Studied by 10 people
What is the purpose of a financial system? what is it doing?
purpose: to move money from people who are not using them (savers) in order to invest (buying stocks, bonds…)
what do we mean by investment in economics?
the purchase of new capital, factory or house (land)
Give an example of an investment
firm buys $5000 worth of equipment
parents spend $300,000 to build new house
direct vs. indirect finance
direct: savers decide what to do with their money
indirect: the institution decide what to do with your money
Give an example of direct finance
savers buying their own stocks and bonds from companies of your choosing
Give example of indirect finance
when you put your money in the bank, and they take that money to invest in stocks and bonds of their choosing
Define interest rate
cost of borrowing money or compensation for saving the money
give an example of transaction with interest rate
you put money in a savings account that yields 2% every month.
CD for 1y that yields 4% every month
when we put things in storage, we pay a fee for the storage space. why then, we require a payment from banks to store our money with them?
(In other words: why do lenders need an incentive to loan money in a form of interest rate?)
storage unit: you’re paying for the space and security
bank: they use our money to invest. The more % they give to a savings account, the more people are willing to deposit money, therefore, more money to invest
2 key main difference between stocks vs. bonds
stocks: promised that you are going to get paid. you’re part of the payout, but not knowing when or how much
bonds: promised to be paid a certain amount when times come, and you’ll know how much you’re going to get out of it
what is the difference between stocks and bonds when a company goes bankrupt?
stock: last in line to be paid
bond: first in line to be paid
Define future value
how much money you’re going to get in the future
Define present value
$1 paid one year from now is less valuable than $1 paid today
How we determine the price of bonds (include formula)
by finding the PV
PV = sum( C / (1+r)^t) +…+ FV/(1+r)^t )
With a 5% discount rate, calculate PV for a security that pays $55 in 1 year and $133 in three years
PV= 55( 1+5%) + 133(1+5%)³ = 167.27
How we determine the price of stocks (include formula)
Suppose a family wants to save $60,000 for childʹ s tuition. The child will be attending college in 18 years. For simplicity, assume the family is saving for a one- time college tuition payment. If the interest rate is 2%, then about how much does this family need to deposit in the bank today? (2 points)
explain completely your answer.
PV = 60,000 / (1+2%)^18 = $42,722.47
Calculate the price of a 4-year coupon bond with face value of $1000 and coupon rate of 5% if discount rate is 7%
For how much can you sell it two years from now, if discount rate increases to 12%?
Define yield to maturity (include formula)
the interest rate that equals the PV of cf payment with its value today
Under which conditions do you need to calculate YTM?
You need to know: PV, FV,
when do we all “i” in the PV formula discount rate?
when do we call it YTM?
“discount rate” when we know the FV
“YTM” when given PV and FV
which one of the following bonds would you prefer to sell? (1 point)
$1,000 face-value with 10% coupon selling for $1,000
$1,000 face-value with 9% coupon selling for $1,000
$1,000 face-value with 7% coupon selling for $1,000
$1,000 face-value with 7% coupon selling for $1,100 (it has the lowest coupon rate for the selling price)
$1,000 face-value with 7% coupon selling for $800
bond 5, because as a seller, I would want to pay a lower % to the buyer in order to make money off of it (debt)
define rate of return
payments to the owner plus the changes of the security’s value
define capital gain
profit made from the sale of assets when its’ selling price exceeds the original price that was bought
why are some bond prices more volatile than others even though from the same seller?
it depends on factors: coupon rate, time to maturity, ratings.
Longer bonds are more volatile. 30y vs 3y (less volatile)
Example of a more volatile and less volatile bonds
more volatile bond: 10y bond with high interest rate (small companies, or distressed firm)
less volatile: US treasury (due to high credit rating and lower risk)
how do we correct interest rate for inflations? (include formula)
give example of a transaction and the correction for inflation
R= i - 3.14 ^e
i= nominal
3.14 = pei (inflation)
e= expected
why is it expected instead of actual inflation?
give example of expected and actual inflation
expected because nominal interest rate is a contract between today and the future, and since it’s a contract we don’t if inflation is going to happen (today or tomorrow)
what does negative real interest rate mean?
Give an example of a transaction with negative rate and explain completely what happens to purchasing power of both sides of transaction
when the inflation rate exceeds the nominal interest rate on an investment resulting a - pay out
Which of the following situation is the best one for a lender? (1 point)
The interest rate is 25 percent and the expected inflation rate is 50 percent.
The interest rate is 9 percent and the expected inflation rate is 7 percent.
The interest rate is 4 percent and the expected inflation rate is 1 percent.
The interest rate is 13 percent and the expected inflation rate is 15 percent.
option 3, it gives the lender the highest real return on their money.
4%-1% = 3%
higher interest rate is better for lender
if inflation is expected to be 2% and interest rate is 1% would you prefer to be a borrower or lender?
borrower because I pay back lenders with money that's worth less than the money they originally borrowed
Note 
Flashcard (25)