Time Value Of Money Flashcards
What is interest rate?
A rate of return that reflects required compensation to receive same value of money in the future
How can interest rate be considered?
- min rate of return for investor to accept investment
- discount rate- discount the future value to find the value today
- opportunity cost-value investors forgo choosing one investment over another
Formula for interest rate?
real risk free interest rate + inflation premium + default risk + liquidity premium (risk of loss of value) + maturity premium
What is nominal risk free rate?
Risk free rate plus inflation premium
Formula for FV?
FV= PV(1+r)^N
Formula for non annual compounding?
PV(1+r/m)^mN
Formula for continuous compounding?
PV*e^rN
What is effective annual rate formula?
EAR=(1+ periodic interest rate)^m-1
How do you find periodic interest rate?
EAR^-m=periodic interest rate
What’s annuity?
Series of payments made at equal time intervals
What’s ordinary annuity?
1st cash flow that occurs one period from now
What’s annuity due?
First cash flow immediately, at t=0
What’s perpetuity?
Never ending sequence CF
Formula for ordinary annuity?
A((1+r)^N-1/r))
What’s a PV of a single CF?
PV=FV(1+r)^-N
What’s PV of annuity?
A(1-1/(1+r)^N)/r))
What’s formula for PV of perpetual annuity?
A/r
How do you solve for interest rate?
r=FV/PV-1
How do you solve for growth rate?
FV/PV^1/N-1
What’s default risk premium?
Lenders charge for possibility that borrowers won’t meet their ovligations
Liquidity premium?
Compensates investors for converting investment into cash
Maturity premium?
Earned by investors willing to lend over longer periods
Exercise on interest rate?
Usually 1 year government bond is risk free rate. Difference between 10 year gov. Bond and 1 year is maturity premium. Difference between corporate bond and 1 year government bond is the premium over nominal risk free rate (risk free plus inflation) and represents sum of default and liquidity risk
