1. The Time Value of Money Flashcards
TVM is abbreviation for
Time Value of Money
FV is abbreviation for
Future Value
PV is abbreviation for
Present Value
Discounting is used to calculate
Present Value (PV)
Compounding is used to calculate
Future Value (FV)
Interest rates can be interpreted as…
Required rate of return; discount rate; opportunity cost of current consumption
Explain ‘required rate of return’
The return that investors and savers require to get them to willingly lend their funds
Explain ‘discount rate’
If an individual borrows funds at interest rate of 10%, then they should discount payments to be made in the future at that rate to get their equivalent value in current $
Explain ‘opportunity cost’
If the market rate of interest on 1-year securities is 5%, earning an additional 5% is the opportunity forgone when current consumption is chosen rather than saving (postponing consumption)
Real risk-free rate is…
…a theoretical rate on a single-period loan that has no expectation of inflation
Real rate of return is =
real risk-free rate - expected inflation
What are T-bills
U.S. Treasury Bills
Nominal risk-free rate =
Real risk-free rate + expected inflation rate
Securities may have one or more types of risk, and each added risk [increases/decreases] the required rate of return.
increases
Default risk is
the risk that a borrower will not make the promised payments in a timely manner
Liquidity risk is
the risk of receiving less than fair value for an investment if it must be sold for cash quickly
Maturity risk is
the risk that the price of longer-term bonds are more volatile than shorter term bonds. Longer maturity bonds have more maturity risk than shorter-term bonds
nominal rate of interest =
nominal risk-free rate + default risk premium + liquidity risk premium + maturity risk premium
An interest rate is best interpreted as:
A. a discount rate or a measure of risk
B. a measure of risk or a required rate of return
C. a required rate of return or the opportunity cost of consumption
An interest rate is best interpreted as a required rate of return or the opportunity cost of consumption
An interest rate from which the inflation premium has been subtrated is known as:
A. a real interest rate
B. a risk-free interest rate
C. a real risk-free interest rate
An interest rate from which the inflation premium has been subtrated is known as a real interest rate
