Fin 320_ Exam Review 2 (Presenter Version) (1)

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Finance Review Part I: Vocabulary Economic assets : Economic assets are entities functioning as stores of value and over which ownership rights are enforced by institutional units, individually or collectively, and from which economic benefits may be derived by their owners by holding them, or using them, over a period of time (the economic benefits consist of primary incomes derived from the use of the asset and the value, including possible holding gains/losses, that could be realized by disposing of the asset or terminating it) OECD Glossary of Statistical Terms Economic value: Economic value is the maximum dollar price someone will pay for an economic asset. Economic decision-making: Economic decision-making involves calculating economic values and comparing the economic value of an asset to the cost of obtaining the asset. Creating wealth: Economic decisions create wealth when the price paid for an economic asset is less than its economic value. This is at the heart of financial decisions and is the basis for every action in markets. Positional goods: Goods and services that people value because of their limited supply, and because they convey a high relative standing within society. They derive most of their value if they succeed in distinguishing their owners as members of a favored group. In general, the definition of positional goods extends to luxury services, memberships and vacations, even though these are not goods. Opportunity cost: The best alternative that is not chosen because another course of action is pursued. Economic decisions generally involve comparing rates of return. Opportunity cost is often called the discount rate, the hurdle rate, the benchmark rate, or the required rate of return. The time value of money: The concept that money available at the present time is worth more than the identical sum in the future due to its potential earning capacity. This core principle of finance holds that, provided money can earn interest, any amount of money is worth more the sooner it is received. Investopedia.com. Interest rate: a rate of return on an investment or paid on a debt. The First Principle of Finance: A dollar received today is worth more than a dollar received in the future. Cash flow: The flow of purchasing power that can be used to value and facilitate the transfer of economic assets.

Risk: The uncertain nature of future cash flows and rates of return will cause current economic values to vary. This variability is the major issue with all financial decisions. Present value: The value of a future cash flow stated as of today.. Future value: The future value of an amount given today. Compounding: The process of using a rate of return to determine a future value. Discounting: The process of using a rate of return to determine a present value. Decision rule: A quantitative rule that evaluates whether a course of action should be undertaken. Internal Rate of Return (IRR): The rate of return earned on an investment adjusted for time value. Net Present Value (NPV): A decision-making process using time value and opportunity cost to compare the benefits of a decision with its costs. If the benefits exceed the costs then the decision creates wealth. Fairly valued asset: The asset offers an acceptable rate of return equal to the rate of return offered on assets of equivalent risk. The IRR is equal to the opportunity cost, and the NPV = $0. This is an acceptable investment. Overvalued asset: The asset's rate of return is less than the rate of return offered on assets of equivalent risk. The IRR is less than the opportunity cost, and the NPV is negative. This is not an acceptable investment. Undervalued asset: The asset's rate of return is greater than the rate of return offered on assets of equivalent risk. The IRR exceeds the opportunity cost, and the NPV is positive. This is a desirable investment. Expected return: The future return, generally uncertain, that one expects to get from an investment. This is the return that is used in making most business decisions. Realized return: The return that is actually received at the end of the investment period. Risk-free rate of return: A rate of return on an asset whose future cash flows are certain.. Given the known payment made today for the promise of future cash flows that will be received with certainty, the rate of return is also certain. Risk premium: The extra return above the risk-free rate that is required given the uncertainty of the future cash flows.

Market price: The current price at which an asset can be exchanged between a willing buyer and a willing seller. Value in use: The value that a user expects to get from the use of an asset. Simple Interest is Interest earned on the original principal. Each period the interest rate is applied, but the principal remains the same. Compound Interest occurs when the Interest earned is applied to the principal each period. With compound interest, the principle grows over time and, if the principle grows so does the amount of interest paid each period. Annuity: A series of regular payments at regular intervals for a defined period of time. . Level annuity: An annuity with the same cash flow for each period of time. Level annuities are further classified as to when the payments are made in each period. Ordinary annuity: Payments occur at the end of each period. Annuity due: Payments occur at the beginning of each period. Growing annuity: An annuity where payments grow at a steady rate. Perpetuity: A series of regular payments for regular periods that go on indefinitely. Level perpetuity: Perpetual payments of the same amount at regular intervals Growing perpetuity: Perpetual payments where the amounts grow at a constant rate. Compounding period: The length of time that passes before interest is recognized and added to the principle. Stated annual interest rate: The interest rate stated on an annual basis. This is the rate normally used in contacts, including loans such as credit cards, auto loans and mortgages. Annual percentage rate (APR): The interest rate charged per period multiplied by the number of periods per year. Periodic interest rate: The interest per period, such as the semiannual rate for bond interest payments and the quarterly rate paid via dividends. Effective annual interest rate: The annual interest rate that reflects the impact of intra-year compounding.

Frequency distribution: A representation of the historic returns over a period of time which shows how often each return occurs. Probability distribution: A formula or table of information that gives the potential outcomes and the likelihood of those outcomes. There are two types of probability distributions. Discrete probability distribution: A probability distribution that contains a discrete, or countable, number of observations. Continuous probability distribution: A probability distribution that contains an infinite number of observations, which are analyzed using quantitative measures based on mathematical relationships and calculus. Expected return: The average of the possible realized returns weighted by their probability of occurring Variance: A measure of how the possible realized returns might vary from the expected return. Standard deviation: The square root of the variance. Portfolio: A collection of economic assets. Diversification: The process of reducing the risk of a portfolio by holding assets whose returns are not perfectly correlated. Joint probability distribution: A probability distribution containing the likelihood of two events occurring together Expected return of a portfolio: The wealth-weighted average of the returns expected from the assets held in the portfolio. Portfolio variance: The combination of the wealth-weighted average of the variances of the two assets and their covariance. Covariance: A statistical measure of the degree to which two rates of return move together. Correlation coefficient: Measures not only the direction of covariability (positive or negative) but also the strength of the relationship. Unique risk: The risk that is unique to an individual company. Unique risk, varying from company to company, is the risk that can be diversified.

Market risk: The risk that affects all companies in the economy. Market risk, because it affects all market participants, cannot be diversified away and thus the risk that is relevant for determining the opportunity cost. A mutual fund is an investment vehicle made up of a pool of moneys collected from many investors for the purpose of investing in securities such as stocks, bonds, money market instruments and other assets. Mutual funds are operated by professional money managers, who allocate the fund's investments and attempt to produce capital gains and/or income for the fund's investors. A mutual fund's portfolio is structured and maintained to match the investment objectives stated in its prospectus. Investopedia.com Hedge funds are alternative investments using pooled funds that employ numerous different strategies to earn active return, or alpha, for their investors. Hedge funds may be aggressively managed or make use of derivatives and leverage in both domestic and international markets with the goal of generating high returns (either in an absolute sense or over a specified market benchmark). It is important to note that hedge funds are generally only accessible to accredited investors as they require less SEC regulations than other funds. One aspect that has set the hedge fund industry apart is the fact that hedge funds face less regulation than mutual funds and other investment vehicles. Investopedia.com Beta: a measure of the market/systematic risk of an asset: how the asset return varies with the market return, and is thus a measure of the risk that cannot be diversified away. Capital Asset Pricing Model (CAPM): a model that uses market/systematic risk to calculate the opportunity cost/expected rate of return.

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