Reading 1 - Time Value of Money

Quantitative Methods
Time Value of Money

Study Session 1
Reading No – 1
Version 2022
Learning Outcome Statements
The candidate Should be able to:
a. interpret interest rates as required rates of return, discount rates, or opportunity costs;
b. explain an interest rate as the sum of a real risk-free rate and premiums that compensate investors for
bearing distinct types of risk;
c. calculate and interpret the effective annual rate, given the stated annual interest rate and the frequency of
compounding;
d. calculate the solution for time value of money problems with different frequencies of compounding;
e. calculate and interpret the future value (FV) and present value (PV) of a single sum of money, an ordinary
annuity, an annuity due, a perpetuity (PV only), and a series of unequal cash flows;
f. demonstrate the use of a time line in modeling and solving time value of money problems.
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Los a,b: Interest Rates
Receive
Pay $10000
Not An Acceptable Arrangement $9000
Acceptable Arrangement
Because $9000 today won’t retain its Receive
Pay $9000 same value in 1 year. $10000 in 1 year
The numeric that makes it happen is
Interest rate
Los a,b: Interest Rates
Interest rates can be interpreted in many
ways
Minimum 1. Minimum Required returns that an
Require investor must receive in order to accept
Discount
rate of the investment
Rates Return 2. Discount Rate, the rate at which could
find the present value of future cash flow
3. Opportunity Cost, the existing return that
the investor already makes. Hence a new
Opportunity investment opportunity would be
Cost evaluated basis an opportunity cost or
rate
Los a,b: Components of Interest Rates
Rate
• The idea here is to show what could be a
reason why some rates are high and
some rates are low.
• Not necessarily advocating that every
Composition
rate will have this components.
Real Risk Free Inflation Premium Default Premium Liquidity Premium Maturity Premium
Compensating investors
Probability of Default Risk of loss if
10 Year Government for long term sensitivity
Average Inflation Rate and Compensation for investments need to be
Bonds Rate of the asset . For eg
that risk converted to cash
Long term bonds
Nominal Risk Free Rate

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Opinion: Risk Premiums
Returns and Drawdown We must understand finance concepts and
45% 0% knowledge with the acceptance that nothing is
40% binary. For e.g.
-10%
35% 13% 14%
12%
30%
-20%
• You might be tempted to think that higher risk
25% 7% -30% means higher return. But check the data on the
15% 13%
20% 11%
-40% left.
8%
15%
-50%
• Nifty Small cap & Nifty mid cap both
10%
16%
supposedly to be more risky didn’t give
15% 15% 14% -60%
5% higher returns between three testing
0% -70% periods
NIFTY 50 NIFTY 100 NIFTY Small 100 NIFTY MID CAP
• April 2016 to 2021
Apr-16 Apr-17 Apr-18 Drawdown
• April 2017 to 2021
Sharpe • Apr 2018 to 2021
100% • The Sharpe which is a highly followed
0.42 0.22
80% 0.05
0.19 metric for understanding returns for risk
60% 0.29
0.35 0.32
also says that Nifty 50 or Nifty 100 gives
40% 0.42 better returns for the same risk
20%
0.41
0.42 0.27 • Our research says that this is due to the
0% -0.03 business dynamics in India. Larger companies
Jan-16 Jan-17 Jan-18 are somehow able to sustain their growth and
-20%
NIFTY 50 NIFTY 100 NIFTY Small 100 NIFTY MID CAP stability with good management and better
governance.
compounding;
Los e &f: Compounding
Its best to understand all Quant concepts using the approach: Example and then equation. Else
these concepts will have to be memorized, which we highly advise against for the Level 1 Exam
Consider you want to invest $100,000 for 6 Years at 2% rate of compounding. Now before you take
out your calculators, what we really want to understand is the mechanics.
No of Compounds
21= 1 22 =4 26 =64
0 1 Yr. 2 Yr. 6 Yr.

