Class Workbook, CFA Level I

Study Session 2

Reading 6: The Time Value of Money

Quantitative Methods Economics Quants SS2

Module 1
SS2 SS3 SS4 SS5 Reading 6
CFA® Level I Route map

Reading 7
Financial Reporting & Analysis Reading 8
Module 2
SS6 SS7 SS8 SS9

Corporate Finance Equity Fixed Income

Module 3
SS10 SS11 SS12 SS13 SS14 SS15

Derivatives Alternatives Portfolio Management Ethics

Module 4
SS16 SS17 SS18 SS19 SS1

Time Value of Money

Quantitative Methods

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 Class Workbook, CFA Level I

The Time Value of Money – outline

• Interest rates
• Compounding and discounting
• Present and future values
• Annuities and annuities due
• Generalized TVM diagram
• Nominal and effective rates
• Continuous compounding
• Perpetuities
• Uneven cash flows
• Worked examples

Time Value of Money

Quantitative Methods

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 Class Workbook, CFA Level I

§1
Composition of interest rates
How do we interpret interest rates? What are the components of an interest rate?
1. Required rate of return + Real risk-free rate
Nominal risk-free rate
2. Discount rate + Inflation premium
+ Default risk premium
3. Opportunity cost
+ Liquidity premium
+ Maturity premium

Example: Suppose that the real risk-free rate = 0.80%, with premiums of 2.10% for inflation,
1.30% for default risk, 0.60% for liquidity, and 0.80% for maturity. Calculate the appropriate
interest rate.
Solution: Interest rate = 0.80% + 2.10% + 1.30% + 0.60% + 0.80% = 5.60%.

Insight: Slightly more accurately, we can say for the risk-free rate that:
• (1 + nominal) = (1 + real) x (1 + inflation)
In this example, we calculate nominal as (1 + real) x (1 + inflation) – 1 = 1.008 x 1.021 – 1 = 2.92%. The resulting
interest rate is 2.92% + 1.30% + 0.60% + 0.80% = 5.62%.

LOS a/b: Interpret IRs as required rates of return, discount rates, or opportunity
costs; explain an interest rate as the sum of a real risk-free, and premiums that Quantitative Methods
compensate investors for bearing distinct types of risk

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 Class Workbook, CFA Level I

Future and present values

Say T0 T1 T2 T3
• interest rate r = 6%
Q4

• no of periods N = 3
$100 $106 $112.36 $119.10

x 1.06 x 1.06 x 1.06

÷ 1.06 ÷ 1.06 ÷ 1.06

In general:

“Compounding” “Discounting” §1

LOS e: calculate and interpret the future value (FV) Time Value of Money
and present value (PV) of a single sum of money … Quantitative Methods

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 Class Workbook, CFA Level I

§2
Ordinary annuities: future and present values
Calculate the PV T0 T1 T2 T3 T4
and FV of a four-
year annuity Q4

paying $2000 at
the end of each $2000 $2000 $2000 $2000
year, with r = 6%.
1886.79
+1779.99 +2120.00
+1679.24 +2247.20
+1584.19 +2382.03
BA II Plus calculator solution
PV = $6930.21 FV = $8749.23
4 N 6 I/Y

2 0 0 0 +/– PMT

0 FV CPT PV
PV= 6930.21
0 PV FV
CPT
FV= 8749.23

LOS e: calculate and interpret the future value (FV) Time Value of Money
and present value (PV) of … an ordinary annuity … Quantitative Methods

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 Class Workbook, CFA Level I

Annuities due: future and present values

Calculate the PV T0 T1 T2 T3 T4
and FV of a four- Q4

year annuity due

paying $2000 at the $2000 $2000 $2000 $2000
start of each year,
with r = 6%. 1886.79 +2120.00
+1779.99 +2247.20
+1679.24 +2382.03
BA II Plus calculator solution
PV = $7346.02 +2524.95
2ND BGN 2ND SET BGN
FV = $9274.18
C/CE 4 N 6 I/Y

2 0 0 0 +/– PMT

0 FV CPT PV PV= 7346.02

0 PV CPT FV FV= 9274.19

2ND BGN 2ND SET END

LOS e: calculate and interpret the future value (FV) Time Value of Money
and present value (PV) of … an annuity due … Quantitative Methods

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 Class Workbook, CFA Level I

Generalized TVM diagram

PMT PMT PMT PMT PMT

BGN mode: 0 1 2 N-2 N-1 N

PV FV

END mode: 0 1 2 3 N-1 N

PV FV

Note some obvious “rules”:

1. PV is at T0
2. FV is at TN or: FV is N periods after PV
3. BGN: first PMT is at T0 or: PV is at same time as first PMT
4. BGN: last PMT is at TN–1; or: FV is 1 period after last PMT
5. END: first PMT is at T1; or: PV is 1 period before first PMT
6. END: last PMT is at TN or: FV is at same time as last PMT
7. N and PMT define N payments (doh!) §2

LOS e: calculate and interpret the future value (FV)

Time Value of Money
and present value (PV) of … an ordinary annuity, an Quantitative Methods
annuity due …

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 Class Workbook, CFA Level I

A See Solutions

§3
Nominal and effective rates
If rates are compounded more frequently than annually, then the quoted or nominal rate can
be restated as the effective annual rate, or EAR.
• Nominal: the rate quoted or stated, divided into equal subdivisions of a year.
• Effective: the (compounded) amount received at the end of the year.

