Test 2

time value of money

the difference in value between a dollar in hand today and a dollar promised in the future; a dollar today is worth more than a dollar in the future

time zero

the beginning of a transaction; often the current point in time

future value (FV)

the value of an investment after it earns interest for one or more periods

principal

the amount of money on which interest is paid

simple interest

interest earned on the original principal amount only

interest on interest

interest earned on interest that was earned in previous periods

compounding

the process by which interest earned on an investment is reinvested, so in future periods interest is earned on the interest as well as the principal

compound interest

interest earned both on the original principal amount and on interest previously earned

discounting

the process by which the present value of future cash flows is obtained

discount rate

the interest rate used in the discounting process to find the present value of future cash flows

present value (PV)

the current value of future cash flows discounted at the appropriate discount rate

annuity

a series of equally spaced and level cash flows extending over a finite number of periods

perpetuity

a series of level cash flows that continue forever

ordinary annuity

an annuity in which payments are made at the ends of the periods

present value of an annuity (PVA)

the present value of the cash flows from an annuity, discounted at the appropriate discount rate

amortizing loan

a loan for which each payment contains repayment of some principal and a payment of interest that is based on the remaining principal to be repaid

amortization schedule

a table that shows the loan balance at the beginning and end of each period, the payment made during that period, and how much of that payment represents interest and how much represents repayment of principal

future value of an annuity (FVA)

the value of an annuity at some point in the future

annuity due

an annuity in which payments are made at the beginning of each period

growing annuity

an annuity in which the cash flows increase at a constant rate

growing perpetuity

a cash flow stream that grows at a constant rate forever

annual percentage rate (APR)

the simple interest rate charged per period multiplied by the number of periods per year

effective annual interest rate (EAR)

the annual interest rate that reflects compounding within a year

quoted interest rate

a simple annual interest rate, such as the APR

Truth-in-Lending Act

a federal law requiring lenders to fully inform borrowers of important information related to loans, including the annual percentage rate charged

Truth-in-Savings Act

a federal law requiring institutions offering consumer savings vehicles, such as a certificates of deposits CDs), to fully inform consumers of important information about the saving vehicles, including the annual percentage rate paid

total holding period return

the total return on an asset over a specific period of time or holding period

expected return

an average of the possible returns from an investment, where each return is weighted by the probability that it will occur

variance

a measure of the uncertainty associated with an outcome

standard deviation

the square root of the variance

normal distribution

a symmetric frequency distribution that is completely described by its mean and standard deviation; also known as a bell curve due to its shape

portfolio

the collection of assets an investor owns

diversification

reducing risk by investing in two or more assets whose values do not always move in the same direction at the same time

coefficient of variation (CV)

a measure of the risk associated with an investment for each 1 percent of expected return

Sharpe ratio

A measure of the return per unit of risk for an investment

covariance of returns

a measure of how the returns on two assets covary, or move together

unsystematic or diversifiable risk

risk that can be eliminated through diversification

systematic or nondiversifiable risk

risk that cannot be eliminated through diversification

market portfolio

the portfolio of all assets

market risk

a term commonly used to refer to nondiversifiable, or systematic, risk

beta

a measure of nondiversifiable, systematic, or market, risk

Capital Asset Pricing Model (CAPM)

a model that describes the relation between risk and expected return

Security Market Line (SML)

a plot of the relation between expected return and systematic risk

fixed-income securities

debt instruments that pay interest in amounts that are fixed for the life of the contract

coupon payments

the interest payments made to bondholders

face value (par value)

the amount on which interest is calculated and that is owed to the bondholder when a bond reaches maturity

coupon rate

the annual coupon payment of a bond divided by the bond's face value

opportunity cost

the return from the best alternative investment with similar risk that an investor gives up when he or she makes a certain investment

par-value bonds

bonds that sell at par value, or face value; whenever a bond's coupon rate is equal to the market rate of interest on similar bonds, the bond will sell at par (face) value

discount bonds

bonds that sell at prices below par (face) value

premium bonds

bonds that sell at prices above par (face) value

yield to maturity

for a bond, the discount rate that makes the present value of the coupon and principal payments equal to the price of the bond

effective annual yield (EAY)

the annual yield that takes compounding into account; another name for the effective annual interest rate (EAR)

realized yield

for a bond, the interest rate at which the present value of the actual cash flows from a bond equals the bond's price

interest rate risk

uncertainty about future bond values that is caused by the unpredictability of interest rates

investment-grade bonds

bonds with low risk of default that are rated Baa (BBB) or above

noninvestment-grade bonds

bonds rated below Baa (or BBB) by rating agencies; often called speculative-grade bonds, high-yield bonds, or junk bonds

term structure of interest rates

the relation between yield to maturity and term to maturity

yield curve

a graph representing the term structure of interest rates, with the term to maturity on the horizontal axis and the yield on the vertical axis

bid price

the price a securities dealer will pay for a given stock

offer (ask) price

the price at which a securities dealer seeks to sell a given stock

post

a specific location on the floor of a stock exchange at which auctions for a particular security take place

specialist

the trader designated by an exchange to represent orders placed by public customers at auctions of securities; specialists handle a small set of securities and are also allowed to act as dealers

dividend yield

a stock's annual dividend divided by its current price

common stock

an equity share that represents the basic ownership clam in a corporation; the most common type of equiry security

preferred stock

an equity share in a corporation that entitles the owner to preferred treatment over owners of common stock with respect to dividend payments and claims against the firm's assets in the event of bankruptcy or liquidation, but that typically has no voting