Principal
Principal 100000
100000
Notice how the interest on the
Interest
previous period acts like principal
2000
100,000 at 2% in the next. That’s the magic of
for 6 Years
Principal compounding
Interest 2000
2000 Interest On Interest or Compounding
Simple Interest Interest
40
Interest
Los e &f: Compounding
Staying with same example, lets observe and Now lets present the calculation at Year 1
conclude. 6 with their Names
• FV(102000)= PV (10000) R(2%)+ PV(10000)
Simplifying
4 Lets call this n( Periods) 5 Lets call it r ( Rate) • FVn=PV (1+r)n Or the Future value of
Lumpsum
0 1 Yr. 2 Yr. This is a value in future so 6 Yr.

100,000 x 2%+ 100000 =102000 x2%+ 102000
3 lets call it FV
100,000
= 102,000 =104,040
Both have something in Lets substitute that with a new

1 Common. It’s the value at 0 2 name PV( Present Value)
Using the Calculator: TA BII Plus
1: Press Compute
2:Press After Value 2:Press After Value 2:Press After Value 2: Press FV
1: Enter N
1: Enter Rate
1 :Press after value
Los e &f: Inter-relationship Between the
Equations
This is just a simple re arrangement of the Equation we derived in the previous slide to establish
relationship
• FV= PV(1+r)n
• PV=FV/ (1+r)n
• R=(FV/PV)1/n -1
This brings us to the conclusion that if we have any of the three variables ,then we can easily find
the fourth.
For e.g.
• If we have the FV,PV, Periods for the PV to compound to FV. Then we can find the rate.
These equations become more clearer as we progress through questions.
Example
You are the lucky winner of your state’s lottery of $5 million after taxes. You invest your winnings in a five-year
certificate of deposit (CD) at a local financial institution. The CD promises to pay 7 percent per year
compounded annually. This institution also lets you reinvest the interest at that rate for the duration of the CD.
How much will you have at the end of five years if your money remains invested at 7 percent for five years with
no withdrawals?
*We have not given the solution for this question just to promote a discussion and conviction on your
calculation. But as ball park value, you are answer should be near $ 7 Million.
compounding;
Los d: Non Annual Compounding
Stated Rate
This is nothing but
=0.54% x 12
= 6.5%
Stated Rate Because at compounded Level

