Test 2 vocab

Economic assets

Economic assets are entities functioning as stores of value and over which ownership rights are enforced by institutional units, individually or collectively, and from which economic benefits may be derived by their owners by holding them, or using them, over a period of time (the economic benefits consist of primary incomes derived from the use of the asset and the value, including possible holding gains/losses, that could be realized by disposing of the asset or terminating it)

Economic value

Economic value is the maximum dollar price someone will pay for an economic asset.

Opportunity cost

he best alternative that is not chosen because another course of action is pursued. Economic decisions generally involve comparing rates of return. Opportunity cost is often called the discount rate, the hurdle rate, the benchmark rate, or the required rate of return.

Interest rate

a rate of return on an investment or paid on a debt.

The time value of money

The concept that money available at the present time is worth more than the identical sum in the future due to its potential earning capacity. This core principle of finance holds that, provided money can earn interest, any amount of money is worth more the sooner it is received.

The First Principle of Finance

A dollar received today is worth more than a dollar received in the future.

Cash flow

The flow of purchasing power that can be used to value and facilitate the transfer of economic assets.

Risk

The uncertain nature of future cash flows and rates of return will cause current economic values to vary.  This variability is the major issue with all financial decisions. 

Present value

The value of a future cash flow stated as of today..

Future value

The future value of an amount given today.

Compounding

The process of using a rate of return to determine a future value.

Discounting

The process of using a rate of return to determine a present value.

Wealth

The control of economic assets.

Economic decision-making

Economic decision-making involves calculating economic values and comparing the economic value of an asset to the cost of obtaining the asset.

Creating wealth

Economic decisions create wealth when the price paid for an economic asset is less than its economic value. This is at the heart of financial decisions and is the basis for every action in markets.

Decision rule

A quantitative rule that evaluates whether a course of action should be undertaken.

Internal Rate of Return (IRR)

The rate of return earned on an investment adjusted for time value.

Internal Rate of Return rule

accept an investment if its IRR (the rate of return that you're earning on the project) exceeds its opportunity cost (the rate of return you would earn on equivalent investments).

Net Present Value (NPV)

A decision-making process using time value and opportunity cost to compare the benefits of a decision with its costs. If the benefits exceed the costs then the decision creates wealth.

NPV rule

accept an investment if its NPV is positive.  A positive NPV means that the benefits of the decision exceed its costs when adjusting for time value and the opportunity cost.

Risk

Risk is possibility of getting a lower rate of return that you expected to get.

Expected return

The future return, generally uncertain, that one expects to get from an investment. This is the return that is used in making most business decisions.

Realized return

The return that is actually received at the end of the investment period.

Risk-free rate of return

A rate of return on an asset whose future cash flows are certain..  Given the known payment made today for the promise of future cash flows that will be received with certainty, the rate of return is also certain.

Risk premium

The extra return above the risk-free rate that is required given the uncertainty of the future cash flows.

Simple Interest

Interest earned on the original principal.  Each period, the interest rate is applied, but the principal remains the same.

Compound Interest

occurs when the Interest earned is applied to the principal each period.  With compound interest, the principle grows over time and, if the principle grows so does the amount of interest paid each period.

Annuity

A series of regular payments at regular intervals for a defined period of time

Level annuity

 An annuity with the same cash flow for each period of time.  Level annuities are further classified as to when the payments are made in each period.

Ordinary annuity

Payments occur at the end of each period.

Annuity due

Payments occur at the beginning of each period.

Growing annuity

An annuity where payments grow at a steady rate.

Perpetuity

A series of regular payments for regular periods that go on indefinitely.

 Level perpetuity

Perpetual payments of the same amount at regular intervals

Growing perpetuity

Perpetual payments where the amounts grow at a constant rate.

Compounding period

The length of time that passes before interest is recognized and added to the principle. 

Stated annual interest rate

The interest rate stated on an annual basis.  This is the rate normally used in contacts, including loans such as credit cards, auto loans and mortgages.

Periodic interest rate

The interest per period, such as the semiannual rate for bond interest payments and the quarterly rate paid via dividends.

Effective annual interest rate

The annual interest rate that reflects the impact of intra-year compounding.

Annual percentage rate (APR)

The interest rate charged per period multiplied by the number of periods per year.

Frequency distribution

 A representation of the historical returns over a period of time which shows how often each return occurs.

Probability distribution

A formula or table of information that gives the potential outcomes and the likelihood of those outcomes.  There are two types of probability distributions.

 Discrete probability distribution

A probability distribution that contains a discrete, or countable, number of observations.

Continuous probability distribution

 A probability distribution that contains an infinite number of observations, which are analyzed using quantitative measures based on mathematical relationships and calculus.

Expected return

The average of the possible realized returns weighted by their probability of occurring

Variance

A measure of how the possible realized returns might vary from the expected return.

Standard deviation

The square root of the variance.

Portfolio

A collection of economic assets.

Diversification

The process of reducing the risk of a portfolio by holding assets whose returns are not perfectly correlated.

Joint probability distribution

 A probability distribution containing the probabilities for two or more random variables. It provides insights into the relative changes in the variables.

Expected return of a portfolio

The wealth-weighted average of the returns expected from the assets held in the portfolio

Portfolio variance

The combination of the wealth-weighted average of the variances of the two assets and their covariance.

Covariance

A statistical measure of the degree to which two rates of return move together.

Unique risk

The risk that is unique to an individual company.  Unique risk, varying from company to company, is the risk that can be diversified

Market risk

The risk that affects all companies in the economy. Market risk, because it affects all market participants, cannot be diversified away and thus the risk that is relevant for determining the opportunity cost.

Beta

a measure of the market/systematic risk of an asset:  how the asset return varies with the market return, and is thus a measure of the risk that cannot be diversified away.

Capital Asset Pricing Model (CAPM)

a model that uses market/systematic risk to calculate the opportunity cost/expected rate of return.

Why are there two measures of volatility?

There are two measures of volatility because variance measures the spread of returns, while standard deviation converts that measure into a normal percentage that is easier to interpret and compare.

IRR Equation (Internal Rate of Return)

Ending Value - Beginning Value

IRR =  —----------------------------------——

Beginning Value 

Future Value Equation

PV*(1+r)^n

Present Value Equation

FV/(1+r)^n