Interest Rates, Present Value & Future Value Flashcards
What does it mean that money has a time value?
Individuals value a given amount of money more highly the earlier it is received: a smaller amount of money now may be equivalent in value to a larger amount received at a future date.
What is the definition of “interest rate”?
Denoted “r”, it is a rate (%) of return that reflects the relationship between differently dated cash flows.
What are the 3 ways of thinking about interest rates?
- required rates of return: minimum rate of return an investor must receive in order to accept the investment.
- discount rates: how much we discount the future amount to find its value today.
- opportunity costs: it’s the value that investors forgo by choosing a particular course of action.
What is the definition of “opportunity cost”?
They represent the potential benefits that an individual, investor, or business misses out on when choosing one alternative over another.
How are interest rates set in the marketplace?
By the forces of supply (investors) and demand (borrowers).
What is an interest rate “r” composed of?
r = real risk-free interest rate + inflation premium + default risk premium + liquidity premium + maturity premium
What is the definition of “real risk-free interest rate”?
The single-period interest rate for a completely risk-free security if no inflation were expected. It reflects the time preferences of individuals for current vs. future real consumption.
What is the definition of “inflation premium”?
It compensates investors for expected inflation and reflects the average inflation rate expected over the maturity of the debt.
What is the “nominal risk-free interest rate”?
The sum of the “real risk-free interest rate” and the “inflation premium”.
What is the definition of “default risk premium”?
It compensates investors for the possibility that the borrower will fail to make a promised payment at the contracted time and in the contracted amount.
What is the definition of “liquidity premium”?
It compensates investors for the risk of loss relative to an investment’s fair value if the investment needs to be converted to cash quickly.
What is the definition of “maturity premium”?
It compensates investors for the increased sensitivity of the market value of debt to a change in market interest rates as maturity is extended, in general (holding all else equal).
What is the relation between Present Value (PV), Future Value (FV), Interest Rate (r) and period (N)?
FV N = PV(1 + r)N
What is the definition of “principal”?
It is the amount of funds originally invested.
What is the definition of “compounding”?
It is the process in which an asset’s earnings are reinvested to generate additional earnings over time.
