Growth in value comes not only from interest on the principal, but interest on the previously
earned interest
"Interest on interest"
ANSWER
Compound interest
Involves projecting the cash flows forward, on the basis of an appropriate compound inter-
est rate to the end of the investment's life
ANSWER
Future Value
Brings cash flows backwards to the beginning of an investment's life based on an appropri-
ate compound interest rate
ANSWER
Present Value
Required Rates of return for a particular investment
ANSWER
Equilibrium Interest Rates
The return that investors and savers require to willingly lend their funds
ANSWER
Market Rate of Return
1
,If someone borrows funds at 10% then they should discount payments to be made in the fu-
ture at that rate in order to get their equivalent value in dollars
"Today's value of money to be received in the future"
ANSWER
Interest rates = Discount Rates
If the market rate of interest on a one-year security is 5%, that opportunity is foregone when
current consumption is chosen over saving
ANSWER
Interest Rates = Opportunity Cost of Current Consumption
A theoretical rate on a single-period loan that has no expectation of inflation on it
ANSWER
Real Risk-free Rate of Interest
An interest rate that has been adjusted for inflation
- inflation has been subtracted out
ANSWER
Real Interest Rate
An investor's increase in purchasing power after adjusting for inflation
ANSWER
Real Rate of Return
Nominal Risk-free rates because they contain an inflation premium
ANSWER
2
,T-Bill Rates
Nominal Risk-free Rate
= Real Risk-free rate + expected inflation rate
ANSWER
Nominal Risk-free rate equation
Three types of Risk in Securities
ANSWER
1) Default Risk
2) Liquidity Risk
3) Maturity Risk
Risk that a borrower will not make promised payments
ANSWER
Default Risk
The risk of receiving less that fair value if an investment may have to be sold quickly for cash
ANSWER
Liquidity Risk
Prices of longer term bonds have more volatility than short term bonds
- Longer term bonds require a premium
-there is more time that can contribute to uncertainty in payments or value of bonds
ANSWER
Maturity Risk
3
, = Nominal Risk-free Rate
= Real Risk-free rate
+ Expected Inflation
+ Liquidity Premium
+ Maturity Premium
ANSWER
Required Interest rate on a Security
EAR = (1 + Periodic Rate)^m -1
Periodic Rate = stated annual rate / m
m= # compound periods per year
ANSWER
Effective Annual Rate Equation
Represents the actual annual rate of return being earned after adjustments have been made
for different compounding periods
Increases as compounding frequency increases
ANSWER
Effective Annual Rate
FV = PV(1+i)^n
ANSWER
Future Value of a Single Sum
PV = FV / (1+i)^n
4
earned interest
"Interest on interest"
ANSWER
Compound interest
Involves projecting the cash flows forward, on the basis of an appropriate compound inter-
est rate to the end of the investment's life
ANSWER
Future Value
Brings cash flows backwards to the beginning of an investment's life based on an appropri-
ate compound interest rate
ANSWER
Present Value
Required Rates of return for a particular investment
ANSWER
Equilibrium Interest Rates
The return that investors and savers require to willingly lend their funds
ANSWER
Market Rate of Return
1
,If someone borrows funds at 10% then they should discount payments to be made in the fu-
ture at that rate in order to get their equivalent value in dollars
"Today's value of money to be received in the future"
ANSWER
Interest rates = Discount Rates
If the market rate of interest on a one-year security is 5%, that opportunity is foregone when
current consumption is chosen over saving
ANSWER
Interest Rates = Opportunity Cost of Current Consumption
A theoretical rate on a single-period loan that has no expectation of inflation on it
ANSWER
Real Risk-free Rate of Interest
An interest rate that has been adjusted for inflation
- inflation has been subtracted out
ANSWER
Real Interest Rate
An investor's increase in purchasing power after adjusting for inflation
ANSWER
Real Rate of Return
Nominal Risk-free rates because they contain an inflation premium
ANSWER
2
,T-Bill Rates
Nominal Risk-free Rate
= Real Risk-free rate + expected inflation rate
ANSWER
Nominal Risk-free rate equation
Three types of Risk in Securities
ANSWER
1) Default Risk
2) Liquidity Risk
3) Maturity Risk
Risk that a borrower will not make promised payments
ANSWER
Default Risk
The risk of receiving less that fair value if an investment may have to be sold quickly for cash
ANSWER
Liquidity Risk
Prices of longer term bonds have more volatility than short term bonds
- Longer term bonds require a premium
-there is more time that can contribute to uncertainty in payments or value of bonds
ANSWER
Maturity Risk
3
, = Nominal Risk-free Rate
= Real Risk-free rate
+ Expected Inflation
+ Liquidity Premium
+ Maturity Premium
ANSWER
Required Interest rate on a Security
EAR = (1 + Periodic Rate)^m -1
Periodic Rate = stated annual rate / m
m= # compound periods per year
ANSWER
Effective Annual Rate Equation
Represents the actual annual rate of return being earned after adjustments have been made
for different compounding periods
Increases as compounding frequency increases
ANSWER
Effective Annual Rate
FV = PV(1+i)^n
ANSWER
Future Value of a Single Sum
PV = FV / (1+i)^n
4
