D076 Finance Skills for Managers - Unit 3
3 Things that determines interest rates
1. Opportunity Cost 2. Risk 3. Inflation
3 Variables of TVM
1. The amount of cash flows 2. The timing of cash flows 3. The rate at which the value of cash flows changes due to the passage of time.
In 1980, the inflation rate was 5% and a particular investment gave a return of 15%. In 2010, the inflation rate was 5% and the same investment gave a return of 12%. In which year did stockholders gain greater purchasing power and why?
1980 because the real rate was higher than in 2010
You are considering purchasing a house for $250,000. You have two options to finance it. One is a 20-year mortgage with an interest rate of 3.5%, and the other is a 30-year mortgage with an interest rate of 3.5%. Which mortgage option requires you to pay more in total interest?
A 30-year mortgage
Treasury Bill
A bill issued by the U.S. government as a financial security with no interest and a maturity of less than one year; abbreviated as T-bill
Risk Retention
A company's or individual's decision to take responsibility for a particular risk instead of transferring the risk to someone else.
What is a default risk?
A firm-specific risk that comes from the probability of a loss resulting from a borrower's failure to repay a contractual obligation
What is the term for the return over the entire period that an investor owns a financial security?
A holding period return
Expected Return
A hypothesized estimate of future prices or returns under different scenarios based on expectational data.
What is an expected return?
A hypothesized estimate of future returns under different scenarios based on expectational data
Treasury note
A note issued by the U.S. government as a financial security with a fixed interest rate and a short maturity between 1 and 10 years; abbreviated as T-note
Which statement correctly contextualizes what a return is? - A return is the gain that one makes on an investment over a period of time. - A return is probably one of the simplest terms in finance but is used only as part of data analytics. - A return is the amount of time it will take for an investor to recuperate their initial investment. - A return is the gain or loss on an investment over some period of time.
A return is the gain or loss on an investment over some period of time.
Annuity
A stream of cash flows of an equal amount paid every consecutive period.
Risk Avoidance
A way to manage risk by not performing an activity that may carry risk.
You signed an apartment contract today. You are going to pay $1,500 at the beginning of each month for the next 12 months, starting today. What type of cash flows is this contract?
An annuity due
Which phrase accurately depicts what interest rate risk is?
An example of market risk where the value of a bond is affected by changes in interest rates
Why does an increased demand for goods and services cause inflation?
An increase in demand often causes an insufficient supply in the market, which causes prices to go up until the demand is once again equal to the supply.
Real Rate
An interest rate that is adjusted to remove the effects of inflation.
What is the name for the interest rate expressed on an annual basis?
Annual percentage rate
Twenty years ago, Mateo started an investment account with $2,000. He then invested $100 into the account every month at the end of each month. Today, he has $46,528 in the same account. What is the term for the $100 monthly cash flows?
Annuity
How is the interest rate expressed?
As a percentage
Suppose Sophia is considering a new stock investment for her retirement account. This stock has significant risk, but is quite popular in the market. Inflation for the next few years is expected to be 2-3% per year, and the current U.S. Treasury rates are about 2%. How should she use this information to decide what type of return she can expect from the stock?
Based on the inflation rate, she should expect this stock to provide a return higher than this for the associated risk.
Why does the time value of money play an important role in financial decision-making?
Because the benefits of investments received at different times are comparable only when you consider the time value of money
U.S. Treasuries
Bonds, Bills, and notes issued by the U.S. government; considered to the the highest quality securities available.
Why would a company or individual want to retain risk? - Both companies and individuals retain risk when they cannot afford the cost to reduce the risk. - Companies never retain risk because they are already prone to so much market risk. - Both companies and individuals retain risk when they believe that the cost of pursuing an activity is less than the alternative. - Individuals retain risk because they are unable to transfer that risk to other entities.
Both companies and individuals retain risk when they believe that the cost of pursuing an activity is less than the alternative.
You just inherited $25,000 from a long-lost relative. You decide to put the money in a savings account for the time being. What would be considered an opportunity cost of putting the money in savings? - Buying a brand new car worth $25,000 - Earning interest on the $25,000 you just put in savings - Having access to the money should you have some sort of financial emergency - The fees you must pay to your bank to hold the $25,000
Buying a brand new car worth $25,000
Which situation is a real-life example of risk transfer? - Buying home insurance—risk is transferred from the policyholder to the insurer - Using your 401(k) investment to buy a home—risk is transferred from the 401(k) fund to the home - Purchasing U.S. Treasury bonds—risk is transferred from the holder of the bond to the government - Changing investment vehicles—risk is transferred from one asset to another
Buying home insurance—risk is transferred from the policyholder to the insurer
Which type of interest rate includes interest on interest in addition to interest on the principal?
