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File Size : 362.5KB (371220 Bytes)
Date Taken : 2002/01/27 18:01:37
Image Size : 1600 x 1200 pixels
Resolution : 300 x 300 dpi
Bit Depth : 8 bits/channel
Protection Attribute : Off
Hide Attribute : Off
Camera ID : N/A
Camera : E775
Quality Mode : NORMAL
Metering Mode : Matrix
Exposure Mode : Programmed Auto
Speed Light : No
Focal Length : 9.1 mm
Shutter Speed : 1/37.6 second
Aperture : F3.4
Exposure Compensation : 0 EV
White Balance : Auto
Lens : Builtin
Flash Sync Mode : Normal
Exposure Difference : N/A
Flexible Program : N/A
Sensitivity : Auto
Sharpening : Auto
Image Type : Color
Color Mode : N/A
Hue Adjustment : N/A
Saturation Control : N/A
Tone Compensation : Normal
Latitude(GPS) : N/A
Longitude(GPS) : N/A
Altitude(GPS) : N/AAdobed
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___PPT9/0]cdefghY[^cj{}D:\Interaction\Web Site\MRA PWS Site\Notes\Fin525Fall04Class1.htmE0(]^_?V, BProfessor Ross Miller " Fall 2006O=xFinance 525 Week 17Introduction to the Course and to the Concept of Money88 Fin 525 Mission StatementRTo give every student a practical understanding of how the world of finance works."SR$$dCourse SyllabusAvailable on paper in class
Also available on the Internet at: http://www.riggedonline.com/Finance/Fin525Fall2006Syllabus.pdf
The most critical points from the syllabus are reiterated on the next several slides6J0?}8Overview of the Course CalendarWeeks 1 3 (Part I): Money of all Kinds
Weeks 3 (Part II) 5: LongTerm Debt
Week 6: Midterm Exam
Weeks 7 11: Equity and Portfolio Management
Week 12: Capital Budgeting
Week 13: (Optional) Final ExamT 1 / ^Grading4The raw grade for the course is the average of the best three of the following four:
Midterm exam
Stock prediction and hedging exercise
401(k) group project
Final exam (optional)
Class participation and evidence of improvement will influence grades of students with grades near the border between two grades6U_U_e0What is Different About How I Teach This CoursevTextbooks and traditional finance classes focus on the wonderful things that academics have discovered
This course focuses on financial instruments, how they are used, and how finance professionals attempt to value them
Topics concerning international finance and derivative securities are integrated directly into the course and not ignored or relegated to advanced courseswZwReadingsCustom course textbook
Time value of money and capital budgeting covered by Ross/Westerfield/Jaffe (RWJ) chapters
Stocks and portfolios covered by Bodie/Kane/Marcus (BKM)
Other basic content covered by material on class slides or on the Internet (with links from the slides and/or WebCT)
Current financial events from the Wall Street Journal:10week subscription for $13.95 or a 15week subscription for $19.95 (School zip code is 12222)XZZZb\Q7']J0BU[J0WkYJ0
aA Note on the Custom TextbookIt is designed as a central source for financial formula and their application
It is not designed to entertain you (that is my job)
The financial world moves so quickly that all textbooks are outofdate even before they are publishedgUse of WebCT in the CoursePRepository for course materials
Primary means of contacting the professor (via Email)
Can also send mail to rmmiller@uamail.albany.edu
Discussions and notifications (especially concerning topics that arise in class discussions and problem solutions)
Slides are also available at: http://home.earthlink.net/~millerrisk/FinanceNotes.htmFX1X174n/J0nJ0P9AssignmentsMAssignments appear on the last slide for each week and on WebCT
Most weeks have specific readings that must be read prior to the next class meeting
Most weeks also have examlike problems to answer
Assignments are not handed in or graded, but experience indicates that students who fail to do them encounter real trouble on the examsNZN:Smile\I will take digital photos of all class members at both the Week 2 and Week 3 class meetings]]YA Bit of AdviceuIf you are lost, others probably are lost too, soASK THE PROFESSOR TO EXPLAIN WHAT IN THE WORLD HE IS TALKING ABOUT!fA DisclaimerThe slides used in this course incorporate much more information per slide than is considered acceptable for standard corporate communications
This is done so that they can serve as a more comprehensive form of notes that goes well beyond what is in the textbook
What is Finance?Two major elements
Time
Uncertainty (particularly involving the risk of an unfavorable outcome)
A typical very simple financial transaction
Borrow money to purchase capital equipment to produce goods or services and use some of the revenue to repay the money at a specified later timeLM,M,Finance Focuses on Cash FlowsyThere are three basic ways that cash flows can be structured
Straight financing: Pay cash now in return for the right to receive something, often just more cash, later
Forward contract: Agree now to buy or sell an item at a fixed price at some future date(s)
Option contract: Pay cash now in return for the option to buy or sell an item at a fixed price at some future date(s)
R=<"
#<CFinancial Instruments Involve the Creative Packaging of Cash Flows8Stocks and bonds
Pay now, have the right to (but not necessarily receive) a stream of future cash flows
Futures contracts
A forward contract with collateral (called margin) paid up front and maintained until delivery
Mutual funds (including ETFs)
An often useful bundle of stocks, bonds, or a combination of bothtW_BW_BD&Valuation is Done Two WaysDiscounting
Cash in the future is worth less than the same amount of cash held now
A lot of finance is about determining how large this difference in value is or should be
This is known (depending on context) as an interest rate, discount rate, or discount factor
Arbitrage
Turn something new that you wish to value into pieces of something old ( slice and dice ) that you already know how to valueZZ
Z}Z
}bFMuch of Finance is about Shopping Accomplish a financial goal at the least possible cost
Corporate financing
Household financing
Accomplish a financial goal with the least possible risk
Find bargains and sell them to others at a profit
Avoid getting ripped off (too often)67(7(=2Finance Is Also AboutInformation and ExpectationsPPrices reflect existing information and expectations
Prices change as information and expectations change
Just how well prices reflect information and expectations is hotly debated but the consensus is very well, though not perfectly
Prices also take other things into account most notably, risk)Z)@A Side Note on Internet SourcesInternet sources of financial information, definitions are usually but not always correct
Investopedia is especially good, but even it has misinformation
Be especially careful about using Wikipedia$Cu^J0ZgcJ0RThe Six Types of Objects in This CourseFinancial Instruments
Analytic Methods
Financial Indicators (indexes)
Events (both historical and current)
Institutions
People
*8Financial Instruments Fall Roughly Into Four CategoriesBMoney (shortterm debt and cash)
Longterm debt
Equity
Real assetsGoogle Stock (Nasdaq: GOOG)hJ04Google went public in August 2004
Is volatile and can behave in ways that are atypical of most stocks
Fin 525 s pet stock in AY2004 2005 and AY2005 2006> 6This is an Analytic Methods Slide (Believe It or Not)S&P 500 Stock IndexJThe stock index most often used by financial professionals
Vanguard s mutual fund that is designed to replicate the performance of the index is among the largest mutual fund in the U.S.
Are also the basis for the exchangetraded fund (ETF) with the symbol SPY that are known as Spiders (SPDRs)< gJ0(/Both Current and Historical Events Are Covered$United States Department of TreasurylIssuer of many of the financial securities covered in the early on in the course
The largest single player in the world economy because it is responsible for funding the Federal government s budget deficit
Because its securities are considered risk free, the rates of interest that it pays serve as baselines4Steven A. ( Stevie ) Cohen"jJ0Superstar billionaire hedge fund manager
His company, SAC Capital, is responsible for a significant amount of the volume on U.S. stock exchanges
Traders at SAC Capital have attracted the attention of securities regulators
+Any Questions? U.S. Federal Reserve Note (Cash)
Federal Reserve BankcJ0The central bank of the United States
Founded in 1913 as the central bank of the U.S.
Original mission was to provide financial stability
Federal Reserve Notes constitute the bulk of its liabilities
Visit its current balance sheet
Text format
PDF format
<ZZZdJ0eJ0So, What Is Money Anyway?%Money in Prison
Cash is Trash zCash pays no interest and its value is eaten away by inflation
Therefore, businesses try to hold as little cash as possible
To deal with shortterm funding requirements, businesses hold other forms of money
Bank deposits (and things that resemble them, like most moneymarket funds) are a preferred form of money
>Z>5HWalMart s Cash on the Balance SheetJ0
6_How Do We Know How Much Cash WalMart has in its Cash Registers?Is Lots of Cash a Good Thing? Certificates of Deposits (CDs)/Issued by banks
How they work
Deposit money with bank right now (cash outflow)
Receive even more money at a specified maturity date (cash inflow)
CDs are a form of time deposit (in contrast to a demand deposit)
We will focus on CDs that mature in under one year, the boundary between short and long term^ tA ] t"CCDs Rates are Required by Law to be Quoted as Annual Interest Rates}A popular place to find CD rates is bankrate.com
CD calculator
This deals with time periods other than a year and compounding&????*$
@fJ0$0gJ01>7Computing the Future Value (FV) of a CD(RWJ pp. 6061)Parameters
Cash outflow now: C0 = $10,000
CD interest rate: r = 12% or 0.12
Formula (for a single period)
FV = C0 (1+r)
Applying the formula
FV = $10,000 (1 + 0.12) = $10,000 (1.12) = $11,200
A44.
Reality CheckVInterest rates on any form of bank deposit have during a single period of American history and may never be that high again
The textbook then uses 12% virtually riskfree return on the CD as the discount rate to evaluate (compute the present value, PV) of a risky project, which is not a good idea1)What If You Really Could Get 12% on CDs?**0FSuppose You Want to Receive $11,424 One Year From Now at 12% InterestThe size of the CD you will purchase now is the present value (PV) of the $11,424 in one year
Formula (for a single period)
PV = C1 / (1+r)
Applying the formula
PV = $11,424 / (1 + 0.12) = $11,424 / (1.12) = $10,200
PV is also a builtin Excel function
7&7&/Computing Present ValuesWe will introduce two complications
Periods of time shorter or longer than the period over which the interest rate is quoted (usually one year)
Compounding: Getting interest on interest
PV is easy to compute on any calculator, not just financial calculators
PV is a builtin Excel function
Note: For Excel C0 is a negative number, which makes sense, but is not the way textbooks do itt$ZZhZ_Z$hM2UComputing NPV (Net Present Value), Which Is PV with the Initial Investment Netted OutParameters
Cash outflow now: C0 = $10,000
Cash inflow in one year: C1 = $11,200
Interest rate on 8/22/05: 4.30%
Formula: NPV = C0 + C1 / (1+r)
Applying the formula
NPV = $10,000 + $11,200 / (1 + 0.043) = $10,000 + $10,738.26 = $738.26e6L$+ $ 3
Excel and NPVThe computation on the previous slide is difficult to do automatically in Excel
Minor problem: Excel has an NPV function, but it makes no provision for the first cash flow to occur right now
The PV function can be coaxed to do this
6*B.Summary of Bank Time Deposits and Discounting"Simple payment scheme from bank CDs
Pay money in now
Get more money out later
The interest rate determines how much money is paid out later relative to the amount paid in
To get future value multiple by (1+r) to get present value divide by (1+r), where r is the interest rate for the periodl$*$*$ %CMThe Fundamental Relationship BetweenInterest Rate (r) and Present Value (PV)Interest rates and the PV of any every financial instrument with constant future cash flows (fixedincome securities like CDs and bonds) always move in opposite directions
Example: The PV of $10,000 at 4% interest in 1 year is $10,000/1.04 = $9,615.38
If the interest rate goes up to 5%, the PV drops to $10,000/1.05 = $9,523.81
If the interest rate goes down to 3%, the PV rises to $10,000/1.03 = $9,708.748PD$More on the Fundamental RelationshipWe will examine the sensitive of various fixedincome securities to interest rates before midterm using a measurement called duration
While the prices of stocks and some risky bonds (both have very uncertain cash flows) tend to move in the opposite direction of interest rates, they sometimes move in the same direction when the change in interest rates indicates strength or weakness in the economy$~
E>Converting Annual Interest Rates to Periods Less Than One YearjObvious method
Multiply rate by the appropriate fraction of a year
Examples:
12% for 6 months (or year) is (12%) = 6%
8% for 3 months (or year) is (8%) = 2%
Warning
The financial world often does not conform to the obvious method because annual rates can be quoted oddly or based on a 360day yeart4
Z4
ZF3FV and PV for Less Than a Year with No CompoundingConvert interest rate to new period length as demonstrated earlier
Apply the FV and PV formulas as before
FV = C0 (1+r)
PV = C1 / (1+r)
FV of $10,000 paying 4% annual rate for 6 months ( year)
FV = $10,000 (1 + 0.04/2) = $10,200j<$j<$G5Suppose We Reinvest in an Identical CD After 6 Months]Now our outflow (initial investment) is $10,200
The future value in six months is $10,200 (1.02)= $10,404
Notice that this is the same as investing for an entire year at 4.04%
4.04% is known as the APY (annual percentage yield) or EAR (effective annual rate)
Compounding accounts for the extra 0.04%, commonly known as 4 basis points (b.p.) or bipsD^0Z2BYH5The General Formula for Future Valuewith Compounding
New parameters:
m: Number of interest periods in a year
m = 2 means semiannual interest
m = 4 means quarterly interest
m = 12 means monthly interest
m = 365 means daily interest
T: Future time (in years or a fraction of a year) when inflow of cash occurs
Formula:
({N ' M
IUsing the Compounding FormulaExample: $10,000 at 4% annual rate for 6 months, compounded monthly
Parameters:
C0 = $10,000
r = 4% = 0.04
m = 12
T = 0.5
Plugging in: FV = $10,000 (1 + 0.04/12)0.5(12) = $10,000 (1.0033& )6 = $10,201.67P*qP
(J>APY (or Effective Annual Interest Rate) Formula from RWJ p. 72K*The Difference a Bip (or a Few Bips) Makes,nAt current interest rates, APY tends to be only a few bips (hundredths of a percentage point, also known as basis points or b.p.) higher than the simple interest rate
It is important to keep interest rates straight because although they low small, every bip matters when you invest millions of dollars
Professional bond traders and investors look at spreads (the interest rate relative to other securities) and these are measured in bipsZ>6LSA Note on Use of the Compounding Formula by Ross/Westerfield/Jaffe (RWJ) on page 731For the moment this course is focused on financial instruments that take one year or less to mature
The RWJ formula states it is for multiple years, but it also works for fractions of a year as we saw in the previous slide
Similarly, the Excel FV function can deal with both fractional and whole years though you have to adjust the interest rate and number of periods manually, which is not very convenientZM+Three Important Points Worth Mentioning Now&Compounding is magic because the interest on interest (and interest on interest on interest& ) adds up over time
Over long periods of time (10 years or more depending on interest rates), small difference in the interest rate can make large differences in the future value of the investment
Note that compounding only works if we do not withdraw the interest at the time that it is paid
We will not consider the receipt of more than one cash flow from a financial instrument until we get to Treasury notes and bonds in a few weeks.ZZ\Assignment For Week 2
Check out the links in the slides covered in class
Read RWJ Ch. 4, pp. 6073
Do the problems on the 4 slides that follow this one
Justify each TrueFalse answer
For the CD problems 13, use a calculator for one of the CDs and a calculator or spreadsheet for the rest&]$TrueFalse Statements (Page 1 of 2)fOne can make the annual percentage yield from a CD as high as one wants by choosing a short enough compounding interval.
