QUANTITATIVE METHODS: BASIC CONCEPTS

THE TIME VALUE OF MONEY

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READING 6 THE TIME VALUE OF MONEY 2

 INTERPRETATION OF INTEREST RATES

Interest rates can be thought of in three ways:

 Required rate of return is the minimum rate of return an investor must receive
in order to accept the investment.

 The discount rate is the rate that must be applied to a cash flow in order to
determine its present value.

 The opportunity cost is the value that investor forgo by choosing a particular
course of action.

READING 6 THE TIME VALUE OF MONEY 3

 INTEREST RATE AS THE SUM OF A REAL RISK-FREE RATE, AND PREMIUMS THAT
COMPENSATE INVESTORS FOR BEARING RISKS

COMPENSATION
FOR THE RISK OF
LOSS RELATIVE TO
REFLECTS THE TIME AN INVESTMENT’S
PREFERENCES OF FAIR VALUE IF THE
INDIVIDUALS FOR INVESTMENT
CURRENT VERSUS NEEDS TO BE
FUTURE REAL CONVERTED TO
CONSUMPTION. CASH QUICKLY

REAL EXPECTED DEFAULT

INTEREST LIQUIDITY MATURITY
RISK‐FREE INFLATION RISK
RATE PREMIUM PREMIUM
RATE PREMIUM PREMIUM

COMPENSATION COMPENSATION
FOR POSSIBILITY FOR INTEREST
NOMINAL THAT THE RATE SENSITIVITY
RISK‐FREE BORROWER WILL
RATE FAIL TO MAKE A (LONG-TERM
PROMISED DEBTS MORE
PAYMENT IN TIME SENSITIVE,
AND IN FULL OTHER THINGS
AMOUNT EQUAL)

READING 6 THE TIME VALUE OF MONEY 4

 CALCULATE AND INTERPRET THE EFFECTIVE ANNUAL RATE, GIVEN THE STATED
ANNUAL INTEREST RATE AND THE FREQUENCY OF COMPOUNDING

Saving account after 1 year

𝐹𝑉1 = 𝑃𝑉 + 𝑃𝑉 × 𝑟𝑎𝑡𝑒 = 𝑃𝑉(1 + 𝑟𝑎𝑡𝑒)

Saving account after 2 years

𝐹𝑉2 = 𝐹𝑉1 + 𝐹𝑉1 × 𝑟𝑎𝑡𝑒 = 𝐹𝑉1 (1 + 𝑟𝑎𝑡𝑒) = 𝑃𝑉 × (1 + 𝑟𝑎𝑡𝑒) 2

…
Saving account after n years

𝐹𝑉𝑛 = 𝐹𝑉𝑛−1 + 𝐹𝑉𝑛−1 × 𝑟𝑎𝑡𝑒 = 𝐹𝑉𝑛−1 × (1 + 𝑟𝑎𝑡𝑒) = 𝑃𝑉 × (1 + 𝑟𝑎𝑡𝑒) 𝑛

𝐹𝑉𝑛 = 𝑃𝑉 × (1 + 𝑟) 𝑛

READING 6 THE TIME VALUE OF MONEY 5

 CALCULATE AND INTERPRET THE EFFECTIVE ANNUAL RATE, GIVEN THE STATED
ANNUAL INTEREST RATE AND THE FREQUENCY OF COMPOUNDING

The stated annual rate (SAR) is a rate used in calculation of EAR.

The effective annual rate (EAR) – is a rate which an investor really gets.
SAR does not account for intra-year compounding, while EAR does.

Suppose the stated annual interest rate on a savings account is 10%, and you put
$100 into this savings account.

If there is no intra-year compounding, then after one year, it would be $110.

EAR = SAR
But, if the account has a intra-year compounding feature, then effective rate of
return will be higher than 10% and it would be more than $110

EAR ≥ SAR

READING 6 THE TIME VALUE OF MONEY 6

 EXAMPLE
Stated annual interest rate on a savings account with quarterly compounding
feature is 10%. The initial investment is $100.