Compound Interest
Total Interest=Principal×(1+Interest Rate)^Number of Periods−Principal
Compounding Interest
Perpetuity
Constant stream of identical cash flows that continues forever.
What is the name for the process of "spreading" money over many different assets?
Diversification
Compounding
Finding a future value given a present value
Discounting
Finding a present value given a future value.
1. A company's labor force goes on strike 2. A company's top management dies in a plane crash 3. An oil tank bursts and floods a company's production area 4. Better-than-expected earnings
Firm-Specific Risk Factor Examples
Which type of risk can be reduced by adding a variety of different assets into a portfolio? - Interest rate risk - Systematic risk - Firm-specific risk - No risk
Firm-specific Risk
Which statement accurately describes firm-specific risk?
Firm-specific risk is the risk associated with problems that companies may face because of lawsuits, labor problems, or management decisions, among other factors.
If you invest $10,000 today and then $5,000 each year for the next 5 years into an investment with an interest rate of 4%, you can withdraw $39,248.14 in 5 years. What does $39,248.14 represent?
Future Value
A company that produces soap, shampoo, lotion, and other personal care products has recently taken a hit due to a competitor's new product line. The company decides to reduce wages for its labor force to save money while the company focuses on building up its reputation again, but the company's labor force goes on strike to protest the pay cuts. What type of risk does the strike represent?
Idiosyncratic risk
Five years ago, Ahmed decided he was going to save up to purchase a car with cash. The car he wants is priced at $15,000. He saved $245 a month in an account that gave him enough interest to have $15,000 in five years. Today, he pulled out $15,000 from his account to buy the car, but the price of the car is now $16,562. Which component of the required rate of return did Ahmed forget to consider?
Inflation
What is the rate at which the average price level of particular goods and services in an economy increases over a period of time?
Inflation Rate
What does the risk-free rate indicate
Inflation and opportunity cost
What is the term for the risk that changes in interest rates will impact the value of a bond?
Interest Rate Risk
What is the term for the percentage of the principal that a lender charges a borrower for the use of assets?
Interest rate
What is the main purpose of charging interest?
It allows borrowers to pay to use the assets of another entity to accomplish their own goals.
Why is the required rate of return also known as the hurdle rate?
It is the minimum rate that a firm must surpass to accept a project.
1. Unexpected changes in interest rates 2. Unexpected changes in cash flows due to tax changes 3. Business cycle changes 4. Changes in laws 5. Natural disasters 6. Political instability 7. Currency value changes
Market Risk Factor Examples
What makes market risk different from firm-specific risk?
Market risk cannot be diversified away, and firm-specific risk can.
Which type of interest rate is the rate at which invested money grows for a certain period time?
Nominal Rate
Which description below correctly identifies one type of price risk?
Operating risk
What is a component of the required rate of return? - Hurdle Rate - Simple Interest - Compound Interest - Opportunity Cost
Opportunity Cost
What is the name for a series of equal payments made at the end of consecutive periods over a fixed length of time?
Ordinary Annuity
Annuity Due
Paid at the beginning of consecutive periods
Lolo invested $30,000 today in an account that gives 3% interest. Starting one year from today, she will be able to pull out little over $3,500 a year. What does the $30,000 represent?
Present Value
What happens to prices in a market in which there is inflation?
Prices rise.
What is the compensation for risk given to investors called?
Risk Premium
How is risk separation different from diversification? - Risk separation involves dispersing resources across different investment vehicles within the same asset class. - Risk separation involves dispersing resources geographically in one location instead of across several locations. - Risk separation involves dispersing assets across economies instead of focusing them in one economy - Risk separation involves dispersing assets geographically instead of concentrating them in one location.
Risk separation involves dispersing assets geographically instead of concentrating them in one location
Market Risk
Risk that is inherent in the economy as a whole and cannot be diversified away; also called systematic risk or nondiversifiable risk
Firm-Specific Risk
Risk that results from factors at a particular firm and can be reduced through diversification; also called nonsystematic risk or idiosyncratic risk.
Which component of an interest rate is an indicator of inflation and opportunity cost?
Risk-Free Rate
Ordinary Annuity
Series of equal payments made at the end of consecutive periods over a fixed length of time.
