Chapter 5 Flashcards
(16 cards)
EAR
Actual amount of interest that will be earned at the end of one year
Equivalent n period discount rate
(1 + r) ^n - 1
APR
Indicates the amount of simple interest earned in one year –> without the effect of compounding
It is typically less than the actual amount of interest that you will earn
Interest rate per compounding period formula
APR / k periods per year
Converting APR to EAR
1 + EAR = ( 1 + (APR/K) ) ^k
Amortising loans
Each month you pay interest on the loan plus some part of the loan balance
Outstanding balance of a loan
Present value of the loan payments when evaluated using the effective interest rate per payment interval based on the loan rate
Nominal interest rates
The common interest rates indicated by banks or other financial institutes
- Indicate the rate at which your money will grow if invested for a certain period
Real interest rates
Nominal interest rates, adjusted for inflation
- The rate of growth of your purchasing power, after adjusting for inflation (rr)
Growth in purchasing power
1 + rr = (1+r) / (1 + i)
= Growth of Money / Growth of Prices
Real interest rate equation
Rr = r - i / ( 1 + i)
Therefore, the real interest rate is approximately equal to the nominal interest rate - inflation
Term structure
The relationship between the investment term (horizon of the investment) and the interest rate
If investors expect interest rates to rise in the future
Long term interest rates will rise
If investors expect interest rates to fall
Long term interest rates will fall
After tax interest rate formula
r - (t x r) = r(1 - t)
Opportunity cost of capital
The best available expected return offered in the market on an investment of comparable risk and term to the cash flow being discounted
