Time Value of Money (CFA Video)

Answer:

1. Money has different values at different time
1. due to compounding of interest
2. Reference of time
1. Present: Present Value (PV)
2. Future: Future Value (FV) e.g. the FV of today’s $1million (PV) = $1.2million
3. $100 today ≠ $100 one year later
4. I would not lend you $100 today and just get back $100 one year later
5. I will require you to pay me interest at certain rate:
1. Required rate of return
2. aka discount rate
3. aka opportunity cost
6. Required Rate of Return =
7. real risk-free rate +
8. expected inflation +
9. default risk premium +
10. liquidity risk premium +
11. maturity risk premium
12. The effective interest you will earn in 1 year
13. Since financial institutes usually quote annual interest rates and compounding frequency (n):
1. EAR = (1 + annual rate/n)ⁿ – 1
2. EAR = exp(annual rate) – 1 for continuous compounding
14. If a bank tells you that the CD annual rate is 5%, what is the EAR?
15. Since compounding period is not given, we can assume continuous compounding:
16. EAR = exp(0.05)-1 = 5.13%