Annual Interest = Principal x Interest Rate
Simple Interest
2 Types of interest
Simple and Compound
What is used to measure total risk?
Standard Deviation
How does the amount of time affect the risk associated with different investment vehicles? - Time does not affect the level of risk associated with each investment vehicle. - Stock investments are more risky over a shorter period of time than over a longer period of time. - Corporate bonds are riskier over time because it is uncertain whether the company will be around that long. - Treasury bills are more risky over a longer period of time than over a short period of time.
Stock investments are more risky over a shorter period of time than over a longer period of time.
Annual precentage rate (APR)
The annual interest rate that is charged for borrowing money or that is earned through investment.
Risk Premium
The compensation for the amount of risk taken on by investors.
Cost of Capital
The cost to a firm to use an investor's capital; see interest rate
What makes the expected return subjective and different from other types of returns?
The expected return is based on expectational data and the probability of different scenarios occurring.
Time Value of Money (TVM)
The idea that money that is available at the present time is worth more than the same amount in the future.
Simple Interest
The interest earned only on the principal.
Compounding Interest
The interest on the principal plus the interest on earned interest.
Correlation
The measure of the relationship between two variables that move in relation to each other
Return
The money gained or lost on an investment over a certain period of time.
Discount Rate
The name for interest rate when used in time value of money calculations.
The word risk is used in many different contexts. How is risk defined in finance?
The possibility that the realized or actual return will differ from the expected return
Nominal Rate
The rate at which invested money grows for a certain period of time.
What is the inflation rate?
The rate at which the average price level of a basket of goods and services in an economy increases
Holding Period Return
The return over the entire period that an investor owns a financial security.
What tends to happen to the risk of an investment that offers a higher return? - The risk of a well-diversified portfolio with high returns is always higher than the highest-risk stock in the portfolio. - The risk is lower for an investment with a higher return. - The risk is higher for an investment with a higher return. - The risk is not affected when an investment has a higher return.
The risk is higher for an investment with a higher return.
Future Value
The worth of cash flows in terms of the dollar amount in the relative future.
Present Value
The worth of cash flows in terms of the dollar amount in the relative past.
Why would a long-term investment require a higher rate of return?
There is greater risk involved and a higher opportunity cost.
What is the name for the concept that a dollar today is worth more than a dollar in the future?
Time Value of Money
Which statement correctly identifies the relationship between systematic risk and different types of firms? - Utility companies have high systematic risk because as the market moves up and down, more people will invest in their stocks and bonds. - Utility companies have low systematic risk because as the market moves up and down, their level of risk will also move up and down but in a diminished way. - Luxury good providers have low systematic risk because as the market moves up and down, their level of risk will also move up and down but in a diminished way. - Luxury companies have high systematic risk because as the market moves up and down, more people will invest in their stocks and bonds.
Utility companies have low systematic risk because as the market moves up and down, their level of risk will also move up and down but in a diminished way.
Why is built-in inflation linked to adaptive expectations?
Workers want higher wages to keep their standard of living as prices increase, which pushes the prices even higher.
Standard Deviation
a measure of dispersion of possible outcomes about the mean (average).
Risk Reduction
a series of techniques that help reduce the amount of risk a person is exposed to by taking a particular action. AKA Risk Mitigation
Fisher Effect
an economic theory developed by Irving Fisher holding that the real interest rate is equivalent to the nominal interest rate minus the expected inflation rage.
Risk-Free Rate
an indicator of inflation and opportunity cost and describes the rate on an investment with no risk.
Price Risk
is the potential for the decline in the price of a financial security or an asset relative to the market.
Risk Seperation
risk management technique that involves dispersing assets geographically instead of concentrating them in one location.
Risk Transfer
risk management technique that involves reducing the amount of risk you are exposed to by transferring that risk to another entity.
Opportunity Cost
the loss of potential gain from other alternatives when one alternative is chosen.
Interest Rate
the percentage of the principal that a lender charges a borrower for the use of assets.
Risk
the possibility that the realized or actual return will differ from the expected return.
Default Risk
the probability of a loss resulting from a borrower's failure to repay a contractual obligation.
Interest Rate Risk
the probability that changes in interest rates will impact the value of a bond.
Diversification
the process of "spreading" your money over many different assets.
Required rate of return
the rate of return or compensation that an investor or a lender will accept for investments such as stocks, bonds, or loans.
Inflation
the rate which the average price level of goods and services in an economy increases over a period of time.
