Second Attempt OA Readiness Review

Module 4

Lesson 12 - Interest Rate:

Notes:

Learning Objective: Identify the fundamentals of interest rates.

What is an Interest Rate (Discount Rate)? It is the required return rate or the percentage of the total principal (outstanding balance) that is charged by a lender for using their assets (i.e. credit card, car/ house loan, etc.). Interest Rate is typically expressed annually as the “annual percentage rate” (APR) and is often paid in cash. However, any tangible asset can be used to pay the interest.

Types of Interest:

Simple Interest: Calculated on the principal balance only.

Annual Interest = Principal x Interest Rate

Compound Interest: Calculated on the principal amount plus any accumulated interest

(interest on interest). More common.

Total Interest = Principal x (1 + Interest Rate) ^{Number of Periods} - Principal

Other Names:

Required Rate: the rate that the lender requires the borrower to pay (lender’s POV)

Cost of Capital: cost of borrowing for the borrower (borrower’s POV)

Lesson Questions:

1) What is the term for the percentage of the principal that a lender charges a borrower for the use of assets?

• Interest Rate

2) How is the interest rate expressed?

• As a percentage

3) What is the main purpose of charging interest?

• It allows borrowers to pay to use the assets of another entity to accomplish their own goals because the funds don’t belong to the borrower, they have to pay to use them.

Pre-Assessment Questions:

1) Why can compounding interest be a good tool but also a significant detriment?

• Compounding interest can be a good tool because it allows a lender to gain interest on interest, but it is a detriment because it causes a borrower to pay interest on interest.

Lesson 13 - Required Return:

Notes:

Learning Objective: Identify the fundamentals of required return.

What is the Required Rate of Return? It is the compensation that an investor or lender will accept for the level of risk associated with investments (stocks, bonds, or loans). It’s also known as the hurdle rate in corporate finance. An investor must consider three components when coming up with the required return (Opportunity Cost, Inflation, and Risk).

Components of Required Return:

• Opportunity Cost: the potential gain lost when one alternative is chosen over another. For investors, it represents the earnings forgone from other possible investments.

• Inflation: the rate at which the average price of goods/ services increases, decreasing the purchasing power of money. It must be considered to maintain value over time.

• Risk: the possibility that the actual return will differ from the expected return. It’s the uncertainty of not receiving the expected outcome. Generally, if the risks are higher, then the higher the required rate of return will be.

These components collectively determine the interest rate or the required rate of return.

Lesson Questions:

1) What is a component of the required rate of return?

• The required rate of return is composed of opportunity cost, risk, and inflation.

2) Why would a long-term investment require a higher rate of return?

• If there is a greater risk and a higher opportunity cost to the lender.

3) You just inherited $25,000 from a long-lost relative. You decide to put the money in a savings account for the time being. What would be considered an opportunity cost of putting the money in savings?

• Buying a brand-new car worth $25,000 because it is something you are giving up by keeping the money in your savings account.

4) Five years ago, Ahmed decided he was going to save up to purchase a car with cash. The car he wants is priced at $15,000. He saved $245 a month in an account that gave him enough interest to have $15,000 in five years. Today, he pulled out $15,000 from his account to buy the car, but the price of the car is now $16,562. Which component of the required rate of return did Ahmed forget to consider?

• Inflation, the price of the car has gone up due to inflation.

Pre-Assessment Questions:

1) Which component of the required rate of return takes into account the loss of potential gain from other alternatives?

• Opportunity Cost

Lesson 14 - Inflation:

Notes:

Learning Objective: Identify the fundamentals of inflation.

What is inflation? It is the rise of prices over time for goods/ services. Often expressed as a percentage and indicates a decline in the purchasing power of goods/ services given the same amount of money.

What causes inflation? There are many sources of inflation, but the three main ones are: the increase in demand for goods/ service, rising costs, and adaptive expectations.

• Increased Demand for Goods/ Services - resources, goods, and service are scarce, meaning there isn’t enough to keep up with the demand. This in turn pushes the costs up so that the supply and demand balance out.

• Rising Costs - costs may increase due to regulations, accidents, high demand, tariffs, etc. If the cost to produce something goes up, the suppliers must increase the prices of their goods/ services.

• Adaptive Expectations - when the price of goods/ services goes increase, employees expect/ demand an increase in wages to be able to cover the cost of living.

Technology Impact: Technological advancements can reduce the effects of inflation by decreasing the cost of goods, increasing productivity, and substituting labor with automation. However, other factors like the use of new and more expensive technology, the cost of raw materials, and the adaptive expectations of employees for higher wages contribute to overall inflation.

Lesson Questions:

1) Why is built-in inflation linked to adaptive expectations?

• Workers want higher wages to keep their standard of living as prices increase, which makes them increase even more.

2) Why does an increased demand for goods and services cause inflation?

• Scarcity. Increases in demand often lead to insufficient supply in the market, which makes prices go up until supply and demand are equal again.

3) What happens to prices in a market in which there is inflation?

• Prices go up.

