QM PREREQ1 – Interest Rates, Present Value and Future Value Flashcards
What are the 3 rules of money?
- Money soon is worth more than money later
- Larger cash flows are worth more than smaller
- Less risky cash flows are worth more than more risky
What are the 3 ways of thinking about interest rates?
- Required rate of return: RoR required by an investor ot lender.
Money today * (1 + r) = money tomorrow - Discount rate: rate at which some future value is discounted to arrive at a value today
Money tomorrow / (1 + r) = Money today - Opportunity cost: the value an investor or lender forgoes by chhoosing a particular action.
I.e., r is the opportunity cost of current consumption
Typically required rate of return = discount rate = opportunity cost
What 4 premiums will be built into the rate of return if I lend someone money, on top of the risk-free rate?
- Inflation premium: compensates for expected inflation ( π^e)
- Default risk premium: compensates lender for credit risk
- Liquidity premium: compensation for risk of loss versus fair value if an investment needs to be converted to cash quickly
- Maturity premium: greater interest rate risk (i.e., price risk) with longer maturities. This is because as yields increase, bond price increases. So if yields increase, your bond may be devalued.
This will also include a premium for inflation.
It is ultimately due to uncertainty: the longer the time period, the more uncertain we are about the level of expected inflation
Ideally these would be multiplicative rather than additive, but additive is just fine
What is the nominal risk-free rate?
r⌄f + π^e = nominal risk-free rate
Where r⌄f is the risk-free rate
and π^e is the inflation premium
The nominal risk-free rate might be measured by something like the return on a US Treasury 3-month T-bill
It build in an inflation premium as well as the underlying risk-free rate
What does it mean to say that r must be in the same periodicity as N when calculating the future value of a single cash flow?
r represents the interest rate, N represents the number of periods
If the interest rate was 6% per year over 10 years with an annual periodicity, the final nominal value is 100(1.06)^10
If it had semi-annual periodicity it would be 100(1.03)^20
If it had quarterly periodicity it would be 100(1.015)^40
These will result in different values so we need to match the periodicity
How do we calculate FV?
Future Value = Present Value x (1 + r)^N
Where r = interest rate
N = number of periods
What is simple interest?
Interest calculated on the original amount
Contrasted to compounded interest, which is calculated on the amount from the last period
i.e., 5% interest on £1000 over 20 years would return (0.05 * 1000 * 20) = £2000
How do you calculate future value of £10m you receive in 5yrs and invest at 9% RoR for 10 years?
It doesn’t matter when you receive it, it is still money invested for 5 years.
Method 1: FV = 10m(1.09)^10 = 23.7m
Method 2: N=10, I/Y = 9, PMT = 0
PV = -10m
CPT FV = 23.7m
To calculate value of the 10m today using this interest rate, we can discount it by (1.09)^5 and divide 10m by this amount
10m / (1.09)^5 = 6.5m
How are interest rates stated?
Rates are ALWAYS quoted annually
That means if you see a 3-month T-bill yielding 3%, you do not get 3%, only 1/4 of 3% across the 3 months (which is 0.75%)
r⌄s = stated interest rate
How do we calculate value of $1m held over 1 year with a rate of 3% that is compounded monthly?
FV = 1m (1 + (6% / 12)) ^ (12 x 1)
What is continuous compounding?
This is really just an easier way of calculating or implementing the idea of daily compounding, which can get clunky to use (dividing rates by 365)
We have to use Euler’s constant, e, for continuous compounding. We multiply the present value by e to the power of rate x number of periouds
FV = PV x e ^(r x N)
What do we press on the calculator to calculate using continuous compounding the future value of 50,000 at an interest rate of 7% held for 3 years?
On the calculator we do:
0.07 x 3 = 2nd function, LN x 50 000
We must use the equals because 0.07 x 3 should effectively be in brackets
How to calculate stated rate if we know EAR?
If we know Effective Annual Rate we can work backwards to find the effective annual rate when we also know the periodicity.
