Intro to Finance Midterm Notes

Finance

Study of how individuals and firms acquire, spend, and manage scarce resources

Cash flows differ along three dimensions… which are?

1. size

2. timing

3. risk

Compounding means…

the future value

Discounting means…

the present value

Perpetuity

an investment paying a fixed sum (C) at the end of every year forever

Growing Perpetuity

an investment paying a growing sum (at a rate g) every t1 year forever

Annuity

an investment that pays a fixed sum (C) at the end of each year for T years

Growing annuity

is an investment that pays a growing sum (at the rate g) at the end of every year, and stops after T years

Net Present Value (NPV)

PV (benefits) - PV (costs)

Annual rate

AKA the nominal rate or APR is the interest rate as quoted per year without adjusting for compounding frequency

Effective rate

is the actual percentage change in money over one year after computing the compounding

Possible scenarios for annual vs effective rates (compounding)

1.        Interest compounded more than once per year  effective rate > nominal rate

2.        Interest compounded less than once per year  effective rate < nominal rate

3.        Interest compounded more than once per year  effective rate = nominal rate

Interest rate

is the exchange rate that allows us to convert money from one point in time to another

Bond

Is a security (a loan contract) that obliges the issuer to make specified coupon and principal payments to the holder on specified dates

Face Value

AKA principal (amount that needs to be paid back at maturity)

Coupon rate

% paid as interest on a bond

Coupon

amount of interest paid per period on a coupon bond

Yield

the expected annual return on a bond investment expressed as a percentage

Types of bonds

1. Pure discount/zero-coupon bonds (pay face value at maturity)

2. Coupon bonds (pay stated coupon at periods and face value at maturity)

3. Floating rate bonds (pay a variable coupon and resets periodically to a reference rate)

4. Perpetual bonds (pay coupon at intervals but no maturity date)

5. Annuity/self amortizing bonds (pay a regular fixed amount each period and part of the fixed amount is interest)

No-arbitrage principle

in an efficient market it is impossible to make a risk free profit because any price discrepancies are quickly corrected (2 investments with same risk and same FV must be priced the same)

Arbitrage

taking advantage of price differences for the same asset in different markets to earn a risk-free profit

Accrued interest

the interest that accumulates between the last coupon payment and the current date

Dirty price

total price of the bond including accrued interest

Clean price

bond price excluding accrued interest

Yield to maturity (YTM)

annualized rate of return an investor earns if they buy a bond at its current price and hold it until maturity (same as the nominal rate)

Credit risk

possibility a bond issuer will fail to pay back (default)

Riskier vs Risk-free bonds

riskier bonds: must offer higher yields to attract investors (junk bonds and corporate bonds)

risk-free bonds: government bonds from stable countries

Inflation risk

risk that the purchasing power of your investment returns will be eroded by inflation

Fisher equation

is the key equation to express the relationship between nominal IR, real IR, and inflation

Real vs Nominal interest rates

nominal rates have not been adjusted for inflation whereas real rates have (investors care about real rates to forecast inflation and expectations)

The expectation theory

Says that long-term interest rates reflect what the market expects short-term interest rates to be in the future (uses a long-term rate to forecast future short-term rates)

The Yield Curve

Is a graph of the YTM against the time to maturity of bonds

·      If the yield curve is upward sloping  investors are expecting short rates to rise in the future

·      If the yield curve is flat  investors are expecting short rates to stay the same in the future

If the yield curve is downward slopinginvestors are expecting short rates to fall in the future