Pre-Assessment Questions:

1) Which factor contributes to the inflation of the prices of goods and services over time?

• Increase in demand for goods/ services.

2) How is inflation calculated?

• By determining the rate at which the average price level of particular goods/ services increases over a period of time in an economy.

Lesson 15 - Nominal Rate and Real Rate:

Notes:

Learning Objective: Describe how interest rates, required return, and inflation can inform decision-making.

Interest Rates (or the required return) are determined by two components using the following:

Rate = Risk-Free Rate + Risk Premium

Risk Free Rate - an indicator of inflation and opportunity cost. It describes the rate of return on an investment with no risk (i.e. U.S. bonds).

Risk Premium - is the compensation for the amount of risk taken on by investors (higher risks = higher returns required)

Nominal Rate v. Real Rate:

The Nominal Rate is the most common interest rate used in our daily lives. It is the rate at which invested money grows over a certain period of time. It includes inflation so it doesn’t tell you the purchasing power that you will have in the future, just how much money you will have.

The Inflation Rate represents the rate at which prices are increasing.

The Real Rate is an interest rate that is adjusted to remove the effects of inflation. It is the same as the growth rate in purchasing power.

Real Rate = Actual Purchasing Power

Lesson Questions:

1) What is the compensation for risk given to investors called?

• Risk Premium

2) Which type of interest rate is the rate at which invested money grows for a certain period of time?

• Nominal Rate

3) Which component of an interest rate is an indicator of inflation and opportunity cost?

• Risk-Free Rate (only measures inflation and opportunity cost)

Module 4 Quiz:

1) What is the name for the interest rate expressed on an annual basis?

• Annual Percentage Rate (APR)

2) Why is the required rate of return also known as the hurdle rate?

• It is the minimum rate that a firm must surpass to accept a project

3) What is the inflation rate?

• The rate at which the average price level of a basket of goods and services in an economy increases.

4) What does the risk-free rate indicate?

• Inflation and Opportunity Cost

5) Suppose Sophia is considering a new stock investment for her retirement account. This stock has significant risk but is quite popular in the market. Inflation for the next few years is expected to be 2–3% per year, and the current U.S. Treasury rates are about 2%. How should she use this information to decide what type of return she can expect from the stock?

• Based on the inflation rate, she should expect this stock to provide a return higher than this for the associated risk.

• Since the inflation of 2–3% will reduce any nominal returns she receives by this amount, she would want a higher return to accommodate for the opportunity costs and risks associated with the investment.

Module 6

Lesson 19 - Return:

Notes:

Learning Objective: Identify measures of return.

What is Return? It is the gain or loss on an investment over some period of time. Usually, expressed as an annualized percentage (ratio of money made v. invested).

What is the Holding Period Return? It is the return an investor gets over the entire period that they own a financial security. (i.e. stock, bond) and is calculated using:

(Ending Price - Beginning Price) / the Beginning Price

What is the Expected Return? Allows for an estimate of what is expected to happen based on the likelihood of different potential scenarios happening. In finance, you use both historical data and expectational data. Expectational data is used to calculate a “best guess” estimate of future prices/ returns. When using expectational data, the return is based on the probability of different scenarios happening and the returns expected in each.

What is a Real Return?

Both HPR and expected return are presented in nominal terms and include three factors: inflation, risk, and opportunity cost. Real Return is found by subtracting the inflation rate. Real returns are helpful in that they compare returns over different periods as inflation rates fluctuate:

(Return – inflation rate).

Lesson Questions:

Lesson 20 - Risk:

Notes:

Learning Objective: Describe types of risk.

What is risk? Defined as the possibility that the actual return will differ from the expected return. It is the uncertainty associated with return. The greater the standard deviation, the greater the uncertainty.

Market Risk (Systematic Risk): risk that is present in the economy as a whole and cannot be diversified away (i.e. unexpected changes in interest rates or political instability).

Firm-Specific Risk (Non-Systematic Risk): risk that results from factor at a particular firm or a handful of firms (i.e. better than expected earnings or a company’s labor force goes on strike).

Interest Rate Risk: probability that changes in interest rates will impact the value of a bond. It is an example of a Market Risk. Market interest rates and bond prices move in opposite directions (interest rates increase = bond prices decrease).

Default Risk: probability of a loss resulting from a borrower’s failure to repay a contractual obligation. This is an example of Firm-Specific Risk (higher probability of default = higher default risk = higher required rate of return).

Price Risk: the potential for the decline in the price of a financial security or an asset relative to the market (i.e. operating risk, financial risk, business cycle).

Lesson Questions:

Lesson 21 - Risk Management:

Lesson 22

Module 8

Lesson 28

Lesson 29

Lesson 30

Lesson 31

Module 9

Lesson 32

Lesson 33

Lesson 34

Lesson 35

Lesson 36

Module 10

Lesson 37

Lesson 38

Lesson 39

Lesson 40

Lesson 41

Module 11

Lesson 42

Lesson 43

Lesson 44

Lesson 45