At higher stated yields, the compounding interval will make more of a difference to the annual percentage yield.
In general, a $1,000 6month bank CD should cost less to purchase now than it did at this time last year (September 2005).
,ee^$TrueFalse Statements (Page 2 of 2)(Doubling the interest rate on a CD will double its APY
If two oneyear CDs both pay $10,000 at maturity, then the one with the lower APY will cost more to purchase now
The financial markets expect that the U.S. will grow faster in the second half of 2006 than it did in the first quarter of 2006.))_Questions about the Next SlidenCompute the APY (known in the textbook as Effective Annual Interest Rate) for each CD.
Compute the future value at maturity for each CD for an investment of $10,000 today.
Compute the present value of $10,000 received at maturity from each CD.
You are considering the 3month and 12month (1 year) CDs offered by Beal bank. Bank of Miller (BoM) is willing to guarantee you a 9month when the 3month Beal CD matures if you sign with them now. What APY must BoM provide you so that after a year you will have the same amount you would have buying Beal s 12month CD.
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A DisclaimerWhat is Finance?Finance Focuses on Cash FlowsDFinancial Instruments Involve the Creative Packaging of Cash FlowsValuation is Done Two Ways$Much of Finance is about Shopping3Finance Is Also About Information and Expectations A Side Note on Internet Sources*The Six Types of Objects in This Course9Financial Instruments Fall Roughly Into Four CategoriesGoogle Stock (Nasdaq: GOOG)7This is an Analytic Methods Slide (Believe It or Not)S&P 500 Stock Index0Both Current and Historical Events Are Covered%United States Department of TreasurySteven A. (Stevie) CohenAny Questions?!U.S. Federal Reserve Note (Cash)Federal Reserve BankSo, What Is Money Anyway?Money in PrisonCash is Trash%WalMarts Cash on the Balance Sheet`How Do We Know How Much Cash WalMart has in its Cash Registers? Is Lots of Cash a Good Thing?Certificates of Deposits (CDs)DCDs Rates are Required by Law to be Quoted as Annual Interest Rates8Computing the Future Value (FV) of a CD (RWJ pp. 6061)Reality Check*What If You Really Could Get 12% on CDs?GSuppose You Want to Receive $11,424 One Year From Now at 12% InterestComputing Present ValuesVComputing NPV (Net Present Value), Which Is PV with the Initial Investment Netted OutExcel and NPV/Summary of Bank Time Deposits and DiscountingNThe Fundamental Relationship Between Interest Rate (r) and Present Value (PV)%More on the Fundamental Relationship?Converting Annual Interest Rates to Periods Less Than One Year4FV and PV for Less Than a Year with No Compounding6Suppose We Reinvest in an Identical CD After 6 Months6The General Formula for Future Value with CompoundingUsing the Compounding Formula?APY (or Effective Annual Interest Rate) Formula from RWJ p. 72+The Difference a Bip (or a Few Bips) MakesTA Note on Use of the Compounding Formula by Ross/Westerfield/Jaffe (RWJ) on page 73,Three Important Points Worth Mentioning NowAssignment For Week 2%TrueFalse Statements (Page 1 of 2)%TrueFalse Statements (Page 2 of 2)Questions about the Next Slide1CD Interest Rates Compiled on September 6, 2005Fonts UsedDesign TemplateEmbedded OLE Servers
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___PPT9/0]cdefghY[^cj{}D:\Interaction\Web Site\MRA PWS Site\Notes\Fin525Fall04Class1.htmE0(]^_?V, BProfessor Ross Miller " Fall 2006O=xFinance 525 Week 17Introduction to the Course and to the Concept of Money88 Fin 525 Mission StatementRTo give every student a practical understanding of how the world of finance works."SR$$dCourse SyllabusAvailable on paper in class
Also available on the Internet at: http://www.riggedonline.com/Finance/Fin525Fall2006Syllabus.pdf
The most critical points from the syllabus are reiterated on the next several slides6J0?}8Overview of the Course CalendarWeeks 1 3 (Part I): Money of all Kinds
Weeks 3 (Part II) 5: LongTerm Debt
Week 6: Midterm Exam
Weeks 7 11: Equity and Portfolio Management
Week 12: Capital Budgeting
Week 13: (Optional) Final ExamT 1 / ^Grading4The raw grade for the course is the average of the best three of the following four:
Midterm exam
Stock prediction and hedging exercise
401(k) group project
Final exam (optional)
Class participation and evidence of improvement will influence grades of students with grades near the border between two grades6U_U_e0What is Different About How I Teach This CoursevTextbooks and traditional finance classes focus on the wonderful things that academics have discovered
This course focuses on financial instruments, how they are used, and how finance professionals attempt to value them
Topics concerning international finance and derivative securities are integrated directly into the course and not ignored or relegated to advanced courseswZwReadingsCustom course textbook
Time value of money and capital budgeting covered by Ross/Westerfield/Jaffe (RWJ) chapters
Stocks and portfolios covered by Bodie/Kane/Marcus (BKM)
Other basic content covered by material on class slides or on the Internet (with links from the slides and/or WebCT)
Current financial events from the Wall Street Journal:10week subscription for $13.95 or a 15week subscription for $19.95 (School zip code is 12222)XZZZb\Q7']J0BU[J0WkYJ0
aA Note on the Custom TextbookIt is designed as a central source for financial formula and their application
It is not designed to entertain you (that is my job)
The financial world moves so quickly that all textbooks are outofdate even before they are publishedgUse of WebCT in the CoursePRepository for course materials
Primary means of contacting the professor (via Email)
Can also send mail to rmmiller@uamail.albany.edu
Discussions and notifications (especially concerning topics that arise in class discussions and problem solutions)
Slides are also available at: http://home.earthlink.net/~millerrisk/FinanceNotes.htmFX1X174n/J0nJ0P9AssignmentsMAssignments appear on the last slide for each week and on WebCT
Most weeks have specific readings that must be read prior to the next class meeting
Most weeks also have examlike problems to answer
Assignments are not handed in or graded, but experience indicates that students who fail to do them encounter real trouble on the examsNZN:Smile\I will take digital photos of all class members at both the Week 2 and Week 3 class meetings]]YA Bit of AdviceuIf you are lost, others probably are lost too, soASK THE PROFESSOR TO EXPLAIN WHAT IN THE WORLD HE IS TALKING ABOUT!fA DisclaimerThe slides used in this course incorporate much more information per slide than is considered acceptable for standard corporate communications
This is done so that they can serve as a more comprehensive form of notes that goes well beyond what is in the textbook
What is Finance?Two major elements
Time
Uncertainty (particularly involving the risk of an unfavorable outcome)
A typical very simple financial transaction
Borrow money to purchase capital equipment to produce goods or services and use some of the revenue to repay the money at a specified later timeLM,M,Finance Focuses on Cash FlowsyThere are three basic ways that cash flows can be structured
Straight financing: Pay cash now in return for the right to receive something, often just more cash, later
Forward contract: Agree now to buy or sell an item at a fixed price at some future date(s)
Option contract: Pay cash now in return for the option to buy or sell an item at a fixed price at some future date(s)
R=<"
#<CFinancial Instruments Involve the Creative Packaging of Cash Flows8Stocks and bonds
Pay now, have the right to (but not necessarily receive) a stream of future cash flows
Futures contracts
A forward contract with collateral (called margin) paid up front and maintained until delivery
Mutual funds (including ETFs)
An often useful bundle of stocks, bonds, or a combination of bothtW_BW_BD&Valuation is Done Two WaysDiscounting
Cash in the future is worth less than the same amount of cash held now
A lot of finance is about determining how large this difference in value is or should be
This is known (depending on context) as an interest rate, discount rate, or discount factor
Arbitrage
Turn something new that you wish to value into pieces of something old ( slice and dice ) that you already know how to valueZZ
Z}Z
}bFMuch of Finance is about Shopping Accomplish a financial goal at the least possible cost
Corporate financing
Household financing
Accomplish a financial goal with the least possible risk
Find bargains and sell them to others at a profit
Avoid getting ripped off (too often)67(7(=2Finance Is Also AboutInformation and ExpectationsPPrices reflect existing information and expectations
Prices change as information and expectations change
Just how well prices reflect information and expectations is hotly debated but the consensus is very well, though not perfectly
Prices also take other things into account most notably, risk)Z)@A Side Note on Internet SourcesInternet sources of financial information, definitions are usually but not always correct
Investopedia is especially good, but even it has misinformation
Be especially careful about using Wikipedia$Cu^J0ZgcJ0RThe Six Types of Objects in This CourseFinancial Instruments
Analytic Methods
Financial Indicators (indexes)
Events (both historical and current)
Institutions
People
*8Financial Instruments Fall Roughly Into Four CategoriesBMoney (shortterm debt and cash)
Longterm debt
Equity
Real assetsGoogle Stock (Nasdaq: GOOG)hJ04Google went public in August 2004
Is volatile and can behave in ways that are atypical of most stocks
Fin 525 s pet stock in AY2004 2005 and AY2005 2006> 6This is an Analytic Methods Slide (Believe It or Not)S&P 500 Stock IndexLThe stock index most often used by financial professionals
Vanguard s mutual fund that is designed to replicate the performance of the index is among the largest mutual funds in the U.S.
Are also the basis for the exchangetraded fund (ETF) with the symbol SPY that are known as Spiders (SPDRs)N SJ0(/Both Current and Historical Events Are Covered$United States Department of TreasurylIssuer of many of the financial securities covered in the early on in the course
The largest single player in the world economy because it is responsible for funding the Federal government s budget deficit
Because its securities are considered risk free, the rates of interest that it pays serve as baselines4Steven A. ( Stevie ) Cohen"jJ0Superstar billionaire hedge fund manager
His company, SAC Capital, is responsible for a significant amount of the volume on U.S. stock exchanges
Traders at SAC Capital have attracted the attention of securities regulators
+Any Questions? U.S. Federal Reserve Note (Cash)
Federal Reserve BankcJ0The central bank of the United States
Founded in 1913 as the central bank of the U.S.
