Unit 4 Video Notes Flashcards by M. L. Riley

Simple Interest Rates

You earn money on the original funds
No “interest on interest”
$100 x 10% for 10 years = $200 ($100 original + 10 interest payments of $10 each)

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Compound Interest Rates

You earn money on all funds
Yes “interest on interest”
$100 x 10% for 10 years = $259.37

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Interest Rate Drivers

Economists generally agree that the interest rates yielded by any investment take into account: the risk-free cost of capital, inflationary expectations*, the level of risk in the investment, and the costs of the transaction
* = Assume perfect information; inflation expectations are built into risk free instrument

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three theories to explain term structure

Expectation hypothesis
Liquidity premium theory
Segmented Market

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Expectation hypothesis

long-term rate determined by the market’s expectation for the short-term rate plus a constant risk premium

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Liquidity premium theory

long-term rates reflect investors’ future interest rate assumptions + a premium for holding long-term bonds.

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Segmented Market

S/T and L/T not substitutable, Rates are determined by Supply and Demand

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Term Structure of Interest Rates

Longer Maturity (time)= Higher Yield (interest rates)
Under “normal” conditions rates rise as time lengthens
Risk of Default
Unforeseen Events (“What If’s”)
Normal Curve = Upward sloping: Inverted = Downward

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Types of inflation

Cost push vs. demand pull

PUSHED by COSTS
Production at full capacity (can’t make any more)
Costs rise, so companies produce less and supply drops
No change in Demand
Companies that “stay in the game” charge more

PULLED by DEMAND
Production not at full capacity
Demand Increases
Companies must increase spending to produce more (pay overtime, etc)
Companies that “stay in the game” charge more

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Under “normal” conditions rates rise as

time lengthens

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There are three theories to explain term structure. They are:

Expectation hypothesis; long-term rate determined by the market’s expectation for the short-term rate plus a constant risk premium
Liquidity premium theory; long-term rates reflect investors’ future interest rate assumptions + a premium for holding long-term bonds.
Segmented Market: S/T and L/T not substitutable, Rates are determined by Supply and Demand

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Inflation type - Pushed by COSTS

Production at full capacity (can’t make any more)
Costs rise, so companies produce less and supply drops
No change in Demand
Companies that “stay in the game” charge more

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Inflation type - Pulled by Demand

Production not at full capacity
Demand Increases
Companies must increase spending to produce more (pay overtime, etc)
Companies that “stay in the game” charge more

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In the U.S., the Federal Reserve (often referred to as ‘The Fed’) implementsmonetary policieslargely by targeting the federal funds rate.
The federal funds rate is:

This is the rate that banks charge each other for overnight loans of federal funds, which are the reserves held by banks at the Fed.

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Expansionary monetary policy is

traditionally used to try to combat unemployment in a recession by lowering interest rates in the hope that easy credit will entice businesses into expanding.

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Contractionary monetary policy is intended to

slow inflation in hopes of avoiding the resulting distortions and deterioration of asset values.

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Crowding out is a phenomenon occurring when

expansionary fiscal policy paradoxically causes interest rates to rise, thereby reducing investment spending.
Increased government spending, financed by borrowing “crowds out” investment by the private sector

Time Value of Money (TVM) permits us to do the analyses to identify

the “cost (or value) of waiting”

Elements used to solve TVM problems

PV or Present Value – Money Now, lump sum stated in dollars (or euros, yen, etc)
FV, or Future Value – Money in the future, lump sum
N – Number of Periods – stated in terms of years or parts thereof
PMT – Payments, multiple sums of money, stated in dollars
I – Interest rate – FV is compounded, PV is discounted
TVM problems can be thought of as “Use four to solve five” - i.e., you will be given four of the inputs and use them to solve for the missing value

How much would $777 earning 7% be worth in a year?

SOLUTION FV = 777(1.07) , or , FV = $831.39

What would be the present value of $925, discounted at 8% for a year?

SOLUTION PV = 925/1.08, or, PV = $856.48

For a single period, simple interest and compound interest operate…

the same way

Bob deposited $333 for 3 years @ 3 %, what was it worth at that time?

SOLUTION PV = $- 333, N = 3, I/Y = 3

FV= 363.88

Barb won an award of $825,000 to be paid in 5 years. She believes she can earn 4.75% on her money. What’s the value of her award, today?