Insight: Provided there are at least 2 compounding periods a year,

then effective > nominal. This is a very useful rule.

Calculator shortcut: use interest conversion worksheet by pressing 2ND ICONV

with NOM = nominal, C/Y = compounding frequency, EFF = EAR.

Example. A bank states that it will pay 2% interest per year, compounded quarterly. Calculate (1) the
effective rate, (2) the value of a £1000 deposit after five years.

Solution:

LOS c/d: calculate and interpret the effective

Time Value of Money
annual rate …; solve time value of money problems
for different frequencies of compounding
Quantitative Methods

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 Class Workbook, CFA Level I

B See Solutions

Continuous compounding
Let us explore the frequency of The limit is eNom – 1 where e is the natural
compounding. base, 2.7182818 and Nom is the quoted (in
fact continuous) rate.
Calculate the effective annual rate (EAR) if a
bank quotes 6% interest, but pays interest Calculate the effective rate, given a stated
(1) annually, (2) quarterly, (3) monthly, (4) (continuous) rate of 6%.
daily, (5) every second.

Solution:
The continuously compounded return
can be calculated from the EAR as:

Rc = ln(1 + EAR)

Calculate the continuous rate of return if

the effective rate is 8%.

LOS c/d: calculate and interpret the effective

Time Value of Money
annual rate …; solve time value of money problems
for different frequencies of compounding
Quantitative Methods

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 Class Workbook, CFA Level I

A See Solutions

Perpetuities and deferred perpetuities

A perpetuity is a “perpetual annuity” with cash flows accruing at the end of each period
forever. The present value is simply:

Example
A preferred share pays an annual dividend of $8. Assuming a rate of return of 5%, calculate
the value of the share if the first dividend is (1) in one year’s time, (2) today, and (3) in four
years’ time.

Solution

LOS e: calculate and interpret the … present value Time Value of Money
(PV) of … a perpetuity … Quantitative Methods

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 Class Workbook, CFA Level I

Uneven cash flows – present & future values

$200 $300 $300 $400
Calculate the PV and
FV of the following T0 T1 T2 T3 T4
project, using r = 6%:
Q4

BA II Plus calculator solution Future value: now compound up to T4:

CF 2ND CLR WORK FV = 1024.4 x 1.064 = $1,293.28
p 2 0 0 ENTER C01= 200
BA II Plus calculator solution
p p 3 0 0 ENTER C02= 300
p p 3 0 0 ENTER C03= 300 BA II Plus
Pro only
p p 4 0 0 ENTER C04= 400
NPV 6 ENTER p CPT NPV= 1024.40 p CPT NFV= 1293.28

§3

LOS e: calculate and interpret the future value

Time Value of Money
(FV) and present value (PV) of … a series of Quantitative Methods
unequal cash flows

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 Class Workbook, CFA Level I

See Solutions

§4
Worked examples
Example 1. Shrina and Saahil Patel have just bought a property with a mortgage of
€200,000. The quoted interest rate is 6% and the payments will reduce the mortgage to zero
over 25 years. Calculate the monthly payment, assuming end of month cash flows.

Example 2. Jane Jones wishes to save for her daughter’s college tuition, starting in 15 years’
time. She will need $30,000 at the start of each of four years. Assuming a rate of 6%,
calculate today’s required deposit.

LOS f: demonstrate the use of a time line in Time Value of Money

modeling and solving time value of money problems Quantitative Methods

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 Class Workbook, CFA Level I

See Solutions

Worked examples (2)

Example 3. Andrea Adams is 35 years old and plans to retire in 25 years’ time. She will save
£10,000 at the start of each year, from today until her 59th birthday. On retirement at 60 her life
expectancy is a further 30 years. Assuming a constant 5% rate of return, calculate the pension
income she will receive if payments are at the start of each year, beginning on her 60th birthday.

Example 4. Lars Beckenberg deposits €50,000 into an account and wishes to withdraw €4,000
from it every 6 months, beginning in 6 months’ time, for 5 years. He wants there to be €20,000
left after the last withdrawal. Calculate the stated rate, if the account compounds quarterly.

§4

LOS f: demonstrate the use of a time line in Time Value of Money

modeling and solving time value of money problems Quantitative Methods

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 Class Workbook, CFA Level I

The Time Value of Money

Summary Tips

• This is a key chapter, providing essential skills for all three CFA levels. You must be completely familiar
with calculator functions (the TVM buttons and the CF worksheet so far) where they can be faster than
algebraic methods. Visit the Quartic Calculator Tutorial for further details and explanations.
• For basic TVM problems, enter four figures and compute the fifth.
• Know the difference between a regular annuity and an annuity due, END vs BGN. Always switch BGN
back to END after using it (hint: look at the screen!).
• Be able to convert from nominal to effective rates and back again.
• Calculate the value of a perpetuity, including when the first cash flow is not when you would expect.
• Practise two-step problems, e.g. “toothbrush” cash flows, shifting time position, or problems needing
rates to be converted.
• Overall, you need to understand the principles of TVM in depth, as the exam is more analytical (and less
quantitative) than you may think.

Time Value of Money

Quantitative Methods

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