Exam 2 COB 300B Questions with
Correct Answers
Future Value - Answer-The effect of compounding is small for a small number of
periods, but increases as the number of periods increases
TIme Line - Answer-helps you visualize what's happening in a particular problem
Future Value - Answer-The amount of to which a cash flow or serves of cash floes will
grow over a given period of time when compounded at a given interest rate.
Present Value - Answer-The value today of a future cash flow or series of cash flows
Compounding - Answer-The arithmetic process of determining the final value of a cash
flow or series of cash flows when compound interest is applied.
Compound Interest - Answer-occurs when interest is earned on prior periods' interest
Simple Interest - Answer-occurs when interest is not earned on interest
Discounting - Answer-The process of finding the present value of a cash flow or a series
of cash flows: discounting is the reverse of compounding.
Annuity - Answer-A series of equal payments at fixed intervals for a specified number of
periods.
Ordinary (or deferred) annuity - Answer-An annuity whose payments occur at the end of
each period.
Annuity Due - Answer-an annuity whose payments occur at the beginning of each
period
Perpetuity - Answer-A stream of equal payment at fixed interval expected to continue
forever
Uneven, or non-constant, cash flows - Answer-A series of cash flows where the amount
varies from one period to the next.
Payment (PMT) - Answer-this term designates equal cash flows coming at regular
intervals
Cash flow - Answer-This term designates a cash flow that's not part of an annuity.
,annual compunding - Answer-The arithmetic process of determining the final value of a
cash flow or series of cash flows when interest is added once a year.
semiannual compounding - Answer-The arithmetic process of determining the final
value of a cash flow or series of cash flows when interest is added twice a year.
Nominal Interest Rate - Answer-The contracted interest rate.
Effective annual rate - Answer-The annual rate of interest actually being earned, as
opposed to the quoted rate.
Amortized Loan - Answer-a loan that is repaid in equal payments over its life
Production Opportunities - Answer-The investment opportunities in productive (cash-
generating) assets.
Time Preferences for Consumption - Answer-Time preferences of consumers for current
consumption as opposed to saving for future consumption.
Risk - Answer-in a financial market context, the chance that an investment will provide a
low or negative return
Inflation - Answer-The amount by which prices increase over time
r - Answer-the quoted, or nominal rate of interest on a given security
r* - Answer-the real risk-free rate of interest (r* is pronounced r star and the rate that
would where no inflation was expected
rRF - Answer-the real risk-free rate of interest and the rate that would exist on a riskless
security in a world where no inflation was expected
IP - Answer-Inflation premium, IP is equal to the average expected rate inflation over
the life of the security. The expected future inflation rate is not necessarily equal to the
current inflation.
DRP - Answer-Default Risk Premium. This premium reflects the possibility that the
issuer will not pay the promised interest or principal at the stated time. DRP is zero for
US Treasury Securities, but it rises as the riskiness of the issuer increases.
LP (liquidity premium) - Answer-This is a premium charged by lenders to reflect the fact
that some securities cannot be converted to cash on short notice at a reasonable, LP is
very low for treasury securities and for securities issued by large, strong firms, but is
relatively high on securities issued by small, privately held firms.
,MRP= Maturity Risk Premium - Answer-As we will explain later, longer-term bonds,
even treasury bonds, are exposed to a significant risk of price declines due to increases
in inflation and interest rates, and a maturity risk premium is charged by lenders to
reflect this risk.
nominal, or quoted, risk-free rate, rRF - Answer-The rate of interest on a security that is
free of all risk; is proxied by the T-bill rate or the T-bond rate; includes an inflation
premium.
IP (Inflation Premium) - Answer-A premium equal to expected inflation that investors
add to the real risk-free rate of return
Default Risk Premium (DRP) - Answer-The difference between the interest rate on a US
Treasury bond and a corporate bond of equal maturity and marketability.
Liquidity Premium (LP) - Answer-A premium added to the equilibrium interest rate on a
security if that security cannot be converted to cash on short notice and at close to its
"fair market value"
Reinvestment rate risk - Answer-The risk that a decline in interest rates will lead to
lower income when bonds mature and funds are reinvested.
Term structure of interest rates - Answer-The relationship between bond yields and
maturities
Yield curve - Answer-A graph showing the relationship between bond yields and
maturities.
