Investors are risk averse individuals do not like

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Investors are risk-averse : Individuals do not like risk and want to be compensated for risk. Compensation for bearing risk is usually in the form of a higher return (higher interest) – the risk premium . Interest – periodic payments to lenders of funds to compensate them for the time value of money and for the risk associated with the repayment of the amount loaned. Discount rate – interest rate used to compute the present value of future cash flows. The greater the risk, the higher the discount rate. Business Financial Management Risk 04 Spring 2015 - Yang 64 With any financing or investment decision, there is some uncertainty about the general economy and factors that influence the entire market. Government bonds In addition, with any decision, there is some uncertainty about the specific stream of cash flows that will be received. Corporate bonds We’ll examine the relationship between interest rates and inflation first.
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1/25/2015 33 Business Financial Management Inflation and interest rates 04 Spring 2015 - Yang 65 Inflation – a rise in the general level of prices of goods and services in an economy over a period of time. The interest rate on bonds is a nominal rate. Nominal interest rate – interest rate or rate of return that has not been adjusted for inflation . The nominal rate consists of inflation and: Real interest rate – interest rate or rate of return that has been adjusted for inflation (what you actually earned after inflation has been taken into consideration). Because investors are concerned with what they can buy with their money, they require compensation for inflation. Business Financial Management Example – inflation 04 Spring 2015 - Yang 66 You have $100 today. You can either A) put $100 in a bank that pays 10% interest per year or B) buy pizzas at $2 per slice. Inflation is expected to be 5% per year. What is your (nominal) return? What is your real return?
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1/25/2015 34 Business Financial Management Inflation and the Fisher effect 04 Spring 2015 - Yang 67 Fisher effect – the relationship between nominal returns, real returns, and inflation: The nominal rate on an investment is the percentage change in the number of dollars you receive. The real rate on an investment is the percentage change in how much you can buy with your dollars (i.e. the percentage change in your buying power) Fisher effect : Sometimes you will see the relationship approximated as:  i r r REAL NOMINAL 1 1 1 i r r REAL NOMINAL Business Financial Management Example – Fisher effect 04 Spring 2015 - Yang 68 You have $100 today. You can either A) put $100 in a bank that pays 10% interest per year or B) buy pizzas at $2 per slice. Inflation over is expected to be 5% per year. What is your (nominal) return? What is your real return?
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1/25/2015 35 Business Financial Management The Fisher effect: international focus 04 Spring 2015 - Yang 69 Business Financial Management Interest rates and maturity 04 Spring 2015 - Yang 70 The interest rate increases with maturity. Why?
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  • Fall '13
  • LynnDoran
  • Business Financial Management

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