WITHOUT WITH
QUARTER DIFFERENCE
COMPOUNDING COMPOUNDING

0 100 100 -

1 102,5000 102,5000 -

2 105,0000 105,0625 +0.0625

3 107,5000 107,6891 +0.1891

4 110,0000 110,3813 +0.3813

READING 6 THE TIME VALUE OF MONEY 7

 CALCULATE AND INTERPRET THE EFFECTIVE ANNUAL RATE, GIVEN THE STATED
ANNUAL INTEREST RATE AND THE FREQUENCY OF COMPOUNDING

EAR = (1 + 𝑟/𝑚)𝑚 −1
r – SAR (another name is annual percentage rate (APR))
m - the number of compounding periods per year

Sberbank offers an account that pays 9%, compounded monthly, for any deposits
of 10 000 000 RUB or more that are left in the account for a period of 5 years.
The effective annual rate of interest on this account is:

SAR = 9% and m = 12

then

EAR = (1 + 9%/12)12 −1 ≈ 9.38%

READING 6 THE TIME VALUE OF MONEY 8

 CALCULATE AND INTERPRET THE EFFECTIVE ANNUAL RATE, GIVEN THE STATED
ANNUAL INTEREST RATE AND THE FREQUENCY OF COMPOUNDING

As number of compounding periods per year increases EAR increases but at

decreasing rate.

M EAR

1 (no intra-year compounding) 9,0000%

2 (semi-annually) 9,2025%

4 (quarterly) 9,3083%

12 (monthly) 9,3807%

365 (daily) 9,4162%

525 600 (every minute) 9,4174%

READING 6 THE TIME VALUE OF MONEY 9

 DISCRETE AND CONTINUOUS

As number of compounding periods per year goes to infinity (continuous

compounding) EAR goes to its upper limit.

𝑟 𝑚
𝐸𝐴𝑅 = lim (1 + ) −1 = 𝑒 𝑟 − 1
𝑚→∞ 𝑚

READING 6 THE TIME VALUE OF MONEY 10

 QUESTION

John has funds on deposit with ABC bank. It is currently earning 2% interest.
If he withdraws $500 to purchase a laptop, the 2% interest rate can be best
thought of as a(n):

A) discount rate.

B) opportunity cost.

C) required rates of return.

2% interest can be best characterized as an opportunity cost - the return he could

earn by postponing his laptop purchase until the future.

READING 6 THE TIME VALUE OF MONEY 11

 QUESTION

Mr. Holmes has just inherited 70 000 pounds and wants to set some of it aside for a
vacation in France one year from today. His bank account earns 1% interest. To
determine how much must be set aside and held for the vacation, he should use
the 1% as a:

A) opportunity cost.

B) discount rate.

C) required rates of return.

He needs to figure out how much the trip will cost in one year, and use the 1% as a
discount rate to convert the future cost to a present value.
READING 6 THE TIME VALUE OF MONEY 12
 QUESTION

Yield of short-term highly liquid OFZ (Russian government bond nominated in

Russian rubles) can be thought of as:

A) real risk-free rates because they contain an inflation premium.

B) nominal risk-free rates because they do not contain an inflation premium.

C) nominal risk-free rates because they contain an inflation premium.

OFZ is a government issued security and is therefore considered to be default risk

free. Short-term and highly liquid mean that bond is maturity risk free and liquidity
risk free respectively.
READING 6 THE TIME VALUE OF MONEY 13
 QUESTION

Which one of the following statements best describes the components of the
required interest rate on a security?

A) The nominal risk-free rate, average inflation rate, the default risk premium, a
liquidity premium and a premium to reflect the risk associated with the maturity of
the security.

B) The real risk-free rate, the default risk premium and the liquidity premium.

C) The real risk-free rate, the expected inflation rate, the default risk premium, a
liquidity premium and a premium to reflect the risk associated with the maturity of
the security.

The components of the required interest rate are the nominal rate (the real risk-
free rate plus the expected inflation rate), the default risk premium, the liquidity
premium and premium to reflect the risk associated with the maturity of the
security.
READING 6 THE TIME VALUE OF MONEY 14
 QUESTION

As the number of compounding periods increases, what is the effect on the EAR?

A) EAR increases at a decreasing rate.

B) EAR decreases at an increasing rate.

C) EAR remains the same.

As number of compounding periods increases the value of EAR goes to its upper
limit (𝑒 𝑆𝑡𝑎𝑡𝑒𝑑 𝑎𝑛𝑛𝑢𝑎𝑙 𝑟𝑎𝑡𝑒 −1)

READING 6 THE TIME VALUE OF MONEY 15

 QUESTION

Microfinance company offers you to borrow $10 loan and repay $11 one week later.
Assuming 52 weeks in one year. What would the stated annual interest rate and
EAR be on this loan, with weekly compounding.

