Its all about money, honey!!

Jaikumar L 07-08-2006

Misys International Banking Systems

What is money?

• Money is the set of assets in the economy that people regularly use to buy goods and services from other people.

“something generally accepted as a medium of exchange, a measure of value, or a means of payment.”
Misys International Banking Systems

In other words…

Characteristics of Money
– – – – Portable Divisible Durable Stable

The Functions of Money
– Medium of Exchange – Store of Value – Unit of Account

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A Brief History of Money
I. Physical Goods Money

Barter

Electronic barter

V. Electronic Money E-money

Commodity money Cybermoney II. Coins Creditcards Bank money III. Paper & Accounting Money
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IV. Electronic Transfers EFT

Development of Money
Monetary History: Barter (direct exchange of goods) ABSTRACTION Medium of exchange (arrowheads, salt) Coins (gold, silver) Tokens (paper) Notational money (bank accounts) NEED Dematerialized schemes (pure information) BANKS

• • • • • •

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Barter
• Direct exchange of goods and services -- possible when production exceeds individual needs • Problem: “double coincidence of wants”
– Trade a bicycle for a cow – Alice must have a bicycle and want a cow – Bob must have a cow and want a bicycle
UNLIKELY

• • • • •

But: Internet allows rapid discovery of wants Problem: remote barter requires an escrow (or risk) Problem: outside the monetary and tax systems When money is not trusted, barter returns Electronic barter systems exist

Misys International Banking Systems

Types of Money: Fiduciary vs. Scriptural
• Fiduciary money (fiat money, legal tender)
– Issued by a central (government) bank – Has real “discharging power” (to discharge debts) – Cannot be refused

• Scriptural money
– Money not issued by a central bank – Examples: bank accounts, travelers checks, gift certificates, scrips – Discharging power based on trust in issuer

• Commodity Money
– something that performs the function of money and has alternative, nonmonetary uses. – Examples: Gold, silver, cigarettes
Misys International Banking Systems

Types of Money: Token vs. Notational
• Token money
– Represented by a physical article (e.g. cash) – Can be lost

• Notational money
– Examples: bank accounts, frequent flyer miles – Electronic (scriptural) money: wide recognition – Jeton = electronic token with limited recognition

• Hybrid money
– Check – Telephone card (carries jetons for future service)

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The Money Matrix

TOKEN FIDUCIARY • CASH • GOVERNMENT BEARER BOND • CERTIFIED CHECK • TRAVELER’S CHECK

NOTATIONAL • ACCOUNT WITH CENTRAL BANK

HYBRID • GOVERNMENT CHECK

SCRIPTURAL

• BANK ACCOUNT • FREQUENT FLYER MILES

• PERSONAL CHECK • GIFT CERTIFICATE

Misys International Banking Systems

Money creation First National Bank
Assets
Reserves $10.00 Loans $90.00 Total Liabilities $100.00

Liabilities
Deposits $100.00

Total Assets $100.00

Misys International Banking Systems

Money creation
• When a bank makes a loan (from it’s reserves) the money supply increases. When banks hold only a fraction of deposits in reserve, banks create money. • The creation of money through loans does not create any wealth, but allows banks to charge interest several times on the same bit of wealth.

Misys International Banking Systems

The Money Multiplier

• When one bank loans money, that money is generally deposited into another or the same bank thus creating more deposits and more reserves to be lent out. • The Money Multiplier is the amount of money that the banking system generates with each dollar of reserves.

Misys International Banking Systems

The Money Multiplier
First National Bank
Assets
Reserves $10.00 Loans $90.00 Total Liabilities $100.00

Liabilities
Deposits $100.00

Total Assets $100.00

Misys International Banking Systems

The Money Multiplier
First National Bank
Assets
Reserves $10.00 Loans $90.00 Total Liabilities $100.00

Second National Bank
Assets
Reserves $9.00 Loans $81.00 Total Liabilities $90.00

Liabilities
Deposits $100.00

Liabilities
Deposits $90.00

Total Assets $100.00

Total Assets $90.00

Misys International Banking Systems

The Money Multiplier
First National Bank
Assets
Reserves $10.00 Loans $90.00 Total Liabilities $100.00

