Chapter 1 – The time value of money. This chapter explain an interest rate as the sum of a real risk-free rate and premiums that compensate investors for distinct types of risk, distinguish between the stated annual interest rate and the effective annual rate, calculate the future value (FV) or present value (PV) of a single sum of money,. | The Time value of money In all likelihood, your audience will fall into two distinct groups: 1) experienced in time value of money (TVM) calculations and 2) not experienced. If the audience is predominantly in the first category, you may want to try to cover Chapters 1 and 2 at one time. The value of practicing TVM calculations can’t be overstated, so assigning problems here may be of particular value. One thing to avoid is “teaching the instrument”—for example, bonds have one cash flow pattern, equities another, and so on. If you focus on the valuation of the patterns without referencing particular securities, it is easier to generalize the process. Toward the later part of the lecture, you can introduce such language as “this cash flow pattern is bond-like in that it has regular fixed payments and a large single lump sum at the end of its life.” It may be worth noting other things that also have similar patterns (., rental property with nonescalating rent and a future sale). 1 . | The Time value of money In all likelihood, your audience will fall into two distinct groups: 1) experienced in time value of money (TVM) calculations and 2) not experienced. If the audience is predominantly in the first category, you may want to try to cover Chapters 1 and 2 at one time. The value of practicing TVM calculations can’t be overstated, so assigning problems here may be of particular value. One thing to avoid is “teaching the instrument”—for example, bonds have one cash flow pattern, equities another, and so on. If you focus on the valuation of the patterns without referencing particular securities, it is easier to generalize the process. Toward the later part of the lecture, you can introduce such language as “this cash flow pattern is bond-like in that it has regular fixed payments and a large single lump sum at the end of its life.” It may be worth noting other things that also have similar patterns (., rental property with nonescalating rent and a future sale). 1 Decomposing Interest Rates We often view interest rates as compensation for bearing risk. Interest rates can then be viewed as compensation for Delaying consumption “risklessly” (the risk-free real rate, Rf) Bearing inflation risk over the life of the instrument (inflation risk premium, or IRP) The possibility that the borrower will not make the promised payments at the promised time (default risk premium, or DRP) The possibility that the investor will need to convert the investment to cash quickly and will not receive a fair value (liquidity risk premium, or LRP) The increased sensitivity of longer-maturity instruments to changes in prevailing market rates (maturity risk premium, or MRP) 2 Nominal Risk-Free Rate (approximately) LOS: Explain an interest rate as the sum of a real risk-free rate and premiums that compensate investors for distinct types of risk. Pages 2–3 These are generally self-explanatory. When using examples to illustrate, be careful to hold any other risk factors .
