part 1: quantitative analysis

Question 1

what are Interest rates determined by?

Answer 1

by the interaction between the supply of funds from savers and the demand for funds from borrowers

Question 2

calculating interest rates using a building block approach

Answer 2

r=rf+I+D+L+M

rf: is the real risk-free rate that investors require as compensation (in real terms) for lending today rather than consuming.

I: is the inflation premium that compensates lenders for expected inflation. Adding this to the real risk-free rate gives the nominal risk-free interest rate.

D: is the default risk premium that lenders charge for the possibility that borrowers will not meet their obligations on time and in full.

L: is a liquidity premium that compensates the investor for the extra cost of converting the investment to cash.

M: is the maturity premium earned by investors who are willing to lend over longer periods, which requires greater exposure to interest rate risk.

Question 3

what happens to interest rates if there are more borrowers than savers?

Answer 3

interest rates will go up

Question 4

nominal risk free rate formula

Answer 4

risk free rate + inflation premium

Question 5

default risk premium

Answer 5

compensates investors for the risk of the borrower not making a promised payment.

Question 6

liquidity premium

Answer 6

needed to cover the extra cost of converting some investments quickly into cash.

Question 7

maturity premium

Answer 7

compensates investors for holding longer-maturity securities. Longer maturities coincide with more interest rate risk.

For example, the price of a 30-year bond is more sensitive to interest rates than the price of a 1-year bond. This is the concept of duration

Question 8

Which of the following is least likely to be included in the portion of a corporate bond’s yield that reflects investors’ time preferences for current versus future nominal consumption?

A: Inflation premium

B: Liquidity premium

C: Real risk-free rate

Question 9

the formula for compounding period (1 per year)

Answer 9

FV = PV * (1 + i)^n

Question 10

the formula for compounding period (multiple compounding periods per year per year)

Answer 10

FV = PV * (1 + i/m)^m*n

Question 11

The highest future value possible

Answer 11

produced by continuous compounding

Question 12

continuous compounding

Answer 12

assumes an infinite number of compounding periods per year

With m→∞ compounding periods per year, the future value formula is:

FVn = PV * e^i*n

Question 13

An annuity

Answer 13

a specified number of level cash flows

Question 14

Ordinary annuities

Answer 14

start one period from now

Question 15

annuity due

Answer 15

begins immediately