Let’s say that we have an EAR of 10%
0.1 = (1 + rs /12)^12 - 1
1.1 = (1 + rs/12)^12
(1.1)^1/12 = 1 + rs/12
(1.1)^1/12 -1 = rs/12
((1.1)^1/12 - 1) x 12 = rs
0.0957 = 9.57% = rs
9.57% = stated rate
How do we calculate stated rate if we have EAR using continuous compounding?
EAR = 5.5%
0.055 = e^rs - 1
1.055 = e^rs
ln(1.055) = rs
0.0535 = rs
5.35% = rs = stated return
What is an annuity?
A finite set of level sequential cash flows
Something cannot be an annuity if:
- the cash flow differs
- some years are missed out
- the cash flows do not have an end date
What is an ordinary annuity?
What is an annuity due?
Ordinary annuity: where the first cash flow happens at the end of the first year
Annuity due: where the first cash flow happens at the beginning of the first year
Important because the cash can earn interest over the period
How do you calculate the future value of an ordinary annuity?
Enter number of years and press N
Enter payment amount and press PMT
Enter rate and press I/Y
Enter present value and press PV
Press CPT FV to calculate
How do you calculate the future value of an annuity due?
An annuity due starts paying in from the beginning of the first year, rather than the end
This means that interest can accrue over the year starting from t=0
The first payment out can therefore grow for the entire duration of the annuity, rather than n-1
You can calculate the value of an annuity due by just calculating the value of an ordinary annuity and multiply it by (1+r) to account for that additional year of compounding
You could also enter Begin mode (BGN) on your financial calculator to perform the annuity due calculation. However it might be sometimes inconvenient or lead to errors if you keep flipping back and forth. Therefore MM keeps his calculator in END mode and just multiplies at the end
How do you calculate the future value of unequal cash flows?
It can be calculated manually or using the calculator functions
Calculating it manually involves multiplying each annuity payment by the number of years it has to gain interest. Then adding these together.
We can use the calculator function NFV to find the future value of a series of cashflows. However not all calculators have this function. If they do, it works the same as the NPV function in terms of inputs
How do you calculate the present value of a single cash flow?
Multiply the single cash flow (the future value) by:
(1 + r)^-N
Which is the same as:
FV / (1 + r)^N
How do you calculate the present value of a series of cash flows for an ordinary annuity?
PV = A [(1 - 1 / {1 + r}^N) / r ]
Where PV = Present Value
A = Annuity Due
r = rate of return / interest rate
N = number of years
i.e., if A = 1000 (payment in per year)
r = 0.07
N = 6
PV = 1000 * [(1 - 1 / 1.07^6 ) / 0.07)]
PV = 4 767
How do you calculate the present value of a series of cash flows for an annuity due?
It is the initial payment in plus the PV of a series of cash flows for an ordinary annuity for N - 1 years of the annuity
I.e. you would add
PV = A + A [(1 - 1 / {1 + r}^[N-1]) / r ]
Where PV = Present Value
A = Annuity Due
r = rate of return / interest rate
N = number of years
You can add the time value of money keys to calculate that
What is a perpetuity?
An annuity that pays out forever.
The cash flows from a perpetuity are:
- level
- sequential
- infinite
We can find the present value of a perpetuity by dividing the amount the perpetuity pays per year by r
where r is the discount rate
I.e., if our perpetuity pays out £100 per year and the discount rate is 5%, the present value is 100/0.05 = £2000
Because of the constant discounting as time progresses, no matter what time you consider the perpetuity to start it will always have the same value, if you take the discounting into account
How can we create a 7-year annuity from perpetuities?
We find 2 perpetuities that are identically matched. They pay out the same amount each period. However, one starts at t=0 and another at t=7. We go long the first one and short the second.
Until t=7, we are only exposed to cash flows from the long perpetuity. This gives us the annuity payments. When t=7 begins, we pay the perpetuity short using the cash from the perpetuity long. These balance out, and we are left with net zero cash flows.
