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Mgmt 326 > Ch 5: Interest Rates > Flashcards

Ch 5: Interest Rates Flashcards

1
Q

What is the cost of money?

A

The rate you pay the lender to borrow the money

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2
Q

What is an interest rate?

A

The rate of cost per year to use someone else’s money

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3
Q

Inflation

A

The decrease of the purchasing power of currency over time

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4
Q

What causes inflation to rise?

A

The demand for goods & services grows faster than supply of goods & services; an increase in the amount of money in circulation in an economy

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5
Q

What does the interest rate compensate the lender for?

A

The lost of the opportunity to use that money, the loss of the value over time due to inflation, and the chance that they won’t get the money back

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6
Q

Nominal or Quote Rate

A

r = r* + IP + RP + DRP + LP + MRP

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7
Q

r*

A

Real (risk free) rate which is the opportunity cost

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8
Q

IP

A

Inflation premium which compensates for inflation

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9
Q

RP

A

Risk premium which compensates for possible default; increases with lower credit score

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10
Q

What are the two basic types of interest?

A

Simple interest and compound interest

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11
Q

What are the major factors that affect the cost of money?

A

Opportunity cost, risk, expected inflation, federal reserve policy, business activity/state of the economy, federal deficits, and foreign trade balance

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12
Q

What components of an interest rate are the risk premium?

A

DRP, LP, MRP

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13
Q

How is IP computed?

A

The average expected inflation rate over the life of the loan

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14
Q

DRP

A

Default risk premium which compensates the lender for possible default

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15
Q

What is concerned a riskless asset?

A

30-Day Treasury Bill

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16
Q

What is the DRP of a 30-Day Treasury Bill?

A

0%

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17
Q

LP

A

Liquidity premium which accounts for the ability of a borrower to repay a load with the firm’s asset

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18
Q

When is LP higher?

A

When assets are not very liquid (i.e. real estate, buildings, equipment)

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19
Q

Liquid asset

A

Non cash asset that can be converted quickly into cash and without significant loss in value

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20
Q

Does the U.S. pay LP? Why or why not?

A

No because they have the ability to print cash which is the most liquid asset

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21
Q

MRP

A

Maturity Risk Premium which depends on how long you are borrowing

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22
Q

What does MRP compensate for?

A

Interest rate risk and reinvestment risk

23
Q

Nominal Risk-Free Rate

A

r sub rf; Same as the interest rate on a 30-Day Treasury Bill, because there is no risk premium

24
Q

How do you calculate r*?

A

Nominal Risk-Free Rate - Current Inflation Rate

25
Q

Why do company’s hold little cash on hand?

A

Because cash invested makes more money than cash on hand

26
Q

What is yield?

A

Rate of Return

27
Q

How do you compute r for loans shorter than 1 year maturity?

A

r = nominal risk free rate + DRP + LP + MRP

28
Q

How do you compute r for loans longer than 1 year maturity?

A

r = r* + IP + RP + DRP + LP + MRP

29
Q

What is the difference between calculating r for short term and long term rates?

A

Short term rates do not have IP

30
Q

How do you calculate IP for long term loans?

A

(Inflation year 1 + Inflation year 2 + Inflation year 3…)/number of years of maturity

31
Q

Market Interest Rate

A

Equilibrium Rate

32
Q

What factors tend to lower interest rates?

A

Banks wanting cash flow from your interest payments, trying to offer more attractive rates, and often entering into risky lending in pursuit of cash flow

33
Q

The interest rate a borrow pays is equal to what?

A

The lenders rate of return

34
Q

How do you calculate the ROR of stock?

A

r* + IP + RP

35
Q

What is the required ROR for anything?

A

r* + IP + RP

36
Q

Even if an investment is risk free, what does the ROR compensate for?

A

Opportunity cost and inflation

37
Q

What component of r is the only thing that changes for different investments?

A

Compensation for risk

38
Q

What is the opportunity cost of capital?

A

The best available expected return offered in the market on an investment of comparable risk and length

39
Q

Capital

A

Wealth in the form of money or property that can be used to produce more wealth

40
Q

Term Structure

A

The relationship between interest rates (yields) and different loan lengths (maturities)

41
Q

Why do bonds of longer maturity have higher interest rates?

A

More uncertainty with all risk

42
Q

Yield Curve

A

A graph of the term structure that tells you the relationship at a specific date

43
Q

What does a yield curve not predict?

A

Future interest rates

44
Q

Upward sloping yield curve

A

Smaller interest rates on short term bonds, markets expect inflation to rise

45
Q

Downward sloping yield curve

A

Higher interest rates on short term bonds, markets expect inflation to decrease

46
Q

What does the shape of the yield curve indicate?

A

What the bond markets think inflation (and thus interest rates) might do in the future

47
Q

What do yield curves not take into account?

A

Actions by the Federal Reserve

48
Q

Concave yield curves

A

Markets predict direction of inflation is about to change

49
Q

Flat line yield curves

A

Markets uncertain about direction of inflation

50
Q

How should you borrow if the yield curve is upward sloping?

A

Borrow now because interest rates are expected to rise; borrow long term because you will lock in that lower interest rate for longer

51
Q

How should you borrow if the yield curve is downward sloping?

A

Borrow later because interest rates are expected to drop; if you have to borrow, borrow short term so you can refinance sooner when the rates are expected to be lower

52
Q

How should you borrow if the yield curve has been downward and is now flat?

A

Borrow now, long term because it is very unlikely rates will get lower soon

53
Q

Which part of the yield curve changes more drastically?

A

Short term

54
Q

Which firms have higher interest rates?

A

Higher risk firms

Mgmt 326 (4 decks)

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