FINA Ch5

MRP stands for

Maturity Risk premium

Time preference for comsumption

The preference of a consumer for current consumption as opposed saving for future consumption.

The value of any asset is

the PV of the Expected Cash Flow discounted at an investor's required rate of return.

The more money available,

the cheaper it is

The higher the expectations for inflation,

the higher the interest rate

The higher the rate of Interest.

the lower a firm's profits

Norminal Rate is

rate without inflation

Federal Reserve Policy;

1) Controls supply of money in the economy 2) Open Market Operations -Buy/Sell US treasury securities 3) Setting the Discount Rate -The rate at which the Treasury loans to bank

4 Other factors that influence interest rate levels are

1) Federal Reserve Policy 2) Federal deficits 3) International Business (Foreign trade balance) 4) Economic Activity

4 factors that affect the cost of money

1) What price suppliers of capital demand and what price users of capital are willing to pay. m(Supply and Demand, 2) Time; how long will the capital be used. 3) Risk associated with getting paid back. 4) Inflation Expectations.

Inverted, Abnormal, or Yield Curve

A downward-sloping yield curve

Yield Curve

A graph showing the relationship between yields and maturities of securities on a particular date.

Liquidity Premium (LP)

A premium added to the rate on a security if the security cannot to be converted to cash on short notice at a price that is close to the original cost.

Inflation Premium (IP)

A premium investors add to the real risk-free rate of return to account for inflation that is expected to exist during the life of an investment.

Maturity Risk Premium (MRP)

A premium that reflects interest rate risk; bonds with longer maturities have greater interest rate risk. Because their prices change more than price of shorter-term bonds for a given change in market rates.

Yield or Rate or Return =

Amount Received / Amount Provided

Normal Yield Curve

An upward-sloping yield curve.

Cost of Money is measured in

Interest Rate

LP stands for

Liquidity Premium

DRP stands for

Default Risk Premium

Economic Activities are

Expansion Contraction Recession Inflation

Measures of Returns are

Holding Period Return Average Return Geometric Return

Risk

In a financial market context, the chance that the financial asset will not earn the return promised.

2 components to yield are

Income (always positive) Capital gains

Open market operations

Operations in which Federal Reserve buys or sells Treasury securities to expand or contract the U.S. money supply.

Holding Period Return is

Return received over the holding period. Does not account for Time Value of Money.

Average Return is

Return received/Holding Period. Does not account for Time Value of money. Used deceptively to inflate actual annualized returns.

Nominal Rate =

Risk Free Rate + [DRP+LP+MRP]

Default Risk Premium (DRP)

The difference between the interest rate on a U.S. Treasury Bond and a corporate bond of equal maturity and marketability; compensation for the risk that a corporation will not meet its debt obligation.

Term structure of interest rates

The relationship between yield and maturities of securities.

Production Opportunity

The return available within an economic from investment in a productive asset.

Inflation

The tendency of the general prices to increase over time.

The greater the default risk, the higher the default risk premium. a. True b. False

a. true

The interest rate on five-year Treasury bonds is 5.3%, the rate on six-year T-bonds is a. 5.5% b. 7.9% c. 5.3% d. 8.5%

b. 7.9%

Which of the following statements about the foreign trade deficit is true? a. A trade deficit reduces the interest rates. b. A trade deficit hinders measures to combat recession. c. The smaller the trade deficit, the more a country must borrow. d. A trade deficit occurs when a country's exports are greater than its imports.

b. A trade deficit hinders measures to combat recession.

The default risk premium is an important contributor in determining what happens to which of the following? a. Exchange rates b. Market interest rates c. Inflation rate d. Bond maturity date

b. Market interest rates

Which of the following actions is taken by the Federal Reserve during an expansion? a. The Federal Reserve purchases securities to increase interest rates. b. The Federal Reserve sells securities to increase interest rates. c. The Federal Reserve increases the trade deficit to decrease interest rates. d. The Federal Reserve increases the federal deficit to decrease interest rates.

b. The Federal Reserve sells securities to increase interest rates.

Which of the following statements regarding the cost of money (interest rate) is true? a. When rates in the financial markets increase, the prices (values) of financial assets increase. b. When rates in the financial markets increase, the prices (values) of financial assets decrease. c. The cost of money has no impact on the price of stock. d. The cost of money has no impact on the price of bonds.

b. When rates in the financial markets increase, the prices (values) of financial assets decrease.

Can the real interest rate ever be negative? a. No b. Yes

b. Yes

Nominal interest rate shows you a more accurate rate of return than the real interest rate. a. True b. False

b. false

If Chovita Corporation's stock pays a dividend of $40 and the investors need a 5% return on their investment, then the investors should pay _____ for the stock. a. $350 b. $720 c. $800 d. $200

c. $800

Which of the following statements regarding liquidity is true? a. Liquidity reduces as the asset is closer to maturity. b. All assets have the same degree of liquidity. c. Financial assets are more liquid than real assets. d. Treasury securities have the least liquidity.

c. Financial assets are more liquid than real assets.

Which of the following statements regarding supply/demand and interest rates is true? a. If the demand for funds increases, the interest rates decrease. b. If the supply of funds decreases, the interest rates decrease. c. If the supply of funds increases, the interest rates decrease. d. If the demand for funds decreases, the interest rates increase.

c. If the supply of funds increases, the interest rates decrease.

Which of the following statements is true regarding real and nominal interest rates? a. Real interest rates are nominal interest rates plus inflation b. Real interest rates are the ones you see in the market c. Real interest rates are nominal interest rates minus inflation d. Nominal interest rates are the real interest rate minus inflation

c. Real interest rates are nominal interest rates minus inflation

The term structure of interest rates is shown graphically with the: a. Beta curve analysis. b. Market return curve. c. Yield Curve. d. PE ratio curve.

c. Yield curve.

Real Rate is

rate net of inflation

The real risk-free rate of interest is the rate that a. would exist when liquidity is maximum. b. incorporates the credit rating of an asset. c. would exist when inflation is zero. d. reflects the maturity risk of an asset.

c. would exist when inflation is zero.

Geometric Return

considers Time Value of Money. It is the true annualized rate of return.

Which of the following increases the cost of money? a. Low inflation b. Low time preference for consumption c. High production opportunity d. High risk

d. High risk

The term structure of interest rates shows: a. How taxes impact the after tax rate of return on securities. b. How interest rates change over time. c. The relationship between default risk and return. d. How securities that are similar in every other way but have different maturities have different yields.

d. How securities that are similar in every other way but have different maturities have different yields.

A(n) _____ is a graph that shows the relationship between the yields and maturities of similar-risk securities. a. term yield line b. liquidity preference picture c. open market curve d. yield curve

d. yield curve

Risk-Free rate

includes an inflation premium