Flashcards in Topic 2: Part 1 and 2 Deck (29):
Time value of money
We typically prefer money immediately to money in the future
-risk, inflation, preference
Time value of money reflects opportunity cost
Gross interest is interest before taxes
Net interest is interest after taxes
Annual Percentage Rate (APR)
The annual percentage rate (APR) is the true annual interest rate which takes account of the timing of interest and principal payments.
•in context of banks, expressed as annual equivalent rate (AER)
Simple interest is the interest computed only on the principal.
FVsi = P(1+n.i)
Compound interest is the Internet paid on the sum which accumulates, ie the principal plus interest.
FVci = P(1+i)^n
Interest is paid m times each year
Compound interest rate is i
FVci = P(1+i/m)^nm
APR = (1+i/m)^m -1
APR and Final Value
FV = P(1+APR)^n
The present value is the current worth of future cash flows
Discounting is the process of reducing cash flows to present values
An annuity is a constant annual cash flow for a prescribed amount of time
A perpetuity is a constant annual cash flow for an infinite period of time
•we assume a fixed coupon rate
•we assume a yearly payment schedule (unless stated otherwise)
The discount is the amount below the face value of a financial instrument at which it sells
•coupon rate less than market rate (interest)
The premium is the amount above the face value of a financial instrument at which it sells
•coupon rate must be more than market rate (interest)
Yield to Maturity
The interest rate at which the present value of the future cash flows equals the current market price
Interest rate = coupon rate
•Yields are changing over time
•yields upward sloping at a given time
Why is the yield curve upwards sloping?
-investors believe interest rates to rise in the long run
Liquidity preference theory
-investors prefer to have cash on hand rather than invest
Market segmentation theory
-different agents active on market for short term and long term bonds
A dividend is a distribution of a portion of a company's earnings or profits in the form of a sum of money paid (typically annually) to its shareholders.
Difference between primary and secondary market
Primary market: direct sale of securities to owners/creditors
Secondary market: securities traded between owners/creditors
Difference between auction and dealer market
Auction markets: market matches buyers and sellers
Dealer markets: buying and sleeping done by dealers
Why do financial intermediaries exist?
The need of lenders and borrowers rarely match perfectly, so financial intermediaries step in to alleviate this issue.
Explain why money now is worth more than money in the future.
Risk: money today is certain.
Inflation: value of money declines over time.
Preference: we prefer immediate consumption.
APR is the true annual interest rate which takes into account of the timing of interest and principal payments.
What is the difference between an annuity and a perpetuity?
Annuity: a constant annual cash flow for a prescribed period of time.
Perpetuity: a constant annual cash flow for an infinite period of time.
When do bonds trade at a discount and when at a premium?
Discount: coupon rate (bond interest) is less than market interest rate.
Premium: bond more attractive than putting money in the bank.
3 explanations why yield curve is upwards slopping
1. Expectations theory
Implies investors believe interest rates to rise in the long run.
2. Liquidity preference theory
Investors prefer to have cash on hand rather than invests.
3. Market segmentation theory
Different agents on market for short term and long term.