BA 3303 Exam 2 Solved 100% Correct

Interest rates - ANSWER--The cost of borrowing money stated as a percentage of the loan -A measure of what an investor can expect on a debt related investment. Basis point - ANSWER-Common term for a unit of interest rates in finance 1 basis point = .01% 100 basis points = 1.00% Nominal interest rate - ANSWER-Interest rate that is observed in the marketplace Risk free rate - ANSWER-Interest rate on a debt instrument with no default, maturity, or liquidity risks (Treasury securities are the closest example). Basic equation of interest rates: rn = r r + i p + dfp - ANSWER-r n : Nominal Rate of interest r r : Real Rate of interest. Interest rate on a risk-free debt instrument when no inflation is expected i p : Inflation Premium Average inflation rate expected over the life of the security d fp : Default Risk Premium Compensation for the possibility of the borrower's failure to pay interest and/or principal when due Default risk - ANSWER-Risk that a borrower will not pay interest and/or repay the principal on a loan according to the agreed contractual terms nominal interest rate = 7% real rate = 2% inflation premium = 3% What is the default risk premium? - ANSWER-dfp = r n - r r - i p dfp = 7% - 2% - 3% dfp = 2% Interest rate risk - ANSWER-Definition: Possible price fluctuations in fixed-rate debt instruments associated with changes in market interest rates Reason: An inverse relationship exists between debt instrument values or prices and nominal interest rates in the marketplace Current 5 year US Treasury rates is 4.5%. Annual inflation is 2.5%. Assuming that the default premium is 0, what is the nominal interest rate ( also called market rate)? - ANSWER-7.0% U.S. Treasury Debt Obligations: Treasury Bills - ANSWER-Obligations that bear the shortest (up to one year) original maturities U.S. Treasury Debt Obligations: Treasury Notes - ANSWER-Obligations issued with maturities of one to ten years U.S. Treasury Debt Obligations: Treasury Bonds - ANSWER-Obligations issued with maturities usually over ten years and up to thirty years What is the "term structure of interest rates"? What is a "yield curve"? - ANSWER-Term structure: the relationship between interest rates (or yields) and maturities. A graph of the term structure is called the yield curve. Term structure - ANSWER-Relationship between interest rates or yields and the time to maturity for debt instruments of comparable quality. Yield curve - ANSWER-Graphic presentation of the term structure of interest rates at a given point in time. Term Structure Theories: Expectations Theory - ANSWER-Shape of the yield curve indicates investor expectations about future inflation rates Term Structure Theories: Liquidity Preference Theory - ANSWER-Investors are willing to accept lower interest rates on short-term debt securities which provide greater liquidity and less interest rate risk Term Structure Theories: Market Segmentation Theory - ANSWER-Interest rates may differ because securities of different maturities are not perfect substitutes for each other Types of Inflation: Inflation - ANSWER-Occurs when an increase in the price of goods or services is not offset by an increase in quality Types of Inflation: Cost-Push Inflation - ANSWER-Occurs when prices are raised to cover rising production costs, such as wages Types of Inflation: Demand-Pull Inflation - ANSWER-Occurs during economic expansions when demand for goods and services is greater than supply Types of Inflation: Speculative Inflation - ANSWER-Caused by the expectation that prices will continue to rise, resulting in increased buying to avoid even higher future prices Inflation risk - ANSWER-Risk that the rate of inflation will exceed the rate of return of an investment. Factoring into interest rates the average rate of inflation to compensate for erosion in purchasing power. Investment grade bonds - ANSWER-Ratings of BAA or higher (Aaa, Aa, or A) that meet financial institution investment standards High Yield Bonds - ANSWER--High-yield or junk bonds that have a substantial probability of default -Credit rating below BBB One of the six principles of finance is... - ANSWER-Money has a time value -Money can grow or increase over time and money today is worth less than money received in the future Time Value of Money is math of... - ANSWER-finance whereby interest is earned over time by saving or investing money What is principal? - ANSWER-Basic amount of funds invested. What is simple interest? - ANSWER-Interest earned only on the principal of the initial investment without the benefit of compounding Compounding is the process of... - ANSWER-moving cash flows forward in time Discounting is the process of... - ANSWER-moving cash flows back in time. The frequency with which interest is calculated is known as - ANSWER-compounding Amount of principal times the stated rate of interest for a single period with no compounding. - ANSWER-Simple interest Periodic rate - ANSWER-If the period of time for which we are examining simple interest is less than a year, the interest rate for a single period Annual Percentage Rate (APR) or a quoted interest rate. - ANSWER-If the instrument pays interest more than once a year Equivalent Annual Rate (EAR) - ANSWER-(1 + Periodic interest rate) m-1 Periodic interest rate = Annual percentage rate (APR) / number of compounding periods (m)