=(1+0.54%)12 -1
=6.67%
This is nothing but the future value formula

• FV= PV(1)(1+0.54%(rate))12(n) – we are finding the future
value of $1
• FV= PV(1)(1+0.54%(rate))12(n) -1 ( To remove the effect of $1)
That’s nothing but the formula for EAR( Effective Annual Rate)
EAR= (1+ Periodic Int Rate)m -1
b. explain an interest rate as the sum of a real risk-free rate and premiums that compensate investors
for bearing distinct types of risk;
c. calculate and interpret the effective annual rate, given the stated annual interest rate and the
frequency of compounding;
d. calculate the solution for time value of money problems with different frequencies of
compounding;
e. calculate and interpret the future value (FV) and present value (PV) of a single sum of money, an
ordinary annuity, an annuity due, a perpetuity (PV only), and a series of unequal cash flows;
Los c & d: Continuous Compounding, Stated
& Effective Rates Itscompounding
impractical to continuously increase the
periods but we could do that easily
by using a mathematical expression- exponential
We realised the magic of
compounding, but what if we
FV( Infinite Compounding)= PV e rsN Find the future value of
keep on increasing the frequency
$10000 which will earn 8% for
1. Annual 2 years compounded
e= 2.7182818 continuously.
2. Half Year
3. Quarter 1:Multiply 2: Press 2nd and 3: Press 4: FV Calculated
8% with LN. You should get multiply and Exponential
4. Monthly 2(Years) this value enter 10000 compounded
5. Daily
6. Hourly
7. Every Minute
8. Every sec
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The incremental effect of Compounding
Daily Hour Miniute
12% 0.05% 0.00% 0.00% Its an interesting exercise to
go beyond Minutes. You will
Periods 240 5760 345600 realise the FV starts
dropping.
Investment 100000 100000 100000
Future Value 112746.30 112749.54 112749.68 Can you explain or discuss
why?
Incremental Effect of Increasing the compounding
CFA Curriculum Question
A bank quotes a stated annual interest rate of 4.00%. If that rate is equal to an effective annual rate of 4.08%,
then the bank is compounding interest:
Solution
• A is correct. The effective annual rate (EAR) when compounded daily is 4.08% .EAR = (1 + Periodic interest
rate)m – 1 EAR = (1 + 0.04/365)365 – 1
• EAR = (1.0408) – 1 = 0.04081 ≈ 4.08%.
d. calculate the solution for time value of money problems with different frequencies of
compounding;
Los d,e: Future value of cashflow series and
annuity due
Before we learn the calculation, it is imperative to know the various types of cash flows in an investment
product
1. Annuity- Finite cash flows
2. Ordinary Annuity – The first cash flow occurs at T=1 not 0
3. Annuity due- The first cash flow occurs immediately at T=0
4. Perpetuity- Infinite cash flows with first cash flow at T=1
Los d,e: Ordinary Annuity
The Complex Formula
Easier Explanation
Again before using the equation. Lets look at this intuitively, please do not try to remember the complex formula. Trust me you won’t
remember it
• Notice that in each cash flow (1+r) is common and so is $1000 ( but we can skip using $1000 because it wont matter
• So lets write it as (1+5%)5 so solving this we get 1.276282
• That’s basically tell us the future of $1 compounded at 5% for 5 Years
• If we deduct 1 (1.276282-1)= 0.276282. This means the returns generated on 1$
• But we can’t simply multiple $1000 with 1.276282, because that would mean we only invested once.
• So lets try to find what this 0.276282 (return) compared to just one period return of 0.05 ( Basically how many times is 0.27
compared to 0.05)
• 0.276282/0.05 = 5.525631 ( The annuity factor). So we could simply multiply $1000 with the annuity factor and get the answer
Los d,e: Uneven Cashflows
Well this is straightforward and you cant really find a factor trick like the previous
slide. So this is going to be some manual work, if its for the exam but in the real
world spreadsheet exists.
In the calculator my recommendation is
to use the manual method of
calculation each of these future values
separately and add it up.
There is an alternative method in the

calculator but there are more chances
to get the wrong answer, plus the
chances of getting such a calculation
intense question in the exam is low.
Los e,f: Present value of cashflows
Recollect from here, that by re arranging the equation you could find any other value.
PV= FV/(1+R)n. Since this is very straight forward we will directly skip into a more complex version
of present value or atleast complex for now.
Suppose you are considering purchasing a financial asset that promises to pay €1,000 per year for five years, with
the first payment one year from now. The required rate of return is 12 percent per year. How much should you
pay for this asset?
We exactly use the opposite of what we did in future value

1: since PV= FV/(1+r)n Complex Expression
2: We assume FV as 1 for now, so the equation becomes 1/(1+ 12%)^5 =0.57
3: Now lets reduce 1 from the equation. 1- 0. 57=0.43
4: Now just like before, lets find the proportion of this to a single period
discount of 0.12
5: 0.43/0.12= 3.604776
6: Multiply 1000 with The factor of 3.604776 = 3604.78
7: Of course you could skip both the methods and simply find the PV for each
cashflows but this just makes it faster
Los e,f: Present value of Uneven cash flows
No magics here. This is plain hard work in calculator if done using the individual PV method but we could use
the CF Function
Open your TA B2 plus