A) 520%, 18027%

B) 10%, 14104%

C) 520%, 14104%

Stated Weekly Rate= 11/10 − 1 = 10%

Stated Annual Rate = 10% * 52 = 520%

520% 52
EAR = (1 + ) −1 = 14104%
52

READING 6 THE TIME VALUE OF MONEY 16

 SOLVE TIME VALUE OF MONEY PROBLEMS FOR DIFFERENT
FREQUENCIES OF COMPOUNDING

𝑟 𝑡𝑚
𝐹𝑉 = 𝑃𝑉 1 +
𝑚

If you had $100 right now, and interest rates were 10% with quarterly
compounding, what would be the FV of your money in three years?

𝑃𝑉 = 100
𝑟 = 10%
m =4
𝑡 =3

0.10 3х4
𝐹𝑉 = 100 (1 + ) = 134.491
4

READING 6 THE TIME VALUE OF MONEY 17

 SOLVE TIME VALUE OF MONEY PROBLEMS FOR DIFFERENT
FREQUENCIES OF COMPOUNDING

SINGLE CASH FLOW FORMULAS

𝑟 𝑡𝑚
𝐹𝑉 = 𝑃𝑉 1 +
𝑚
𝐹𝑉
𝑃𝑉 = 𝑡𝑚
𝑟
1+
𝑚

𝑟 𝑡𝑚 𝐹𝑉
= −1
𝑚 𝑃𝑉

𝐹𝑉
𝑡𝑚 = 𝑙𝑜𝑔(1+ 𝑟 )
𝑚 𝑃𝑉

READING 6 THE TIME VALUE OF MONEY 18

 SOLVE TIME VALUE OF MONEY PROBLEMS FOR DIFFERENT
FREQUENCIES OF COMPOUNDING

𝐹𝑉𝑛
𝑃𝑉 =
(1 + 𝑟)𝑛

Calculating the PV involves determining the value in today’s terms of a cash flow
or cash flow stream that will be received in the future.

If you were offered a payment of $103 a year from today, and interest rates were
3%, calculating the PV of this cash flow would involve determining the amount,
which invested today at 3%, would yield $103 in a year.

𝐹𝑉 = 103
𝑟 = 3%
n =1

103
𝑃𝑉 = = 100
(1 + 3%)1

READING 6 THE TIME VALUE OF MONEY 19

 AN ORDINARY ANNUITY, AN ANNUITY DUE AND A PERPETUITY

Calculating FVs and PVs for annuities is different from calculating FVs and PVs for
single cash flows because we have to find the value of a stream of periodic
payments.

SET OF IDENTICAL CASH FLOWS

FINITE SET INFINITE SET

CASH FLOWS OCCUR CASH FLOWS OCCUR

AT THE END OF EACH AT THE BEGINNING OF
COMPOUNDING EACH COMPOUNDING PERPETUITY
PERIOD. PERIOD.

ORDINARY ANNUITY
ANNUITY DUE

READING 6 THE TIME VALUE OF MONEY 20

 FORMULA OF SUM OF GEOMETRIC SEQUENCE

Sum of geometric sequence 𝑏 − first term

𝑆 = 𝑏 + 𝑏𝑞 + 𝑏𝑞2 + ⋯ + 𝑏𝑞𝑛−1 𝑞 − common ratio

Let’s multiply both sides by q

𝑆𝑞 = 𝑏𝑞 + 𝑏𝑞2 + ⋯ + 𝑏𝑞𝑛−1 + 𝑏𝑞𝑛
Let’s add b to both sides
𝑆𝑞 + 𝑏 = (𝑏 + 𝑏𝑞 + 𝑏𝑞 2 + ⋯ + 𝑏𝑞𝑛−1 ) + 𝑏𝑞𝑛
Let’s substitute (𝑏 + 𝑏𝑞 + 𝑏𝑞2 + ⋯ + 𝑏𝑞 𝑛−1 ) with S
𝑆𝑞 + 𝑏 = 𝑆 + 𝑏𝑞𝑛
Let’s group
𝐹𝑜𝑟 𝑖𝑛𝑓𝑖𝑛𝑖𝑡𝑒 𝑠𝑒𝑞𝑢𝑒𝑛𝑐𝑒
𝑆 𝑞 − 1 = 𝑏 𝑞𝑛 − 1 𝑏
𝑖𝑓 𝑞 < 1, 𝑡ℎ𝑒𝑛 lim 𝑞𝑛 = 0 ⇒ 𝑆 =
𝑛→∞ 1−𝑞
Here is our formula
𝒒𝒏 − 𝟏 𝑖𝑓 𝑞 ≥ 1, 𝑡ℎ𝑒𝑛 𝑆 = ∞
𝑺=𝒃
𝒒−𝟏

