Flashcards in Cards for The Final Deck (44)
Why do Lenders charge interest?
Because they would want compensation for:
-The loss of the opportunity to use that money while its loaned
-The loss of value over time due to inflation
-The Chance that they won't get money back
What are the different components of interest rates?
What is r*?
This is the "Real (risk free) rate" which is the opportunity cost.
What is IP?
This is the Inflation Premium which compensates for inflation
What is RP?
The risk premium which compensates for possible default (this premium can be broken up into several different premiums)
What is DRP?
This is the default risk premium and compensates the lender for possible default.
What is LP?
This is the liquidity premium and compensates the lender for the ability of the lender to pay or not pay back a loan.
What is MRP?
This is the length of the loan and compensates for interest rate risk. The longer the term, the greater the interest rate risk, thus a higher MRP.
What is the term structure of interest rates?
This is the relationship between interest rates (Yields) and different loan lengths (maturities).
What is a yield curve?
A snapshot in time. It tells you what the relationship between maturities and interest rates are a ta specific date.
What influences the shape of the yield curve?
The yield curves change over time due to changes in the factors that govern interest rate components (IP, DRP, LP & MRP)
What does the shape of the yield curve tell us about future interest rates?
The shape of the yield curve gives some indication about what bond markets think inflation (and thus, interest rates) might do in the future.
What is the opportunity cost of capital?
The Opportunity Cost of Capital is the best available expected return offered in the market on an investment
of comparable risk and length. This is the return the investor forgoes on an alternative investment of equivalent risk
and term when the investor takes on the alternative investment.
This is the best available expected return offered in the market on an investment of comparable risk and length (term)
Make A BORROWING DECISION USING THE YIELD CURVE.
Look at the old tests.
What is the definition of the future value?
The amount to which an investment grows when it earns a positive rate or return.
What is the definition of present value?
The value today (the value in "today's dollars") of a future future cash flows or series of cash flows.
What is the financial valuation principle?
The present value of any financial asset depends on usable, after-tax cash flow it is expected to produce in the future.
How do you find the financial asset of any financial asset?
Discount all future expected cash flows to the present (find the PV @ t=0 of all cash flows) and adding them up.
What is the definition of compounding?
Compounding is the ability of an asset to generate earnings, which are then reinvested in order to generate their own earnings.
What is TVM?
Time Value of Money says that the worth of a unit of money is going to be changed in future. Put simply, the value of one rupee today, will be decreased in future. The whole concept is about the present value and future value of money. Compounding method is used to know the future value of present money while Discounting is a way to compute the present value of future money. Both the tools are very important to know the worth of money at different points of time. Here, we provide you the main differences between Compounding and Discounting.
What is the definition of discounting?
A way to compute the present value of future money.
What is the Effective Annual rate?
The EAR express an interest rate that compounds more than once per year. This is the actual rate of return being earned or paid per year, when compounding is factored in.
The current value of any financial asset such as stocks, bonds, projects, businesses, collectable artworks,
etc. can be found by discounting all the future promised or expected cash flows back to the present and summing. WHY?
Due to the concept of “Time Value of Money” we have to discount those expected future cash flows in order
to convert them into today’s dollars. This is the difference in value between money received today and money
received in the future; also, the observation that two cash flows at two different points in time have different values.
What does it mean to sell something at par?
selling at face value
What does it mean to sell something at premium?
selling above face value
What does it mean to sell something at discount?
selling below face value
What happens to a bond when market interest rates increase?
Market interest rates are likely to increase when bond investors believe that inflation will occur. As a result, bond investors will demand to earn higher interest rates. The investors fear that when their bond investment matures, they will be repaid with dollars of significantly less purchasing power.
What happens to a bond when market interest rates decrease?
Market interest rates are likely to decrease when there is a slowdown in economic activity. In other words, the loss of purchasing power due to inflation is reduced and therefore the risk of owning a bond is reduced.
How does maturity affect bond prices?
Long-term bonds have greater duration than short-term bonds. Because of this, a given interest rate change will have greater effect on long-term bonds than on short-term bonds.