FIN 3080 Prof Xin Li Week 6 Notes
FIN 3080 Prof Xin Li Week 6 Notes FIN 3080C
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This 3 page Class Notes was uploaded by Brady Zuver on Thursday September 29, 2016. The Class Notes belongs to FIN 3080C at University of Cincinnati taught by Xin Li in Fall 2016. Since its upload, it has received 7 views. For similar materials see Business Finance in Finance at University of Cincinnati.
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Date Created: 09/29/16
Fin 3080 Prof Xin Li Week 6 Notes Ch 6 Continued 1. Compounding Rates: The Effects of Compounding a. Effective annual Rates (EAR) i. The rate you will earn ii. EAR = [1+(Quoted Rate/m)] -1m 1. M= number of times interest is compounded over the year 2. Quoted Rate= APR iii. Annual Percentage Rate (APR) 1. Interest Rates per period times number of periods per year a. Need to calculate EAR to see what is actually being paid iv. Continuous Compounding 1. EAR= e -1 a. Q=quoted rate b. Upper limit of EAR with continuous compounding 2. Loan Types and Loan Amortization a. Pure Loan Discounts i. Simplest form of loan ii. Borrower receives money today and repays a single lump sum in the future 1. Ex: If you borrow $100 at 10% for one year, at the end of the year you will pay $100 (1+.1) = $110 b. Interest-Only Loans i. The borrower pays interest each period and repay the entire principal at some point in the future 1. Interest is paid at the end of each year, the final year the interest plus the initial principal is paid a. Ex: 3 year loan of $1000 at 10%, First two years, only the interest is paid which is $100 each year i. The third year the $100 interest is paid, plus the initial $1000 principal ii. If there is only one period, Interest-only and Pure loan discount are the same c. Amortized Loan *** i. Lender may require borrower to repay parts of the loan amount over time ii. Providing the loan be paid off by making regular principal reductions 1. Approach 1 a. Pay the interest each period, plus some fixed amount i. EX on slide 41 on Chapter 6 slides 2. Approach 2 a. Have the borrower make a single, fixed payment each period i. Majority of loans work this way ii. Ex on slides 43-45 in Chapter 6 slides Chapter 7 Interest Rates and Bonds 1. Bonds and Bond Valuation a. A bond is normally an interest only loan, where the borrower will pay interest every period. b. Important Definitions Relating to Bonds i. Coupon: The stated interest payment made on a bond 1. Ex: 12% rate on $1000 means coupon is $120 ii. Face Value (or Par Value): The principal amount of a bond that is repaid at the end of the term 1. If you use the same example from above, you would get $1000 back at the end of the term iii. Coupon Rate: The annual coupon divided by the face value of a bond 1. Coupon rate above $120/$1000= 12% iv. Maturity: The number of years until the face value is paid is called the bond’s time to maturity 1. Corporate bonds often have maturities of 30 years c. Bond Values and Yields i. Yield to Maturity (YTM) (Sometimes called bond’s yield) 1. The interest rate required in the market on a bond 2. Interest rates change in the marketplace, but cash flows from a bond stay the same a. This causes value of a bond to fluctuate b. As interest rates increase, the present value of a bond declines, as they decrease, the present value rises ii. Value of a bond 1. By hand a. Value = Present value of coupons + Present value of face amount b. PV of coupons= C* [1-1/(1+r) ]/r t c. PV of Face Amount= F/(1+r) 2. Financial Calc a. Insert Years (N), Rate (I/Y), Coupon (PMT) and Face Value (FV) then compute for present value iii. When Coupon Rate=YTM then the bind sells for face value iv. When Market interest rate is higher than the coupon rate, then people are willing to pay less than the $1000 face value 1. This is called a Discount Bond 2. Bond prices and interest rates move in opposite directions a. Interest rate increase, bond price decrease b. Interest rate decrease, bond price increase 2. Interest Rate Risk a. The risk that arises for bond owners from fluctuating interest rates i. 2 Properties 1. Generally, (all other things held equal) the longer the time to maturity, the greater the interest rate risk. 2. All things equal, The lower the coupon rate, the greater the rate risk ii.
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