IFM chapter 3 - what do interest rates mean and what is their role in valuation?

What is present discounted value?

A dollar of cash flow payed to you one year from now is less valuable to you than a dollar payed to you today. Can be th ePV of a single cash flow or the sum of a sequence or group of cash flows.

What is discounting the future cash flows?

Process of calculating todays value of dollars received in the future

What does compounding mean?

Compounding is the process of generating earnings on an asset's reinvested earnings, leading to exponential growth over time.

What is a simple loan?

Requires payment of one amount which equals the loan principal plus the interest.

What is a fixed-payment loan?

A fixed-payment loan requires the borrower to make equal payments over the life of the loan, which covers both principal and interest.

Explain loan principle

The amount of funds the lender provides to the borrower

What is maturity date?

The date the loan must be repaid

What is loan term?

From initiation to maturity date

What is an interest payment?

The cash amount that the borrower must pay the lender for the use of the loan principle

What does simple interest rate mean?

The interest payment divided by the loan principal; % of principal that must be paid as interest to the lender

What does convention mean?

Expressed on an annual basis, irrespective of the loan term

What does growing annuity mean?

An annuity where the amount of your recurring cash flow (CF) increases at a constant rate g

What is a consol?

A perpetual bond with:

• no maturity

• No repayment of the principal

  • Fixed coupon payments of C forever

What are the two main properties of coupon bonds current yield (CY)?

1. If a bonds price is near par and has a long maturity, then CY is a good approximation

2. A change in the current yield always signals a change in the same direction as yield to maturity