number of periods per year (3) Period rate = APR / number of periods per year (4) NOTE THAT YOU SHOULD NEVER DIVIDE THE EFFECTIVE RATE BY THE NUMBER OF PERIODS PER YEAR- it will not give you the period rate. Effective Annual Rate (EAR) Implied rate of interest / discount rate: We can re-arrange the basic PV and FV equations and then solve for the implied interest rate i Different types of loans: (1) Pure discount loans (2) Interest only loans (3) Loans with fixed principal payments (4) Amortised loans Pure discount loans: (1) No interest; principal paid to maturity; issued at discount which means their purchase price is less than principal (2) T bills are excellent examples of pure discount loans. The principal amount is repaid at some future date, without any periodic interest payments Interest only loan: (1) Interest paid throughout the load period; principal paid at maturity (2) Consider a 3 year, interest only loan with a 7% interest rate, principal amount is $10000. (3) Year 1 and 2: $700. Year 3: $10700 (4) this cash flow stream is similar to the cash flows on corporate bonds Loan with fixed principal payment: (1) Interest and fixed amount of principal paid throughout the load period (2) Consider a $50000, 10 year loan at 8% interest. The loan agreement requires the firm to pay $5000 in principal each year plus interest of that year. Amortised loans: Each equal payment covers the interest expense plus reduces principal Lecture 4: Risk & Return- Part 1 Different kinds of stocks/investments: (1) Standard & Poor’s 500 (S&P 500) (2) Small stocks (3) World portfolio (4) Corporate bonds (5) Treasury bills (T bills) Investment returns measure the financial results of an investment. Returns can be historical or prospective (anticipated). Dollar terms : amount received – amount invested Percentage terms : (amount received – amount invested) / amount invested When an investor buys a stock or a bond, their return comes in 2 forms: (1) Any dividend or interest payment (income) received (2) A capital gain or a capital loss (due to change in price) Dividend yield = dividend / initial share price Capital gain yield = capital gain / initial share price To convert from nominal rate to real rate of return: 1 + real return = (1 + nominal return) / (1 + inflation rate) Approximation: real return = nominal return – expected inflation Expected returns are returns that take into account uncertainties that are present in different scenarios.
If using historical data of an asset to estimate average return, can just find the arithmetic average : We benchmark the expected returns to the required rate of returns . Rate of returns depends on the risk of the investment. High risk = high rate of returns. Risk is the uncertainty associate with future possible outcomes. Investment risk refers to the potential for the investment return to fluctuate- go up or down- in value from year to year.