Exam 4 Flashcards
Annuity
A level stream of cash flows for a fixed period of time
How many types of Annuities
2
Perpetuity
a series of equal payments that continues forever
Perpetuity formula
perpetuity= cash amount (annuity)/rate
Rate and present value realtionaship
inverse
Future value of annuity(fva)
value of periodic payments at the end of a specified period
Relationship between the rate of discount and the price of perpetuity
inverse and proportional
The relationship between future value of annuity (FVA) and the future value of annuity due
FVAD = is FVA times (1+r)
The simplest form of a loan
pure discount loan
Identify key variables to figure out which table to use
-PVA
-FVA
-periodic rate
-time
-annuity
-pva/annuity (ratio)
-fva/annuity (ratio)
Amortized loan
when the lender requires the borrower to repay parts of the loan amount over time
Interest only loan
has a repayment plan that calls for the borrower to pay interest each period and to repay the entire principal (the original loan amount) at some point in the future
Pure discount loan
(the simiplets form of a loan) and repays a single lump sum at some time in the future
A simple way of amortizing a loan
to have the borrower pay the interest each period plus some fixed amount. This approach is common with medium-term business loans.
Truth -in- Lending Law
Lenders disclose an APR on all consumer loans, all your loans must show an APR
Principle
the amount of money that you borrowed
According to the truth and lending bill you are required to report on APR (truth or false)
true
APR
annual percentage rate, the interest rate charged per period multiplied by the number of periods per year
EAR
effective annaul rate, the interest rate expressed as if it were compounded once per year
How is the effective annual rate (EAR) greater than the APR
With Intra-year compounding
Which is more relevant for financial decisions?
The EAR is greater than the APR, the EAR is more relevant for financial decisions. Its always the more relevant number.
In multiple cash flow calculations, when is it assumed that cash flows occur?
They occur at the end of each period
What is the point of a loan?
Point = 1% of a loan
What is a T-bill the same as
a pure discount loan
Why are truth and lending laws controversial
APR understates the actual interest rates
When is the interest exempt from the federal income tax?
municipal bonds
What does the dirty price of a bond represent?
The clean price plus accrued interest
What is the difference between a real and a nominal rate of return?
- The real is adjusted for inflation
- A nominal rate is not adjusted for inflation
What does historical data suggest about the nature of short-term and long-term interest rates?
Call provision is an advantage to issuer and disadvantage to investor
What has the lowest cumulative default risk over 20 years?
-Triple a, double a, a, and triple b are investment gradings
-When looking at default risk the first three rates have lowest default risk
What does a bond rating say about the risk of fluctuations in a bond’s value resulting from interest rate changes?
- Rated below triple B is a high yield (junk)
-The price of high rated bond can be very volatile
Is it true that a U.S. Treasury security is risk-free?
No because its subject to interest rate risk
With regard to bid and ask prices on a Treasury bond, is it possible for the bid
price to be higher? Why or why not?
No, because if it was true the deal would lose money, and the bid price will always be lower
The treasury bid and ask quotes are sometimes given in terms of yields, so there would be a bid yield and an ask yield. Which do you think would be larger? Explain.
the bid price would be lower on the ask price so the yield for the bid would be higher
Are there any circumstances under which an investor might be more concerned about the nominal return on an investment than the real return?
It depends on how the future obligations are denominated, if they are denominated in terms of dollars then it’s relevant
What is the relationship between the price of a
bond and its YTM?
Inverse relationship
What is the advantage of a traditional IRA
You might be able to qualify for 2 tax deferrals
Drawback of traditional IRA
- You have to pay taxes when you take the money
- When you take the money out you are subject to taxes
Par value & face value are the same…?
amount you receive on maturity date
Par bond
the current price is equal to par. Capital gain is 0
Discount bond
the current price is lower than par leading to a gain
Two components of investments
future return and initial investment
Roth IRA advantage
- when you take the money out it is tax free
- Roth Ira can make more than traditional because after tax initial investment is higher
Drawback of Roth IRA
the initial investment is not tax deductible
Why would you rather have money now than in the future?
- Inflation
- Investment opportunities
How do we measure the time value of money?
interest rate
2 types of interests rates
compound & simple interest
Simple interest
is earned only on the principle, the money does not grow that fast because the interest is on the principal only, the is linear growth
Compound interest
earning interest on interest, interest is converted to and becomes principle, this is exponential growth, the rate stays the same but the interest per period rises gradually
Fun Fact about Benjamin Franklin
- He used compound interest
- to fund student loans
- in a trust agreement that stated that the money had to be used for student for loans for the first 100 years
Future value of a single sum formula
FVSS= PV(1+r) ^t
What’s the relation between the rate and FVSS
Direct
What’s the relation between time and FVSS
Direct
Future value interest factor formula
(1+r)^t= FVIF
Future Value is the same as?
Future Value Interest Factor
Periods are represented in what?
quarters (4 quarters in a year)
EAR formula
(1+PR)^t-1=EAR
How does inflation affect the rate of interest?
Direct relationship
How does credit risk affect the interest rate?
Direct relationship
When you have a tight monetary policy how will it affect the interest?
With other things being equal, it will make the rate go up, a term for this is QT(quantitative tightening)
Expansionary monetary policy
(QE) quantitative expansion, it causes the rate to go down when other things are equal
Similarity between chapter 4 &5
they both deal with the compound interest
What do we mean by the future value of an investment?
the number of dollars you’ll have at the end of the specified period
What do we mean by compound interest? How does it differs from simple interest
Interest on interest, simple interest is interest on principle
What are the determinants of interest
- inflation
- credit risk
- monetary policy
- expanision monetary policy
Monetary expansion is the same as
quantitative expansion (QE)
When you raise the interest rate what do you limit
monetary spending
Present value of a single sum
the money you will pay now in exchange for a certain amount to be received in the future
The PVSS formula
future value of a single sum (fvss)/(1+r)^t
Difference between a stock and a bond
Bonds are loans from companies (debt) stock is equity/ownernship. The bond pays the interest and stock pays the dividends.
- Bonds have the first claim to the company’s cash flow and assets
- stocks have residual claims, they are paid last.
The relationship between PVSS with rate and time
inverse
The process of discounting a future amount back to the present is the opposite of doing what?
Compounding
What do we mean by discounted cash flow, or DCF, valuation?
calculating the present value of a future cash flow to determine its worth today
What is the Rule of 72
72/r= number of periods required to double your money
In order for a company to refinance what do they have to do?
it sells new bonds and pays off old bonds, this happens when rates drop.
Yield to maturity (YTM)
How investors get compensated
When we go into a recession, sooner or later what will happen?
- Interest rates go down.
- Based on historical evidence. Interest rates that drop are significant drops and continuous.
What is the best predictor of mutual funds performance according to morning star?
Management operating expense as a percentage of net asset value
Why does the treasury have a zero default risk?
they can pay off the debt by increasing taxes or creating more money
In general, what is the relationship between a stated interest rate and an effective interest rate?
The effective interest rate is always higher
How do Call provisions make the investment?
less desirable because it is possible that they may never have their investment fully mature
