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1

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…)

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2

what do we mean by investment in economics?

the purchase of new capital, factory or house (land)

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3

Give an example of an investment

firm buys $5000 worth of equipment

parents spend $300,000 to build new house

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4

direct vs. indirect finance

direct: savers decide what to do with their money

indirect: the institution decide what to do with your money

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5

Give an example of direct finance

savers buying their own stocks and bonds from companies of your choosing

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6

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

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7

Define interest rate

cost of borrowing money or compensation for saving the money

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8

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

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9

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

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10

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

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11

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

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12

Define future value

how much money you’re going to get in the future

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13

Define present value

$1 paid one year from now is less valuable than $1 paid today

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14

How we determine the price of bonds (include formula)

by finding the PV

PV = sum( C / (1+r)^t) +…+ FV/(1+r)^t )

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15

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

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16

How we determine the price of stocks (include formula)

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17

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

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18

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%?

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19

Define yield to maturity (include formula)

the interest rate that equals the PV of cf payment with its value today

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20

Under which conditions do you need to calculate YTM?

You need to know: PV, FV,

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21

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

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22

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)

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23

define rate of return

payments to the owner plus the changes of the security’s value

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24

define capital gain

profit made from the sale of assets when its’ selling price exceeds the original price that was bought

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25

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)

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26

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)

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27

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

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28

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)

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29

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

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30

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

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31

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

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