LOS 2.b

Question 1

How do you work out the rate of return if you have the price of a security and it’s future cash flows?

Answer 1

Face Value / (1+ rate)^years

Question 3

What’s the cash flow additivity principle

Answer 3

The cash flow additivity principle says that if you calculate the present value of each of these future payments separately and then add them up, you’ll get the same result as if you calculated the present value of all the payments together as one combined stream of cash flows.

Question 4

What is it’s relationship with the non-arbitrage condition

Answer 4

Relationship: No-arbitrage principle says that if two sets of future cash flows are identifcal under all conditions, they iwll have the same price today (or if they don’t then investors will buy the lower price one, and sell the higher price one, driving their prices together)

Question 5

What’s a forward interest rate and spot rate? What’s the notation?

Answer 5

Spot rate: Interest rate for loan to be made today
Forward Interest rate: Interest rate for a loan to be made on a later date
Notation: (How long until loan is made)y(Length of loan)y
e.g 1y1y is the rate for a 1-year loan to be made one year from now; 2y1y is the rate for a 1-year loan to be made two years from now

Question 6

How does it relate to cash flow additivity principle

Answer 6

Borrowing for three years at the three year spot rate, or borrowing for one year periods in three successive years, should have the same cost today. In fact, any combination of spot and forward interest rates that cover the same time period should have the same cost.

Question 7

How to work out forward change rates

Answer 7

Forward = spot (1+ interest rate[price]) / (1+ interest rate[base])
Exchange rates are price/base