Time Value of Money

A rupee today is more valuable than a rupee a year hence. Why?

Individuals prefer current consumption to future consumption. Capital can be employed productively to generate positive returns. In an inflationary period, a rupee today represents a greater real purchasing power than a rupee a year hence.

Time lines and Notation

A time line shows the timing and the amount of each cash flow in a cash stream. Period of time Point of time Cash flow can be positive (cash inflow) or negative (cash outflow) Notations used: PV : Present Value FVn : Future value n years hence Ct : Cash flow occurring at the end of year t A : A stream of constant periodic cash flow over a given time r : Interest rate or discount rate g : Expected growth rate in cash flows n : Number of periods over which the cash flows occur.

Future value of a Single amount

The process of investing money as well as reinvesting the interest earned thereon is called Compounding. The future value or compounded value of an investment after n years when the interest rate is r percent : FVn = PV(1+r)n In case of Simple Interest, the investment grows as follows: FV = PV [ 1+ Number of years * Interest rate ] Doubling Period: Rule of 72 Rule of 69 Finding the growth rate

Present value of a Single amount

The process of discounting , used for calculating the present value , is the inverse of compounding. PV = FVn [ 1 / (1+r)n ] Present Value of an uneven cash flow stream:

PVn = t=1 [At / (1+r)t ]

Where, PVn = Present value of a cash flow stream At = Cash flow occuring at the end of year t r = Discount rate n = Duration of the cash flow stream

Annuity
An annuity is a stream of constant cash flows occurring at regular intervals of time. Regular/Deferred annuity (end of the period) Annuity due (beginning of the period) Future value of an annuity The future value of an annuity : FVAn = A [ (1+r)^n 1] / r
Where, FVAn = FV of an annuity which has a duration of n periods A = Constant periodic flow r = interest rate per period n = duration of the annuity

Present value of an annuity

The present value of an annuity: PVAn = A [ {1- (1/1+r)^n} / r ]

Annuities Due The cash flows of an annuity due occur one period earlier in comparison to the cash flows on an ordinary annuity.

Annuity due value = Ordinary annuity value* (1+r)

Present value of a Perpetuity

A perpetuity is an annuity of indefinite duration. The present value of a perpetuity : P = A * PVIFAr,
Where, P = Present value of a perpetuity A= The constant annual payment

PVIFAr = [1/(1+r)t] =1/r t=1

Risk and Return

Risk is the chance that the actual return differ from its expected return. The riskiness of a financial asset is measured in terms of the riskiness of its cash flows. Diversification is the key to effective risk management.

Risk and Return of a Single Asset

Rate of return: Annual income + Ending price - Beginning price Beginning price Probability distributions: The probability for a particular outcome is simply the chance that the specified outcome will occur. The result of considering these outcomes and their probabilities together is a probability distribution.

Expected rate of return

It is the weighted average of all possible returns multiplied by their respective probabilities.

Variance of returns It is the difference between an expected and actual result. It is a measure of dispersion of a set of data points around their mean value. = pi (Ri - E(R)) Where, = Variance
Ri = Return for the ith possible outcome pi= The probability associated with the ith possible outcome E (R)= Expected return

Standard deviation of returns It is a statistic used as a measure of dispersion or variation in a distribution It is equal to the square root of the arithmetic mean of the squares of the deviations from the arithmetic mean. =()^1/2
Where, = Standard deviation

Risk and Return of a Portfolio

Portfolio: A collection of investments all owned by the same individual or organization. These investments often include: Stocks (which are investments in individual businesses) Bonds (which are investments in debt that are designed to earn interest) Mutual funds (which are essentially pools of money from many investors that are invested by professionals or according to indices)

Expected return on a portfolio

E(R p ) w iE(R i )
i1
Where, E(Rp) = The expected return on portfolio wi= The proportion of portfolio invested in security i E(Ri)= The expected return on security i

Measurement of Market risk

The market risk of a security reflects its sensitivity to market movements.

Total risk= Unique risk + Market risk

Unique risk/Unsystematic risk/Diversifiable risk Market risk/Systematic risk/Non-diversifiable risk

 The sensitivity of a security to market movements is called beta (). Calculation of Beta
Rjt= j + jRMt +ej
Where, Rjt = The return of security j in period t

j = The intercept term alpha

j = The regression coefficient , beta RMt = The retun on market portfolio in period t

ej

= The random error term

j= Cov(Rj,RM) / 2M

Beta for market portfolio = 1

Thank you