Original mission was to provide financial stability
Federal Reserve Notes constitute the bulk of its liabilities
Visit its current balance sheet
Text format
PDF format
<ZZZdJ0eJ0So, What Is Money Anyway?%Money in Prison
Cash is Trash zCash pays no interest and its value is eaten away by inflation
Therefore, businesses try to hold as little cash as possible
To deal with shortterm funding requirements, businesses hold other forms of money
Bank deposits (and things that resemble them, like most moneymarket funds) are a preferred form of money
>Z>5HWalMart s Cash on the Balance SheetJ0
6_How Do We Know How Much Cash WalMart has in its Cash Registers?Is Lots of Cash a Good Thing? Certificates of Deposits (CDs)/Issued by banks
How they work
Deposit money with bank right now (cash outflow)
Receive even more money at a specified maturity date (cash inflow)
CDs are a form of time deposit (in contrast to a demand deposit)
We will focus on CDs that mature in under one year, the boundary between short and long term^ tA ] t"CCDs Rates are Required by Law to be Quoted as Annual Interest Rates}A popular place to find CD rates is bankrate.com
CD calculator
This deals with time periods other than a year and compounding&????*$
@fJ0$0gJ01>7Computing the Future Value (FV) of a CD(RWJ pp. 6061)Parameters
Cash outflow now: C0 = $10,000
CD interest rate: r = 12% or 0.12
Formula (for a single period)
FV = C0 (1+r)
Applying the formula
FV = $10,000 (1 + 0.12) = $10,000 (1.12) = $11,200
A44.
Reality CheckVInterest rates on any form of bank deposit have during a single period of American history and may never be that high again
The textbook then uses 12% virtually riskfree return on the CD as the discount rate to evaluate (compute the present value, PV) of a risky project, which is not a good idea1)What If You Really Could Get 12% on CDs?**0FSuppose You Want to Receive $11,424 One Year From Now at 12% InterestThe size of the CD you will purchase now is the present value (PV) of the $11,424 in one year
Formula (for a single period)
PV = C1 / (1+r)
Applying the formula
PV = $11,424 / (1 + 0.12) = $11,424 / (1.12) = $10,200
PV is also a builtin Excel function
7&7&/Computing Present ValuesWe will introduce two complications
Periods of time shorter or longer than the period over which the interest rate is quoted (usually one year)
Compounding: Getting interest on interest
PV is easy to compute on any calculator, not just financial calculators
PV is a builtin Excel function
Note: For Excel C0 is a negative number, which makes sense, but is not the way textbooks do itt$ZZhZ_Z$hM2UComputing NPV (Net Present Value), Which Is PV with the Initial Investment Netted OutParameters
Cash outflow now: C0 = $10,000
Cash inflow in one year: C1 = $11,200
Interest rate on 8/22/05: 4.30%
Formula: NPV = C0 + C1 / (1+r)
Applying the formula
NPV = $10,000 + $11,200 / (1 + 0.043) = $10,000 + $10,738.26 = $738.26e6L$+ $ 3
Excel and NPVThe computation on the previous slide is difficult to do automatically in Excel
Minor problem: Excel has an NPV function, but it makes no provision for the first cash flow to occur right now
The PV function can be coaxed to do this
6*B.Summary of Bank Time Deposits and Discounting"Simple payment scheme from bank CDs
Pay money in now
Get more money out later
The interest rate determines how much money is paid out later relative to the amount paid in
To get future value multiple by (1+r) to get present value divide by (1+r), where r is the interest rate for the periodl$*$*$ %CMThe Fundamental Relationship BetweenInterest Rate (r) and Present Value (PV)Interest rates and the PV of any every financial instrument with constant future cash flows (fixedincome securities like CDs and bonds) always move in opposite directions
Example: The PV of $10,000 at 4% interest in 1 year is $10,000/1.04 = $9,615.38
If the interest rate goes up to 5%, the PV drops to $10,000/1.05 = $9,523.81
If the interest rate goes down to 3%, the PV rises to $10,000/1.03 = $9,708.748PD$More on the Fundamental RelationshipWe will examine the sensitive of various fixedincome securities to interest rates before midterm using a measurement called duration
While the prices of stocks and some risky bonds (both have very uncertain cash flows) tend to move in the opposite direction of interest rates, they sometimes move in the same direction when the change in interest rates indicates strength or weakness in the economy$~
E>Converting Annual Interest Rates to Periods Less Than One YearjObvious method
Multiply rate by the appropriate fraction of a year
Examples:
12% for 6 months (or year) is (12%) = 6%
8% for 3 months (or year) is (8%) = 2%
Warning
The financial world often does not conform to the obvious method because annual rates can be quoted oddly or based on a 360day yeart4
Z4
ZF3FV and PV for Less Than a Year with No CompoundingConvert interest rate to new period length as demonstrated earlier
Apply the FV and PV formulas as before
FV = C0 (1+r)
PV = C1 / (1+r)
FV of $10,000 paying 4% annual rate for 6 months ( year)
FV = $10,000 (1 + 0.04/2) = $10,200j<$j<$G5Suppose We Reinvest in an Identical CD After 6 Months]Now our outflow (initial investment) is $10,200
The future value in six months is $10,200 (1.02)= $10,404
Notice that this is the same as investing for an entire year at 4.04%
4.04% is known as the APY (annual percentage yield) or EAR (effective annual rate)
Compounding accounts for the extra 0.04%, commonly known as 4 basis points (b.p.) or bipsD^0Z2BYH5The General Formula for Future Valuewith Compounding
New parameters:
m: Number of interest periods in a year
m = 2 means semiannual interest
m = 4 means quarterly interest
m = 12 means monthly interest
m = 365 means daily interest
T: Future time (in years or a fraction of a year) when inflow of cash occurs
Formula:
({N ' M
IUsing the Compounding FormulaExample: $10,000 at 4% annual rate for 6 months, compounded monthly
Parameters:
C0 = $10,000
r = 4% = 0.04
m = 12
T = 0.5
Plugging in: FV = $10,000 (1 + 0.04/12)0.5(12) = $10,000 (1.0033& )6 = $10,201.67P*qP
(J>APY (or Effective Annual Interest Rate) Formula from RWJ p. 72K*The Difference a Bip (or a Few Bips) Makes,nAt current interest rates, APY tends to be only a few bips (hundredths of a percentage point, also known as basis points or b.p.) higher than the simple interest rate
It is important to keep interest rates straight because although they low small, every bip matters when you invest millions of dollars
Professional bond traders and investors look at spreads (the interest rate relative to other securities) and these are measured in bipsZ>6LSA Note on Use of the Compounding Formula by Ross/Westerfield/Jaffe (RWJ) on page 731For the moment this course is focused on financial instruments that take one year or less to mature
The RWJ formula states it is for multiple years, but it also works for fractions of a year as we saw in the previous slide
Similarly, the Excel FV function can deal with both fractional and whole years though you have to adjust the interest rate and number of periods manually, which is not very convenientZM+Three Important Points Worth Mentioning Now&Compounding is magic because the interest on interest (and interest on interest on interest& ) adds up over time
Over long periods of time (10 years or more depending on interest rates), small difference in the interest rate can make large differences in the future value of the investment
Note that compounding only works if we do not withdraw the interest at the time that it is paid
We will not consider the receipt of more than one cash flow from a financial instrument until we get to Treasury notes and bonds in a few weeks.ZZ\Assignment For Week 2
Check out the links in the slides covered in class
Read RWJ Ch. 4, pp. 6073
Do the problems on the 4 slides that follow this one
Justify each TrueFalse answer
For the CD problems 13, use a calculator for one of the CDs and a calculator or spreadsheet for the rest&]$TrueFalse Statements (Page 1 of 2)fOne can make the annual percentage yield from a CD as high as one wants by choosing a short enough compounding interval.
At higher stated yields, the compounding interval will make more of a difference to the annual percentage yield.
In general, a $1,000 6month bank CD should cost less to purchase now than it did at this time last year (September 2005).
,ee^$TrueFalse Statements (Page 2 of 2)(Doubling the interest rate on a CD will double its APY
If two oneyear CDs both pay $10,000 at maturity, then the one with the lower APY will cost more to purchase now
The financial markets expect that the U.S. will grow faster in the second half of 2006 than it did in the first quarter of 2006.))_Questions about the Next SlidenCompute the APY (known in the textbook as Effective Annual Interest Rate) for each CD.
Compute the future value at maturity for each CD for an investment of $10,000 today.
Compute the present value of $10,000 received at maturity from each CD.
You are considering the 3month and 12month (1 year) CDs offered by Beal bank. Bank of Miller (BoM) is willing to guarantee you a 9month when the 3month Beal CD matures if you sign with them now. What APY must BoM provide you so that after a year you will have the same amount you would have buying Beal s 12month CD.
8Z8,Trl `0CD Interest Rates Compiled on September 6, 2005/8}
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___PPT9/0]cdefghY[^cj{}D:\Interaction\Web Site\MRA PWS Site\Notes\Fin525Fall04Class1.htmE0(]^_?V, BProfessor Ross Miller " Fall 2006O=xFinance 525 Week 17Introduction to the Course and to the Concept of Money88 Fin 525 Mission StatementRTo give every student a practical understanding of how the world of finance works."SR$$dCourse SyllabusAvailable on paper in class
Also available on the Internet at: http://www.riggedonline.com/Finance/Fin525Fall2006Syllabus.pdf
The most critical points from the syllabus are reiterated on the next several slides6J0?}8Overview of the Course CalendarWeeks 1 3 (Part I): Money of all Kinds
Weeks 3 (Part II) 5: LongTerm Debt
Week 6: Midterm Exam
Weeks 7 11: Equity and Portfolio Management
Week 12: Capital Budgeting
Week 13: (Optional) Final ExamT 1 / ^Grading4The raw grade for the course is the average of the best three of the following four:
Midterm exam
Stock prediction and hedging exercise
401(k) group project
Final exam (optional)
Class participation and evidence of improvement will influence grades of students with grades near the border between two grades6U_U_e0What is Different About How I Teach This CoursevTextbooks and traditional finance classes focus on the wonderful things that academics have discovered
This course focuses on financial instruments, how they are used, and how finance professionals attempt to value them
Topics concerning international finance and derivative securities are integrated directly into the course and not ignored or relegated to advanced courseswZwReadingsCustom course textbook
Time value of money and capital budgeting covered by Ross/Westerfield/Jaffe (RWJ) chapters
Stocks and portfolios covered by Bodie/Kane/Marcus (BKM)
Other basic content covered by material on class slides or on the Internet (with links from the slides and/or WebCT)
Current financial events from the Wall Street Journal:10week subscription for $13.95 or a 15week subscription for $19.95 (School zip code is 12222)XZZZb\Q7']J0BU[J0WkYJ0
aA Note on the Custom TextbookIt is designed as a central source for financial formula and their application
It is not designed to entertain you (that is my job)
The financial world moves so quickly that all textbooks are outofdate even before they are publishedgUse of WebCT in the CoursePRepository for course materials
Primary means of contacting the professor (via Email)
Can also send mail to rmmiller@uamail.albany.edu
Discussions and notifications (especially concerning topics that arise in class discussions and problem solutions)
Slides are also available at: http://home.earthlink.net/~millerrisk/FinanceNotes.htmFX1X174n/J0nJ0P9AssignmentsMAssignments appear on the last slide for each week and on WebCT
Most weeks have specific readings that must be read prior to the next class meeting
Most weeks also have examlike problems to answer
Assignments are not handed in or graded, but experience indicates that students who fail to do them encounter real trouble on the examsNZN:Smile\I will take digital photos of all class members at both the Week 2 and Week 3 class meetings]]YA Bit of AdviceuIf you are lost, others probably are lost too, soASK THE PROFESSOR TO EXPLAIN WHAT IN THE WORLD HE IS TALKING ABOUT!fA DisclaimerThe slides used in this course incorporate much more information per slide than is considered acceptable for standard corporate communications
This is done so that they can serve as a more comprehensive form of notes that goes well beyond what is in the textbook
What is Finance?Two major elements
Time
Uncertainty (particularly involving the risk of an unfavorable outcome)
A typical very simple financial transaction
Borrow money to purchase capital equipment to produce goods or services and use some of the revenue to repay the money at a specified later timeLM,M,Finance Focuses on Cash FlowsyThere are three basic ways that cash flows can be structured
Straight financing: Pay cash now in return for the right to receive something, often just more cash, later
Forward contract: Agree now to buy or sell an item at a fixed price at some future date(s)
Option contract: Pay cash now in return for the option to buy or sell an item at a fixed price at some future date(s)
R=<"
#<CFinancial Instruments Involve the Creative Packaging of Cash Flows8Stocks and bonds
Pay now, have the right to (but not necessarily receive) a stream of future cash flows
Futures contracts
A forward contract with collateral (called margin) paid up front and maintained until delivery
Mutual funds (including ETFs)
An often useful bundle of stocks, bonds, or a combination of bothtW_BW_BD&Valuation is Done Two WaysDiscounting
Cash in the future is worth less than the same amount of cash held now
A lot of finance is about determining how large this difference in value is or should be
This is known (depending on context) as an interest rate, discount rate, or discount factor
Arbitrage
Turn something new that you wish to value into pieces of something old ( slice and dice ) that you already know how to valueZZ
Z}Z
}bFMuch of Finance is about Shopping Accomplish a financial goal at the least possible cost
Corporate financing
Household financing
Accomplish a financial goal with the least possible risk
Find bargains and sell them to others at a profit
Avoid getting ripped off (too often)67(7(=2Finance Is Also AboutInformation and ExpectationsPPrices reflect existing information and expectations
Prices change as information and expectations change
Just how well prices reflect information and expectations is hotly debated but the consensus is very well, though not perfectly
Prices also take other things into account most notably, risk)Z)@A Side Note on Internet SourcesInternet sources of financial information, definitions are usually but not always correct
Investopedia is especially good, but even it has misinformation
Be especially careful about using Wikipedia$Cu^J0ZgcJ0RThe Six Types of Objects in This CourseFinancial Instruments
Analytic Methods
Financial Indicators (indexes)
Events (both historical and current)
Institutions
People
*8Financial Instruments Fall Roughly Into Four CategoriesBMoney (shortterm debt and cash)
Longterm debt
Equity
Real assetsGoogle Stock (Nasdaq: GOOG)hJ04Google went public in August 2004
Is volatile and can behave in ways that are atypical of most stocks
Fin 525 s pet stock in AY2004 2005 and AY2005 2006> 6This is an Analytic Methods Slide (Believe It or Not)S&P 500 Stock IndexLThe stock index most often used by financial professionals
Vanguard s mutual fund that is designed to replicate the performance of the index is among the largest mutual funds in the U.S.
