Time Value of Money

Question 1

Why do asset prices matter?

Answer 1

• Asset prices are affected by current and expected future activity
• Asset prices also affect decisions which affect current activity

Question 2

Describe compound interest.

Answer 2

• Investment of £n today grows to (1+Rt)£n next year, (1+Rt) (1+Rt+1)£n in two years etc
• When future rates are uncertain: £(1+Rt) (1+R^e t+1)

Question 3

Expected present discounted value.

Answer 3

• The value today of the expected sequence of payments
• Future payments and interest rates are unknown - present value calculations must rely on expected values of future payments and short run interest rates

Question 4

Expected Present Discounted Value formula:

Answer 4

£Vt = £Zt + 1/(1+Rt)*(£Z^e t+1)
where…
- £Vt = expected present discounted value of the sequence of payments
- £Zt = today’s payment
- £Z^e t+1 = payment a year from today
- 1/1+Rt = discount factor

Question 5

Implications of Expected Present Discounted Value:

Answer 5

• Expected present discounted value depends positively on today’s actual payment and expected future payments
• Expected present discounted value depends negatively on current and expected future interest rates