Normal Yield Curve - Answer-An upward slopping yield curve
Humped Yield Curve - Answer-A yield curve where interest rates on intermediate-term
maturities are higher than rates on both short- and long-term maturities.
Pure Expectations Theory - Answer-A theory that states that the shape of the yield
curve depends on investors' expectations about future interest rates.
Foreign Trade Deficit - Answer-The situation that exist when a country imports more
than it exports
Bond - Answer-a long-term debt instrument
Treasury Bonds - Answer-Bonds issued by the federal government sometimes referred
to as government bonds.
Coporate Bonds - Answer-bonds issued by corporations
, Municipal Bonds - Answer-Bonds issued by state and local government
Foreign bonds - Answer-Bonds issued by foreign government or by foreign corporations
Par Value - Answer-The face value of a bond.
Coupon Payment - Answer-the specified number of dollars of interest paid each year
Coupon Interest Rate - Answer-the stated annual interest rate on a bond
fixed rate bonds - Answer-bonds whose interest rate is fixed for their entire life
Floating rate bonds - Answer-bonds whose interest rate fluctuates with shifts in the
general level of interest rates
Zero Coupon Bonds - Answer-bonds that pay no annual interest but are sold at a
discount below par, thus compensating investors in the form of capital appreciation
Original Issue Discount (OID) Bond - Answer-any bond originally offered at a price
below its par value
Maturity Date - Answer-A specified date on which the par value of a bond must be
repaid
Originial Maturity - Answer-The number of years to maturity at the time a bond is issued
Call Provision - Answer-a provision in a bond contract that gives the issuer the right to
redeem the bonds under specified terms prior to the normal maturity date
Sinking fund provision - Answer-A provision in a bond contract that requires the issuer
to retire a portion of the bond issue each year
Convertible Bonds - Answer-Bonds that are the exchangeable at the option of the
holder for the issuing firms common stock
Warrants - Answer-long-term options to buy a stated number of shares of common
stock at a specified price
Putable Bonds - Answer-Bonds with a provision that allows investors to sell them back
to the company prior to maturity at a prearranged price
Income Bond - Answer-a bond that pays interest only if it is earned
Indexed, or purchasing power, bond - Answer-A bond that has interest payments based
on an inflation index so as to protect the holder from inflation.
Correct Answers
Future Value - Answer-The effect of compounding is small for a small number of
periods, but increases as the number of periods increases
TIme Line - Answer-helps you visualize what's happening in a particular problem
Future Value - Answer-The amount of to which a cash flow or serves of cash floes will
grow over a given period of time when compounded at a given interest rate.
Present Value - Answer-The value today of a future cash flow or series of cash flows
Compounding - Answer-The arithmetic process of determining the final value of a cash
flow or series of cash flows when compound interest is applied.
Compound Interest - Answer-occurs when interest is earned on prior periods' interest
Simple Interest - Answer-occurs when interest is not earned on interest
Discounting - Answer-The process of finding the present value of a cash flow or a series
of cash flows: discounting is the reverse of compounding.
Annuity - Answer-A series of equal payments at fixed intervals for a specified number of
periods.
Ordinary (or deferred) annuity - Answer-An annuity whose payments occur at the end of
each period.
Annuity Due - Answer-an annuity whose payments occur at the beginning of each
period
Perpetuity - Answer-A stream of equal payment at fixed interval expected to continue
forever
Uneven, or non-constant, cash flows - Answer-A series of cash flows where the amount
varies from one period to the next.
Payment (PMT) - Answer-this term designates equal cash flows coming at regular
intervals
Cash flow - Answer-This term designates a cash flow that's not part of an annuity.
,annual compunding - Answer-The arithmetic process of determining the final value of a
cash flow or series of cash flows when interest is added once a year.
semiannual compounding - Answer-The arithmetic process of determining the final
value of a cash flow or series of cash flows when interest is added twice a year.
Nominal Interest Rate - Answer-The contracted interest rate.
Effective annual rate - Answer-The annual rate of interest actually being earned, as
opposed to the quoted rate.
Amortized Loan - Answer-a loan that is repaid in equal payments over its life
Production Opportunities - Answer-The investment opportunities in productive (cash-
generating) assets.
Time Preferences for Consumption - Answer-Time preferences of consumers for current
consumption as opposed to saving for future consumption.