Are also the basis for the exchangetraded fund (ETF) with the symbol SPY that are known as Spiders (SPDRs)*J0(/Both Current and Historical Events Are Covered$United States Department of TreasurylIssuer of many of the financial securities covered in the early on in the course
The largest single player in the world economy because it is responsible for funding the Federal government s budget deficit
Because its securities are considered risk free, the rates of interest that it pays serve as baselines4Steven A. ( Stevie ) Cohen"jJ0Superstar billionaire hedge fund manager
His company, SAC Capital, is responsible for a significant amount of the volume on U.S. stock exchanges
Traders at SAC Capital have attracted the attention of securities regulators
+Any Questions? U.S. Federal Reserve Note (Cash)
Federal Reserve BankcJ0The central bank of the United States
Founded in 1913 as the central bank of the U.S.
Original mission was to provide financial stability
Federal Reserve Notes constitute the bulk of its liabilities
Visit its current balance sheet
Text format
PDF format
<ZZZdJ0eJ0So, What Is Money Anyway?%Money in Prison
Cash is Trash zCash pays no interest and its value is eaten away by inflation
Therefore, businesses try to hold as little cash as possible
To deal with shortterm funding requirements, businesses hold other forms of money
Bank deposits (and things that resemble them, like most moneymarket funds) are a preferred form of money
>Z>5HWalMart s Cash on the Balance SheetJ0
6_How Do We Know How Much Cash WalMart has in its Cash Registers?Is Lots of Cash a Good Thing? Certificates of Deposits (CDs)/Issued by banks
How they work
Deposit money with bank right now (cash outflow)
Receive even more money at a specified maturity date (cash inflow)
CDs are a form of time deposit (in contrast to a demand deposit)
We will focus on CDs that mature in under one year, the boundary between short and long term^ tA ] t"CCDs Rates are Required by Law to be Quoted as Annual Interest Rates}A popular place to find CD rates is bankrate.com
CD calculator
This deals with time periods other than a year and compounding&????*$
@fJ0$0gJ01>7Computing the Future Value (FV) of a CD(RWJ pp. 6061)Parameters
Cash outflow now: C0 = $10,000
CD interest rate: r = 12% or 0.12
Formula (for a single period)
FV = C0 (1+r)
Applying the formula
FV = $10,000 (1 + 0.12) = $10,000 (1.12) = $11,200
A44.
Reality CheckVInterest rates on any form of bank deposit have during a single period of American history and may never be that high again
The textbook then uses 12% virtually riskfree return on the CD as the discount rate to evaluate (compute the present value, PV) of a risky project, which is not a good idea1)What If You Really Could Get 12% on CDs?**0FSuppose You Want to Receive $11,424 One Year From Now at 12% InterestThe size of the CD you will purchase now is the present value (PV) of the $11,424 in one year
Formula (for a single period)
PV = C1 / (1+r)
Applying the formula
PV = $11,424 / (1 + 0.12) = $11,424 / (1.12) = $10,200
PV is also a builtin Excel function
7&7&/Computing Present ValuesWe will introduce two complications
Periods of time shorter or longer than the period over which the interest rate is quoted (usually one year)
Compounding: Getting interest on interest
PV is easy to compute on any calculator, not just financial calculators
PV is a builtin Excel function
Note: For Excel C0 is a negative number, which makes sense, but is not the way textbooks do itt$ZZhZ_Z$hM2UComputing NPV (Net Present Value), Which Is PV with the Initial Investment Netted OutParameters
Cash outflow now: C0 = $10,000
Cash inflow in one year: C1 = $11,200
Interest rate on 8/22/05: 4.30%
Formula: NPV = C0 + C1 / (1+r)
Applying the formula
NPV = $10,000 + $11,200 / (1 + 0.043) = $10,000 + $10,738.26 = $738.26e6L$+ $ 3
Excel and NPVThe computation on the previous slide is difficult to do automatically in Excel
Minor problem: Excel has an NPV function, but it makes no provision for the first cash flow to occur right now
The PV function can be coaxed to do this
6*B.Summary of Bank Time Deposits and Discounting"Simple payment scheme from bank CDs
Pay money in now
Get more money out later
The interest rate determines how much money is paid out later relative to the amount paid in
To get future value multiple by (1+r) to get present value divide by (1+r), where r is the interest rate for the periodl$*$*$ %CMThe Fundamental Relationship BetweenInterest Rate (r) and Present Value (PV)Interest rates and the PV of any every financial instrument with constant future cash flows (fixedincome securities like CDs and bonds) always move in opposite directions
Example: The PV of $10,000 at 4% interest in 1 year is $10,000/1.04 = $9,615.38
If the interest rate goes up to 5%, the PV drops to $10,000/1.05 = $9,523.81
If the interest rate goes down to 3%, the PV rises to $10,000/1.03 = $9,708.748PD$More on the Fundamental RelationshipWe will examine the sensitive of various fixedincome securities to interest rates before midterm using a measurement called duration
While the prices of stocks and some risky bonds (both have very uncertain cash flows) tend to move in the opposite direction of interest rates, they sometimes move in the same direction when the change in interest rates indicates strength or weakness in the economy$~
E>Converting Annual Interest Rates to Periods Less Than One YearjObvious method
Multiply rate by the appropriate fraction of a year
Examples:
12% for 6 months (or year) is (12%) = 6%
8% for 3 months (or year) is (8%) = 2%
Warning
The financial world often does not conform to the obvious method because annual rates can be quoted oddly or based on a 360day yeart4
Z4
ZF3FV and PV for Less Than a Year with No CompoundingConvert interest rate to new period length as demonstrated earlier
Apply the FV and PV formulas as before
FV = C0 (1+r)
PV = C1 / (1+r)
FV of $10,000 paying 4% annual rate for 6 months ( year)
FV = $10,000 (1 + 0.04/2) = $10,200j<$j<$G5Suppose We Reinvest in an Identical CD After 6 Months]Now our outflow (initial investment) is $10,200
The future value in six months is $10,200 (1.02)= $10,404
Notice that this is the same as investing for an entire year at 4.04%
4.04% is known as the APY (annual percentage yield) or EAR (effective annual rate)
Compounding accounts for the extra 0.04%, commonly known as 4 basis points (b.p.) or bipsD^0Z2BYH5The General Formula for Future Valuewith Compounding
New parameters:
m: Number of interest periods in a year
m = 2 means semiannual interest
m = 4 means quarterly interest
m = 12 means monthly interest
m = 365 means daily interest
T: Future time (in years or a fraction of a year) when inflow of cash occurs
Formula:
({N ' M
IUsing the Compounding FormulaExample: $10,000 at 4% annual rate for 6 months, compounded monthly
Parameters:
C0 = $10,000
r = 4% = 0.04
m = 12
T = 0.5
Plugging in: FV = $10,000 (1 + 0.04/12)0.5(12) = $10,000 (1.0033& )6 = $10,201.67P*qP
(J>APY (or Effective Annual Interest Rate) Formula from RWJ p. 72K*The Difference a Bip (or a Few Bips) Makes,nAt current interest rates, APY tends to be only a few bips (hundredths of a percentage point, also known as basis points or b.p.) higher than the simple interest rate
It is important to keep interest rates straight because although they low small, every bip matters when you invest millions of dollars
Professional bond traders and investors look at spreads (the interest rate relative to other securities) and these are measured in bipsZ>6LSA Note on Use of the Compounding Formula by Ross/Westerfield/Jaffe (RWJ) on page 731For the moment this course is focused on financial instruments that take one year or less to mature
The RWJ formula states it is for multiple years, but it also works for fractions of a year as we saw in the previous slide
Similarly, the Excel FV function can deal with both fractional and whole years though you have to adjust the interest rate and number of periods manually, which is not very convenientZM+Three Important Points Worth Mentioning Now,Compounding is magic because the interest on interest (and interest on interest on interest& ) adds up over time
Over long periods of time (10 years or more depending on interest rates), a small difference in the interest rate can make a large difference in the future value of the investment
Note that compounding only works if we do not withdraw the interest at the time that it is paid
We will not consider the receipt of more than one cash flow from a financial instrument until we get to Treasury notes and bonds in a few weeks.ZZ,
\Assignment For Week 2
Check out the links in the slides covered in class
Read RWJ Ch. 4, pp. 6073
Do the problems on the 4 slides that follow this one
Justify each TrueFalse answer
For the CD problems 13, use a calculator for one of the CDs and a calculator or spreadsheet for the rest&]$TrueFalse Statements (Page 1 of 2)fOne can make the annual percentage yield from a CD as high as one wants by choosing a short enough compounding interval.
At higher stated yields, the compounding interval will make more of a difference to the annual percentage yield.
In general, a $1,000 6month bank CD should cost less to purchase now than it did at this time last year (September 2005).
,ee^$TrueFalse Statements (Page 2 of 2)(Doubling the interest rate on a CD will double its APY
If two oneyear CDs both pay $10,000 at maturity, then the one with the lower APY will cost more to purchase now
The financial markets expect that the U.S. will grow faster in the second half of 2006 than it did in the first quarter of 2006.))_Questions about the Next SlidenCompute the APY (known in the textbook as Effective Annual Interest Rate) for each CD.
Compute the future value at maturity for each CD for an investment of $10,000 today.
Compute the present value of $10,000 received at maturity from each CD.
You are considering the 3month and 12month (1 year) CDs offered by Beal bank. Bank of Miller (BoM) is willing to guarantee you a 9month when the 3month Beal CD matures if you sign with them now. What APY must BoM provide you so that after a year you will have the same amount you would have buying Beal s 12month CD.
