Module: 6.1: Study - EAY and Compounding Frequency

Question 1

What is the required rate of return?

Answer 1

The market rate of return is the return that investors and savers require to get them to willingly lend their funds.

Question 2

What is a discount rate?

Answer 2

Interchangeable with interest rate, required rate of return.

Question 3

What is the real risk-free rate?

Answer 3

interest on a single period loan that has no expectation of inflation in it.

US T-bills are nominal risk-free rates because they have an inflation premium.

Question 4

What is default risk?
What is liquidity risk?
What is maturity risk?

Answer 4

Default risk - risk the borrower will not make the promised payments

Liquidity risk - risk of receiving less than fair value for an investment if sold for cash quickly.

Maturity risk - volatility longer the maturity of the loan.

Question 5

What is the formula for required rate of return on a security?

Answer 5

nominal risk free rate + default risk premium + liquidity risk premium + maturity risk premium

Question 6

what is the effective annual rate?

Answer 6

The rate of interest that investors actually realize as a result of compounding

Question 7

What is the formula for effective annual rate?

Answer 7

EAR = [(1 + periodic rate) ^(m) ]-1

periodic rate = stated annual rate / m
m = the number of compounding periods per year.