Chapter 5: Lecture Notes Flashcards
What is the time value of money (TVM)?
The time value of money is the concept that money available today is worth more than the same amount in the future because it can be invested to earn a return.
What is opportunity cost in finance?
Opportunity cost is the cost of giving up something in exchange for something else, often measured by the interest rate that could be earned by investing the money.
How does simple interest differ from compound interest in terms of growth?
Simple interest grows the principal in a linear manner, earning the same amount each period, while compound interest grows exponentially, earning interest on both the principal and the accrued interest.
What is the difference between an ordinary annuity, an annuity due, and a perpetuity?
Ordinary Annuity: Payments are made at the end of each period.
Annuity Due: Payments are made at the beginning of each period.
Perpetuity: An infinite series of equal periodic payments that continue forever.
What is an Effective Annual Rate (EAR) and how does it differ from a nominal rate?
The Effective Annual Rate (EAR) is the annual interest rate that accounts for compounding within the year.
It is always higher than the nominal (quoted) rate when there is more than one compounding period per year.
How does the frequency of compounding affect the Effective Annual Rate (EAR)?
The more frequent the compounding, the higher the Effective Annual Rate (EAR), because interest is being compounded more often.
What is amortization in the context of loans and mortgages?
Amortization refers to the process of paying off a loan or mortgage over time through regular payments that include both principal and interest.
What is the difference between the amortization period and the mortgage term?
Amortization Period: The total time it takes to fully repay the loan.
Mortgage Term: The period before the next renewal option for the mortgage, after which the interest rate and payment amount might change.
What is a blended payment in a mortgage arrangement?
A blended payment is one where both interest and principal are paid off in each payment, reducing the balance of the loan over time.
How do you calculate the Effective Annual Rate (EAR) given a nominal rate compounded semi-annually?
Use the formula:
EAR = (1 + QR / m)^m - 1
For example, if the nominal rate (QR) is 5.5% compounded semi-annually:
EAR = (1 + 0.055 / 2)^2 - 1 = 5.64%
What steps are involved in solving a retirement problem using time value of money (TVM)?
Calculate the present value of the retirement annuity needed at retirement.
Estimate the future value of current savings.
Determine the gap between required funds and accumulated savings.
Calculate the monthly savings required to fill this gap.
