Session VIII: Revision: Financial Markets & Instruments

Financial Markets & Instruments
Session VIII: Revision
Prof. Sudarshan Kumar

IIM Kozhikode
September 9, 2020
Prof. Sudarshan Kumar IIM Kozhikode Session VIII: Revision September 9, 2020 1
The Cash flow diagram
In finance, we need to value/compare cash flows expected to happen in

different time in the future
$150
$100
t
1 2 3 4
-$100
-$150
The Cash flow diagram
In finance, we need to value/compare cash flows expected to happen in

different time in the future
$150
$100
t
1 2 3 4
-$100
-$150
TVM problem
We need to bring all cash flows together at one point of time
Interest rate: Revisited
1$ (Today) ≥ 1$ (Tomorrow)
• Interest rate is a compensation for

◦ Postponing my today’s consumption for tomorrow
◦ Depreciation of the value of money with time : Inflation
◦ Risk in the investment: Idea of risk aversion
Idea of compounding
• Simple Interest: Money after t years: MtSI = P + P × r × t

• Compound Interest: What if I reinvest the interest earned every period
◦ Money after 1 year
M1 = P + P × r × 1 = P(1 + r )
Idea of compounding

M1 = P + P × r × 1 = P(1 + r )
◦ Money after 2 years
M2 = M1 + M1 × r = P(1 + r ) + P(1 + r ) × r = P(1 + r )2
Idea of compounding

M1 = P + P × r × 1 = P(1 + r )
M2 = M1 + M1 × r = P(1 + r ) + P(1 + r ) × r = P(1 + r )2
M3 = M2 + M2 × r = P(1 + r )2 + P(1 + r )2 × r = P(1 + r )3
Idea of compounding

M1 = P + P × r × 1 = P(1 + r )
M2 = M1 + M1 × r = P(1 + r ) + P(1 + r ) × r = P(1 + r )2
M3 = M2 + M2 × r = P(1 + r )2 + P(1 + r )2 × r = P(1 + r )3
◦ Money after n years ... =
Mn = Mn−1 + Mn−1 × r = P(1 + r )n−1 + P(1 + r )n−1 × r = P(1 + r )3
What if we reinvest the amount at higher frequency??
m frequency compounding rate rm /Y

1
• Money after 1 compounding period ( m years)
rm rm
M1 = P + P × m × 1 = P(1 + 4 )

1
rm rm
M1 = P + P × m × 1 = P(1 + 4 )
2
rm r rm rm rm 2
M2 = M1 + M1 × m = P(1 + m) + P(1 + m) × m = P(1 + m)

1
rm rm
M1 = P + P × m × 1 = P(1 + 4 )
2
rm r rm rm rm 2
M2 = M1 + M1 × m = P(1 + m) + P(1 + m) × m = P(1 + m)
n
• Money after n compounding period ( m years)...
Mn = Mn−1 + Mn−1 × rmm = P(1 + rm n−1
m) + P(1 + rm n−1
m) × rm
m =
P(1 + rmm )n = P(1 + rmm )m×t
Idea of compounding: Revisited
100$ invested for 3 years at 5%/Y simple interest

FV = 100 + 100 × 0.05 × 3 = 115
100$ invested for 3 years at 5%/Y annually compounded interest

FV = 100(1 + 0.05)3 = 115.76
100$ invested for 3 years at 5%/Y semi-annually compounded interest

0.05 3×2
FV = 100(1 + 2 ) = 115.969
P$ invested for t years at r%/Y m freq compounding interest

r t×m
FV = P(1 + m)
Continuous Compounding: m → ∞
r t×m
FV = lim P 1 + = P × e rt
m→∞ m
100$ invested for 3 years at 5%/Y continuous compounding interest

FV = 100 × e 0.05×3 = 116.18
Effective Annual Rate (EAR)
Equivalent annual compounding rate for the m freq compounding rate
• We Should get equal future value for
◦ P$ invested for t years on annual compounding rate rEAR / Y rate
◦ P$ invested for t years on m frequency compounding rate rm / Y rate and
rEAR ←→ r
mt
Solve P(1 + rEAR )t = P 1 + mr
m
=⇒ rEAR = 1 + mr −1
1
Also, =⇒ r = m (1 + rEAR ) m − 1 =
rEAR ←→ rc
Solve P(1 + rEAR )t = Pe rc t
=⇒ rEAR = e rc − 1
Also =⇒ rc = ln(1 + rEAR )
The time machine
FV
From future to present: PV = (1+r )n
150
t
1 2 3 4
-100
The time machine
FV
150 150
(1 + r )4
t
1 2 3 4
-100
The time machine
FV
150 150
(1 + r )4
t
1 2 3 4
-100
From present to future: FV = PV (1 + r )n

