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MGFB10 Midterm Analysis

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Esther Eiling

Midterm Analysis – Eiling Topic 1: Time Value of Money (TVM) TVM is a fundamental concept in finance: money can be invested to earn interest or returns, therefore the value changes over time. You are entitled to some reward when you invest your money because you are selling the ability to use that money to someone else. It is also assumed that any cash can be invested in some way because investing is as easy as putting the money in a bank. Terms:  Future Value (FV): the lump-sum value of an amount of cash or a series of cash flows at some time in the future  Present Value (PV): the lump-sum value of an amount of cash or a series of cash flows as of now.  Simple Interest: when interest is not re-invested to the original principal to generate extra interest on top of interest earned. Example: coupon bond.  Compound Interest: when all interest is re-invested to the original principal so that it helps generate extra interest in the future. Example: bank savings account.  Annuity: a series of periodic cash flows of the same amount. Can be ordinary annuity or annuity due. Ordinary annuity means cash payments are made at the end of each period. Annuity due means cash payments are made in the beginning of each period. For simplicity, you can use the same formula for both. Just bring the lump-sum value of the annuity due 1 year forward to find the correct PV (this is a magic trick that will save you a lot of hassle. You don’t need a separate annuity due formula).  Growing annuity: a series of periodic cash flows that grow at a fixed rate  Perpetuity: a series of infinite cash flows of the same amount  Growing perpetuity: a series of infinite cash flows that grow at fixed rate Compounding Frequency: compounding frequency refers to how many times a principal earns interest in a given period (usually in a year).  Quoted Rate (QR): period rate times the number of periods per year – not a very significant concept in Finance by still good to know  Effective Annual Rate (EAR): an investment’s conceptual annual rate of interest when compounding occurs more than once per year. Of course, when compounding only occurs once a year, the EAR is the same as the stated rate.  Continuous compounding: compounding occurs continuously (infinitely many times) throughout a period (year). Use formula: A = Pe^(rt); A = Amount after growth. P = initial Principal investment. e = constant. r = interest rate (7% would be 0.07). t = number of periods. In any formula plugging, be careful to match the correct interest rate with the correct number of periods. If the interest rate you plug in is a yearly interest rate, then use number of years as t. If you plug in monthly interest rate, then use number of months as t. Questions: the mortgage questions Question: mortgage question Topic 2: Bond Valuation The idea of bond valuation is to find a theoretical intrinsic value of a bond. This is technically not a new topic but merely an extension of the time value of money chapter. Just remember this core concept: the value of a bond right now is the present value of all the future cash flows this bond will give you, discounted at the current market rate of the interest. Terms:  What is a Bond: a bond is a debt contract between a lender and a borrower. Selling a bond means borrowing money from someone else. Similarly, buying a bond means lending out money (get this concept straight or you will stumble in your senior year classes)  Face Value (F): the value printed/stated on a bond contract (in practice, usually $1000). At the end of the bond contract, the borrower will return to the lender an amount equivalent to the face value
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