Second National Bank
Assets
Reserves $9.00 Loans $81.00 Total Liabilities $90.00

Liabilities
Deposits $100.00

Liabilities
Deposits $90.00

Total Assets $100.00

Total Assets $90.00

Misys International Banking Systems

The Money Multiplier
First National Bank
Assets
Reserves $10.00 Loans

Second National Bank
Assets
Reserves $9.00 Loans

Liabilities
Deposits $100.00

Liabilities
Deposits $90.00

Total Money Supply = $190.00!
$90.00 Total Liabilities $100.00 $81.00 Total Liabilities $90.00 Total Assets $90.00

Total Assets $100.00

Misys International Banking Systems

Query to ALL
There are two options available. Which one would you prefer – $10,000 today or $10,000 in 3 years? years

Misys International Banking Systems

Learning Objectives
• • • • • Time Value of Money Future Value Present Value Concepts of Compounding / Discounting Types of Interest
– Simple – Compound

• Interest calculation

Misys International Banking Systems

Query to ALL
There are two options available. Which one would you prefer – $10,000 today or $10,000 in 3 years? years Most of us would prefer $10,000 today. today We already recognize that there is TIME VALUE TO MONEY!! MONEY

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Why Time ?
Why is TIME such an important element in our decision?
TIME allows us the opportunity to postpone consumption and earn INTEREST. INTEREST

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Future Value
If you choose option A and invest the total amount at an annual rate of 4.5%, the future value of your investment at the end of the first year is $10,450. This is calculated by multiplying the principal amount of $10,000 by the interest rate of 4.5% and then adding the interest gained to the principal amount: Future value of investment at end of first year: = ($10,000 x 0.045) + $10,000 = $10,450

Misys International Banking Systems

Future Value
You can also calculate the total amount of a one-year investment with a simple manipulation of the above equation: Original equation: ($10,000 x 0.045) + $10,000 = $10,450 Manipulation: $10,000 x [(1 x 0.045) + 1] = $10,450 Final equation: $10,000 x (0.045 + 1) = $10,450 The manipulated equation above is simply a removal of the likevariable $10,000 (the principal amount) by dividing the entire original equation by $10,000.

Misys International Banking Systems

Future Value
If the $10,450 left in your investment account at the end of the first year is left untouched and you invested it at 4.5% for another year, how much would you have? To calculate this, you would take the $10,450 and multiply it again by 1.045 (0.045 +1). Future value of investment at end of second year: = $10,450 x (1+0.045) = $10,920.25 The above calculation, then, is equivalent to the following equation: Future Value = $10,000 x (1+0.045) x (1+0.045)

Misys International Banking Systems

Future Value
Using rule of exponents, the equation can be represented as the following: Future value = $10,000 x (1+0.045) (1 + 1)
= $10,000 x (1+0.045) 2

= $10,920.25 We can see that the exponent is equal to the number of years for which the money is earning interest in an investment. So, the equation for calculating the three-year future value of the investment would look like this: Future value = $10,000 x (1+0.045) (1 + 1 + 1) = $10,000 x (1+0.045) 3 = $11,411.66
Misys International Banking Systems

Future Value
This calculation shows us that we don'need to calculate the future t value after the first year, then the second year, then the third year, and so on. If you know how many years you would like to hold a present amount of money in an investment, the future value of that amount is calculated by the following equation: Future Value = Original Amount X (1 + Interest Rate per Period) (No. of periods)

= P * (1 + i) n

Misys International Banking Systems

Future Value
Future Value is the Amount to which an investment will grow after earning interest. FV = PV (1 + i)^n Where FV = Future Value PV = Present Value n = number of periods i = interest rate per period

Misys International Banking Systems

Future Value
What is the future value of $34 in 5 years if the interest rate is 5%? FV= PV ( 1 + i ) ^n FV= $ 34 ( 1+ .05 ) ^5 FV= $ 34 (1.2762815) FV= $43.39.