8Z8,Trl `0CD Interest Rates Compiled on September 6, 2005/8
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___PPT9/0]cdefghY[^cj{}D:\Interaction\Web Site\MRA PWS Site\Notes\Fin525Fall04Class1.htmE0(]^_?V, BProfessor Ross Miller " Fall 2006O=xFinance 525 Week 17Introduction to the Course and to the Concept of Money88 Fin 525 Mission StatementRTo give every student a practical understanding of how the world of finance works."SR$$dCourse SyllabusAvailable on paper in class
Also available on the Internet at: http://www.riggedonline.com/Finance/Fin525Fall2006Syllabus.pdf
The most critical points from the syllabus are reiterated on the next several slides6J0?}8Overview of the Course CalendarWeeks 1 3 (Part I): Money of all Kinds
Weeks 3 (Part II) 5: LongTerm Debt
Week 6: Midterm Exam
Weeks 7 11: Equity and Portfolio Management
Week 12: Capital Budgeting
Week 13: (Optional) Final ExamT 1 / ^Grading4The raw grade for the course is the average of the best three of the following four:
Midterm exam
Stock prediction and hedging exercise
401(k) group project
Final exam (optional)
Class participation and evidence of improvement will influence grades of students with grades near the border between two grades6U_U_e0What is Different About How I Teach This CoursevTextbooks and traditional finance classes focus on the wonderful things that academics have discovered
This course focuses on financial instruments, how they are used, and how finance professionals attempt to value them
Topics concerning international finance and derivative securities are integrated directly into the course and not ignored or relegated to advanced courseswZwReadingsCustom course textbook
Time value of money and capital budgeting covered by Ross/Westerfield/Jaffe (RWJ) chapters
Stocks and portfolios covered by Bodie/Kane/Marcus (BKM)
Other basic content covered by material on class slides or on the Internet (with links from the slides and/or WebCT)
Current financial events from the Wall Street Journal:10week subscription for $13.95 or a 15week subscription for $19.95 (School zip code is 12222)XZZZb\Q7']J0BU[J0WkYJ0
aA Note on the Custom TextbookIt is designed as a central source for financial formula and their application
It is not designed to entertain you (that is my job)
The financial world moves so quickly that all textbooks are outofdate even before they are publishedgUse of WebCT in the CoursePRepository for course materials
Primary means of contacting the professor (via Email)
Can also send mail to rmmiller@uamail.albany.edu
Discussions and notifications (especially concerning topics that arise in class discussions and problem solutions)
Slides are also available at: http://home.earthlink.net/~millerrisk/FinanceNotes.htmFX1X174n/J0nJ0P9AssignmentsMAssignments appear on the last slide for each week and on WebCT
Most weeks have specific readings that must be read prior to the next class meeting
Most weeks also have examlike problems to answer
Assignments are not handed in or graded, but experience indicates that students who fail to do them encounter real trouble on the examsNZN:Smile\I will take digital photos of all class members at both the Week 2 and Week 3 class meetings]]YA Bit of AdviceuIf you are lost, others probably are lost too, soASK THE PROFESSOR TO EXPLAIN WHAT IN THE WORLD HE IS TALKING ABOUT!fA DisclaimerThe slides used in this course incorporate much more information per slide than is considered acceptable for standard corporate communications
This is done so that they can serve as a more comprehensive form of notes that goes well beyond what is in the textbook
What is Finance?Two major elements
Time
Uncertainty (particularly involving the risk of an unfavorable outcome)
A typical very simple financial transaction
Borrow money to purchase capital equipment to produce goods or services and use some of the revenue to repay the money at a specified later timeLM,M,Finance Focuses on Cash FlowsyThere are three basic ways that cash flows can be structured
Straight financing: Pay cash now in return for the right to receive something, often just more cash, later
Forward contract: Agree now to buy or sell an item at a fixed price at some future date(s)
Option contract: Pay cash now in return for the option to buy or sell an item at a fixed price at some future date(s)
R=<"
#<CFinancial Instruments Involve the Creative Packaging of Cash Flows8Stocks and bonds
Pay now, have the right to (but not necessarily receive) a stream of future cash flows
Futures contracts
A forward contract with collateral (called margin) paid up front and maintained until delivery
Mutual funds (including ETFs)
An often useful bundle of stocks, bonds, or a combination of bothtW_BW_BD&Valuation is Done Two WaysDiscounting
Cash in the future is worth less than the same amount of cash held now
A lot of finance is about determining how large this difference in value is or should be
This is known (depending on context) as an interest rate, discount rate, or discount factor
Arbitrage
Turn something new that you wish to value into pieces of something old ( slice and dice ) that you already know how to valueZZ
Z}Z
}bFMuch of Finance is about Shopping Accomplish a financial goal at the least possible cost
Corporate financing
Household financing
Accomplish a financial goal with the least possible risk
Find bargains and sell them to others at a profit
Avoid getting ripped off (too often)67(7(=2Finance Is Also AboutInformation and ExpectationsPPrices reflect existing information and expectations
Prices change as information and expectations change
Just how well prices reflect information and expectations is hotly debated but the consensus is very well, though not perfectly
Prices also take other things into account most notably, risk)Z)@A Side Note on Internet SourcesInternet sources of financial information, definitions are usually but not always correct
Investopedia is especially good, but even it has misinformation
Be especially careful about using Wikipedia$Cu^J0ZgcJ0RThe Six Types of Objects in This CourseFinancial Instruments
Analytic Methods
Financial Indicators (indexes)
Events (both historical and current)
Institutions
People
*8Financial Instruments Fall Roughly Into Four CategoriesBMoney (shortterm debt and cash)
Longterm debt
Equity
Real assetsGoogle Stock (Nasdaq: GOOG)hJ04Google went public in August 2004
Is volatile and can behave in ways that are atypical of most stocks
Fin 525 s pet stock in AY2004 2005 and AY2005 2006> 6This is an Analytic Methods Slide (Believe It or Not)S&P 500 Stock IndexLThe stock index most often used by financial professionals
Vanguard s mutual fund that is designed to replicate the performance of the index is among the largest mutual funds in the U.S.
Are also the basis for the exchangetraded fund (ETF) with the symbol SPY that are known as Spiders (SPDRs)*J0(/Both Current and Historical Events Are Covered$United States Department of TreasurylIssuer of many of the financial securities covered in the early on in the course
The largest single player in the world economy because it is responsible for funding the Federal government s budget deficit
Because its securities are considered risk free, the rates of interest that it pays serve as baselines4Steven A. ( Stevie ) Cohen"jJ0Superstar billionaire hedge fund manager
His company, SAC Capital, is responsible for a significant amount of the volume on U.S. stock exchanges
Traders at SAC Capital have attracted the attention of securities regulators
+Any Questions? U.S. Federal Reserve Note (Cash)
Federal Reserve BankcJ0The central bank of the United States
Founded in 1913 as the central bank of the U.S.
Original mission was to provide financial stability
Federal Reserve Notes constitute the bulk of its liabilities
Visit its current balance sheet
Text format
PDF format
<ZZZdJ0eJ0So, What Is Money Anyway?%Money in Prison
Cash is Trash zCash pays no interest and its value is eaten away by inflation
Therefore, businesses try to hold as little cash as possible
To deal with shortterm funding requirements, businesses hold other forms of money
Bank deposits (and things that resemble them, like most moneymarket funds) are a preferred form of money
>Z>5HWalMart s Cash on the Balance SheetJ0
6_How Do We Know How Much Cash WalMart has in its Cash Registers?Is Lots of Cash a Good Thing? Certificates of Deposits (CDs)/Issued by banks
How they work
Deposit money with bank right now (cash outflow)
Receive even more money at a specified maturity date (cash inflow)
CDs are a form of time deposit (in contrast to a demand deposit)
We will focus on CDs that mature in under one year, the boundary between short and long term^ tA ] t"CCDs Rates are Required by Law to be Quoted as Annual Interest Rates}A popular place to find CD rates is bankrate.com
CD calculator
This deals with time periods other than a year and compounding&????*$
@fJ0$0gJ01>7Computing the Future Value (FV) of a CD(RWJ pp. 6061)Parameters
Cash outflow now: C0 = $10,000
CD interest rate: r = 12% or 0.12
Formula (for a single period)
FV = C0 (1+r)
Applying the formula
FV = $10,000 (1 + 0.12) = $10,000 (1.12) = $11,200
A44.
Reality CheckVInterest rates on any form of bank deposit have during a single period of American history and may never be that high again
The textbook then uses 12% virtually riskfree return on the CD as the discount rate to evaluate (compute the present value, PV) of a risky project, which is not a good idea1)What If You Really Could Get 12% on CDs?**0FSuppose You Want to Receive $11,424 One Year From Now at 12% InterestThe size of the CD you will purchase now is the present value (PV) of the $11,424 in one year
Formula (for a single period)
PV = C1 / (1+r)
Applying the formula
PV = $11,424 / (1 + 0.12) = $11,424 / (1.12) = $10,200
PV is also a builtin Excel function
7&7&/Computing Present ValuesWe will introduce two complications
Periods of time shorter or longer than the period over which the interest rate is quoted (usually one year)
Compounding: Getting interest on interest
PV is easy to compute on any calculator, not just financial calculators
PV is a builtin Excel function
Note: For Excel C0 is a negative number, which makes sense, but is not the way textbooks do itt$ZZhZ_Z$hM2UComputing NPV (Net Present Value), Which Is PV with the Initial Investment Netted OutParameters
Cash outflow now: C0 = $10,000
Cash inflow in one year: C1 = $11,200
Interest rate on 8/22/05: 4.30%
Formula: NPV = C0 + C1 / (1+r)
Applying the formula
NPV = $10,000 + $11,200 / (1 + 0.043) = $10,000 + $10,738.26 = $738.26e6L$+ $ 3
Excel and NPVThe computation on the previous slide is difficult to do automatically in Excel
Minor problem: Excel has an NPV function, but it makes no provision for the first cash flow to occur right now
The PV function can be coaxed to do this
6*B.Summary of Bank Time Deposits and Discounting"Simple payment scheme from bank CDs
Pay money in now
Get more money out later
The interest rate determines how much money is paid out later relative to the amount paid in
To get future value multiple by (1+r) to get present value divide by (1+r), where r is the interest rate for the periodl$*$*$ %CMThe Fundamental Relationship BetweenInterest Rate (r) and Present Value (PV)Interest rates and the PV of any every financial instrument with constant future cash flows (fixedincome securities like CDs and bonds) always move in opposite directions
Example: The PV of $10,000 at 4% interest in 1 year is $10,000/1.04 = $9,615.38
If the interest rate goes up to 5%, the PV drops to $10,000/1.05 = $9,523.81
If the interest rate goes down to 3%, the PV rises to $10,000/1.03 = $9,708.748PD$More on the Fundamental RelationshipWe will examine the sensitive of various fixedincome securities to interest rates before midterm using a measurement called duration
While the prices of stocks and some risky bonds (both have very uncertain cash flows) tend to move in the opposite direction of interest rates, they sometimes move in the same direction when the change in interest rates indicates strength or weakness in the economy$~
E>Converting Annual Interest Rates to Periods Less Than One YearjObvious method
Multiply rate by the appropriate fraction of a year
Examples:
12% for 6 months (or year) is (12%) = 6%
8% for 3 months (or year) is (8%) = 2%
Warning
The financial world often does not conform to the obvious method because annual rates can be quoted oddly or based on a 360day yeart4
Z4
ZF3FV and PV for Less Than a Year with No CompoundingConvert interest rate to new period length as demonstrated earlier
Apply the FV and PV formulas as before
FV = C0 (1+r)
PV = C1 / (1+r)
FV of $10,000 paying 4% annual rate for 6 months ( year)
FV = $10,000 (1 + 0.04/2) = $10,200j<$j<$G5Suppose We Reinvest in an Identical CD After 6 Months]Now our outflow (initial investment) is $10,200
The future value in six months is $10,200 (1.02)= $10,404
Notice that this is the same as investing for an entire year at 4.04%
4.04% is known as the APY (annual percentage yield) or EAR (effective annual rate)
Compounding accounts for the extra 0.04%, commonly known as 4 basis points (b.p.) or bipsD^0Z2BYH5The General Formula for Future Valuewith Compounding
New parameters:
m: Number of interest periods in a year
m = 2 means semiannual interest
m = 4 means quarterly interest
m = 12 means monthly interest
m = 365 means daily interest
T: Future time (in years or a fraction of a year) when inflow of cash occurs
Formula:
({N ' M
IUsing the Compounding FormulaExample: $10,000 at 4% annual rate for 6 months, compounded monthly
Parameters:
C0 = $10,000
r = 4% = 0.04
m = 12
T = 0.5
Plugging in: FV = $10,000 (1 + 0.04/12)0.5(12) = $10,000 (1.0033& )6 = $10,201.67P*qP
(J>APY (or Effective Annual Interest Rate) Formula from RWJ p. 72K*The Difference a Bip (or a Few Bips) Makes,nAt current interest rates, APY tends to be only a few bips (hundredths of a percentage point, also known as basis points or b.p.) higher than the simple interest rate
It is important to keep interest rates straight because although they low small, every bip matters when you invest millions of dollars
Professional bond traders and investors look at spreads (the interest rate relative to other securities) and these are measured in bipsZ>6LSA Note on Use of the Compounding Formula by Ross/Westerfield/Jaffe (RWJ) on page 731For the moment this course is focused on financial instruments that take one year or less to mature
The RWJ formula states it is for multiple years, but it also works for fractions of a year as we saw in the previous slide
Similarly, the Excel FV function can deal with both fractional and whole years though you have to adjust the interest rate and number of periods manually, which is not very convenientZM+Three Important Points Worth Mentioning Now,Compounding is magic because the interest on interest (and interest on interest on interest& ) adds up over time
Over long periods of time (10 years or more depending on interest rates), a small difference in the interest rate can make a large difference in the future value of the investment
Note that compounding only works if we do not withdraw the interest at the time that it is paid
We will not consider the receipt of more than one cash flow from a financial instrument until we get to Treasury notes and bonds in a few weeks.ZZ,
\Assignment For Week 2
Check out the links in the slides covered in class
Read RWJ Ch. 4, pp. 6073
Do the problems on the 4 slides that follow this one
Justify each TrueFalse answer
For the CD problems 13, use a calculator for one of the CDs and a calculator or spreadsheet for the rest&]$TrueFalse Statements (Page 1 of 2)fOne can make the annual percentage yield from a CD as high as one wants by choosing a short enough compounding interval.
