Principles of Finance

The cut-off between short term and long term

1 Year

Who sets short term interest rates

The Fed (The Federal Reserve Bank)

What are the short term interest rates based off of?

Current Economic Conditions

Who sets long term interest rates?

Bond market

What are long time interest rates based off of?

Future inflation expectations

Interest

The cost of borrowing money

Spread

The difference between 2 interest rates

Basis point

One 100th of a percentage point (remove the percentage and decimal)

Money market securities

Debt securities maturing in 1 year or less

Risk

Uncertainty about the outcome

Inflation

An increase in prices over time

Real

Adjusted for inflation/having the effects of inflation pulled out

Weak economies are accompanied by a…

Decreased demand in capital

A decreased demand in capital leads to…

Lower interest rates

A strong economy leads to…

An increase in demand for capital

An increase in demand for capital leads to…

Higher interest rates

Examples of securities

Money market and bonds

What does CPI stand for?

Consumer Price IndexW

What is CPI?

Inflation from the consumer’s perspective

What is core CPI?

CPI that is excluding volatile categories of products (food and energy)

What does PPI stand for?

Producer Price Index

What is PPI?

Inflation of prices from the producer’s perspective

Positive real interest rate

When interest rates are more than inflation rate

Negative real interest rates

When interest rates are less than inflation rates

Positive nominal return

When return is more than zeroN

Negative nominal return

When return is less than zero

The risk-return trade off

The greater the risk, the greater the POTENTIAL return

Bp, BPS stands for…

Basis Points

When the yield curve is positive…

Short term rates are lower than long term rates

A positive yield curve is also known as a…

Upward-sloping, normal yield curve

When a yield curve is negative…

Short term rates are higher than long term rates

Negative yield curves are also known as…

Inverted/abnormal yield curves

When the yield curve is flat…

Short term interest rates are the same as long term interest rates

Negative yield curves suggests…

A recession may be coming

The Traditional definition of a recession

When 2 or more consecutive quarters have a negative GDP

The leading indicator of a recession

An economic variable, if it occurs before the economy changes

When the spread of long term vs short term interest rates increases…

the yield curve steepens

When the difference between long term for short term rates decreases…

The yield curve flattens

An inflation premium is part of the nominal risk-free rate or real risk-free rate?

Nominal

What is the rate used on U.S. treasuries?

Nominal risk-free rate

Default Risk

The possibility that the borrower will be unable to pay the interest on the loan and/or repay the principal

Required return

The minimum acceptable potential return based on investment’s risk

Bond ratings indicate…

The issuer’s ability to make scheduled interest and principal payments

What is another term for default risk?

Credit risk

When the interest increases the market price of a bond…

Decreases

When the interest of a bond decreases, the market price…

Increases

Do U.S treasuries have default risk?

No. This is because U.S. bond securities are considered the “safest investment” in the world.Do

Do U.S. treasuries have liquidity risk?

No. This is because U.S. bond securities are always able to be turned into cash.