Misys International Banking Systems

Present Value
If you received $10,000 today, the present value would of course be $10,000 because present value is what your investment gives you now if you were to spend it today. If $10,000 were to be received in a year, the present value of the amount would not be $10,000 because you do not have it in your hand now, in the present. To find the present value of the $10,000 you will receive in the future, you need to pretend that the $10,000 is the total future value of an amount that you invested today. In other words, to find the present value of the future $10,000, we need to find out how much we would have to invest today in order to receive that $10,000 in the future.

Misys International Banking Systems

Present Value
The future value equation can be rewritten by replacing the P variable with present value (PV) and manipulated as follows: Original equation: FV = PV * (1 + i) n Manipulation: Divide both sides by (1 + i) n Final equation: PV = FV / (1 + i) n or PV = FV * (1 + i) -n

Present value for three year investment = $10,000 x (1+0.045) -3 = $8762.97

Misys International Banking Systems

Present Value
Let’s walk backwards from the $10,000 offered in option B. Remember, the $10,000 to be received in three years is really the same as the future value of an investment. If today we were at the two-year mark, we would discount the payment back one year. At the two-year mark, the present value of the $10,000 to be received in one year is represented as the following: Present value of future payment of $10,000 at end of year two = $10,000 x (1+0.045) -1 = $9569.38

Misys International Banking Systems

Present Value
Note that if today we were at the one-year mark, the above $9,569.38 would be considered the future value of our investment one year from now. Continuing on, at the end of the first year we would be expecting to receive the payment of $10,000 in two years. At an interest rate of 4.5%, the calculation for the present value of a $10,000 payment expected in two years would be the following: Present value of $10,000 in two years = $10,000 x (1+0.045) -2 = $9157.30

Misys International Banking Systems

Present Value
Using the rule of exponents, we don'have to calculate the future t value of the investment every year counting back from the $10,000 investment at the third year. We could put the equation more concisely and use the $10,000 as FV. So, here is how you can calculate today' present value of the s $10,000 expected from a three-year investment earning 4.5%: Present value for three year investment = $10,000 x (1+0.045) -3 = $8762.97

Misys International Banking Systems

Evaluation of query
So the present value of a future payment of $10,000 is worth $8,762.97 today if interest rates are 4.5% per year. In other words, choosing option B is like taking $8,762.97 now and then investing it for three years. The equations above illustrate that option A is better not only because it offers you money right now but because it offers you $1,237.03 ($10,000 - $8,762.97) more in cash! Furthermore, if you invest the $10,000 that you receive from option A, your choice gives you a future value that is $1,411.66 ($11,411.66 - $10,000) greater than the future value of option B.

Misys International Banking Systems

Present Value
How much you have now is the Present Value. PV = FV (1 + i)^-n Where PV = Present Value FV = Future Value n = number of periods i = interest rate per period

Misys International Banking Systems

Present Value
What is the present value of $1000 in 5 years if the interest rate is 6%? PV = FV (1 + i)^-n = 1000 (1 + 0.06)^ -5 = 1000 (0.74726) = 747.26

Misys International Banking Systems

Time Value of Money
• It is a concept in interest rates. • It implies that the value of one rupee today is not equal to one rupee tomorrow. • It may be more or less depending upon the interest rates. If interest rates are positive, we get more money on a future date in return for letting someone else use our money today. • All products offered by the financial services industry which involve interest calculations are based on this concept
Misys International Banking Systems

Time Value of Money
• Translating a value to the present is referred to as Discounting. • Translating a value to the future is referred to as Compounding.

Misys International Banking Systems

Types of Interest
• Simple Interest
– Interest earned only on the original investment.

• Compound Interest
- Interest earned on interest. Interest earned on the previous period’s balance.

Misys International Banking Systems

Types of Interest
• Simple Interest
– Interest paid (earned) on only the original amount, or principal borrowed (lent). – It is used in financial institutions for interest periods of less than one year. – If the rate is expressed as an annual rate (normal practice), then the time period (t) must be a fraction of a year.

