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Exam2Objectives - BMGT 340 Exam 2 Objectives Things you...

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BMGT 340 Exam 2 Objectives Things you should know (and know how to do by the time of the first exam) Note that problems on exams will never be exactly like problems done in class or on old exams – the purpose of the class is to teach you methods and critical reasoning that can be applied to many situations. Chapter 6 – Interest Rates 1. Know that people have differing consumption opportunities and time preferences for consumption. The return an asset receives depends on its risk which is reflected in the interest rate or discount rate that is used. Know the terms nominal (inflation premium included) and real (no inflation premium). 2. Interest rates depend on the supply and demand for funds. An interest rate that you see in the Wall Street Journal will contain the real risk-free interest rate (r star), an inflation premium, a default risk premium, a liquidity premium and a maturity risk premium. Know what each of these premiums is compensating investors for. Also know the risks of investing long term versus short term. There is more interest rate risk for long term – not knowing what interest rates will be in the far future, but reinvestment risk for short term investors – if you must reinvest frequently there is a risk that interest rates will be low when it is time for you to reinvest. 3. Be able to use the interest rate equation to solve problems. In other words, if you know some of the variables, be able to solve for the missing variables. Know that maturity risk premium usually increase with time – in other words, a 20 year bond is likely to have a larger maturity risk premium than an equivalent 10 year bond. 4. Be able to break down the interest rate equation into its components, understanding which components apply to which kind of security. For example, know that default risk and liquidity risk premiums are not added to Treasury securities, but are added to corporate securities. 5. Know that there is a term structure of interest rates, and that usually long term interest rates are higher than short term rates to compensate investors for the greater risk of investing long-term since it is harder to predict interest rates far into the future. A normal yield curve is upward sloping. 6. Know how to use the yield curve to estimate future interest rates. Know the definition of expectations theory. Be able to solve an expectations theory problem – when you are given a listing of various term bonds and yields, you can find what the yield would be on a bond at some point in the future. 7. Know the other determinants of interest rates, including Federal Reserve policy, government budget deficits and surpluses, international factors, and business conditions. 8. Understand and apply basic economic theory of supply and demand as it relates to interest rates (for example, if there is more demand for money, interest rates are likely to rise). Understand what factors influence supply and demand; for
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example, what happens if Americans save more or less? What happens to interest rates in recessions? What happens if inflation increases or decreases?
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