LOS 1.a

Question 1

What is an interest rate?

Answer 1

• Discount Rate -
• Required Rate of return - return required to lend funds
• Opportunity cost of current consumption

Question 2

What is real risk free rate

Answer 2

• Theoretical rate on a single-period loan that contains no expectation of inflation and no probablity of default
• Represents time preference - degree to which current consumption is preferred

Question 3

What is the calculation for nominal risk-free rate

Answer 3

• (1 + nominal risk-free rate) = (1 + real risk-free rate)(1 + expected inflation rate)
• Nominal risk-free rate ≅ real risk-free rate + expected inflation rate
• Nominal rate of interest = real risk-free rate + inflation premium + default risk premium + liquidity premium + maturity premium

Question 4

What are the three types of risk

Answer 4

• Default risk - risk that a borrower will not make payments
• Liquidity Risk - risk of recieving less than fair value for an investment if it must be sold quickly
• Maturity Risk - Risk for holding