Lecture 2 Flashcards
Define Growing Annuity
Growing Annuity: Payments grow over time at rate g (for a
specified period of time).
Define Annuity
Annuity: A fixed stream of cash flows (𝑪) received over a
specified period of time.
if we are solving for PV, we are discounting to determine the ?
present value = 𝑷𝑽 = 𝑭𝑽/ (𝟏 + 𝒓)𝑡
if we are solving for FV, we are compounding to determine the ?
Future value = 𝑭𝑽 = 𝑷𝑽 (𝟏 + 𝒓)𝑡
Define Growing Perpetuity
Growing Perpetuity: Payments grow over time at rate g - PV = c/r-g
What does real interest rates take into account ?
Takes inflation into account.
*Represents the change in your purchasing power.
What does Nominal Interest Rates take into account
Not adjusted for inflation (e.g. rates we see in the market).
Represents the % change in the amount of cash you have
Define the fisher affect
Fisher Effect (from economist Irving Fisher)
Relationship between nominal returns, real returns and
inflation.
List out the variables represented in this equation 1 + R = (1 + r ) x (1 + h)
R is the nominal rate, r is the real rate and h is the
inflation rate
What estimate can be used when interest rates and real interest are low
R = r + h
This estimate can be used when inflation and interest
rates are low.
* It is less accurate when inflation and interest rates
are high.
Define Compounding
Compounding :The process of accumulating interest on an investment over time to earn more interest.
Define Interest on interest
Interest on interest: Interest earned on the reinvestment of previous
interest payments
Define Compound interest
Compound interest: Interest earned on both the initial principal and the interest reinvested from prior periods.
Define Simple interest
Simple interest: Interest earned only on the original principal amount
invested.
Define Discounting
Discounting: Converting a value received in a future time period to an
equivalent value received immediately
Define Coupon interest
rate
The stated annual interest rate on the bond.
It is usually fixed for the life of the bond.
Define current yield
The coupon interest payment divided by the
current market price of the bond.
Define Face amount
The maturity value of the bond. The holder of
the bond will receive the face amount from
the issuer when the bond matures. Face
amount is synonymous with par value.
Define Indenture
The contract that accompanies a bond and
specifies the terms of the loan agreement. It
includes management restrictions, called
covenants.
Define market rate
The interest rate currently in effect in the
market for securities of similar risk and
maturity. The market rate is used to value
bonds.
Define maturity
The number of years or periods until the
bond matures and the holder is paid the face
amount.
Define Par value
The same as face amount, the maturity value
of the bond.
Define Yield to maturity
The yield an investor will earn if the bond is
purchased at the current market price and
held until maturity
How would an expected increase in inflation affect the yield on a corporate bond? Explain.
The yield, or nominal rate, would be expected to increase in order to compensate the investor (i.e. lender or buyer of the bond) for the rise in inflation. Future inflation erodes the value of the cash that will be returned to the investor
As the ____________ of a bond increases, the yield _______________.
a. interest rate risk; decreases
b. liquidity; decreases
c. default risk; decreases
d. expected future inflation; stays the same
Answer: b
The possibility that a bond issuer (i.e. borrower) may not pay back what the investor (i.e. lender) is owed with respect to coupon payments and face value, is associated with which determinant of bond yields?
a. interest rate risk
b. expected future inflation
c. default risk
d. liquidity
e. taxability
Answer: c
