Quantiative Methods - TVM - EAY and Compounding Frequency Flashcards
define compound interest
the growth in the value of the investment from period to period reflects not only the interest earned on the original principal amount but also on the interest earned on the previous period’s interest earnings
what is compound interest AKA
interest on interest
what is the process of discounting cash flows
moving cash flows to the beginning of the investment period to calculate the PV
what is the process of compounding cash flows
moving cash flows to the end of the investment period to calculate the FV
what is an equilibrium interest rate AKA
required rate of return
why do required rates of return differ?
due to risk differences in financial securities.
what are interest rates AKA?
discount rates, opportunity costs, required rate of returns and costs of capital
when would the definition of discount rates be appropriate when referring to interest rates?
when referring to an individual wishing to save money and therefore discounting payments to be made in the future
when would the definition of opportunity costs be appropriate when referring to interest rates?
when referring to the opportunity forgone when current consumption is chosen rather than saving
define the real risk-free rate of interest
theoretical rate on a single-period loan that has no expectation of inflation in it
what is a real rate of return?
an investor’s increase in purchasing power (after adjusting for inflation)
how do you calculate the nominal risk-free rate?
nominal risk-free rate = real risk-free rate + expected inflation rate
what does a nomical risk-free rate include?
an inflation premium
what are the differnet types of risk that securities may have?
default, liquidity and maturity
define default risk
The risk that a borrower will not make the promised payments in a timely manner