At higher stated yields, the compounding interval will make more of a difference to the annual percentage yield.
In general, a $1,000 6month bank CD should cost less to purchase now than it did at this time last year (September 2005).
,ee^$TrueFalse Statements (Page 2 of 2)(Doubling the interest rate on a CD will double its APY
If two oneyear CDs both pay $10,000 at maturity, then the one with the lower APY will cost more to purchase now
The financial markets expect that the U.S. will grow faster in the second half of 2006 than it did in the first quarter of 2006.))_Questions about the Next SlidenCompute the APY (known in the textbook as Effective Annual Interest Rate) for each CD.
Compute the future value at maturity for each CD for an investment of $10,000 today.
Compute the present value of $10,000 received at maturity from each CD.
You are considering the 3month and 12month (1 year) CDs offered by Beal bank. Bank of Miller (BoM) is willing to guarantee you a 9month when the 3month Beal CD matures if you sign with them now. What APY must BoM provide you so that after a year you will have the same amount you would have buying Beal s 12month CD.
8Z8,Trl `0CD Interest Rates Compiled on September 6, 2005/8r6:X01(
w$rmiller@albany.eduJhttp://finance.yahoo.com/q?d=t&s=^DJIh]&Wall Street Journal&http://www.wsj.com/c(Federal Reserve Bank<http://www.federalreserve.gov/dText formatfhttp://www.federalreserve.gov/releases/h41/Current/0contentePDF formatthttp://www.federalreserve.gov/releases/h41/Current/h41.pdfdfbankrate.com0http://www.bankrate.com/gCD calculatorhhttp://www.bankrate.com/brm/calc/cdc/CertDeposit.aspfhGOOGBhttp://finance.yahoo.com/q?s=googvWalMart sFhttp://finance.yahoo.com/q/bs?s=WMTjSPYHhttp://finance.yahoo.com/q?d=t&s=SPYY(15week subscriptionBhttp://subscribe.wsj.com/semester[(10week subscription@http://subscribe.wsj.com/quartern^Investopedia 8http://www.investopedia.com/zcWikipediaLhttp://en.wikipedia.org/wiki/Main_PagedEquation Equation.30,Microsoft Equation 3.0eEquation Equation.30,Microsoft Equation 3.0fEquation Equation.30,Microsoft Equation 3.0oWorksheet Excel.Sheet.80@Microsoft Office Excel Worksheet6http://www.riggedonline.com/Finance/Fin525Fall2006Syllabus.pdfhttp://www.riggedonline.com/Finance/Fin525Fall2006Syllabus.pdfjSteven A. Cohenhttp://www.businessweek.com/magazine/content/03_29/b3842001_mz001.htm4rmmiller@uamail.albany.eduBmailto:rmmiller@uamail.albany.edulhttp://home.earthlink.net/~millerrisk/FinanceNotes.htmlhttp://home.earthlink.net/~millerrisk/FinanceNotes.htm/00DTimes New RomanLLԖT0ԖDArialNew RomanLLԖT0Ԗ DWingdingsRomanLLԖT0Ԗ0DTimesngsRomanLLԖT0Ԗ
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___PPT9/0]cdefghY[^cj{}D:\Interaction\Web Site\MRA PWS Site\Notes\Fin525Fall04Class1.htmE0(]^_?V, BProfessor Ross Miller " Fall 2006O=xFinance 525 Week 17Introduction to the Course and to the Concept of Money88 Fin 525 Mission StatementRTo give every student a practical understanding of how the world of finance works."SR$$dCourse SyllabusAvailable on paper in class
Also available on the Internet at: http://www.riggedonline.com/Finance/Fin525Fall2006Syllabus.pdf
The most critical points from the syllabus are reiterated on the next several slides6J0?}8Overview of the Course CalendarWeeks 1 3 (Part I): Money of all Kinds
Weeks 3 (Part II) 5: LongTerm Debt
Week 6: Midterm Exam
Weeks 7 11: Equity and Portfolio Management
Week 12: Capital Budgeting
Week 13: (Optional) Final ExamT 1 / ^Grading4The raw grade for the course is the average of the best three of the following four:
Midterm exam
Stock prediction and hedging exercise
401(k) group project
Final exam (optional)
Class participation and evidence of improvement will influence grades of students with grades near the border between two grades6U_U_e0What is Different About How I Teach This CoursevTextbooks and traditional finance classes focus on the wonderful things that academics have discovered
This course focuses on financial instruments, how they are used, and how finance professionals attempt to value them
Topics concerning international finance and derivative securities are integrated directly into the course and not ignored or relegated to advanced courseswZwReadingsCustom course textbook
Time value of money and capital budgeting covered by Ross/Westerfield/Jaffe (RWJ) chapters
Stocks and portfolios covered by Bodie/Kane/Marcus (BKM)
Other basic content covered by material on class slides or on the Internet (with links from the slides and/or WebCT)
Current financial events from the Wall Street Journal:10week subscription for $13.95 or a 15week subscription for $19.95 (School zip code is 12222)XZZZb\Q7']J0BU[J0WkYJ0
aA Note on the Custom TextbookIt is designed as a central source for financial formula and their application
It is not designed to entertain you (that is my job)
The financial world moves so quickly that all textbooks are outofdate even before they are publishedgUse of WebCT in the CoursePRepository for course materials
Primary means of contacting the professor (via Email)
Can also send mail to rmmiller@uamail.albany.edu
Discussions and notifications (especially concerning topics that arise in class discussions and problem solutions)
Slides are also available at: http://home.earthlink.net/~millerrisk/FinanceNotes.htmFX1X174n/J0nJ0P9AssignmentsMAssignments appear on the last slide for each week and on WebCT
Most weeks have specific readings that must be read prior to the next class meeting
Most weeks also have examlike problems to answer
Assignments are not handed in or graded, but experience indicates that students who fail to do them encounter real trouble on the examsNZN:Smile\I will take digital photos of all class members at both the Week 2 and Week 3 class meetings]]YA Bit of AdviceuIf you are lost, others probably are lost too, soASK THE PROFESSOR TO EXPLAIN WHAT IN THE WORLD HE IS TALKING ABOUT!fA DisclaimerThe slides used in this course incorporate much more information per slide than is considered acceptable for standard corporate communications
This is done so that they can serve as a more comprehensive form of notes that goes well beyond what is in the textbook
What is Finance?Two major elements
Time
Uncertainty (particularly involving the risk of an unfavorable outcome)
A typical very simple financial transaction
Borrow money to purchase capital equipment to produce goods or services and use some of the revenue to repay the money at a specified later timeLM,M,Finance Focuses on Cash FlowsyThere are three basic ways that cash flows can be structured
Straight financing: Pay cash now in return for the right to receive something, often just more cash, later
Forward contract: Agree now to buy or sell an item at a fixed price at some future date(s)
Option contract: Pay cash now in return for the option to buy or sell an item at a fixed price at some future date(s)
R=<"
#<CFinancial Instruments Involve the Creative Packaging of Cash Flows8Stocks and bonds
Pay now, have the right to (but not necessarily receive) a stream of future cash flows
Futures contracts
A forward contract with collateral (called margin) paid up front and maintained until delivery
Mutual funds (including ETFs)
An often useful bundle of stocks, bonds, or a combination of bothtW_BW_BD&Valuation is Done Two WaysDiscounting
Cash in the future is worth less than the same amount of cash held now
A lot of finance is about determining how large this difference in value is or should be
This is known (depending on context) as an interest rate, discount rate, or discount factor
Arbitrage
Turn something new that you wish to value into pieces of something old ( slice and dice ) that you already know how to valueZZ
Z}Z
}bFMuch of Finance is about Shopping Accomplish a financial goal at the least possible cost
Corporate financing
Household financing
Accomplish a financial goal with the least possible risk
Find bargains and sell them to others at a profit
Avoid getting ripped off (too often)67(7(=2Finance Is Also AboutInformation and ExpectationsPPrices reflect existing information and expectations
Prices change as information and expectations change
Just how well prices reflect information and expectations is hotly debated but the consensus is very well, though not perfectly
Prices also take other things into account most notably, risk)Z)@A Side Note on Internet SourcesInternet sources of financial information, definitions are usually but not always correct
Investopedia is especially good, but even it has misinformation
Be especially careful about using Wikipedia$Cu^J0ZgcJ0RThe Six Types of Objects in This CourseFinancial Instruments
Analytic Methods
Financial Indicators (indexes)
Events (both historical and current)
Institutions
People
*8Financial Instruments Fall Roughly Into Four CategoriesBMoney (shortterm debt and cash)
Longterm debt
Equity
Real assetsGoogle Stock (Nasdaq: GOOG)hJ04Google went public in August 2004
Is volatile and can behave in ways that are atypical of most stocks
Fin 525 s pet stock in AY2004 2005 and AY2005 2006> 6This is an Analytic Methods Slide (Believe It or Not)S&P 500 Stock IndexLThe stock index most often used by financial professionals
Vanguard s mutual fund that is designed to replicate the performance of the index is among the largest mutual funds in the U.S.
Are also the basis for the exchangetraded fund (ETF) with the symbol SPY that are known as Spiders (SPDRs)*J0(/Both Current and Historical Events Are Covered$United States Department of TreasurylIssuer of many of the financial securities covered in the early on in the course
The largest single player in the world economy because it is responsible for funding the Federal government s budget deficit
Because its securities are considered risk free, the rates of interest that it pays serve as baselines4Steven A. ( Stevie ) Cohen"jJ0Superstar billionaire hedge fund manager
His company, SAC Capital, is responsible for a significant amount of the volume on U.S. stock exchanges
Traders at SAC Capital have attracted the attention of securities regulators
+Any Questions? U.S. Federal Reserve Note (Cash)
Federal Reserve BankcJ0The central bank of the United States
Founded in 1913 as the central bank of the U.S.
Original mission was to provide financial stability
Federal Reserve Notes constitute the bulk of its liabilities
Visit its current balance sheet
Text format
PDF format
<ZZZdJ0eJ0So, What Is Money Anyway?%Money in Prison
Cash is Trash zCash pays no interest and its value is eaten away by inflation
Therefore, businesses try to hold as little cash as possible
To deal with shortterm funding requirements, businesses hold other forms of money
Bank deposits (and things that resemble them, like most moneymarket funds) are a preferred form of money
>Z>5HWalMart s Cash on the Balance SheetJ0
6_How Do We Know How Much Cash WalMart has in its Cash Registers?Is Lots of Cash a Good Thing? Certificates of Deposits (CDs)/Issued by banks
How they work
Deposit money with bank right now (cash outflow)
Receive even more money at a specified maturity date (cash inflow)
CDs are a form of time deposit (in contrast to a demand deposit)
We will focus on CDs that mature in under one year, the boundary between short and long term^ tA ] t"CCDs Rates are Required by Law to be Quoted as Annual Interest Rates}A popular place to find CD rates is bankrate.com
CD calculator
This deals with time periods other than a year and compounding&????*$
@fJ0$0gJ01>7Computing the Future Value (FV) of a CD(RWJ pp. 6061)Parameters
Cash outflow now: C0 = $10,000
CD interest rate: r = 12% or 0.12
Formula (for a single period)
FV = C0 (1+r)
Applying the formula
FV = $10,000 (1 + 0.12) = $10,000 (1.12) = $11,200
A44.
