Unit 4 Video Notes

Question 1

Simple Interest Rates

Answer 1

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)

Question 2

Compound Interest Rates

Answer 2

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

Question 3

Interest Rate Drivers

Answer 3

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

Question 4

three theories to explain term structure

Answer 4

Expectation hypothesis
Liquidity premium theory
Segmented Market

Question 5

Expectation hypothesis

Answer 5

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

Question 6

Liquidity premium theory

Answer 6

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

Question 7

Segmented Market

Answer 7

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

Question 8

Term Structure of Interest Rates

Answer 8

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

Question 9

Types of inflation

Answer 9

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

Question 10

Under “normal” conditions rates rise as

Answer 10

time lengthens

Question 11

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

Answer 11

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

Question 12

Inflation type - Pushed by COSTS

Answer 12

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

Question 13

Inflation type - Pulled by Demand

Answer 13

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

Question 14

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:

Answer 14

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.

Question 15

Expansionary monetary policy is

Answer 15

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.

Question 16

Contractionary monetary policy is intended to

Answer 16

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

Question 17

Crowding out is a phenomenon occurring when

Answer 17

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

Question 18

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

Answer 18

the “cost (or value) of waiting”

Question 19

Elements used to solve TVM problems

Answer 19

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

Question 20

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

Answer 20

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

Question 21

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

Answer 21

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

Question 22

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

Answer 22

the same way

Question 23

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

Answer 23

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

FV= 363.88

Question 24

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?

Answer 24

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

Question 25

annuities

Answer 25

Payments of a fixed amount at set frequency

Question 26

ordinary annuity

Answer 26

Payments at end of period

Question 27

Payments at beginning of period

Answer 27

annuity due

Question 28

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?

Answer 28

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

FV = 1,927,017

Question 29

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?

Answer 29

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

Question 30

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?

Answer 30

SOLUTION PV -12,000, FV = 3,365,000, N =40

I/Y = 15.13%

Question 31

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?

Answer 31

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

N = 11.75

Question 32

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

Answer 32

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

Question 33

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

Answer 33

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

Question 34

Categorization of Risk Tolerance

Answer 34

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

Question 35

The general progression in the risk-return spectrum is:

Answer 35

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

Question 36

Risk vs return: Beta

Answer 36

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, itssystematic 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.

Question 37

Different Types of Financial Risk

Answer 37

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

Question 38

The expected return of a potential investment can be computed by

Answer 38

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

Question 39

Variance

Answer 39

Varianceis 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

Question 40

Unsystematic risk, Portfolio Diversification

Answer 40

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

Question 41

Systematic risk

Answer 41

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)