FE1 Chapter 5 Time value of Money Compounding the process of accumulating interest on an investment over time to earn more interest Interest on Interest interest earned on the reinvestment of previous interest payments Compound Interest interest earned on both the initial principal and the interest reinvested from prior periods Simple Interest interest earned only on the original principal amount invested Present Value the current value of future cash flows discounted at the appropriate discount rate Discount calculate the present value of some future amount Discount rate the rate used to calculate the present value of future cash flows Discounted cash flow DCF valuation calculating the present value of a fture cash flow to determine its value today Annuity a level stream of cash flows for a fixed period of time Annuity due an annuity for which the cash flows occur at the beginning of the period Perpetuity an annuity in which the cash flows continue forever Consol a type of perpetuity Preferred Stock Bond Stated Interest Rate the interest rate expressed in terms of the interest payment made each period Also known as the quoted interest rate Effective Annual Rate EAR The interest rate expressed as if it were compounded once per year Annual percentage rates APR The interest rate charged per period multiplied by the number of periods per year 1 Chapter 7 Interest Rates and bond valuation Coupon the stated interest payment made on a bond Bonds and Bond valuations Face value the principal amount of a bond that is repaid at the end of the term Coupon rate the annual coupon divided by the face value of a bond Maturity the specified date on which the principal amount of a bond is paid Yield to maturity YTM the rate required in the market on the bond Current yield a bond s annual coupon divided by its price Indenture the written agreement between the corporation and the lender detailing the terms of the debt issue Registered form the form of bond issue in which the registrar of the company records ownership of each bond payment is made directly to the owner of the record Bearer form the form of bond issue in which the bond is issued without record of the owners name payment is made to whomever holds the bond Debenture an unsecured debt usually with a maturity of 10 years or more Note an unsecured debt usually with a maturity under 10 years Sinking fund an account managed by the bond trustee for early bond redemption Call provision an agreement giving the corporation the option to repurchase a bond at a specified price prior to maturity Call premium the amount by which the call price exceeds the par value of a bond Deferred call provision a call provision prohibiting the company from redeeming a bond prior to a certain date Call protected bond a bond that during a certain period cannot be redeemed by the issuer Protective covenant a part of the indenture limiting certain actions that might be taken during the term of the loan usually to protect the lenders interest 2 Zero Coupon bond a bond that makes no coupon payments and is thus initially priced at a deep discount Floating rate bonds the coupon payments are adjustable Bid price the price a dealer is willing to pay for a security Bond Markets Asked price the price a dealer is willing to take for the security Bid ask spread the difference between the bid price and the asked price Clean price the price of a bond net of accrued interest this is the price that is typically quoted Dirty price the price of a bond including accrued interested also known as the full or invoice price This is the price the buyer actually pays Inflation and Interest Rates Real rates interest rates or rates of return that have been adjusted for inflation Nominal rates interest rates or rates of return that have not been adjusted for inflation Fisher effect the relationship between nominal returns real returns and inflation Determinants of Bond Yields Term structure of interest rates the relationship between nominal interest rates on default free pure discount securities and time to maturity that is the pure time value of money Inflation premium the portion of a nominal interest rate that represents compensation for expected future inflation Interest rate risk premium the compensation investors demand for bearing interest rate risk Treasury yield curve a plot of the yields on treasury notes and bonds relative to maturity Default risk premium the portion of a nominal interest rate or bond yield that represents compensation for the possibility of default Taxability premium the portion of a nominal interest rate or bond yield that represents 3 Liquidity premium the portion of a nominal interest rate or bond yield that represents compensation for lack of liquidity 4