Misys International Banking Systems

Simple Interest
In its most basic form, interest is calculated by multiplying principal (amount invested) by rate (percent of interest) multiplied by time (number of periods the interest is calculated). This is called simple interest. Simple interest formula I = PRT where I = Interest P = Principal R = Percentage Interest Rate T = Time in years

Misys International Banking Systems

Simple Interest
Interest earned at a rate of 6% for five years on a principal balance of $100.
Interest Earned Per Year = (100 x 6 X 1)/(100) = $6

Today
1 2

Future Years
3 4 5

Interest Earned 6 6 6 6 6 Value 100 106 112 118 124 130
– Value at the end of Year 5 = $130
Misys International Banking Systems

Simple Interest
Example1: A $10,000 deposit at 8% per year for three years' simple interest. Principal = 10,000 Rate = 8% Time = 3 years

I = PRT Giving

I = (10000)(.08)(3) = 2400

A $10000 deposit at 8% simple interest for three years earns $2400 interest.

Misys International Banking Systems

Simple Interest
The future value (FV) of a simple interest calculation is derived by adding the original principal back to the interest earned.

In example 1, FV = Principal + Interest = $10,000 + $2400 = $12,400 Expressed as a formula: FV = Principal + Principal * Rate * Time FV = P(1 + RT)

Misys International Banking Systems

Simple Interest
Example 2 Principal = 10,000 Rate = 10% (annual) Time = 6 months (hint: convert into years)

I = (10,000 * 10 * 6) / (12 * 100) = 500

Misys International Banking Systems

Simple Interest
Example3: We invest $10,000 in an 8% , 90-day certificate of deposit.

Principal = 10,000 Rate = 8% Time = 90 days

I = (10000 * 8 * 90) / (365 * 100) = 197.26 Our total proceeds at the end of the CD period are: FV = (10000)+(10000)(.08)(90/365) = $10,197.26

Misys International Banking Systems

Simple Interest
The present value (PV) PV = FV /(1+RT) Example: If the bank loans out $10,000 for 90 days at 8% simple interest, the PV is:

PV = 10000 / [1 + (.08)(90/365)] = 10000/ 1.019726 = $9,806.56

Misys International Banking Systems

Types of Interest
• Compound Interest
Interest paid (earned) on any previous interest earned, as well as on the principal borrowed (lent). Interest earned on interest. Interest earned on the previous period’s balance.

Misys International Banking Systems

Compound Interest
If interest is left in the account to accumulate for a longer period (usually longer than one year) common practice (and usually state law!) requires that after interest is earned and credited for a given period, the new sum of principal + interest must now earn interest for the next period, etc. This is compound interest. To distinguish from simple interest, we use "n" to refer to the number of "periods" in which the interest is compounded and added to principal. FV = PV (1+r)^n

Misys International Banking Systems

Compound Interest
Suppose we invest our original $1,000 for three years at 8%, compounded quarterly: (The rate per quarterly period is 8% / 4 or 2%. The number of periods (n) is 3 x 4 = 12 quarterly periods.) FV = PV(1 + i)^n

FV = (1000)(1.02)12 = $1,268.24

Misys International Banking Systems

Compound Interest
If we wanted to know how much we' have to invest d now (PV) at 8% compounded quarterly to earn $10,000 in three years: PV = FV / (1 + i)^n

PV = 10000 / (1.02)12 = $7,884.93

Misys International Banking Systems

Comparison
Simple & Compound Interest

Misys International Banking Systems

INTEREST - Interest rate structures Simple rates A single rate applicable to all of the balance Example 1 Rate of 12% Balance of 25,000 Rate used is 12%

Misys International Banking Systems

INTEREST - Interest rate structures Simple tiered A set of balance thresholds and associated rates The rate used depends on where balance falls within the thresholds or tiers The rate applied to the full balance

Misys International Banking Systems

INTEREST - Interest rate structures Simple tiered Example 1 Rate structure is 5% up to 25,000 6.25 up to 50,000 7.75 up 100,000 8% from 100,000 upwards Balance is 47,000 - what’s the rate?
It’s 6.25%

