CFA 5: The Time Value of Money

Question 1

discount

Interest Rates: Interpretation

Answer 1

To reduce the value of a future payment in allowance for how far away it is in time; to calculate the present value of some future amount. Also, the amount by which an instrument is priced below its face (par) value.

Question 2

interest rate

Interest Rates: Interpretation

Answer 2

A rate of return that reflects the relationship between differently dated cash flows; a discount.

Question 3

opportunity cost

Interest Rates: Interpretation

Answer 3

The value that investors forgo by choosing a particular course of action; the value of something in its best alternative use.

Question 4

real risk-free interest rate

Interest Rates: Interpretation

Answer 4

The single-period interest rate for a completely risk-free security if no inflation were expected.

Question 5

inflation premium

Interest Rates: Interpretation

Answer 5

An extra retun that compensates investors for expected inflation.

Question 6

nominal risk-free interest rate

Interest Rates: Interpretation

Answer 6

The sum of the real risk-free interest rate and the inflation premium.

Question 7

default risk premium

Interest Rates: Interpretation

Answer 7

An extra return that compensates investors for the possibility that the borrower will fail to make a promised payment at the contracted time and in the contracted amount.

Question 8

liquidity premium

Interest Rates: Interpretation

Answer 8

An extra return that compensates investors for the risk of loss relative to an investment’s fair value if the investment needs to be converted to cash quickly.

Question 9

maturity premium

Interest Rates: Interpretation

Answer 9

An extra return that compensates investors for the increased sensitivity of the market value of debt to a change in market interest rates as maturity is extended.

Question 10

present value (PV)

The Future Value of a Single Cash Flow

Answer 10

The present discounted value of future cash flows: For assets, the present discounted value of the future net cash inflows that the asset is expected to generate; for liabilities, the present discounted value of the future net cash outflows that are expected to be required to settle the liabilities.

Question 11

future value (FV)

The Future Value of a Single Cash Flow

Answer 11

The amount to which a payment or series of payments will grow by a stated future date.

Question 12

principal

The Future Value of a Single Cash Flow

Answer 12

The amount of funds originally invested in a project or instrument; the face value to be paid at maturity.

Question 13

compounding

The Future Value of a Single Cash Flow

Answer 13

The process of accumulating interst on interest.

Question 14

simple interest

The Future Value of a Single Cash Flow

Answer 14

The interest earned each period on the original investment; interest calculated on the principal only.

Question 15

stated annual interest rate

The Future Value of a Single Cash Flow

Answer 15

A quoted interest rate that does not account for for compounding within the year. Also called quoted interest rate.

Question 16

effective annual rate (EAR)

The Future Value of a Single Cash Flow

Answer 16

The amount by which a unit of currency will grow in a year with interest on interest included.

Question 17

annuity

The Future Value of a Series of Cash Flows

Answer 17

A finite set of level sequential cash flows.

Question 18

ordinary annuity

The Future Value of a Series of Cash Flows

Answer 18

An annuity with a first cash flow that is paid one period from the present.

Question 19

perpetuity

The Future Value of a Series of Cash Flows

Answer 19

A perpetual annuity, or a set of never-ending level sequential cash flows, with th first cash flow occurring one period from now. A bond that does not mature.

Question 20

cash flow additivity principle

The Future Value of a Series of Cash Flows

Answer 20

The principle that dollar amounts indexed at the same point in time are additive.