Risk - Answer-in a financial market context, the chance that an investment will provide a
low or negative return
Inflation - Answer-The amount by which prices increase over time
r - Answer-the quoted, or nominal rate of interest on a given security
r* - Answer-the real risk-free rate of interest (r* is pronounced r star and the rate that
would where no inflation was expected
rRF - Answer-the real risk-free rate of interest and the rate that would exist on a riskless
security in a world where no inflation was expected
IP - Answer-Inflation premium, IP is equal to the average expected rate inflation over
the life of the security. The expected future inflation rate is not necessarily equal to the
current inflation.
DRP - Answer-Default Risk Premium. This premium reflects the possibility that the
issuer will not pay the promised interest or principal at the stated time. DRP is zero for
US Treasury Securities, but it rises as the riskiness of the issuer increases.
LP (liquidity premium) - Answer-This is a premium charged by lenders to reflect the fact
that some securities cannot be converted to cash on short notice at a reasonable, LP is
very low for treasury securities and for securities issued by large, strong firms, but is
relatively high on securities issued by small, privately held firms.
,MRP= Maturity Risk Premium - Answer-As we will explain later, longer-term bonds,
even treasury bonds, are exposed to a significant risk of price declines due to increases
in inflation and interest rates, and a maturity risk premium is charged by lenders to
reflect this risk.
nominal, or quoted, risk-free rate, rRF - Answer-The rate of interest on a security that is
free of all risk; is proxied by the T-bill rate or the T-bond rate; includes an inflation
premium.
IP (Inflation Premium) - Answer-A premium equal to expected inflation that investors
add to the real risk-free rate of return
Default Risk Premium (DRP) - Answer-The difference between the interest rate on a US
Treasury bond and a corporate bond of equal maturity and marketability.
Liquidity Premium (LP) - Answer-A premium added to the equilibrium interest rate on a
security if that security cannot be converted to cash on short notice and at close to its
"fair market value"
Reinvestment rate risk - Answer-The risk that a decline in interest rates will lead to
lower income when bonds mature and funds are reinvested.
Term structure of interest rates - Answer-The relationship between bond yields and
maturities
Yield curve - Answer-A graph showing the relationship between bond yields and
maturities.
Normal Yield Curve - Answer-An upward slopping yield curve
Humped Yield Curve - Answer-A yield curve where interest rates on intermediate-term
maturities are higher than rates on both short- and long-term maturities.
Pure Expectations Theory - Answer-A theory that states that the shape of the yield
curve depends on investors' expectations about future interest rates.
Foreign Trade Deficit - Answer-The situation that exist when a country imports more
than it exports
Bond - Answer-a long-term debt instrument
Treasury Bonds - Answer-Bonds issued by the federal government sometimes referred
to as government bonds.
Coporate Bonds - Answer-bonds issued by corporations
, Municipal Bonds - Answer-Bonds issued by state and local government
Foreign bonds - Answer-Bonds issued by foreign government or by foreign corporations
Par Value - Answer-The face value of a bond.
Coupon Payment - Answer-the specified number of dollars of interest paid each year
Coupon Interest Rate - Answer-the stated annual interest rate on a bond
fixed rate bonds - Answer-bonds whose interest rate is fixed for their entire life
Floating rate bonds - Answer-bonds whose interest rate fluctuates with shifts in the
general level of interest rates
Zero Coupon Bonds - Answer-bonds that pay no annual interest but are sold at a
discount below par, thus compensating investors in the form of capital appreciation
Original Issue Discount (OID) Bond - Answer-any bond originally offered at a price
below its par value
Maturity Date - Answer-A specified date on which the par value of a bond must be
repaid
Originial Maturity - Answer-The number of years to maturity at the time a bond is issued
Call Provision - Answer-a provision in a bond contract that gives the issuer the right to
redeem the bonds under specified terms prior to the normal maturity date
Sinking fund provision - Answer-A provision in a bond contract that requires the issuer
to retire a portion of the bond issue each year
Convertible Bonds - Answer-Bonds that are the exchangeable at the option of the
holder for the issuing firms common stock
Warrants - Answer-long-term options to buy a stated number of shares of common
stock at a specified price
Putable Bonds - Answer-Bonds with a provision that allows investors to sell them back
to the company prior to maturity at a prearranged price
Income Bond - Answer-a bond that pays interest only if it is earned
Indexed, or purchasing power, bond - Answer-A bond that has interest payments based
on an inflation index so as to protect the holder from inflation.
