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Hiccups

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Portfolio Management – Risk and Return
Copyright © 1996-2006 Investment Analytics

1

Time Value of Money
Simple vs compound interest Daycount methods Discounting principles

Copyright © 1996-2006 Investment Analytics

Portfolio Management – Risk & Return

Slide: 2

Time Value of Money
Basic principle
Money received today is different from money received in the future This difference in value is called the time value of money When we borrow or lend, this difference is reflected by the interest rate

Copyright © 1996-2006 Investment Analytics

Portfolio Management – Risk & Return

Slide: 3

Time Value of Money
Example:
I lend you 100 today but you have to pay me back 110 in one year interest rate is 10%

Meaning:
110 in one year has the same value as 100 today or: the 1-year interest rate is 10%

Copyright © 1996-2006 Investment Analytics

Portfolio Management – Risk & Return

Slide: 4

Present and Futures Value
110 is the future value of 100 today 100 is the present value of 110 in 1 year’s time Meaning: 110 in one year has the same value as 100 today or: the 1-year interest rate is 10%

Copyright © 1996-2006 Investment Analytics

Portfolio Management – Risk & Return

Slide: 5

Compound Interest Example
Suppose interest rate = 10% and I have $100 to invest What will I get in 1 year time? Simple answer: $110
$100 x (1 + 0.1) = $110

Complex answer: depends on how compute interest
By computing interest more frequently I can earn more than $110 Copyright © 1996-2006 Investment Analytics Portfolio Management – Risk & Return Slide: 6

Compounding
Suppose interest is calculated every 6 months
After 6 months, I get interest
how much: (1/2)($100 x 0.1) = $5 this is (1/2) a year’s interest now, my account balance is $105.

At the end of the year, I earn interest for the second half of the year on $105 how much: (1/2)($105 x 0.1) = $5.25

Now I have $110.25
I made $0.25 extra!
Copyright © 1996-2006... [continues]

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