Chapter 2, Module 2 Notes

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FIN 502 – Personal Financial Planning
Chapter 1 – Module 2

Time value of money
* How to compare monetary amounts you pay or receive at different times * The arithmetic with which we convert money between periods, or calculate what rate of return is implied by a given set of cash flows

Single Period – Rate of Return
* N = amount of years
* I% = x (what we’re trying to find)
* PV = How much it’s worth today
* FV = How much it’s worth at maturity date

* Discount bonds pay no interest during it’s life, the interest you receive is part of the final payment (FV) * The interest rate is also known as the discount rate
* The rate that makes us indifferent between present and future amounts (in any pattern). If we use the appropriate discount rate to calculate the present of a future amount, we don’t care whether we receive the present value now or the future value at a later date

Multiperiod – Rate of Return
* Annual rate is always implied when we speak about rate of return * Sometimes interest is given monthly, etc. These need to be converted to annual rate of returns

Arithmetic & Geometric Rates of Return

If we invest $100 for 2 years and at the end of 2 years we receive $120

* Arithmetic (Mutual funds often quote their past rates of return using this method) * $20 / 2 years = 10%

* Geometric (This is correct because it allows for compounding) * TVM = 9.5445%

Arithmetic Mean & Geometric Mean Return

Year| Return (%)|
1990| 17|
1991| 8|
1992| 2|
1993| 15|

* Arithmetic Average
* .17 + .8 + .2 +.15 / 4 = .105 = 10.5%
* Use this in analyzing investments when we want to estimate an average of expected return across different investments in the same period.

* Geometric Average
* Lower than or equal to the arithmetic mean
* nth root of 1.17 x 1.08 x 1.02 x 1.15 – 1 = 10.34 * OR
* n =...
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