READING 6 THE TIME VALUE OF MONEY 21

 PV OF AN ANNUITY

𝑃𝑀𝑇 𝑃𝑀𝑇 𝑃𝑀𝑇 𝑃𝑀𝑇

𝑃𝑉 = + + + ⋯ +
1+𝑟 1+𝑟 2 1+𝑟 3 1+𝑟 𝑛

We have a geometric sequence with

𝑷𝑴𝑻 𝟏
the first term 𝑏 = and common ratio 𝑞 =
(𝟏+𝒓) (𝟏+𝒓)

As sum of a geometric sequence equals

𝒒𝒏 − 𝟏
𝑺=𝒃
𝒒−𝟏

𝑷𝑴𝑻 𝟏
Substituting b and q with (𝟏+𝒓)
and (𝟏+𝒓)
respectively we get

(1 + 𝑟)𝑛 −1
𝑃𝑉(𝑎𝑛𝑛𝑢𝑖𝑡𝑦) = 𝑃𝑀𝑇
𝑟 (1 + 𝑟)𝑛

READING 6 THE TIME VALUE OF MONEY 22

 PV OF AN PERPETUITY

𝑃𝑀𝑇 𝑃𝑀𝑇 𝑃𝑀𝑇

𝑃𝑉 = + 2
+ 3
+⋯
1+𝑟 1+𝑟 1+𝑟

And again, we have a geometric sequence with

𝑃𝑀𝑇 1
the first term 𝑏 = and common ratio 𝑞 =
(1+𝑟) (1+𝑟)

𝑏
since 𝑞 < 1, 𝑡ℎ𝑒𝑛 lim 𝑞𝑛 = 0 ⇒ 𝑆 =
𝑛→∞ 1−𝑞

𝑷𝑴𝑻 𝟏
Substituting b and q with (𝟏+𝒓)
and (𝟏+𝒓)
respectively, we get

𝑃𝑀𝑇
𝑃𝑉(𝑝𝑒𝑟𝑝𝑒𝑡𝑢𝑖𝑡𝑦) =
𝑟

READING 6 THE TIME VALUE OF MONEY 23

 QUESTION

If a person needs $10 000 in 10 years from now and interest rates are currently 2%
how much do they need to invest today if interest is compounded annually?

A) 8 150

B) 8 200

C) 8 250

10000
𝑃𝑉 = 10
= 8203
(1 + 0.02)

READING 6 THE TIME VALUE OF MONEY 24

 QUESTION

If a person has $5 000 right now and needs $10 000 in 10 years from now. What
interest rate can help him to meet her goal.

A) 7.05%

B) 7.15%

C) 7.25%

𝑟 𝑡𝑚 𝐹𝑉 10 10000
= −1= − 1 = 7.17%
𝑚 𝑃𝑉 5000

READING 6 THE TIME VALUE OF MONEY 25

 QUESTION

Suppose we have an ordinary annuity that pays $300 every year for 3 years. Interest
rates equal 3%. What is the future value of this annuity at the end of Year 3?

A) $848.05

B) $927.27

C) $963.49

The first method

2 1 1.033 −1
300 (1 + 0.03) + 300 (1 + 0.03) + 300 = 300 = 927.27
1.03 −1

The second method

END MODE
PMT = −$300; N = 3; I/Y = 3; PV = 0 CPT FV = $927.27
READING 6 THE TIME VALUE OF MONEY 26
 QUESTION

An investor wants to receive $777 at the beginning of each of the next 7 years with
the first payment starting today. If the investor can earn 7 percent interest, how
much does the investor have to put aside?

A) $4 190.

B) $3 885.

C) $4 480.

The first method

END MODE. PMT = $777; N = 7; I/Y = 7; FV = 0 CPT PV = $4187.48
4 187.48 * 1.07 = 4 480.60

The second method

BGN MODE. PMT = $777; N = 7; I/Y = 7; FV = 0 CPT PV = $4480.60

READING 6 THE TIME VALUE OF MONEY 27

 TIME LINE IN MODELING AND SOLVING TVM PROBLEMS

Drawing up timelines can help you avoid some mistakes.

