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final exam review

# final exam review - Final Exam Review Winter 2008 1 Before...

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• ChancellorBraverySquirrel10185
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1 Final Exam Review Winter 2008

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2 Before the midterm Chapter 4 (the time value of money , TVM ) is the most important chapter Chapters 5 and 6 are just applications of the TVM to price bonds and stocks, respectively The fair price of any asset/security is the present value of all the expected cash flows of the asset/security discounted at an interest rate appropriate for the risk level of the cash flows
3 Time value of money Future value is forward looking, present value is backward looking Compound interest (e.g. EAR ), simple interest (e.g. APR ), and period rate Convert period rate to the EAR and APR; and vice versa Draw the timeline of cash flows

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4 Time value of money Multiple cash flows: PV? FV? Special cases: Annuity (at the end of each time period) PV? FV? Examples : coupon bonds, mortgages, and loans Annuity due (at the beginning of each time period) PV? FV? Examples : lease, rent, and tuition …
5 Time value of money Growing annuity : PV? Perpetuity : PV? Constant value perpetuity Examples : dividend discount model ( DDM with no growth, i.e., g = 0), consols (perpetual bonds), and preferred stocks … Growing perpetuity Examples : DDM (when the growth rate g > 0 but < r ), and stock valuation …

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6 Time value of money Maintain a consistency between the interest rate used and the time periods For example : EAR for annual cash flows; quarterly interest rate for cash flows occurring every quarter etc. Nominal interest rate vs. real interest rate: be consistent with cash flows ( nominal or real )
7 Time value of money In general, payment frequency is the same as compounding frequency For instance : monthly payments monthly compounded interest rate … The exception : Canadian mortgages have a mismatch

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8 Review question 1 What is the annual rate compounded monthly that is equivalent to 8% compounded quarterly ? A) 7.72% B) 7.95% C) 8.00% D) 8.24%
9 Bonds Bond pricing formula : months 6 of number the of terms in maturity remaining s bond' where ) ( value Face [ coupon annual - semi M M M M = + + + × - × = + = n r 1 ] ) r 1 ( r 1 r 1 ) value face ( PV ) coupons ( PV price Bond n 6 n 6 6 6 The face value of a bond is usually \$1,000

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10 Bonds There is an inverse relationship between interest rates and bond prices Interest rate risk The longer the bond maturity, the bigger the interest rate risk, other things being equal; and vice versa
11 Bonds Coupon rate ( annual ): constant Three ways to measure the return on bonds: current yield An incomplete measure yield to maturity ( yield , or YTM ) Use a financial calculator (see p. 138 ) or the approximate formula on p. 137 to compute the YTM A complete measure rate of return

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12 Review question 2 What is the price of a 20-year bond with a 5% coupon rate, a face value of \$1,000 and pays coupons semiannually, if the effective annual YTM is 5%?
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final exam review - Final Exam Review Winter 2008 1 Before...

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