Financial Econometrics: The Time Value of Money, Present and Future Va...

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Financial Econometrics: The Time Value of Money, Present and Future Values
Posted on January 6, 2013 | Leave a comment

The most basic concept in the study of finance is the time value of money. The basic idea is that money (or a dollar) gained a year from now is not worth what money (or a dollar) is today. The reason for this is intuitive: We would rather have a dollar in hand than a promise for a dollar a year from now. A follow-up reason is that dollars today can be put to use and generate more than a dollar in the future. The value of money that you have now valued at some point in the future is calculated by the future value formula: FV = PV(1+r)n FV = Future Value PV = Present Value r = interest rate n = number of time periods (typically months or years) An example might be that you have 100 dollars now in a savings account, are offered a simple interest rate of 0.55% per year, and want to know how much money you will have at the end of two years. At the end of two years you would have the following(note that 0.55% is actually 0.0055 as a decimal): FV = 100(1+0.0055)2 FV = 100(1.0055) 2 FV = 100(1.01103025) FV = $101.103025 or ~$101.10 As a result of the interest rate offered, you would have roughly $1.10 more 2 years from now than you do now. Conversely, the formula to calculate future value from present value can be found using algebraic manipulation. PV(1 + r)n = FV PV = FV (1+R)n An example of the present value calculation proceeds: You are offered $1000 three years in the future as a return on an investment with interest compounded twice a year at a rate of 4% biannually. How much is this

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Financial Econometrics: The Time Value of Money, Present and Future Va...

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investment worth to you today? FV =1000; n = 6 periods(three years biannually); r = 4%; PV = ? PV = 1000 (1+.04) 6 PV = 1000 (1.04) 6 PV = 1000 (1.265319018496) PV = $790.31452573014594113833797856928 or ~$790.31 The investment has a value to you today of $790.31. We can also calculate the formula of compound interest rate for a given period: FV = PV(1+r) n FV/PV = (1+r) n
n n

FV/PV = 1 + r FV/PV 1 = r

or r = (FV/PV)(1/n) 1 And finally, we can find the formula for the number of time periods (also known as the investment horizon): FV = PV(1+r) n FV/PV = (1+r) n ln(FV/PV) = ln[(1+r) n] ln(FV/PV) = n ln[(1+r)] n = ln(FV/PV) ln(1+r) One issue I have always had when working on these problems is trying to understand why we use a natural logarithm, or in other words, why we use a logarithm based on Eulers number. It is often not explained coherently, but fortunately I have found an excellent explanation for this at the following website!(This is in no-way a plug for the book, but I am only linking here to provide an EXCELLENT explanation for the use of Eulers number and Natural Logarithm): http://betterexplained.com/articles/an-intuitive-guide-to-exponentialfunctions-e/ To summarize, each of the formulas regarding the time value of money are below: Future Value: FV = PV(1+r)n Present Value: PV = FV

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Financial Econometrics: The Time Value of Money, Present and Future Va...

http://www.econq.com/?p=16

(1+R)n Compound Interest Rate: r = (FV/PV)(1/n) 1 Investment Horizon: n = ln(FV/PV) ln(1+r) This entry was posted in Financial Econometrics. Bookmark the permalink.

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