Unit 3 Fundamentals Flashcards
other terms that mean the same as interest rate
discount rate - savings account
required rate (of return) - loans, stocks bonds
cost of capital - loans
types of interest
simple: annual interest i = pr; total interest = i*t (t is time in years)
compounding: total interest = (p(1+r)^#periods) - p
hurdle rate
required rate of return
factors affecting interest rates
opportunity cost
risk
inflation
Explain Opportunity cost
losses incurred on alternative options when other option is chosen
included in required rate of return
Define Risk
possibility an actual return will differ from expected return
describe inflation
rate that cost of goods/services increase over time
3 main sources of inflation
increased demand for goods
rising costs
adaptive expectations (increase in wages due to inflation)
3 components of interest rates
opportunity cost
risk
inflation
interest rate formula with regard to risk
implications
i = Risk-free Rate + Risk Premium
- higher risk means higher required return
- higher inflation and opportunity cost require higher return
risk-free rate
indicator of opportunity cost and inflation
rate of return on an investment with no risk
risk premium
compensation for risk taken by investors
nominal rate
rate that invested money grows over time
does not factor out inflation
does not measure actual purchasing power after time expires
purchasing power formula
(1 + nominal rate / 1 + inflation) - 1
formula for real rate
((nominal rate - inflation rate)/1 + inflation rate)
approximate formula for real rate
nominal rate - inflation rate
real rate and growth rate in purchasing power are essentially the same
yes
3 variables affecting Time Value of Money
- amount of cash flows
- timing of cash flows
- rate that value of cash flows changes due to passage of time
4 elements of TVM
Present Value - measure of cash flows in relative past
Future Value - cash flows in relative future
Compounding - finding future value from present value
Discounting - finding present value from future value
annuity
stream of equal amount cash flows paid at regular intervals
types of annuities
ordinary - payment at end of period (ie loan)
annuity due - payment at start of period (ie rent)
perpetuity - identical periodical payments with no end date (ordinary annuity with no end)
future value formula
PV * (1+i)^n
present value formula
FV / (1+i)^n
compounding calculates what value
FV
discounting calculates what value
PV
basis point
1/100th percent
return
gain/loss on an investment
Holding period return
annualized percentage
return an investor gets over entire period owning a security
increase in price, plus cash flows like dividends
based on past prices and cash flows
expected return
hypothesized return
real return
found by subtracting inflation
definition of risk
possibility that real return will differ from expected return
amount of uncertainty about the outcome
market risk
aka systematic or nondiversiable risk
risk inherent in the economy as a whole, in the entire market
cannot be diversified
firm specific risk
aka nonsytematic/idiosyncratic/diversifiable risk
risk from factors affecting a particular firm
interest rate risk
type of market risk
probability that interest rate changes will impact value of a bond
interest rates have inverse relationship with bond prices
affected by time to maturity, coupon rate
default risk
probability of loss due to borrower defaulting on a loan
price risk
potential for a security to decline in price relative to market
excludes market risk => diversifiable
types of price risk
operating
financial
risk separation
geographically dispersing assets to reduce risk
risk transfer
risk reduction by transferring risk to another entity ie purchase insurance
risk retention
decision to not transfer risk when cost of risk is less than insuring against it
risk avoidance
manage risk by avoiding an activity that carries risk
luxury good providers are more exposed to systematic risk and providers of staples
yes
positive relationship between risk and return
yes
time diversification
stocks are less risky over longer periods of time vs shorter periods of time
pv/fv sign for cashflow received vs paid
received = + paid = -
