Thursday, August 04, 2011

What Is The Time Value Of Money?

CFA Level 1 - Quantitative Methods

The principle of time value of money - the notion that a given sum of money is more valuable the sooner it is received, due to its capacity to earn interest - is the foundation for numerous applications in investment finance.

Central to the time value principle is the concept of interest rates. A borrower who receives money today for consumption must pay back the principal plus an interest rate that compensates the lender. Interest rates are set in the marketplace and allow for equivalent relationships to be determined by forces of supply and demand.

In other words, in an environment where the market-determined rate is 10%, we would say that borrowing (or lending) \$1,000 today is equivalent to paying back (or receiving) \$1,100 a year from now. Here it is stated another way: enough borrowers are out there who demand \$1,000 today and are willing to pay back \$1,100 in a year, and enough investors are out there willing to supply \$1,000 now and who will require \$1,100 in a year, so that market equivalence on rates is reached.
 Exam Tips and Tricks The CFA exam question authors frequently test knowledge of FV, PV and annuity cash flow streams within questions on mortgage loans or planning for college tuition or retirement savings. Problems with uneven cash flows will eliminate the use of the annuity factor formula, and require that the present value of each cash flow be calculated individually, and the resulting values added together. (See more) The Five Components Of Interest Rates
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