Unit 4: Interest Rates, TVM, and Risk and Return

Single-period Investment

An investment that takes place over one period, usually one year.

You plan to invest $100,000 in a 3 year Certificate of deposit that has a value of 5% compound interest rate. What is its future value? --$115,927. --$115,763. --$105,000. --$115,000..

--$115,000. FV = $100,000 + (3 × 5% × $100,000) = $115,000.

You plan to invest $100,000 in a 3 year Certificate of deposit that has a value of 5% compound interest rate. What is its future value? --$115,763. --$115,927. --$115,000. --$105,000.

--$115,763. FV = $100,000 × 1.053 = $115,763 Using Calculator: N = 3, I/Y = 5, PV = 100,000. [CPT] FV = $115,763.

What is the future value in 30 years of $100,000 invested today in a savings account earning a 1% simple interest rate ever year (rounded up to the nearest dollar)? --More than $134,785. --$30,000. --$143,785. --$130,000.

--$130,000. FV = $100,000 + (30 × 1% x $100,000) = $130,000.

What is the future value in 30 years of $100,000 invested today in a savings account earning a 1% compound interest rate every year (rounded up to the nearest dollar)? --$134,785. --$130,000. --$30,000. --More than $134,785.

--$134, 785.

You have $300,000 that you want to invest in a one year Certificate of Deposit (CD) with a 4% annual interest rate. what will be the value of that CD in a year? --$301,200. --$420,000. --$315,000. --$312, 000.

--$312,000.

You own a perpetuity that pays $1000 in the first year. It has a 5% annual interest rate and a 2% annual growth rate. What is the present value of the perpetuity? --$33,333. --$14,286. --$50,000. --$20,000.

--$33,333. PVGP = A1/(i - g) = $1000/(0.05 - 0.02) = $33,333.

An investment portfolio has a 30% chance of earning $125,000 in a year, and a 40% chance of earring $50,000, a 15% chance of earning nothing and a 15% chance of losing $20,000. What is the expected return? --$62,000. --$50,000. --$38,750. --$54,500.

--$54,500.

What is the present value of $100,000 that will be received 5 years from today if you face a 10% compound interest rate every year (rounded up to the nearest dollar)? --$72,092. --$52,092. --$62,092. --$82,092.

--$62,092. PV = $100,000/(1.105) = $62,092 Using Calculator: N = 5, I/Y = 10, FV = 100,000. [CPT] PV = $62,092.

You expect to receive a payment of $1 million in a year. The annual interest rate is 5%. What is the present value of the future payment? --$105,000. --$995,025. --$952,381. --$666,667.

--$952,380. PV = $1 million/(1.05) = $952,381 Using Calculator: N = 1, I/Y = 5, FV = $1 million. [CPT] PV = $952,381

A portfolio has $70,000 of bonds and $30,000 of stock. The bonds are 80% likely to have a 10% return and 20% likely to have a 0% return. The stock is 50% likely to have a 20% return and 50% likely to have a 10% loss. What is the expected return? --13%. --2.9%. --7.1%. --5.9%.

--7.1%. Expected return on bonds = (80% × 10%) + (20% × 0) = 8% Expected return on stock= (50% × 20%) + (50% × -10%) = 5%Overall expected return = ( 70/100 × 8%) + (30/100 × 5%) = 7.1%

A portfolio is composed of 30% stock, 20% bonds, and 50% mutual funds. The stock is expected to have a 10% return, the bonds a 5% return and the mutual funds a 7% return. What is the expected return of the portfolio? --7.3%. --8.1%. --7%. --7.5%.

--7.5%. Expected return = (30% × 10%) + (20% × 5%) + (50% × 7%) = 7.5%.

Of the following car financing options, which one would you prefer while assuming that you prefer paying the least amount of dollars and that you face a 10% annual compound interest rate on all your financial decisions? --A l ump-sum payment of $20,000 in two years from today. --A lump-sum payment of $19,000 today only. --A lump-sum payment of $20,000 today only. --A payment of $10,000 today and another of $10,000 in one year from today.

