principal amount and any interest already earned.
future value
money paid or received later in time; know the present value and need to figure out the future value, also called compounding.
present value
money paid or received earlier in time; the process of finding the present value of some future amount, is also called discounting.
lump sum
one cash flow
annuity
A series of equal payments at fixed intervals for a specified number of periods
ordinary annuity
an annuity paid in a series of more or less equal payments at the end for a fixed number of periods
annuity due
An annuity for which the cash flows occur at the beginning of the period for a fixed number of periods
perpetuity
annuity with an infinite life (infinite series of equal payments); can only find present value.
i.e.: preferred stock
Effective annual rate
The interest rate expressed as if it were compounded once per year. The more often it is compounded annually the higher the effective annual rate.
nominal rate
the interest rate paid on debt securities without an adjustment for any loss in purchasing power.
pure discount loan
principal amount is repaid at some future date, without any periodic interest payments; borrower pays a single lump sum (principal + interest) at maturity.
i.e. treasury bill
interest only loan
you borrow an amount today and pay only interest over the life of the loan. The full principal is paid back at the end of the contract.
i.e. corporate bond
amortized loan
borrow an amount of money today and pay back principal and interest in equal installments. Interest is paid on outstanding principal (annuity).
bond
long term debt, issued by a business or government. borrower agrees to make payments of interest and principal on specified dates to bondholders.
par (face) value
principal. value stated on the bond, amount repaid at the end of the loan; usually $1000
coupon (stated) rate
annual rate stated on bond (interest)
coupon payment
interest payment; par value x coupon rate / times per year
maturity date
date on which par value must be paid to the bondholder
yield to maturity
the required market rate or rate that makes the discounted cash flows from a bond equal to the bond's market price (annual return)
if YTM > coupon rate = fair value < par value
discount
if YTM < coupon rate = fair value > par value
premium
if YTM = coupon rate = fair value = par value
par
interest rate risk
changes in bond prices due to fluctuating interest rates.
bond indenture
legal written agreement between the debt issuer and the lender detailing the terms of the debt issue
debentures
an unsecured debt with 10 or more years to maturity
note
an unsecured debt with less than 10 years to maturity
sinking funds
issuer required to retire a portion of the bond issued each year
call provisions
the issuer had the right to buy back (redeem/call back it's bonds before maturity.
call premium
the difference between the 2 prices
bond ratings
independent evaluation of the default risk of the issuer's debt.
default risk
risk that companies were unable to make required payments on their debt obligation
rating agencies
Fitch, Standard and Poors (S&P), and Moody's
treasury bonds
bonds issued by the federal government, the interest income is exempt from state taxation
municipal bonds
issued by local/state gov, income is exempt from federal tax
floating rate bonds
coupon payments adjust periodically according to an index
Treasury Inflation Protected Securities (TIPS)
the par value increases with inflation
income bonds
coupon is paid if income is sufficient (higher required return)
convertible bonds
can be converted into stocks at the bondholder's discretion.
put bonds
bondholders have the right to redeem for par at their discretion (lower required return)
real rate of interest (r)
rate adjusted for inflation
inflation (h)
nominal rate - rate not adjusted for inflation
real rate - rate adjusted for inflation
Fisher Effect
a theoretical relationship between nominal returns, real returns, and the expected inflation rate. (1+R) = (1+r)(1+h)
nominal rate of interest (R) =
[(1+r)(1+h)] -1
real rate of interest (r) =
[(1+R)/(1+h)] -1
inflation rate (h) =
[(1+R)/(1+r)] -1
interest rate risk
% changes in bond prices due to fluctuating interest rates
the higher the YTM
The lower the bond value
as YTM increases
bond values decrease at a decreasing rate
the higher (lower) the coupon rate
the lower (higher) the interest rate risk exposure
the longer (shorter) the maturity on a bond issue
the larger (smaller) the interest rate risk exposure
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