Time Value of Money Flashcards
What does FV20 = $200,000 mean?
The Future Value in Year 20 is $200,00
What does Present Value mean?
The value of some future value in the present
What is the discount rate?
The rate of growth.
What is the relationship between Present Value and Future Value?
Present value is always smaller than the future value.
What is the time value of money?
A method of valuing any cash flow in any time through compounding or discounting.
What is the real risk-free interest rate
A theoretical rate that an investor would receive with no risk.
What is an example of a risk-free interest rate?
U.S. Treasury Bill
Why are treasury bills considered to be risk free?
They are backed by the government and are liquid.
What is inflation premium?
Recognizes that investors must be compensated for decreased buying power due to inflation.
What is the real interest rate plus the inflation premium called?
Nominal risk-free rate.
What is default risk premium?
Compensates the investor for default risk, or not getting paid back.
What would increase the default risk premium?
A company takes on more debt and must pay a higher rate.
What is liquidity premium?
Extra compensation for the loss that would be incurred if the investor had to liquidate the security quickly.
What is maturity premium?
Extra compensation for the greater chance of change in the market interest rate, leading to a greater risk for longer maturity bonds.
If a debt instrument had to be sold at a lower price because there were few buyers for that particular instrument. What sort of risk is this?
Liquidity.
What would be an example of an increase in default risk?
A company issuing bonds with very high interest payments and low cash flows.
What is the required rate of return?
The rate you need to earn on an investment in order for it to meet your reward expectations.
What should the required rate of return be viewed as?
A floor when comparing investments.
What does the discount rate measure?
the rate by which the value of a future cash flow is reduced so that you can think of it in terms of cash received today.
What is Opportunity cost, in terms of interest rates?
the rate of return you are missing out on if you choose to forgo the equivalent cash flow.
Do some banks value the ability to increase their assets overnight to meet regulations?
Yes.
What is an equivalence relationship?
When two opportunities yield the same dollar amount over time.
What is the formula for computing the future value of a sum of money today?
FVn = PV(1+r)^N
What is compounding?
Interest earned upon previous interest paid.
What are examples of Frequency of Compounding
Semiannual, quarterly, monthly, weekly, or even daily.
What are annual rates referred to as?
Stated annual rates or quoted interest rate.
What is the stated annual rate referred to if it is compounded other than annually?
It is referred to as the periodic rate
How do you calculate the periodic rate?
r / m
r = stated annual rate. m = number of compounding periods per year.
When there is more than one compounding period per year, the future value formula is expressed as:
FVn = PV ( 1 + r/m) ^mN
What are Annuities
Series of equal cash flows equally interspaced in time.
When compounding is continuous, the equation for future value is
FVn = PVe^rT
What is the Effective Annual Rate (EAR)
It is the annual interest rate compounded annually that is equivalent to a stated annual interest rate that is compounded other than annually.
What is the equation for EAR?
EAR = ( 1 + Periodic Rate)^m - 1
Equation for calculating the future value of an ordinary annuity:
FV = A[(1+r)^N -1 / r ]