--A lump-sum payment of $20,000 in two years from today. PV = $20,000/(1.102) = $16,529 gives the smallest payment in today's value. Using Calculator: N = 2, I/Y = 10, FV = 20,000. [CPT] PV = $16,529.

Which prediction based on a description of the yield curve is not correct? --An inverted yield curve suggests that interest rates will be dramatically cut. --A normal yield curve suggests that interest rates will remain the same in the future. --A flat yield curve suggest that interest rates will be cut. --A normal yield curve suggests that interest rates will be raised in the future.

--A normal yield curve suggests that interest rates will remain the same in the future.

Which answer is not a cost to the investor that is included in the calculation of an investment's interest rate? --Risk of a bad investment. --Opportunity Cost. --Brokerage commissions and fees. --Inflation.

--Brokerage commissions and fees.

The cost of money is not related to the concept of: --depreciation. --the time value of money. --opportunity cost. --time preference.

--Depreciation.

Which option is an adequate method to reduce an investor's risk through diversification? --Invest in a small pool of stocks from companies in the same industry. --Invest in a start-up business that has a broad ownership among a large number of investors. --Invest in a broad pool of US and international stocks and bonds. --Invest in the common stocks of the two companies that have performed the best in the last 5 years.

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

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. --Foreign investment risk. --Asset-backed risk. --Model risk.

--Prepayment risk.

You are considering investing in the common stock of a major US Corporation. Which answer is an example of systematic risk? --Risk related to the possibility of foreign expropriation of the company's property. --Risk related to an impending lawsuit against the company. --Risk resulting from a general decline in the US stock markets. --Risk resulting from general unrest in the company's labor force.

--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? --Liquidity preference. --Inflationary expectations. --Risks of investments. --Deferred consumption.

--Risks of investments.

The most common measure of risk in finance is the: --expected outcome. --expected return. --standard deviation. --standard outcome.

--Standard deviation.

Which answer is not a factor that influences market interest rates? --Alternative investments. --Inflationary expectations. --Deferred consumption. --Stock market activity.

--Stock market activity.

Which statement accurately describes systematic risk? --Systematic risk is what provides a stock's "risk premium." --An example of a systematic risk is if you own stock in a company that has liquidity problems. --By diversifying your stock portfolio, you can minimize systematic risk. --Systematic risk is uncertainty associated with a company or industry in which you invest.

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

The risk that remains after an inventory has extensively diversified his portfolio is primarily: --systematic risk. --variance risk. --unsystematic risk. --standard deviation risk.

--Systematic 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. --The expectation hypothesis. --Time Value of Money Theory. --The liquidity premium theory.

--The segmented market hypothesis.

When crowding occurs, investment spending decreases. What causes this phenomenon? --The total money supply is increased, increasing interest rates. --The total money supply is decreased, increasing interest rates. --The total money supply is decreased, decreasing interest rates. --The total money supply is increased, decreasing interest rates.

--The total money supply is increased, increasing interest rates.

What type of risk can an invest reduce through the process of diversification? --All risk can be reduced. --Systematic risk only. --Uncertainty. --Unsystematic risk.

--Unsystematic risk.

Which answer is not a correct description of a type of yield curve? --When long-term yields fall below short-term yields, the curve is inverted. --When long-term yields are higher than short-term yields, the curve is normal. --When all maturities have similar yields, the resulting curve is flat. --When long-term yields fall below short-term yields, the curve is flat.

--When long-term yields fall below short-term yields, the curve is flat.

Which of the following describes the relationship between present value and future value? --When present value increases, the future value decreases, assuming all variables are constant. --The more time that passes, the higher the present value and the lower the future value. --The higher the interest rate, the higher the present value and the lower the future value. --When one increases, the other increases, assuming all variables are constant.

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

Risk Premium

A risk premium is the minimum amount of money by which the expected return on a risky asset must exceed the known return on a risk-free asset, or the expected return on a less risky asset, in order to induce

Variable Rate Mortgage

A variable-rate mortgage, adjustable-rate mortgage (ARM), or tracker mortgage is a mortgage loan with the interest rate on the note periodically adjusted based on an index which reflects the cost of the lender of borrowing on the credit markets.

