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In: Finance

Explain the differences between a pure discount loan, an interest-only loan, and a level-payment amortized loan....

  1. Explain the differences between a pure discount loan, an interest-only loan, and a level-payment amortized loan.
  2. Explain interest rate risk.
  3. What are the three elements in every time value of money calculation?

Solutions

Expert Solution

A pure discount loan refers to alone in which the individual who borrows receives a certain amount of money today and then repays the amount as a single figure(lump sum) at a specified date.An example would be a person who receives a loan of $25000 today and agreeing to repay it with 8% annual interest and repay it 6 years later with interest.In the case of an interest only loan only the borrower will only pay the interest of the loan as a series of payments during the term of the loan and at the end of the loan period will repay the principal amount the individual borrowed.An example would be $25,000 borrowed for 6 years with 8% annual interest.Here there will be a series of annual interest payment followed by repayment of principal in the final year.A level payment amortized loan also known as straight line amortization, is a type of loan where the borrower repays the loan in fixed amounts of monthly payments.the interest component of the payments will vary from high to loan over the course of the payment period.

Interest rate risk is the term used to refer to the risk of an investment losing its value due to the change in interest rate over a specified time period.An example of interest rate risk would be the change in value of a bond with the change in interest rates.The use of derivatives can help mitigate the interest rate risk.

Time value of money refers to the concept that states that a dollar today is worth more than a dollar tomorrow.The three elements of a time value of money calculation are the present/future value the number of period(n) and the discount rate (r).Eg:if the present value is given as $5000 and the discount rate =6% and then the future value after 10 years would be FV=pv*(1+r)^n =5000*(1.06)^10=$8954.24


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