S2. Time Value of Money

Fabricio Chala, CFA, FRM
Time Value of
Money S2
Future Value
❖  Unless otherwise stated, compounding should always be assumed
❖  Logical relations:
❖  For a given interest rate (r), FV increases with the number of periods (N)
❖  For a given number of periods (N), FV increases with the interest rate (r)
❖  How much would I have in the future if I invest 1,000 soles at…
•  2.5% for 1 year?
•  5.0% for 2 years?
•  10.0% for 10 years?
Interest Rates
❖  Interest can be expressed in different dimensions:
❖  Simple
r ❖  Compound
Frequency of Compounding
❖  So far we have assumed annual interest rates with annual
compounding. But, if an investment pays interest more than once a
year, interests have to be compounded more frequently.
❖  For example:
❖  A time deposit that pays 8% interest compounded monthly
❖  A time deposit that pays a 4% interest compunded quarterly
❖  A time deposit that pays a 6% interest semi-anually

Effective Annual Rate (EAR)
❖  Calculate the EAR for a:

A.  7.0% interest rate compounded weekly
B.  15.0% interest rate compounded semianually
❖  Equivalent rates: Calculate the interest rate compounded semianually

that is equivalent to a 10% interest rate compounded quarterly
Effective Annual Rate (EAR)
Exercises:
1.  Would you prefer to prefer to save your money in bank A, which offers you a
6% yearly interest rate with monthly compounding, or in bank B, that offers you
a 6.10% yearly rate with yearly compounding?
2.  Would you prefer to get a loan at bank C, which charges you 2% per month with
monthly compounding? Or would you prefer to get the loan with bank D, that
charges you 25% yearly rate with weekly compounding?
Continuous Compounding
❖  What if m --> ∞?

Continuous Compounding
Exercises:
1.  How much money would I earn in one year if I deposit $100k at a rate of 4%
with monthly compounding?
2.  With respect to question 1, How much more money would I earn if the interest
is compounded weekly?
is compunded daily?
is compunded continuously?
Interest Rates
❖  Interest can have different dimensions:
❖  Daily Simple
r
❖ 
❖  Monthly ❖  Compound
❖  Annual IMPORTANT: Do not confuse the quotation of the rate

with its compounding period (for instance, a rate
could be expressed in monthly terms, yet the
compounding could occur daily)
❖  …?
Unless stated otherwise, rates can be assumed to be
quoted in annual terms
Day Count Convention
❖  A day count convention determines how interest is calculated,
determining the days between two payments.
❖  It is expressed as number of days between payments over the
number of days in a year, as agreed per convention.
❖  Many different conventions may exist within a market, so it’s
important to understand which one is being used while calculating
the EAR.
❖  For example, for commercial loans in the US and in Peru, banks
will express their “Effective Rate” using ACT / 360 (actual days
between dates over a 360-day year). This increases the actual
amount charged to clients over a year and does not represent the
true EAR.
❖  For the purposes of this class, Actual/365 will be assumed.
Interest Rates
❖  Interest can have different dimensions:
❖  Daily ❖  Simple
❖  Monthly
r ❖  Compound
❖  Annual ❖  ACT / 360

❖  ACT / 365 (aka ACT / ACT)
❖  …? ❖  30 / 360
❖  …?
Present Value
❖  How much should I invest today at a interest rate of “r” to recibe a
a certain amount “FV” in a “N” period of time?
Example: How much is worth today, 15,000 soles that I will recibe in 5
years? Annual interest rate is 5.0%
Present Value
❖  When calculating the PV of a series of Cash Flows it’s important to
understand whether the CFs are being received at the end of the
period…
S/. 50 S/. 50 S/. 50 S/. 50 S/. 50
0 1 2 3 4 5
P1 P3 P5
P2 P4
Present Value
❖  …or at the beginning of it
S/. 50 S/. 50 S/. 50 S/. 50 S/. 50
0 1 2 3 4 5
P1 P3 P5
P2 P4
Present Value
❖  Examples:
❖  How much are worth these payments to be received in the future?
1.  1,000 Soles to be received in one year
2.  2,000 Soles to be received in three years
❖  How much is worth a series of 3 payments to be received at the

beginning of the next three years, starting the next one?
Present Value
❖  Exercises
❖  If you had the opportunity to earn 12% on a bank deposit. Would you
prefer:
1.  90,000 soles today
2.  100,000 soles in one year
3.  Or 113,000 soles in two years
❖  Assume that you have S/.10,000 credit card debt at an interest rate of 2%
per month (24% rate with monthly compounding). Would you prefer S/.
10,000 soles today or S/.12,500 in 1 year?
Additivity Principle
❖  IMPORTANT: Amounts of money indexed at the same
point in time are additive

S2. Time Value of Money

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Fabricio Chala, CFA, FRM

❖  A time deposit that pays 8% interest compounded monthly

❖  A time deposit that pays a 4% interest compunded quarterly

❖  A time deposit that pays a 6% interest semi-anually

❖  Calculate the EAR for a:

❖  Equivalent rates: Calculate the interest rate compounded semianually

❖  Annual IMPORTANT: Do not confuse the quotation of the rate

❖  Annual ❖  ACT / 360

S/. 50 S/. 50 S/. 50 S/. 50 S/. 50

S/. 50 S/. 50 S/. 50 S/. 50 S/. 50

❖  How much are worth these payments to be received in the future?

1.  1,000 Soles to be received in one year

2.  2,000 Soles to be received in three years

❖  How much is worth a series of 3 payments to be received at the

1.  90,000 soles today

2.  100,000 soles in one year

3.  Or 113,000 soles in two years

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S2. Time Value of Money

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S2. Time Value of Money

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Fabricio Chala, CFA, FRM

❖ A time deposit that pays 8% interest compounded monthly

❖ A time deposit that pays a 4% interest compunded quarterly

❖ A time deposit that pays a 6% interest semi-anually

❖ Calculate the EAR for a:

❖ Equivalent rates: Calculate the interest rate compounded semianually

❖ Annual IMPORTANT: Do not confuse the quotation of the rate

❖ Annual ❖ ACT / 360

S/. 50 S/. 50 S/. 50 S/. 50 S/. 50

S/. 50 S/. 50 S/. 50 S/. 50 S/. 50

❖ How much are worth these payments to be received in the future?

1. 1,000 Soles to be received in one year

2. 2,000 Soles to be received in three years

❖ How much is worth a series of 3 payments to be received at the

1. 90,000 soles today

2. 100,000 soles in one year

3. Or 113,000 soles in two years

You might also like

❖  A time deposit that pays 8% interest compounded monthly

❖  A time deposit that pays a 4% interest compunded quarterly

❖  A time deposit that pays a 6% interest semi-anually

❖  Calculate the EAR for a:

❖  Equivalent rates: Calculate the interest rate compounded semianually

❖  Annual IMPORTANT: Do not confuse the quotation of the rate

❖  Annual ❖  ACT / 360

❖  How much are worth these payments to be received in the future?

1.  1,000 Soles to be received in one year

2.  2,000 Soles to be received in three years

❖  How much is worth a series of 3 payments to be received at the

1.  90,000 soles today

2.  100,000 soles in one year

3.  Or 113,000 soles in two years