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Flashcards in Chapter 5 Deck (45)
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1

What is / how would you define the cost of money?

Is the interest rate you pay a lender. This Is what borrowers pay to use (rent) money.

2

Define Inflation.

The decrease of the purchasing power of currency over
time.

3

What can cause inflation?

demand for goods & services grows faster than the supply of
goods & services; as time goes by, goods & services become
more valuable thus more expensive; this reduces the purchasing
power of currency

and

An increase in the amount of money in circulation in an
economy; as quantity of currency increases, value of currency
decreases with respect to the value of goods & services; it takes
more money to purchase goods & services, thus the purchasing
power of currency is reduced

4

Why is there interest rate?

When someone decides to lend money, they want compensation for:

the loss of the opportunity to use that money while it’s loaned
out (opportunity cost)



the loss of value over time due to inflation



the chance that they won’t get the money back

5

In finance what does r mean?

interest rate.

6

In finance what r* mean?

“real (risk free) rate” which is the opportunity cost

7

In finance what does IP mean?

the Inflation Premium which compensates for inflation

8

In finance what does RP mean?

Risk Premium which compensates for possible default (this premium can be broken down into sub-premiums)

9

What are the two basic types of interest?

Simple interest and compound interest

10

What is simple interest?

paid all at once either upon initiating or closing (at the end of)
the loan
no compounding

11

What is compound interest?

paid in little chunks throughout the life of the loan, usually at
the end of the period
interest earned is reinvested; thus interest earns interest (as
discussed in Ch 4)

12

What is the cost of money also referred to as?

The “cost of borrowed capital”
The “cost of debt”
The “cost of leverage”

13

Name the major factors that affect money.

Opportunity Costs (Internal investment vs. external)
Desire to consume (spend) money now versus investing it.
Risk
Expected Inflation (has the greatest influence on cost of money)
Federal Reserve Policy
Business Activity / State of the Economy
Federal Deficits
Foreign Trade Balance

14

What is r referred to as?

r is the Nominal Rate in a particular market1; also called the “Quoted Rate”

15

What is r*

r* = Real Interest Rate (Real Risk-Free Rate )

16

What does r* do?

Compensates the lender for his opportunity costs, regardless of inflation
or any other risks

17

How can you find the real risk free rate?

real risk-free rate can be found by
subtracting current inflation rate from the current 30-day Treasury-bill
rate.

18

Is the r* a constant?

no it changes over time.

19

What is the purpose of having an inflation premium?

Compensates the lender for loss in value over time due to inflation.

20

How do you find the inflation premium?

This is computed as the average expected inflation rate over the life of
the loan (more on this later)
The IP that is often applied is derived from government economic
forecasts. No one really knows what the current inflation rate is but the
one the U.S. Government reports is the commonly accepted value
No one ever really knows what the inflation rate will be in the future

21

What does DRP mean?

This is the default risk premium

22

What does the DRP do for the lender?

Compensates the lender for possible default.

This is kind of like an “insurance payment”
30-day Treasury bills (T-bills; $1,000 face value very short term bonds)
have a DRP of 0% Why?

Answer: T-bills are considered “riskless”.

23

What does LP mean?

This means Liquidity Premium

24

What does a Liquidity premium do?

Accounts for the ability of a borrower to repay a loan with the firm’s assets.

If these assets are not very liquid (i.e. real estate, buildings, equipment, etc.),
LP will be higher

25

What does MRP mean?

MRP = Maturity Risk Premium

26

What does a maturity risk premium do?

Compensates for Interest Rate Risk. The longer the term (time till
maturity), the greater the interest rate risk, thus a higher MRP.

27

What Compensates for Reinvestment (Rate) Risk.?

a maturity risk premium

28

what is the nominal risk free rate?

Since no one really knows what r* is, the financial world uses a commonly
accepted formula: r* ≈ rRF - Current Inflation Rate

The above equation can be re-written as rRF ≈ r* + IP This is the
“Nominal” or “Quoted” Risk-Free Rate (rRF)

29

If a loan is 30 days of less do you have to account for IP when calculating the interest rate of a loan?

No you do not

30

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

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

Find current inflation (what the gov’t reports as current
inflation)

Find the yield on a 30-day T-bill

Compute r* (r* = rRF - Current Inflation Rate)

Find expected inflation for upcoming years

Compute the average value for expected inflation; this is IP
IP = ( I1 + I2 + I3 ……..In) / n where n is the number of years
of maturity and In is the expected inflation for a particular year