ABSTRACT
Chapter 2 introduces foundational concepts regarding interest rates, fixed income securities, and equities. The time value of money is important in finance; cash flows occurring at different times have different values. Interest rates provide an intuitive expression of the time value of money but are quoted with different compounding methods. Market interest rates are a function of time known as the term structure of interest rates. Each default-free zero coupon bond can be valued by discounting its promised cash flow with the market interest rate matching its maturity. Coupon bonds can also be valued using rates from the term structure of zero rates corresponding to each cash flow or heuristically by discounting all cash flows by a single artificial interest rate known as a bond yield. Bootstrapping is a technique to extract the term structure of zero rates from the market quotes of coupon bonds prices. Forward interest rates are discussed and compared with spot rates. Duration and convexity are introduced as important risk measures in the management of interest rate risk. Equities and equity valuation models are briefly discussed. Finally, the chapter introduces Markowitz portfolio theory and the Capital Asset Pricing Model (CAPM) as a foundation for later chapters.
