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What is meant by a loan's proceeds.
- The usable amount received from the loan.
- Loan amount - compensating balance - loan origination costs.
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Define financial return.
The gain or loss that can occur on an asset over a given period
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What are the 3 risk behavior preferences?
- (1) Risk-Indifferent = more risk does not have to equate to a higher return
- (2) Risk-Adverse = more risk must equate to a higher return
- (3) Risk-Seeking (aka Gunslinger) = more risk often causes a lower return (or a lower return is sought after)
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What are the 7 types of investment risk? Give a brief explanation, and a mitigating factor.
- (1) interest rate = if the market interest rate chgs, your bond may not be worth as much. Hedge, forward rate, swaps
- (2) market risk (systematic, non-diversifiable) = the entire market shifts due to economic factors. Short selling.
- (3) firm-specific (unsystematic, diversifiable) = an industry or entity changes value. Diversification
- (4) Credit risk = the entity has poor credit that results in higher interest rates. Fix the credit issues.
- (5) Default risk = the entity to whom you've lent money could not pay you. Don't lend; charge a higher interest rate.
- (6) Liquidity risk = you need cash fast and no-one wants to buy your investment. Invest in items that have an active market.
- (7) Price risk = prices change. Diversify, derivatives, put options
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What is the noncompounded interest formula? What is another name for the rate used in this formula?
- The Annual Percentage Rate (APR)
- R = I/P, where
- I=dollar amount of interest earned (or paid), R=rate of interest, P=Loan Proceeds
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What is the compound interest formula? What is another name for the rate used in this formula? How is this formula simplified if interest is compounded annually?
- The Effective APR or Effective Interest Rate
- [1+(i/n)^nt]-1, where
- i=interest rate, n=compounding periods per year, t=number of years.
- Simple: [(1+i)^t]-1
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An investor may add the following premiums to the risk-free rate to compensate for certain risks. Define the following (1) MRP, (2) IP, (3) LP, (4) DRP. What is another name for IP?
- (1) MRP = maturity risk premium, which increases as the timeframe for maturity increases
- (2) IP = inflation premium (aka purchasing power risk premium), which is used to compensate for price fluctuations over time
- (3) LP = liquidity risk premium, in case investors can't quickly sell the debt on the open market
- (4) DRP = default risk premium, in case the borrower fails to pay on a timely basis
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Which of the following factors is inherent in a firm's operations if it utilizes only equity financing, and why? (1) financial risk, (2) business risk, (3) interest rate risk, (4) marginal risk
- Business Risk
- The possibility a company will have lower than anticipated profits or experience a loss.
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Define "certainty equivalent."
- The point at which the investor is indifferent to risk.
- Consider it the quaranteed return that someone would accept.
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Which types of risk behavior preference occurs when the certainty equivalent is _____ the expected value of the investment alternative: (1) equal to, (2) greater than, (3) less than
- (1) Risk Indifferent
- (2) Risk Seeking
- (3) Risk Averse
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What is formula for the market risk premium?
Market risk premium = Market risk rate - risk free rate
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Which of the following types of risk can be reduced by diversification and why? (1) recessions, (2) inflation, (3) labor strikes, (4) high interest rates
- (3) labor strikes
- Firm-specific risks can be mitigated by diversification. A labor strike would be firm-specific. Diversify by also owning stock in companies not prone to strikes.
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When interest in earned on a compensating balance account (an account required due to receiving a loan), how is the interest applied to the effective interest rate calculation?
- It is subtracted from the interest amount paid on the loan
- (interest paid - interest received from compensating account) / proceeds of loan
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