Section I.B.1 Time Value Of Money

Question 1

What is nominal and effective interest rates?

Answer 1

Nominal - a stated or reported rate which does not consider compounding within the annual period

Effective - an annualized rate that considers the frequency by which interest is compounded within a year

Question 2

How do you calculate effective annual rate?

Answer 2

EAR = (1+Rnom/frequency)^frequency -1

E.g. what is effective rate of 12% compounded quarterly?

= (1+0.03)^4 -1
= 12.55%

Question 3

What are the most common methods of compounding?

Answer 3

Monthly, quarterly, semi-annual, annual

The more frequent the compounding, the higher the rate of return

Question 4

What are nominal and real rates of return?

Answer 4

Nominal - rate of interest that has not been adjusted for the impact of inflation

(1+nominal rate) = (1 +real interest rate) (1+inflation rate)

Real - rate of interest (or return) that has been adjusted for inflation

**Do NOT simply subtract inflation from a nominal rate on the exam. This will give you the wrong answer. Use the equation.

Real interest rate = [(1+nominal)/(1+inflation)] - 1

Question 5

What is the difference between ordinary vs annutiy due?

Answer 5

Ordinary annuity - a finite seriesnof periodic cash flows where cash flow (incoming or outgoing) occurs at the end of the period (set calc to end mode)

Annuity due - a finite series of periodic cash flows in which the cash flow (incoming or outgoing) occurs immediately (set calc to beg mode)

Question 6

What is Internal Rate of Return?

Answer 6

This is also called the effective interest rate.

IRR is a dollar weighted return.

IRR is the discount rate at which the net present value of all cash flows equal zero.

IRR is the discount rate at which present value of all future cash flows is equal to the intial ivestnent or cash outlay (I.e. at which the investment breaks even).

Question 7

What is time weighted return?

Answer 7

• is an average return over different time periods
• each time period is weighted the same
• different amounts of money invested at different times is IRRELEVANT
• must first determine the holding period return for each time period
• uses geometric average return (more accurate than arithmetic average); lower than arthimetic average

TMR = Rg = [(1+R1)(1+R2)(1+R3)…(1+Rn)]^(1/n) -1