Principles of Finance - C708 - UNIT 4

Payments at the beginning of period

Annuity Due

Segment Market

Financial instruments of different terms are not substitutable; therefore supply and demand in the markets for short-term and long-term instruments is determined largely independently

Lower-beta investments

pose less risk, but generally offer lower returns.

Cost Push

- Production at full capacity (can't make more) - Costs rise, so companies produce less and supply drops - No change in demand.

Pulled by Demand

- Production not at full capacity - Demand Increases - Companies must increase spending to produce more.

What fact influences market interest rates?

Alternative investments, inflationary expectations, deffered consumption.

Unsystematic risk, portfolio diversification

By creating a diversified portfolio, an invest can reduce risk (volatility)

Which type of loan interest is calculated on both the principal of the loan and any accumulated interest called?

Compound interest

What is the difference between compounding and discounting of cash flows?

Compounding finds the future value of a present value and discounting finds the present value of a future value.

A manager is planning to receive a lump sum in the future and wants to determine the value of that lump sum in today's dollars. What must be done to the future cash flow to determine this value?

Discount

How can risk be managed in a financial environment?

Diversify investment assets

In the 1920's, a country experienced a monthly inflation of 30,000%.Which type of inflation occurred?

Hyperinflation

What are costs to the investor that is included in the calculation of an investment's interest rate?

Inflation, Opportunity Cost, Risk of a bad investment

What is a characteristic of compound interest?

Interest is earned on the principal balance and on all interest earned in previous periods.

What is a characteristic of simple interest?

Interest is only earned on the initial principal balance no matter how many periods have occurred.

Which option is an adequate method to reduce an investor's risk through diversification?

Invest in a broad pool of US and international stocks and bonds.

How is variance related to expected return?

Investments with high expected return will have a higher variance.

Which concept describes an investor preference for less risky short-term bonds over riskier long-term bonds?

Liquidity premium theory

Liquidity premium theory

Long-term interest rates not only reflect investors' assumptions about future interest rates but also include a premium for holding long-term bonds

Which scenario represents an opportunity cost?

Mary keeps money in her purse instead of partnering in her friend's popular lemonade stand. (think investing!)

What is time value of money (TVM)?

Money today is worth more than the same amount in the future.

Payments at end of period

Ordinary Annuity

Higher-beta

investments tend to be more volatile and therefore riskier but provide the potential for higher returns

A company issues a bond with the provision that it may pay off the debt early. Which type of risk is this bond subject to?

Prepayment risk.

Which investment involves low risk and yields a low return?

Putting money in a bank savings account

A young entrepreneur has a unique new business idea with the potential of achieving high profits starting in the second year of operation. This entrepreneur owns very few assets. Which capital financing strategy should the entrepreneur undertake to start up the business?

Seek equity from investors with a high tolerance for risk

Which term describes the gain or loss on an investment over a period of time?

Rate of return

You are considering investing in the common stock of a major US Corporation. Which answer is an example of systematic risk?

Risk resulting from a general decline in the US stock markets

Government bonds have lower interest rates than do actively traded corporate bonds of the same maturity because the default premium is lower for government bonds. This illustrates which of the major factors influencing market interest rates?

Risks of investment

The most common measure of risk in finance is the

Standard deviation.

The risk that remains after an investor has extensively diversified his portfolio is primarily

Systematic risk

Which statement accurately describes systematic risk?

Systematic risk is what provides a stock's "risk premium."

Expectation hypothesis

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

How would a company define risk in a financial environment?

The chance that an investment's actual return will be different than expected

What type of risk can an investor reduce through the process of diversification?

Unsystematic risk

Which yield curve theory is based on the premises that financial instruments of different terms are not substitutable and therefore the supply and demand in the markets for short-term and long-term instruments is determined largely independently?

The segmented market hypothesis

When crowding out occurs, investment spending decreases. What causes this phenomenon?

The total money supply is increased, increasing interest rates.

What is the purpose of an expected return?

To assess the potential value of an investment

Which of the following describes the relationship between present value and future value?

When one increases, the other increases, assuming all variables are constant.

Which term describes a graphic representation that uses a line to depict the relationship between the cost of borrowing (interest rates) and the term of a debt contract?

Yield curve

Compound Interest Rates

You earn money on all (including interest)

Simple Interest Rates

You earn money on the original funds (no interest on interest)

Yield Curve

a line that plots the interest rates, at a set point in time, of bonds having equal credit quality but differing maturity dates.

Variance

a statistical concept describe the range around the expected return within which an investment return cab be reasonable expected to fall

contractionary monetary policy

increase interest rates to combat inflation

A flat yield curve

suggest that interest rates will be cut.

An inverted yield curve

suggests that interest rates will be dramatically cut.

A normal yield curve

suggests that interest rates will be raised in the future.

Opportunity Cost

the cost of an opportunity forgone (and the loss of the benefits that could be received from that opportunity); the most valuable forgone alternative.

Expansionary monetary policy

to combat unemployment in a recession by LOWERING interest rates