• Press CF and You should see the CFO , press
down arrow key
• You will see C01- that’s the first cashflow, • Continue add all the cashflows till the 5th cash flow
enter the value and press enter. You will see • Press I/Y & Enter the discount rate 5
F01, do nothing and press down key again • Press CPT & NPV & Press down key
An investment pays €300 annually for five years, with the first payment occurring today. The present value (PV)
of the investment discounted at a 4% annual rate is closest to:
Solution
Los e: Present value of Perpetuity
PV Converges to Zero
You can perform an exercise of creating an infinite cash flow
series of $1000 for as much as you can stretch.Use some 900
discount rate like 5% and find the present value. The conclusion 800
should be
700
• The present value of cashflows converges to 0 after some
600
time
500
Which could simply be calculated alternatively as
400
PV= Cashflow (Annuity)/ r
300
200
In this case the answer would be = $1000/ 5%= $20000 , this 100
answer would be very close to the above manual exercise too.
0
257
289
1
17
33
49
65
81
97
113
129
145
161
177
193
209
225
241
273
305
321
337
353
369
385
401
417
433
449
Los e:Solving For I/Y, N & PMT
Since the curriculum has made this explanation extremely lengthy. We will take a simple example which
covers all of them at once.
Given a $1,000,000 investment for Given a $1,000,000 investment Given that we need to collect
four years which becomes $ for four years which becomes $ 11,25,508.81 in 4 years with an
11,25,508.81. What is the rate of 11,25,508.81 with an annual rate annual rate of 3%. What's the
annual compounding. of 3%. What's the n. annual payments?
We simply re arrange the original We could arrange the equation Again skipping the entire theory
equation to: (1+r)n = FV/ PV behind this, since it really doesn’t
Rate = (FV/PV)(1/N)-1 But we would have to add Log add much value. We use the
Hence Normal calculator and find whats called as
=(1125508.81/1000000)(1/3)-1 N Ln(1+r)= ln(FV/PV) PMT.
= 3% N=ln(FV/PV)/ Ln(1+r). However Pv= 0, FV= 1125508.81, I/Y=3%,
using a calculator is easier to find N=4 . Find PMT.= -269027
n as 4.
A couple plans to pay their child’s college tuition for 4 years starting 18 years from now. The current annual
cost of college is C$7,000, and they expect this cost to rise at an annual rate of 5 percent. In their planning,
they assume that they can earn 6 percent annually. How much must they put aside each year, starting next
year, if they plan to make 17 equal payments?
Solution
SUMMARY
• The interest rate, r, is the required rate of return; r is also called the discount rate or opportunity cost.
• An interest rate can be viewed as the sum of the real risk-free interest rate and a set of premiums that compensate
lenders for risk: an inflation premium, a default risk premium, a liquidity premium, and a maturity premium.
• The future value, FV, is the present value, PV, times the future value factor, (1 + r)N.
• The interest rate, r, makes current and future currency amounts equivalent based on their time value.
• The stated annual interest rate is a quoted interest rate that does not account for compounding within the year.
• The periodic rate is the quoted interest rate per period; it equals the stated annual interest rate divided by the
number of compounding periods per year.
• The effective annual rate is the amount by which a unit of currency will grow in a year with interest on interest
included.
• An annuity is a finite set of level sequential cash flows.
• There are two types of annuities, the annuity due and the ordinary annuity. The annuity due has a first cash flow
that occurs immediately; the ordinary annuity has a first cash flow that occurs one period from the present
(indexed at t = 1).
SUMMARY
• On a time line, we can index the present as 0 and then display equally spaced hash marks to represent a
number of periods into the future. This representation allows us to index how many periods away each cash
flow will be paid.
• Annuities may be handled in a similar approach as single payments if we use annuity factors rather than
single-payment factors.
• The present value, PV, is the future value, FV, times the present value factor, (1 + r)−N.
• The present value of a perpetuity is A/r, where A is the periodic payment to be received forever.
• It is possible to calculate an unknown variable, given the other relevant variables in time value of money
problems.
• The cash flow additivity principle can be used to solve problems with uneven cash flows by combining single
payments and annuities.

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Quantitative Methods

Time Value of Money

Nominal Risk Free Rate

0 1 Yr. 2 Yr. 6 Yr.

0 1 Yr. 2 Yr. This is a value in future so 6 Yr.

Both have something in Lets substitute that with a new

Stated Rate Because at compounded Level

This is nothing but the future value formula

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Incremental Effect of Increasing the compounding

There is an alternative method in the

We exactly use the opposite of what we did in future value

Open your TA B2 plus

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