SOLUTION FV = $825,000 N = 5, I/Y = 4.75 PV= $654,159.71
This is the minimum Barb should accept now to transfer award to another party

annuities

Payments of a fixed amount at set frequency

ordinary annuity

Payments at end of period

Payments at beginning of period

annuity due

Miyako has been committed to a secure future for herself and her family since she first started working. She has been putting away $10,000 per year since she started working, and expects to have made 35 deposits when she stops working. She believes that she will earn 8.5% per year during that time. How much will she have when she stops working?

SOLUTION – PV = 0, (why?), N = 35, I/Y= 8.5, PMT = -10,000 | FV = 1,927,017

CONGRATULATIONS! You’re the latest Powerball Jackpot winner! You will receive your $45,000,000 jackpot as a series of 20 annual payments of $2,250,000 (before taxes). You decide that you “need cash now”, and call a structured settlement company. What is the minimum you would accept, if you assume a 5.5% discount rate?

SOLUTION – FV = 0, (why?), N = 20, I/Y= 5.5, PMT = -2,250,000 PV = 26,888,361

Elmer’s Mom bought 24 acres of desert land 40 years ago for $12,000. Today that land is on the outer edge of Scottsdale, AZ and was recently valued at $3,365,000. What was the rate of return on that land purchase?

SOLUTION PV -12,000, FV = 3,365,000, N =40 | I/Y = 15.13%

Sofia just received an email from the exiled prince of a small republic in Africa. His Highness informed her that funds sent to the central bank of his country, earn a preferred interest rate of 21% per year. She can ONLY withdraw her money after the account value reaches $1,000,000 USD. How long will it take, if she can Western Union $25,000 a year?

SOLUTION PV 0, FV = 1,000,000, PMT = -25,000 I/Y = 21 | N = 11.75

The units of the period (e.g., one year) must be the same as the units in

the interest rate (e.g., 7% per year).

You can buy a new car for $27,500. The nice finance manager at the dealership assures you that 9% is a very fair rate (given your credit score). She’ll even let you pay it off over 6 years

Monthly Payment – N=72, I = .75, PV = 27500, FV = 0 PMT = $495.70 TOTAL COST = $495.70 * 72 = $35,691

Categorization of Risk Tolerance

Risk-averse or risk-avoiding - can’t tolerate uncertainty Risk-neutral Risk-loving or risk-seeking – FOMO

The general progression in the risk-return spectrum is:

short-term debt, long-term debt, property, high-yield debt, and equity.

Risk vs return: Beta

Used to determine an investment's return sensitivity in relation to overall market risk. Beta describes the correlated volatility of an asset in relation to the volatility of a benchmark generally estimated via the use of representative indices, such as the S&P 500. Beta is also referred to as financial elasticity or correlated relative volatility, its non-diversifiable risk, its systematic risk, or market risk. Higher-beta investments tend to be more volatile and therefore riskier, but provide the potential for higher returns. Lower-beta investments pose less risk, but generally offer lower returns.

Different Types of Financial Risk

Interest Rate Risk – Rates change Credit Risk – Borrower can’t repay Liquidity Risk – Can’t convert to cash fast enough Market Risk – Decline in market  decline in investment Operational Risk – Bad management Foreign Investment Risk – Risk of investing in foreign markets Model Risk – Past doesn’t predict the future

The expected return of a potential investment can be computed by

multiplying the probability of a given event by the return in that case and adding together the products of each case

Variance

Variance is a statistical concept describing the range around expected return within which an investment return can be reasonably expected to fall. Used to measure the degree of risk in an investment Applied to three main asset classes – money market, bonds and stocks will enable the building of a portfolio for (almost) all investors Time Horizon and Variance Acceptance (risk acceptance) are positively correlated

Unsystematic risk, Portfolio Diversification

In General; Returns among multiple asset classes tend not to move in the same direction at the same time By creating a diversified portfolio, an investor can reduce risk (volatility) Differs from hedging, which seeks negative inter-asset correlations (and is usually expensive)! Portfolios can be either actively, or passively managed

Systematic risk

If You’ve Ever Heard the Phrase “You Can’t Beat the System”, or Something Similar, that Describes Systematic Risk Earlier, we talked about Beta. Beta is the measure of systematic risk Also referred to as “market risk” – it’s the risk of participating in the capital markets Investors receive compensation (higher return) for this risk, as it is not possible to reduce through diversification (systematic risk is also referred to as non-diversifiable risk)