Misys International Banking Systems

INTEREST - Interest rate structures Simple tiered Example 2 Rate structure is 5% up to 25,000 6.25 up to 50,000 7.75 up 100,000 8% from 100,000 upwards Balance is 8,000 - what’s the rate?
It’s 5%

Misys International Banking Systems

INTEREST - Interest rate structures Banded tiered rates A set of balance thresholds and associated rates The balance is apportioned over the tiers Each portion of the balance accrues interest at the rate assigned to each tier

Misys International Banking Systems

INTEREST - Interest rate structures Banded tiered Example 1 Rate structure is 5% up to 25,000 6.25% up to 50,000 7.75% up 100,000 8% from 100,000 upwards Balance is 47,000 - what’s the rate?

It’s 5% on the first 25,000 and 6.25% on 22,000

Misys International Banking Systems

INTEREST - Interest rate structures Banded tiered Example 2 Rate structure is 5% up to 25,000 6.25% up to 50,000 7.75% up 100,000 8% from 100,000 upwards Balance is 500,000 - what’s the rate?

Misys International Banking Systems

INTEREST - Interest rate structures Banded tiered Example 2 - answer 5% on the first 25,000 6.25% on the next 25,000 !!! 7.75% on the next 50,000 !!! 8% on the remaining 400,000 upwards

Misys International Banking Systems

PV & FV tables
• Because raising interest factors to an exponent of "n" was a difficult calculation before calculators, some mathematicians used logarithmic functions to calculate the exponent factor. • Financial professionals acquired tables of these functions so that either of the above problems could be calculated simply by looking up a FV factor (or to discount, a PV factor) based on the interest rate and number of compounding periods and multiplying the principal by the interest factor. • Now, computerized spreadsheets can build in these financial functions and easily do the work for us.

Misys International Banking Systems

EMI Calculation Loan Payment Formula

Misys International Banking Systems

MS EXCEL - Future Value
Returns the future value of an investment based on periodic, constant payments and a constant interest rate. Syntax
FV(rate,nper,pmt,pv,type) Rate is the interest rate per period. Nper is the total number of payment periods in an annuity. Pmt is the payment made each period; it cannot change over the life of the annuity. Typically, pmt contains principal and interest but no other fees or taxes. Pv is the present value, or the lump-sum amount that a series of future payments is worth right now. If pv is omitted, it is assumed to be 0 (zero). Type is the number 0 or 1 and indicates when payments are due. If type is omitted, it is assumed to be 0.

Misys International Banking Systems

MS EXCEL - Future Value
Try this problem in Excel: Invest $1,000 (present value) at 8% annual interest compounded quarterly for three years to see how much we can receive (future value) (hint: use the =FV function)
1. Invest $1,000 at 8% compounded quarterly for 3 years: Principal Rate Nper Fut. Val -1000 2% 12 (enter as negative) (8% / 4 qtrs) (3 yrs x 4 qtrs)

$1,268.24 =FV

Misys International Banking Systems

MS EXCEL - Future Value
You deposit $1,000 into a savings account that earns 4 percent annual interest compounded monthly (monthly interest of 4%/12, or 0.33%). You plan to deposit $100 at the beginning of every month for the next 12 months. How much money will be in the account at the end of 12 months?

FV (0.0033, 12, -100, -1000, 1) = $2266.38

Misys International Banking Systems

MS EXCEL - Present Value
Returns the present value of an investment. The present value is the total amount that a series of future payments is worth now. For example, when you borrow money, the loan amount is the present value to the lender.
Syntax PV(rate,nper,pmt,fv,type) Rate is the interest rate per period. Nper is the total number of payment periods in an annuity. Pmt is the payment made each period; it cannot change over the life of the annuity. Typically, pmt contains principal and interest but no other fees or taxes. Fv is the future value, or the cash balance you want to attain after the last payment is made. If fv is omitted, it is assumed to be 0 (zero). Type is the number 0 or 1 and indicates when payments are due. If type is omitted, it is assumed to be 0.
Misys International Banking Systems

MS EXCEL - Present Value
Now the reverse—how much would we have to invest now (present value) at 8% compounded quarterly to receive $10,000 (future value) in three years? (use the =PV function)
PV (0.02,12, ,-10000,0) = -$7884.93