Reality CheckVInterest rates on any form of bank deposit have during a single period of American history and may never be that high again
The textbook then uses 12% virtually riskfree return on the CD as the discount rate to evaluate (compute the present value, PV) of a risky project, which is not a good idea1)What If You Really Could Get 12% on CDs?**0FSuppose You Want to Receive $11,424 One Year From Now at 12% InterestThe size of the CD you will purchase now is the present value (PV) of the $11,424 in one year
Formula (for a single period)
PV = C1 / (1+r)
Applying the formula
PV = $11,424 / (1 + 0.12) = $11,424 / (1.12) = $10,200
PV is also a builtin Excel function
7&7&/Computing Present ValuesWe will introduce two complications
Periods of time shorter or longer than the period over which the interest rate is quoted (usually one year)
Compounding: Getting interest on interest
PV is easy to compute on any calculator, not just financial calculators
PV is a builtin Excel function
Note: For Excel C0 is a negative number, which makes sense, but is not the way textbooks do itt$ZZhZ_Z$hM2UComputing NPV (Net Present Value), Which Is PV with the Initial Investment Netted OutParameters
Cash outflow now: C0 = $10,000
Cash inflow in one year: C1 = $11,200
Interest rate on 8/22/05: 4.30%
Formula: NPV = C0 + C1 / (1+r)
Applying the formula
NPV = $10,000 + $11,200 / (1 + 0.043) = $10,000 + $10,738.26 = $738.26e6L$+ $ 3
Excel and NPVThe computation on the previous slide is difficult to do automatically in Excel
Minor problem: Excel has an NPV function, but it makes no provision for the first cash flow to occur right now
The PV function can be coaxed to do this
6*B.Summary of Bank Time Deposits and Discounting"Simple payment scheme from bank CDs
Pay money in now
Get more money out later
The interest rate determines how much money is paid out later relative to the amount paid in
To get future value multiple by (1+r) to get present value divide by (1+r), where r is the interest rate for the periodl$*$*$ %CMThe Fundamental Relationship BetweenInterest Rate (r) and Present Value (PV)Interest rates and the PV of any every financial instrument with constant future cash flows (fixedincome securities like CDs and bonds) always move in opposite directions
Example: The PV of $10,000 at 4% interest in 1 year is $10,000/1.04 = $9,615.38
If the interest rate goes up to 5%, the PV drops to $10,000/1.05 = $9,523.81
If the interest rate goes down to 3%, the PV rises to $10,000/1.03 = $9,708.748PD$More on the Fundamental RelationshipWe will examine the sensitivity of various fixedincome securities to interest rates before midterm using a measurement called duration
While the prices of stocks and some risky bonds (both have very uncertain cash flows) tend to move in the opposite direction of interest rates, they sometimes move in the same direction when the change in interest rates indicates strength or weakness in the economy$
,=/E>Converting Annual Interest Rates to Periods Less Than One YearjObvious method
Multiply rate by the appropriate fraction of a year
Examples:
12% for 6 months (or year) is (12%) = 6%
8% for 3 months (or year) is (8%) = 2%
Warning
The financial world often does not conform to the obvious method because annual rates can be quoted oddly or based on a 360day yeart4
Z4
ZF3FV and PV for Less Than a Year with No CompoundingConvert interest rate to new period length as demonstrated earlier
Apply the FV and PV formulas as before
FV = C0 (1+r)
PV = C1 / (1+r)
FV of $10,000 paying 4% annual rate for 6 months ( year)
FV = $10,000 (1 + 0.04/2) = $10,200j<$j<$G5Suppose We Reinvest in an Identical CD After 6 Months]Now our outflow (initial investment) is $10,200
The future value in six months is $10,200 (1.02)= $10,404
Notice that this is the same as investing for an entire year at 4.04%
4.04% is known as the APY (annual percentage yield) or EAR (effective annual rate)
Compounding accounts for the extra 0.04%, commonly known as 4 basis points (b.p.) or bipsD^0Z2BYH5The General Formula for Future Valuewith Compounding
New parameters:
m: Number of interest periods in a year
m = 2 means semiannual interest
m = 4 means quarterly interest
m = 12 means monthly interest
m = 365 means daily interest
T: Future time (in years or a fraction of a year) when inflow of cash occurs
Formula:
({N ' M
IUsing the Compounding FormulaExample: $10,000 at 4% annual rate for 6 months, compounded monthly
Parameters:
C0 = $10,000
r = 4% = 0.04
m = 12
T = 0.5
Plugging in: FV = $10,000 (1 + 0.04/12)0.5(12) = $10,000 (1.0033& )6 = $10,201.67P*qP
(J>APY (or Effective Annual Interest Rate) Formula from RWJ p. 72K*The Difference a Bip (or a Few Bips) Makes,nAt current interest rates, APY tends to be only a few bips (hundredths of a percentage point, also known as basis points or b.p.) higher than the simple interest rate
It is important to keep interest rates straight because although they low small, every bip matters when you invest millions of dollars
Professional bond traders and investors look at spreads (the interest rate relative to other securities) and these are measured in bipsZ>6LSA Note on Use of the Compounding Formula by Ross/Westerfield/Jaffe (RWJ) on page 731For the moment this course is focused on financial instruments that take one year or less to mature
The RWJ formula states it is for multiple years, but it also works for fractions of a year as we saw in the previous slide
Similarly, the Excel FV function can deal with both fractional and whole years though you have to adjust the interest rate and number of periods manually, which is not very convenientZM+Three Important Points Worth Mentioning Now,Compounding
!"#$%&'()*+,./0123456789:;<=>?@ABCDEFGHIJKLMNOPQRSTUVWXYZ[\]^_`abcdefghijklmnopqrstuvwxyz{~ is magic because the interest on interest (and interest on interest on interest& ) adds up over time
Over long periods of time (10 years or more depending on interest rates), a small difference in the interest rate can make a large difference in the future value of the investment
Note that compounding only works if we do not withdraw the interest at the time that it is paid
We will not consider the receipt of more than one cash flow from a financial instrument until we get to Treasury notes and bonds in a few weeks.ZZ\Assignment For Week 2
Check out the links in the slides covered in class
Read RWJ Ch. 4, pp. 6073
Do the problems on the 4 slides that follow this one
Justify each TrueFalse answer
For the CD problems 13, use a calculator for one of the CDs and a calculator or spreadsheet for the rest&]$TrueFalse Statements (Page 1 of 2)fOne can make the annual percentage yield from a CD as high as one wants by choosing a short enough compounding interval.
At higher stated yields, the compounding interval will make more of a difference to the annual percentage yield.
In general, a $1,000 6month bank CD should cost less to purchase now than it did at this time last year (September 2005).
,ee^$TrueFalse Statements (Page 2 of 2)(Doubling the interest rate on a CD will double its APY
If two oneyear CDs both pay $10,000 at maturity, then the one with the lower APY will cost more to purchase now
The financial markets expect that the U.S. will grow faster in the second half of 2006 than it did in the first quarter of 2006.))_Questions about the Next SlidenCompute the APY (known in the textbook as Effective Annual Interest Rate) for each CD.
Compute the future value at maturity for each CD for an investment of $10,000 today.
Compute the present value of $10,000 received at maturity from each CD.
You are considering the 3month and 12month (1 year) CDs offered by Beal bank. Bank of Miller (BoM) is willing to guarantee you a 9month when the 3month Beal CD matures if you sign with them now. What APY must BoM provide you so that after a year you will have the same amount you would have buying Beal s 12month CD.
8Z8,Trl `0CD Interest Rates Compiled on September 6, 2005/8
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$rmiller@albany.eduJhttp://finance.yahoo.com/q?d=t&s=^DJIh]&Wall Street Journal&http://www.wsj.com/c(Federal Reserve Bank<http://www.federalreserve.gov/dText formatfhttp://www.federalreserve.gov/releases/h41/Current/0contentePDF formatthttp://www.federalreserve.gov/releases/h41/Current/h41.pdfdfbankrate.com0http://www.bankrate.com/gCD calculatorhhttp://www.bankrate.com/brm/calc/cdc/CertDeposit.aspfhGOOGBhttp://finance.yahoo.com/q?s=googvWalMart sFhttp://finance.yahoo.com/q/bs?s=WMTjSPYHhttp://finance.yahoo.com/q?d=t&s=SPYY(15week subscriptionBhttp://subscribe.wsj.com/semester[(10week subscription@http://subscribe.wsj.com/quartern^Investopedia 8http://www.investopedia.com/zcWikipediaLhttp://en.wikipedia.org/wiki/Main_PagedEquation Equation.30,Microsoft Equation 3.0eEquation Equation.30,Microsoft Equation 3.0fEquation Equation.30,Microsoft Equation 3.0oWorksheet Excel.Sheet.80@Microsoft Office Excel Worksheet6http://www.riggedonline.com/Finance/Fin525Fall2006Syllabus.pdfhttp://www.riggedonline.com/Finance/Fin525Fall2006Syllabus.pdfjSteven A. Cohenhttp://www.businessweek.com/magazine/content/03_29/b3842001_mz001.htm4rmmiller@uamail.albany.eduBmailto:rmmiller@uamail.albany.edulhttp://home.earthlink.net/~millerrisk/FinanceNotes.htmlhttp://home.earthlink.net/~millerrisk/FinanceNotes.htm/00DTimes New RomanLLԖT0ԖDArialNew RomanLLԖT0Ԗ DWingdingsRomanLLԖT0Ԗ0DTimesngsRomanLLԖT0Ԗ
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___PPT9/0]cdefghY[^cj{}D:\Interaction\Web Site\MRA PWS Site\Notes\Fin525Fall04Class1.htmE0(]^_?V, BProfessor Ross Miller " Fall 2006O=xFinance 525 Week 17Introduction to the Course and to the Concept of Money88 Fin 525 Mission StatementRTo give every student a practical understanding of how the world of finance works."SR$$dCourse SyllabusAvailable on paper in class
Also available on the Internet at: http://www.riggedonline.com/Finance/Fin525Fall2006Syllabus.pdf
The most critical points from the syllabus are reiterated on the next several slides6J0?}8Overview of the Course CalendarWeeks 1 3 (Part I): Money of all Kinds
Weeks 3 (Part II) 5: LongTerm Debt
Week 6: Midterm Exam
Weeks 7 11: Equity and Portfolio Management
Week 12: Capital Budgeting
Week 13: (Optional) Final ExamT 1 / ^Grading4The raw grade for the course is the average of the best three of the following four:
Midterm exam
Stock prediction and hedging exercise
401(k) group project
Final exam (optional)
Class participation and evidence of improvement will influence grades of students with grades near the border between two grades6U_U_e0What is Different About How I Teach This CoursevTextbooks and traditional finance classes focus on the wonderful things that academics have discovered
This course focuses on financial instruments, how they are used, and how finance professionals attempt to value them
Topics concerning international finance and derivative securities are integrated directly into the course and not ignored or relegated to advanced courseswZwReadingsCustom course textbook
Time value of money and capital budgeting covered by Ross/Westerfield/Jaffe (RWJ) chapters
Stocks and portfolios covered by Bodie/Kane/Marcus (BKM)
Other basic content covered by material on class slides or on the Internet (with links from the slides and/or WebCT)
Current financial events from the Wall Street Journal:10week subscription for $13.95 or a 15week subscription for $19.95 (School zip code is 12222)XZZZb\Q7']J0BU[J0WkYJ0
aA Note on the Custom TextbookIt is designed as a central source for financial formula and their application
It is not designed to entertain you (that is my job)
The financial world moves so quickly that all textbooks are outofdate even before they are publishedgUse of WebCT in the CoursePRepository for course materials
Primary means of contacting the professor (via Email)
Can also send mail to rmmiller@uamail.albany.edu
Discussions and notifications (especially concerning topics that arise in class discussions and problem solutions)
Slides are also available at: http://home.earthlink.net/~millerrisk/FinanceNotes.htmFX1X174n/J0nJ0P9AssignmentsNAssignments appear on the last slides for each week and on WebCT
Most weeks have specific readings that must be read prior to the next class meeting
Most weeks also have examlike problems to answer
Assignments are not handed in or graded, but experience indicates that students who fail to do them encounter real trouble on the examsOZO*:Smile\I will take digital photos of all class members at both the Week 2 and Week 3 class meetings]]YA Bit of AdviceuIf you are lost, others probably are lost too, soASK THE PROFESSOR TO EXPLAIN WHAT IN THE WORLD HE IS TALKING ABOUT!fA DisclaimerThe slides used in this course incorporate much more information per slide than is considered acceptable for standard corporate communications
This is done so that they can serve as a more comprehensive form of notes that goes well beyond what is in the textbook
What is Finance?Two major elements
Time
Uncertainty (particularly involving the risk of an unfavorable outcome)
A typical very simple financial transaction
Borrow money to purchase capital equipment to produce goods or services and use some of the revenue to repay the money at a specified later timeLM,M,Finance Focuses on Cash FlowsyThere are three basic ways that cash flows can be structured
Straight financing: Pay cash now in return for the right to receive something, often just more cash, later
Forward contract: Agree now to buy or sell an item at a fixed price at some future date(s)
Option contract: Pay cash now in return for the option to buy or sell an item at a fixed price at some future date(s)
R=<"
#<CFinancial Instruments Involve the Creative Packaging of Cash Flows8Stocks and bonds
Pay now, have the right to (but not necessarily receive) a stream of future cash flows
Futures contracts
A forward contract with collateral (called margin) paid up front and maintained until delivery
Mutual funds (including ETFs)
An often useful bundle of stocks, bonds, or a combination of bothtW_BW_BD&Valuation is Done Two WaysDiscounting
Cash in the future is worth less than the same amount of cash held now
A lot of finance is about determining how large this difference in value is or should be
This is known (depending on context) as an interest rate, discount rate, or discount factor
Arbitrage
Turn something new that you wish to value into pieces of something old ( slice and dice ) that you already know how to valueZZ
Z}Z
}bFMuch of Finance is about Shopping Accomplish a financial goal at the least possible cost
Corporate financing
Household financing
Accomplish a financial goal with the least possible risk
Find bargains and sell them to others at a profit
Avoid getting ripped off (too often)67(7(=2Finance Is Also AboutInformation and ExpectationsPPrices reflect existing information and expectations
Prices change as information and expectations change
Just how well prices reflect information and expectations is hotly debated but the consensus is very well, though not perfectly
Prices also take other things into account most notably, risk)Z)@A Side Note on Internet SourcesInternet sources of financial information, definitions are usually but not always correct
Investopedia is especially good, but even it has misinformation
Be especially careful about using Wikipedia$Cu^J0ZgcJ0RThe Six Types of Objects in This CourseFinancial Instruments
Analytic Methods
Financial Indicators (indexes)
Events (both historical and current)
Institutions
People
*8Financial Instruments Fall Roughly Into Four CategoriesBMoney (shortterm debt and cash)
Longterm debt
Equity
Real assetsGoogle Stock (Nasdaq: GOOG)hJ04Google went public in August 2004
Is volatile and can behave in ways that are atypical of most stocks
Fin 525 s pet stock in AY2004 2005 and AY2005 2006> 6This is an Analytic Methods Slide (Believe It or Not)S&P 500 Stock IndexLThe stock index most often used by financial professionals
Vanguard s mutual fund that is designed to replicate the performance of the index is among the largest mutual funds in the U.S.