150
t
1 2 3 4
-100
The time machine
FV
150 150
(1 + r )4
t
1 2 3 4
-100
From present to future: FV = PV (1 + r )n

150
t
1 2 3 4
-100 −100 × (1 + r )4
Annuity & Annuity Due
Annuity:Equal periodic Payments at the end of the period
100 100 100 100 100
t
0 1 2 3
··· n−1 n
100 100 100 100 100
t
0 1 2 3
···
n−1

n
100 100 100 1 1

PVAnnuity = 1+r + (1+r )2
+ ··· + (1+r )n = 100 r − r (1+r )n
100 100 100 100 100
t
0 1 2 3
···
n−1

n
100 100 100 1 1

PVAnnuity = 1+r + (1+r )2
+ ··· + (1+r )n = 100 r − r (1+r )n
Annuity Due: Equal periodic Payments at the start of the period

100 100 100 100 100
t
n
0 1 2 3
··· n−1

100 100
PVAnnuitydue = 100 + 1+r + ··· + (1+r )n−1
= 100(1 + r ) 1r − 1
r (1+r )n
Perpetuity: Perpetual equal periodic payments
100 100 100

t
0 1 2 3
···∞
100 100 100
PVPerpetuity = 1+r + (1+r )2
+ ··· = r
Growing Annuity & Perpetuity
Periodic payments growing at constant rate g
144
120
100
t
0 1 2 3
···
144
120
100
t
0 1 2 3
···
(n−1) (1+g )n
PVGrowingAnnuity = 100
1+r + 100(1+g
(1+r )2
)
+ · · · + 100(1+g )
(1+r )n = 100
r −g 1− (1+r )n
144
120
100
t
0 1 2 3
···
(n−1) (1+g )n
PVGrowingAnnuity = 100
1+r + 100(1+g
(1+r )2
)
+ · · · + 100(1+g )
(1+r )n = 100
r −g 1− (1+r )n
100 100(1+g ) 100

PVGrowingPerpetuity = 1+r + (1+r )2
+ ··· = r −g
Growing Annuity vs. Annuity
PVAnnuityDue

100 100 1 1
PVAnnuitydue = 100 + 1+r + ··· + (1+r )n−1
= 100(1 + r ) r − r (1+r )n
PVGrowingAnnuity

100 100(1+g ) 100(1+g )(n−1) (1+g )n
PVGrowingAnnuity = 1+r + (1+r )2 + · · · + (1+r )n = r100
−g 1 − (1+r )n
(1+r ) (r −g ) 100
(Assume re = (1+g ) − 1 = (1+g ) and C = 1+r )
C C C 1 1
= C + 1+r + (1+re )2
+ · · · + n−1 = C (1 + re ) re − re (1+re )n
e
(1+re ) n
100 (1+r ) (1+g ) (1+g )
= 1+r × (1+g ) × (r −g ) × 1 − (1+r )n
PV of Growing annuity with growth rate g is equivalent to PV @ t=1 of

(1+r ) (r −g )
the annuity due with the discounting rate (1+g ) − 1 = (1+g )
Summary

Session VIII: Revision: Financial Markets & Instruments

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Financial Markets & Instruments

Session VIII: Revision

Prof. Sudarshan Kumar

In finance, we need to value/compare cash flows expected to happen in

In finance, we need to value/compare cash flows expected to happen in

• Interest rate is a compensation for

• Simple Interest: Money after t years: MtSI = P + P × r × t

• Simple Interest: Money after t years: MtSI = P + P × r × t

• Simple Interest: Money after t years: MtSI = P + P × r × t

• Simple Interest: Money after t years: MtSI = P + P × r × t

m frequency compounding rate rm /Y

m frequency compounding rate rm /Y

m frequency compounding rate rm /Y

100$ invested for 3 years at 5%/Y simple interest

100$ invested for 3 years at 5%/Y annually compounded interest

100$ invested for 3 years at 5%/Y semi-annually compounded interest

P$ invested for t years at r%/Y m freq compounding interest

100$ invested for 3 years at 5%/Y continuous compounding interest

From present to future: FV = PV (1 + r )n

From present to future: FV = PV (1 + r )n

100 100 100 1 1

100 100 100 1 1

Annuity Due: Equal periodic Payments at the start of the period

100 100 100

Periodic payments growing at constant rate g

Periodic payments growing at constant rate g

Periodic payments growing at constant rate g

100 100(1+g ) 100

PV of Growing annuity with growth rate g is equivalent to PV @ t=1 of

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