FINA3000 Ch6 Study Information.docx

FINA3000 Ch6 Study Information.docx - Chapter 6 Interest...

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Chapter 6: Interest Rates and Bond Valuation Study Information Interest Rate Fundamentals: Interest Rate Required Return Types of Returns: 1. Actual Return 2. Expected Return Equilibrium Rate Factors that affect the equilibrium rate: 1. Inflation 2. Risk 3. Liquidity Preference Liquidity Nominal and Real Interest Rates: Nominal Rates: Example 1: Winston puts $1,000 into an investment with a nominal rate of 3%. Inflation is averaging 3%. Find the cost of the asset and the investment value at the end of 1 year Investment: 1000 times 3% (nominal rate)= 1,030$ Cost: 1,000 times .03 (inflation)= 1,030 Real return is equal to zero Real Interest Rate: Formula to find the Exact Real Interest Rate: r is nominal interest rate, r* is what you are solving for, I is real rate of interest. (1 + r) = (1+ r*)(1 + i) Formula to find the approximate real rate – not always accurate: Not the best alternative, the bigger the difference the more wrong your answer will be. r* = r - i Example 2: Over the next year, an investor is expecting the nominal interest rate to be 9% and expects inflation to average 5%. Find the real rate of interest. (1.09)= (1+r*)(1.05)= 1.09/1.05= 1.0381-1=r* so the answer is r*= 3.81% Approximate rate= 9%-5%= 4% Nominal Interest Rates, Inflation, and Risk: Risk Premium Investments with no risk: R f = r* + i 1
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Investments with risk: r j = R f + RP j Term Structure of Interest Rates: Comparing on a risk free security comparing the maturity to the yield Yield Curve: graphical rep of interest rates. Maturity on horizontal axis, and the yield on the vertical axis.
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