Unit 3 Fundamentals

Question 1

other terms that mean the same as interest rate

Answer 1

discount rate - savings account
required rate (of return) - loans, stocks bonds
cost of capital - loans

Question 2

types of interest

Answer 2

simple: annual interest i = pr; total interest = i*t (t is time in years)
compounding: total interest = (p(1+r)^#periods) - p

Question 3

hurdle rate

Answer 3

required rate of return

Question 4

factors affecting interest rates

Answer 4

opportunity cost
risk
inflation

Question 5

Explain Opportunity cost

Answer 5

losses incurred on alternative options when other option is chosen
included in required rate of return

Question 6

Define Risk

Answer 6

possibility an actual return will differ from expected return

Question 7

describe inflation

Answer 7

rate that cost of goods/services increase over time

Question 8

3 main sources of inflation

Answer 8

increased demand for goods
rising costs
adaptive expectations (increase in wages due to inflation)

Question 9

3 components of interest rates

Answer 9

opportunity cost
risk
inflation

Question 10

interest rate formula with regard to risk

implications

Answer 10

i = Risk-free Rate + Risk Premium

• higher risk means higher required return
• higher inflation and opportunity cost require higher return

Question 11

risk-free rate

Answer 11

indicator of opportunity cost and inflation

rate of return on an investment with no risk

Question 12

risk premium

Answer 12

compensation for risk taken by investors

Question 13

nominal rate

Answer 13

rate that invested money grows over time
does not factor out inflation
does not measure actual purchasing power after time expires

Question 14

purchasing power formula

Answer 14

(1 + nominal rate / 1 + inflation) - 1

Question 15

formula for real rate

Answer 15

((nominal rate - inflation rate)/1 + inflation rate)

Question 16

approximate formula for real rate

Answer 16

nominal rate - inflation rate

Question 17

real rate and growth rate in purchasing power are essentially the same

Answer 17

yes

Question 18

3 variables affecting Time Value of Money

Answer 18

• amount of cash flows
• timing of cash flows
• rate that value of cash flows changes due to passage of time

Question 19

4 elements of TVM

Answer 19

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

Question 20

annuity

Answer 20

stream of equal amount cash flows paid at regular intervals

Question 21

types of annuities

Answer 21

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)

Question 22

future value formula

Answer 22

PV * (1+i)^n

Question 23

present value formula

Answer 23

FV / (1+i)^n

Question 24

compounding calculates what value

Answer 24

FV

Question 25

discounting calculates what value

Answer 25

PV

Question 26

basis point

Answer 26

1/100th percent

Question 27

return

Answer 27

gain/loss on an investment

Question 28

Holding period return

Answer 28

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

Question 29

expected return

Answer 29

hypothesized return

Question 30

real return

Answer 30

found by subtracting inflation

Question 31

definition of risk

Answer 31

possibility that real return will differ from expected return
amount of uncertainty about the outcome

Question 32

market risk

Answer 32

aka systematic or nondiversiable risk
risk inherent in the economy as a whole, in the entire market
cannot be diversified

Question 33

firm specific risk

Answer 33

aka nonsytematic/idiosyncratic/diversifiable risk

risk from factors affecting a particular firm

Question 34

interest rate risk

Answer 34

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

Question 35

default risk

Answer 35

probability of loss due to borrower defaulting on a loan

Question 36

price risk

Answer 36

potential for a security to decline in price relative to market
excludes market risk => diversifiable

Question 37

types of price risk

Answer 37

operating

financial

Question 38

risk separation

Answer 38

geographically dispersing assets to reduce risk

Question 39

risk transfer

Answer 39

risk reduction by transferring risk to another entity ie purchase insurance

Question 40

risk retention

Answer 40

decision to not transfer risk when cost of risk is less than insuring against it

Question 41

risk avoidance

Answer 41

manage risk by avoiding an activity that carries risk

Question 42

luxury good providers are more exposed to systematic risk and providers of staples

Answer 42

yes

Question 43

positive relationship between risk and return

Answer 43

yes

Question 44

time diversification

Answer 44

stocks are less risky over longer periods of time vs shorter periods of time

Question 45

pv/fv sign for cashflow received vs paid

Answer 45

received =  +
paid = -