Cfa V1 R5 Tvm

Question 1

Interest rates- definition & 3 interpretations

Answer 1

Int rate- rate of return that reflects the relationship between cf’s occurring at different dates.

Can be thought of in 3 ways

1) required rate of return- min interest rate investor must receive in order to accept the project
2) discount rate- rate that determines what a future value is worth today; almost interchangeable with interest rate
3) opportunity cost- value that is forgone

Question 2

4 things that determine interest rates from an investors point of view

Answer 2

1) inflation premium- compensation for loss of purchasing power due to inflation. Reflects average inflation expected during period. Real rf rate + inflation premium= nominal rf rate. U.S t- bills can be seen as the nominal rf rate for that time period.
2) default risk premium- compensation for possibility that the borrower will not make the correct payments on the day it’s due
3) liquidity premium- compensation for the risk of loss relative to fair value if the asset must be quickly converted to cash. T bills have no liquidity premium, b/c minuscule transaction cost & no ability to affect price.
4) maturity premium- compensation for the increased sensitivity to interest rates as the maturity in increases.

Question 3

Continuous compounding

Answer 3

Infinite # of compounding periods.

Fv= PVe^r*n

r is stated annual interest rate
n is # of periods
e is a transcendental #, around 2.71828

Question 4

Stated & effective rates

Answer 4

Stated annual rate does not give FV directly, and must be converted into an effective annual rate(EAR)

EAR = (1+ period interest rate)^m -1

Also known as APY in the u.s.

Question 5

Remember!

Answer 5

regular annuity & perpetuity have 1st payment at the end of the year; so an annuity with a payment that begins at t=5 starts at t=4

An annuity due begins payment at the beginning of the first year. Can be thought of a single lump sum followed by an annuity. Also can be computed by multiplying regular annuity by (1+r), b/c each period is discounted 1 less time

Annuity can also be thought of as 2 perpetuities that start at different dates and offset each other starting at a point in time.