Study Guide: Unit 4 Flashcards
Compute rates of return and describe their use in making financial decisions.
o Remember, the rate of return is simply ( End Value – Beginning Value)/Beginning
Value
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Explain how interest rates are determined/Identify the major determinants of market
interest rates
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Compare the use of a simple interest calculation versus a compound interest calculation. o The formula for simple interest is on your formula sheet. The basic formula for compound interest (Future Value) is also there, but for more complex problems, it’s best to use your financial calculator. Remember – in the single period case simple and compound interest produce the same result (single period compound interest is just simple interest, as compounding requires multiple periods)
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Describe the underlying theories (expectation, liquidity preference, market
segmentation) that affect the term structure of interest rates.
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Describe various types of inflation (cost push, demand pull, money supply, speculative,
administrative) and their causes.
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Describe the concept of opportunity cost.
o The concept of opportunity cost used in this course is a bit different from the
one you may have seen in microeconomics. In this case, we are thinking more
specifically about the case of a business making a decision regarding investing.
This could be expanding the business or purchasing another business.
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Explain the concept of time value of money (TVM)
o Time value of money allows us to compare money today vs. Money in the future.
TVM analysis permits us to identify the change in value that we will experience if
we take or make payments at different points on the timeline.
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Explain the importance of the five components of TVM, as applied in a calculation
(discount rate, - term, payment, present value, future value)
o Rate (I/Y) on the TI – BA II + is the interest rate expressed as percent. This can be
annually, or for periods other than a year. If other than annual frequency, divide
annual rate by number of periods. For example, for monthly frequency, divide
stated annual rate by 12
o Term (N) on the TI-BA II + is the time period. This can be annually or for periods
other than a year. If other than annual frequency, multiply term (the number of
years) by the number of periods in a year. For example, for monthly frequency,
multiply the number of years by 12
o Payment (PMT) on the TI-BA II + is a specific sum of money to be paid for a
specific period of time.
o Present Value (PV) on the TI BA II + is a specific lump sum of money, which you
currently possess, or which represents what a sum to be received in the future
would be worth “in today’s dollars”
o Future Value (FV) on the TI-BA II + is a specific lump sum of money which you
expect to receive, or the amount that a sum “in today’s dollars” will grow into by
some future target date
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• Explain how the present value calculation is related to the future value calculation
o Please see notes for other sections for explanations and descriptions of this
relationship
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Perform basic time value of money calculations
o Be sure to review how to calculate for periods other than annually (monthly,
weekly quarterly), This is very important for problems related to funding a
retirement or saving up for a large purchase
o Perpetuities are a specific type of annuity. They come in two types, static
(payment never changes) and growing (payment changes or inflates at a specific
rate). Be sure to review both
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Discuss how compound interest impacts the future value of money
o The basic description of the process is that we compound into the future (future
value is typically larger than present value) and we discount back to the present
(present value is typically smaller than present value)
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• Describe how risk and return relate to each other.
o Higher risk investments require additional effort in researching and monitoring.
(sort of like loaning money to a flaky friend, you need to keep in touch with
them). Since the lender or investor is expending extra time and effort to
perform these activities, she will (rightfully) expect a higher level of
compensation. Thus, the well-known relationship of risk vs. reward
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Describe different types of risk.
o The etext introduces and discusses many different types of risk
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Identify different ways to calculate return. Be able to solve for the expected return of
an investment or a portfolio
o The “ski resort” problem in the e-text provides an example for you to follow on
calculating expected return. For those of you that have taken quant methods or
stats, it is the same thing as calculating a weighted average
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Identify ways to reduce risk.
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