unit 5 | TVM interest rates

Question 1

Effective Annual Rates

Answer 1

• Indicates the total amount of interest that will be earned at the end of one year
• Considers the effect of compounding (exponent)
• Adjusting the EAR to an Effective rate over different time periods

Question 2

What is the effect of compounding?

Answer 2

Total amount of interest earned at the end of the year

Question 3

Other names for “effect of compounding”

Answer 3

Effective annual yield (EAY) or annual percentage yield (APY)

Question 4

Suppose your bank account pays interest with an EAR of 6%. What amount of interest will you earn each month?

Answer 4

Monthly interest rate = (1 + EAR)^(1/compounding period) - 1

(1.06)^1/12 - 1 = 0.4868%

Question 5

Annual Percentage Rates (APR)

Answer 5

Indicates the amount of simple interest earned in 1 year

Question 6

Simple Interest

Answer 6

Amount of interest earned without the effect of compounding

Question 7

Can APR be used as a discount rate?

Answer 7

The APR does not reflect the true amount earned over 1 year, the APR itself cannot be used as a discount rate & is not an effective annual rate (EAR)

Question 8

Term (Mortgage terms example)

Answer 8

5 years payable monthly
- The 7.252% is paid for 5 years. At the end of 5 years, you re-negotiate a new rate based on where interest rates are 5 years from now

Question 9

Amortization (Mortgage terms example)

Answer 9

25 years (the mortgage is paid off in 25 years if nothing else changes to payments)

Question 10

What is the Principal owed after 2 years?

Answer 10

• The principal owed is the PV of the mortgage
• The mortgage payment is known
• Calculate the PV of the mortgage after 2 years by…
  > Or by a mortgage amortization table