Finance 235 Chapter 5: Interest Rates Part 1
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Questions and Answers

What is the formula for calculating the Periodic Interest Rate?

  • r = APR/m (correct)
  • r = APR + m
  • r = m/APR
  • r = APR * m

    • The Periodic Interest Rate is the same as the Annual Percentage Rate (APR).

    False (B)

    If the APR is 12% and the compounding frequency is monthly, what is the Periodic Interest Rate?

    1%

    The formula for the Future Value (FV) is FV = __________.

    <p>P(1 + r)^n</p> Signup and view all the answers

    What is the formula for calculating simple interest?

    <p>P * R * T (C)</p> Signup and view all the answers

    Compound interest is only calculated on the original principal each year.

    <p>False (B)</p> Signup and view all the answers

    Which compounding frequency results in the highest Future Value for the same APR over the same time period?

    <p>Daily (A)</p> Signup and view all the answers

    What does Effective Annual Rate (EAR) represent?

    <p>True rate of return or true cost of borrowing</p> Signup and view all the answers

    What does APR stand for?

    <p>Annual Percentage Rate</p> Signup and view all the answers

    In a financial context, the cost of borrowing money is known as the ______.

    <p>interest rate</p> Signup and view all the answers

    Match the type of compounding to its corresponding 'm' value:

    <p>Annually = 1 Quarterly = 4 Monthly = 12 Daily = 365</p> Signup and view all the answers

    The interest earned from periodic compounding can often be ___________ than simple interest.

    <p>greater</p> Signup and view all the answers

    Match the following types of interest rates with their definitions:

    <p>Simple Interest = Interest calculated only on the original principal Compound Interest = Interest calculated on the principal and previous interest APR = Yearly percentage rate for borrowing or investing EAR = Adjusted for compounding to reflect effective yearly return</p> Signup and view all the answers

    Which statement correctly describes the effective annual rate (EAR)?

    <p>It reflects the total amount of interest earned or paid in a year taking into account compounding. (A)</p> Signup and view all the answers

    Lenders can only charge interest on an annual basis.

    <p>False (B)</p> Signup and view all the answers

    If you deposit $100 at a simple interest rate of 10% for 5 years, how much interest will you earn?

    <p>$50</p> Signup and view all the answers

    What is the Effective Annual Rate (EAR) formula used for?

    <p>Calculating the annual yield of an investment based on compounding (B)</p> Signup and view all the answers

    Real Interest Rate increases when expected inflation rises.

    <p>False (B)</p> Signup and view all the answers

    If the nominal interest rate is 8.5% and expected inflation is 3%, what is the real interest rate?

    <p>5.5%</p> Signup and view all the answers

    The formula for calculating the nominal interest rate is: Nominal rate = Real rate + expected __________.

    <p>Inflation</p> Signup and view all the answers

    What is the main purpose of the Maturity Premium?

    <p>To compensate for waiting time until full repayment (A)</p> Signup and view all the answers

    A risk-free rate guarantees that the borrower will never default.

    <p>True (A)</p> Signup and view all the answers

    Calculate the total interest expense for a $100,000 loan with an APR of 8.5% for one year, compounded monthly.

    <p>$8,839.09</p> Signup and view all the answers

    Match the following terms with their definitions:

    <p>Nominal Interest Rate = Rate at which money invested grows Real Interest Rate = Rate at which the purchasing power of an investment increases Default Premium = The portion compensating for the risk of default Inflation = The rate at which prices are increasing</p> Signup and view all the answers

    Study Notes

    Course: Finance 235 (2024)

    Chapter 5: Interest Rates - Part 1

    •  Interest rates are quoted differently
    •  Periodic interest rates are calculated for periods less than a year
    •  Effective Annual Rate (EAR) shows the actual annual return on investment, considering compounding
    • EAR = [1 + (periodic interest rate)]number of periods - 1

    Learning Outcomes

    • Understanding how interest rates are quoted
    • Calculating annual and periodic interest rates
    • Calculating the effective annual rate (EAR)
    • Explaining the real interest rate and inflation's effect on nominal rates
    • Defining the risk-free rate

    Interest Rate Fundamentals

    •  Interest rate is the cost of borrowing money
    •  Interest rates fluctuate over time
    •  Interest rates are crucial for financial managers

    Types of Interest Rates

    • Simple interest: Calculated only on the principal
    • Simple Interest = PRT (Principal x Rate x Time)
    • Compound interest: Interest is calculated on the principal and accumulated interest

    How Financial Institutions Quote Interest Rates

    • Annual Percentage Rate (APR) - the yearly percentage rate earned or charged
    • Periodic interest rate: This is the interest rate for a period less than a year (e.g., monthly or quarterly). It is calculated by dividing the APR by the number of compounding periods per year. Periodic Interest Rate = APR/m where m = number of compounding periods (monthly = 12, quarterly = 4, daily = 365.

    Effective Annual Rate (EAR)

    • Represents the true annual rate of return
    • Calculated taking into account compounding (the process by which interest is calculated on the accumulated principal and interest from previous periods)

    Nominal and Real Interest Rates

    • Nominal rate: Stated interest rate. It is the rate before adjusting for inflation.
    • Real rate: Interest rate adjusted for inflation. Real rate = Nominal rate – expected inflation.

    Risk-Free Rate

    • Theoretical rate of return that considers a risk-free investment. A risk-free rate describes an investment with absolutely no chance of default.

    Default Premium

    • Compensation for the higher risk associated with probable borrower default.

    Maturity Premium

    • Part of the nominal interest rate compensating the investor or lender for the time to receive the repayment.

    Yield Curve

    • Graph illustrating the relationship between interest rates and maturities for a particular financial instrument.
    • A yield curve shows how borrowing costs change with time to maturity of the debt.

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    Related Documents

    Chapter 5 Interest Rates 2024 - Finance 235 PDF

    Description

    Explore the fundamental concepts of interest rates in this quiz based on Finance 235 Chapter 5. Learn how to differentiate between quoted and periodic interest rates, calculate the Effective Annual Rate (EAR), and understand the impact of inflation on nominal rates. Test your knowledge on both simple and compound interest calculations.

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