Excel displays the PV amount as negative

Misys International Banking Systems

MS EXCEL - Present Value
IF you wish to buy an insurance annuity that pays 1000 at the end of every month for the next 20 years. The cost of the annuity is 110,000, and the money paid out will earn 8 percent. You want to determine whether this would be a good investment. Using the PV function, you find that the present value of the annuity is: PV(0.08/12, 12*20, -1000, , 0) equals -119,199.29 The result is negative because it represents money that you would pay, an outgoing cash flow. The present value of the annuity (119,199.29) is more than what you are asked to pay (110,000). Therefore, you determine this would be a good investment.

Misys International Banking Systems

MS EXCEL - PMT function
Calculates the payment for a loan based on constant payments and a constant interest rate. Syntax
PMT(rate,nper,pv,fv,type) Rate is the interest rate for the loan. Nper is the total number of payments for the loan. Pv is the present value, or the total amount that a series of future payments is worth now; also known as the principal. Fv is the future value, or a cash balance you want to attain after the last payment is made. If fv is omitted, it is assumed to be 0 (zero), that is, the future value of a loan is 0. Type is the number 0 (zero) or 1 and indicates when payments are due.

Misys International Banking Systems

MS EXCEL - PMT function
What is the monthly payment on a $10,00,000 loan at an annual rate of 8 percent that you must pay off in 10 years

PMT(8%/12, 10*12, 1000000) equals - $12,153.91 You need to pay Rs. $12,153.91 every month for the loan of Rs. 10,00,000 @ 8% for 10 years.

Misys International Banking Systems

MS EXCEL - PMT function
You can use PMT to determine payments to annuities other than loans. E.g. Public Provident Fund For example, if you want to save Rs. 500,000 in 15 years by saving a constant amount each month, you can use PMT to determine how much you must save. If you assume you' be able to earn 9 percent interest on your ll savings, you can use PMT to determine how much to save each month.

PMT(9%/12, 15*12, 0, 500000) equals -1321.33 If you pay Rs. 1321.33 into a 9 percent savings account every month for 15 years, you will have Rs. 500,000

Misys International Banking Systems

Exercise
You have two options – You could receive either $15,000 today or $18,000 in four years. Which option would you choose ? Lets assume that Interest rate is 4%. FV for Option1 - FV(0.0033,48,,-15000) = $17569.94 PV for option 2 - PV(0.0033,48,,18000,0) = -$15,367.16. Hence, Option 2 is better.

Misys International Banking Systems

Exercise
You have two options – You could receive either $15,000 today or $17,000 in four years. Which option would you choose ? Lets assume that Interest rate is 5%. FV for Option 1 - FV(5%/12,4*12,,-15000) = $18,342.63 PV for option 2 - PV(5%/12,4*12,,18000) = - $14719.81 Hence option 1 is better.

Misys International Banking Systems

Exercise
What is the monthly payment on a $10,00,000 loan at an annual rate of 9 percent that you must pay off in 15 years

PMT(9%/12, 15*12, 1000000) equals - $10,142.66 You need to pay Rs. $10,142.66 every month for the loan of Rs. 10,00,000 @ 9% for 15 years.

Misys International Banking Systems

Example: Cash Transaction
1. CENTRAL BANK ISSUES FIDUCIARY MONEY (ANTI-FORGERY) + (SERIAL NUMBERS)

CENTRAL BANK

7. SELLER’S BANK SENDS CASH TO CENTRAL BANK

6. SELLER’S BANK CREDITS SELLER’S BANK ACCOUNT

2. CENTRAL BANK SELLS CASH TO BUYER’S BANK

BUYER’S BANK

SELLER’S BANK
5. SELLER DEPOSITS CASH IN SELLER’S BANK ACCOUNT

3. BUYER’S BANK ALLOWS BUYER TO DRAW CASH FROM BUYER’S ACCOUNT

BUYER
4. BUYER PHYSICALLY GIVES CASH TO SELLER

SELLER

Misys International Banking Systems

Thank you

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