A general timeline for the TVM concept

READING 6 THE TIME VALUE OF MONEY 28

 TIME LINE IN MODELING AND SOLVING TVM PROBLEMS

What is the FV after 8 years of five $500 payments to be received at the end of
each of the first 5 years assuming that the interest rate will be constant at 2% for
the next 8 years?
Let’s use the timeline to solve this problem

Step 1: Find FV of this 5-year annuity at the end of Year 5:

N = 5; I/Y = 2; PMT = −$500; CPT FV = $2602.02

Step 2: Find the FV at t = 8:

N = 3; I/Y = 2; PMT = 0; PV = −$2602.02; CPT FV = $2761.28
READING 6 THE TIME VALUE OF MONEY 29
 TIME LINE IN MODELING AND SOLVING TVM PROBLEMS

What is the PV of 5 annual payments of $500 if the first

payment will be received after 6 years and the interest rate is 2%?

Step 1: Find the value of this 5-year annuity at the end of Year 5:
N = 5; I/Y = 2; PMT = −$500; FV = 0; CPT PV = $2356.73

Step 2: Find the value of «$2356.73» as of today:

N = 5; I/Y = 2; PMT = 0; FV = –$2345.73; CPT PV = $2134.56

READING 6 THE TIME VALUE OF MONEY 30

 TIME LINE IN MODELING AND SOLVING TVM PROBLEMS

Present and Future Value of Unequal Cash Flows

When you deal with series of unequal cash flows, you have to calculate the value of
each individual cash flow separately.

The PV (FV) of the cash flow stream is calculated by calculating the PV(FV) of each
of the individual cash flows, and then adding them up.
FV = $350; I/Y = 10; N = 2; PMT = 0; CPT PV = − $289.26
FV = $500; I/Y = 10; N = 3; PMT = 0; CPT PV = − $375.66
FV = $200; I/Y = 10; N = 4; PMT = 0; CPT PV = − $136.60
FV = $1000; I/Y = 10; N = 5; PMT = 0; CPT PV = − $620.92

PV of cash flow stream = Sum of individual future values = $1422.44

READING 6 THE TIME VALUE OF MONEY 31

 TIME LINE IN MODELING AND SOLVING TVM PROBLEMS

If you make a $100 deposit at the beginning of each of the next six months with the
first deposit starting today. How much will you have 7 months from today assuming
a 6% interest rate?

Step 1: Find the FV of annuity due as of the end of month 6:

BGN MODE N = 6; I/Y = 0.5%; PV = 0; PMT = −$100; CPT FV = $610.59

Step 2: Find the future value of 610.59 at the end of month 7:

N = 1; I/Y = 0.5; PV = −$610.59; PMT = 0; CPT FV = $613.64

READING 6 THE TIME VALUE OF MONEY 32

 QUESTION
Ivan Smirnoff is getting a 3 000 000 RUB loan, with an 15% annual interest rate to
be paid in 60 equal monthly installments. If the first payment is due at the end of
the first month, the interest and principal values for the second payment are
closest to:

A) 37 500; 34 300

B) 37 000; 34 000

C) 37 000; 34 300

N = 60; I/Y = 1.25; PV = 3 000 000; FV = 0; CPT PMT = -71 370

Interest for the first payment = 3 000 000 * 1.25% = 37 500

Principal for the first payment = 71370 – 37500 = 33 870

Interest for the second payment = (3 000 000 - 33 870)* 1.25% = 37075
Principal for the first payment = 71370 – 37075 = 34 295

READING 6 THE TIME VALUE OF MONEY 33

 QUESTION

Using a 20% discount rate find the PV of following cash flow stream

YEAR CASH FLOW

1 - 2 000
2 - 3 000
3 -
4 1 000
5 10 000
A) 901.24

B) 625.85

C) 751.03
N = 1; I/Y = 20; PMT = 0; FV = -2000; CPT PV = 1 666.67
N = 2; I/Y = 20; PMT = 0; FV = -3000; CPT PV = 2 083.33
N = 4; I/Y = 20; PMT = 0; FV = 1000; CPT PV = 482.25
N = 5; I/Y = 20; PMT = 0; FV = 10000; CPT PV = 4 018.78
PV of cash flow stream = 751.03

READING 6 THE TIME VALUE OF MONEY 34

 HOMEWORK ASSIGNMENT
READING
CFA® Level I Curriculum (2019) Volume I  Reading 6

PRACTICE PROBLEMS
CFA® Level I Curriculum (2019) Volume I  Reading 6  Practice Problems

READING 6 THE TIME VALUE OF MONEY 35