Are also the basis for the exchangetraded fund (ETF) with the symbol SPY that are known as Spiders (SPDRs)*J0(/Both Current and Historical Events Are Covered$United States Department of TreasurylIssuer of many of the financial securities covered in the early on in the course
The largest single player in the world economy because it is responsible for funding the Federal government s budget deficit
Because its securities are considered risk free, the rates of interest that it pays serve as baselines4Steven A. ( Stevie ) Cohen"jJ0Superstar billionaire hedge fund manager
His company, SAC Capital, is responsible for a significant amount of the volume on U.S. stock exchanges
Traders at SAC Capital have attracted the attention of securities regulators
+Any Questions? U.S. Federal Reserve Note (Cash)
Federal Reserve BankcJ0The central bank of the United States
Founded in 1913 as the central bank of the U.S.
Original mission was to provide financial stability
Federal Reserve Notes constitute the bulk of its liabilities
Visit its current balance sheet
Text format
PDF format
<ZZZdJ0eJ0So, What Is Money Anyway?%Money in Prison
Cash is Trash zCash pays no interest and its value is eaten away by inflation
Therefore, businesses try to hold as little cash as possible
To deal with shortterm funding requirements, businesses hold other forms of money
Bank deposits (and things that resemble them, like most moneymarket funds) are a preferred form of money
>Z>5HWalMart s Cash on the Balance SheetJ0
6_How Do We Know How Much Cash WalMart has in its Cash Registers?Is Lots of Cash a Good Thing? Certificates of Deposits (CDs)/Issued by banks
How they work
Deposit money with bank right now (cash outflow)
Receive even more money at a specified maturity date (cash inflow)
CDs are a form of time deposit (in contrast to a demand deposit)
We will focus on CDs that mature in under one year, the boundary between short and long term^ tA ] t"CCDs Rates are Required by Law to be Quoted as Annual Interest Rates}A popular place to find CD rates is bankrate.com
CD calculator
This deals with time periods other than a year and compounding&????*$
@fJ0$0gJ01>7Computing the Future Value (FV) of a CD(RWJ pp. 6061)Parameters
Cash outflow now: C0 = $10,000
CD interest rate: r = 12% or 0.12
Formula (for a single period)
FV = C0 (1+r)
Applying the formula
FV = $10,000 (1 + 0.12) = $10,000 (1.12) = $11,200
A44.
Reality CheckVInterest rates on any form of bank deposit have during a single period of American history and may never be that high again
The textbook then uses 12% virtually riskfree return on the CD as the discount rate to evaluate (compute the present value, PV) of a risky project, which is not a good idea1)What If You Really Could Get 12% on CDs?**0FSuppose You Want to Receive $11,424 One Year From Now at 12% InterestThe size of the CD you will purchase now is the present value (PV) of the $11,424 in one year
Formula (for a single period)
PV = C1 / (1+r)
Applying the formula
PV = $11,424 / (1 + 0.12) = $11,424 / (1.12) = $10,200
PV is also a builtin Excel function
7&7&/Computing Present ValuesWe will introduce two complications
Periods of time shorter or longer than the period over which the interest rate is quoted (usually one year)
Compounding: Getting interest on interest
PV is easy to compute on any calculator, not just financial calculators
PV is a builtin Excel function
Note: For Excel C0 is a negative number, which makes sense, but is not the way textbooks do itt$ZZhZ_Z$hM2UComputing NPV (Net Present Value), Which Is PV with the Initial Investment Netted OutParameters
Cash outflow now: C0 = $10,000
Cash inflow in one year: C1 = $11,200
Interest rate on 8/22/05: 4.30%
Formula: NPV = C0 + C1 / (1+r)
Applying the formula
NPV = $10,000 + $11,200 / (1 + 0.043) = $10,000 + $10,738.26 = $738.26e6L$+ $ 3
Excel and NPVThe computation on the previous slide is difficult to do automatically in Excel
Minor problem: Excel has an NPV function, but it makes no provision for the first cash flow to occur right now
The PV function can be coaxed to do this
6*B.Summary of Bank Time Deposits and Discounting"Simple payment scheme from bank CDs
Pay money in now
Get more money out later
The interest rate determines how much money is paid out later relative to the amount paid in
To get future value multiple by (1+r) to get present value divide by (1+r), where r is the interest rate for the periodl$*$*$ %CMThe Fundamental Relationship BetweenInterest Rate (r) and Present Value (PV)Interest rates and the PV of any every financial instrument with constant future cash flows (fixedincome securities like CDs and bonds) always move in opposite directions
Example: The PV of $10,000 at 4% interest in 1 year is $10,000/1.04 = $9,615.38
If the interest rate goes up to 5%, the PV drops to $10,000/1.05 = $9,523.81
If the interest rate goes down to 3%, the PV rises to $10,000/1.03 = $9,708.748PD$More on the Fundamental RelationshipWe will examine the sensitivity of various fixedincome securities to interest rates before midterm using a measurement called duration
While the prices of stocks and some risky bonds (both have very uncertain cash flows) tend to move in the opposite direction of interest rates, they sometimes move in the same direction when the change in interest rates indicates strength or weakness in the economy$
E>Converting Annual Interest Rates to Periods Less Than One YearjObvious method
Multiply rate by the appropriate fraction of a year
Examples:
12% for 6 months (or year) is (12%) = 6%
8% for 3 months (or year) is (8%) = 2%
Warning
The financial world often does not conform to the obvious method because annual rates can be quoted oddly or based on a 360day yeart4
Z4
ZF3FV and PV for Less Than a Year with No CompoundingConvert interest rate to new period length as demonstrated earlier
Apply the FV and PV formulas as before
FV = C0 (1+r)
PV = C1 / (1+r)
FV of $10,000 paying 4% annual rate for 6 months ( year)
FV = $10,000 (1 + 0.04/2) = $10,200j<$j<$G5Suppose We Reinvest in an Identical CD After 6 Months]Now our outflow (initial investment) is $10,200
The future value in six months is $10,200 (1.02)= $10,404
Notice that this is the same as investing for an entire year at 4.04%
4.04% is known as the APY (annual percentage yield) or EAR (effective annual rate)
Compounding accounts for the extra 0.04%, commonly known as 4 basis points (b.p.) or bipsD^0Z2BYH5The General Formula for Future Valuewith Compounding
New parameters:
m: Number of interest periods in a year
m = 2 means semiannual interest
m = 4 means quarterly interest
m = 12 means monthly interest
m = 365 means daily interest
T: Future time (in years or a fraction of a year) when inflow of cash occurs
Formula:
({N ' M
IUsing the Compounding FormulaExample: $10,000 at 4% annual rate for 6 months, compounded monthly
Parameters:
C0 = $10,000
r = 4% = 0.04
m = 12
T = 0.5
Plugging in: FV = $10,000 (1 + 0.04/12)0.5(12) = $10,000 (1.0033& )6 = $10,201.67P*qP
(J>APY (or Effective Annual Interest Rate) Formula from RWJ p. 72K*The Difference a Bip (or a Few Bips) Makes,nAt current interest rates, APY tends to be only a few bips (hundredths of a percentage point, also known as basis points or b.p.) higher than the simple interest rate
It is important to keep interest rates straight because although they low small, every bip matters when you invest millions of dollars
Professional bond traders and investors look at spreads (the interest rate relative to other securities) and these are measured in bipsZ>6LSA Note on Use of the Compounding Formula by Ross/Westerfield/Jaffe (RWJ) on page 731For the moment this course is focused on financial instruments that take one year or less to mature
The RWJ formula states it is for multiple years, but it also works for fractions of a year as we saw in the previous slide
Similarly, the Excel FV function can deal with both fractional and whole years though you have to adjust the interest rate and number of periods manually, which is not very convenientZM+Three Important Points Worth Mentioning Now,Compounding is magic because the interest on interest (and interest on interest on interest& ) adds up over time
Over long periods of time (10 years or more depending on interest rates), a small difference in the interest rate can make a large difference in the future value of the investment
Note that compounding only works if we do not withdraw the interest at the time that it is paid
We will not consider the receipt of more than one cash flow from a financial instrument until we get to Treasury notes and bonds in a few weeks.ZZ\Assignment For Week 2
Check out the links in the slides covered in class
Read RWJ Ch. 4, pp. 6073
Do the problems on the 4 slides that follow this one
Justify each TrueFalse answer
For the CD problems 13, use a calculator for one of the CDs and a calculator or spreadsheet for the rest&]$TrueFalse Statements (Page 1 of 2)fOne can make the annual percentage yield from a CD as high as one wants by choosing a short enough compounding interval.
At higher stated yields, the compounding interval will make more of a difference to the annual percentage yield.
In general, a $1,000 6month bank CD should cost less to purchase now than it did at this time last year (September 2005).
,ee^$TrueFalse Statements (Page 2 of 2)(Doubling the interest rate on a CD will double its APY
If two oneyear CDs both pay $10,000 at maturity, then the one with the lower APY will cost more to purchase now
The financial markets expect that the U.S. will grow faster in the second half of 2006 than it did in the first quarter of 2006.))_Questions about the Next SlidenCompute the APY (known in the textbook as Effective Annual Interest Rate) for each CD.
Compute the future value at maturity for each CD for an investment of $10,000 today.
Compute the present value of $10,000 received at maturity from each CD.
You are considering the 3month and 12month (1 year) CDs offered by Beal bank. Bank of Miller (BoM) is willing to guarantee you a 9month when the 3month Beal CD matures if you sign with them now. What APY must BoM provide you so that after a year you will have the same amount you would have buying Beal s 12month CD.
8Z8,Trl `0CD Interest Rates Compiled on September 6, 2005/8
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