Multi-period Investment

An investment that takes place over more than one periods.

Inflation

An increase in the general level of prices or in the cost of living.

Compound Interest

An interested rate applied to multiple applications of interest during the lifetime of the investment.

Liquidity

Availability of cash over the short term; ability to service short-term debt.

Yield

Commonly refers to the dividend, interest or return the investor receives from a security like a stock or bond, and is usually reported as an annual figure.

Simple Interest

Interest paid only on the principal.

Liquidity Premium

Liquidity premium is a term used to explain a difference between two types of financial securities (e.g. stocks), that have all the same qualities except liquidity.

Inflationary Expectations

Most economies generally exhibit inflation, meaning a given amount of money guys fewer goods in the future than it will now. The borrower needs to compensate the lender for this. if the inflationary expectation goes up, then so does the market interest rate and vice versa.

Liquidity Preference

People prefer to have their resources available in a form that can immediately be exchanged, rather than a form that takes time or money to realize. If people are willing to hold more money in hands for convenience, the money supply will contract, increasing the market interest rate.

Systematic Risk

Systematic or non-diversifiable risk is a term given to the portion of risk in a portfolio that cannot be diversified away by holding a pool of individual assets and therefore commands a return in excess of the risk-free-rate.

Effective APR

The amount you pay after fees and compound interest have been added to the charges.

Annual Percentage Rate (APR)

The annual rate charged for borrowing or earned through an investment, expressed as a percentage that represents the actual yearly cost of funds over the term of a loan.

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.

Interest Rates

The cost of borrowing money; generally refers to the interest charged by a lender such as a bank on a loan.

Interest rate (i or r)

The cost of not having money for one period, or the amount paid on an investment per year.

Expected Value

The expected value of a random variable is the weighted average of all possible values that this random variable can take on.

Alternative Investments

The lender has a choice between using his money in different investments. If he chooses one, he forgoes the returns from all the others. Different investments effectively compete for funds, boosting the market interest rate up.

Compounding Period

The length of time between the points at which interest is paid.

Period

The length of time during which interest accrues.

Required Rate of Return

The minimum annual percentage earned by an investment that will induce individuals or companies to put money into a particular security or project.

Growth Rate

The percentage by which the payments grow each period.

Interest Rate Risk

The potential for loss that arises for bond owners from fluctuating interest rates.

Political Risk

The potential loss for a company due to non market factors as macroeconomic and social policies.

Premium

The price above par value at which security is sold.

Monetary Policy

The process by which the monetary authority of a country controls the supply of money, often targeting a rate of interest for the purpose of promoting economic growth and stability.

Discounting

The process of determining how much money paid/received in the future is worth today. You discount future values of cash back to the present using the discount rate.

Capitalization

The process of finding the future value of a sum by evaluating the present value.

Term Structure of Interest Rates

The relationship between the interest on a debt contract and the maturity of the contract.

Systematic Risk

The risk associated with an asset that is correlated with the risk of asset markets generally often measured as its beta.

Cash Flows

The sum of cash revenues and expenditures over a period of time.

Future Value

The value of an asset at a specific date. It measures the nominal future sum of money that a given sum of money is "worth" at a specified time in the future, assuming a certain interest rate, or more generally, rate of return, it is the present value multiplied by the accumulation function.

Future Value (FV)

The value of money in the future.

Present Value (PV)

The value of the money today.

Risks of Investment

There is always a risk that the borrower will abscond, die, go bankrupt, or otherwise default on the loan. This means that a lender generally charges a risk premium to ensure that he is compensated for those that fail, across all his investments. The greater the risk, the higher the market interest rate will get.

Accrue

To add or grow.

Abscond

To flee; to withdraw from.

Periods (t or n)

Units of time. Usually one year.

Unsystematic Risk

Unsystematic or diversifiable risk is a term given to the portion of risk in a portfolio that can be diversified away by holding a pool of individual assets.

Deferred Consumption

When money is loaned, the lender delays spending the money on consumption goods. According to time preference theory, people prefer goods now to goods later. In a free market there will be a positive interest rate.