You are on page 1of 35

CHAPTER 1: The Time Value of Money

1.1 Introduction
ould you lend someone $10,000 today in return for $10,000 in five years? Probably not. In fact, you should not, because $10,000 in five years is not worth $10,000 today. Money received at different times in the future will have different values today. For example, $10,000 in 20 years is probably worth less to you than $10,000 in 10 years. The principle behind this is called the time value of money. So what is $10,000 in the future worth today? The answer depends on the interest rate. The following interactive calculator shows you what happens when the interest rate is 6%.

Time is on the X-axis. The red chart is $10,000 at times in the futures, the yellow chart shows you the value today. By placing your mouse over the dot on the top of the yellow chart, you can see that $10,000 in six years is worth $7,049 today. Similarly, $10,000 in 10 years is worth just about half that amount today. You can change the numbers and click OK. For example, you can verify that if the interest rate is 8%, the $10,000 in five years is worth $6,805 today. Click the numeric button to see all the values. Now try increasing the number of periods to 30, and click OK. This lets you see how the curve changes with time to maturity. You will see the yellow chart take on a pronounced convex shape. This convexity results from discounting because the present value decreases at an increasing rate with the time to maturity. You can also explore how the curve itself changes with interest rates. Scroll the interest rate to see how the whole curve moves as you increase or decrease interest rates. You can see how interest rates capture the time value of money: the higher the interest rate, the lower the value today of money in the future. The Time Value of Money is a central concept of finance because it affects everything that involves borrowing or lending. This includes car loans, mortgages, student loans, bonds, savings accounts, and so on. For example, if you want to borrow money, you can go to a financial institution such as a bank. If you satisfy the bank that you have the ability to repay the loan, plus interest, it will lend you the money. This creates a fixed-income security, which is a contract specifying the timing and amounts of cash flows over time. The "timing" is how often you make payments, and the "amount" is the dollar amount you pay each time. If you take out a car loan, you have the same type of security: a fixed amount that has to be paid over a period of time by you to the bank. For these fixed-income securities, you are the "seller" and the bank is the "buyer" (it owns the loan). That is, you sell a legal obligation to repay the loan plus interest, and in return, you receive the amount of the loan. The interest rate is what the bank charges you for use of the

money. It compensates the bank for not being able to lend the money to anyone else for the term of your loan. Bonds are another large class of fixed-income securities. When an economic unit, such as the U.S. Treasury, borrows cash from the general investing public, it sells bonds. The public is now the buyer that lends money to the Treasury. This fixed-income security specifies the timing and amounts of cash payments by the U.S. Treasury (the seller) to the owner of the fixed-income security. Fixed-income securities are traded in primary and secondary markets. The primary market is the market in which the security is first issued. For example, the U.S. Treasury initially auctions Treasury bills. Once issued in the primary market, securities are re-traded in the secondary market. These markets determine a price for each fixed-income security. Since a fixed-income security specifies a series of future payments (or cash flows), the price of the security represents the value today of future cash flows.

1.2 PRESENT VALUE


A One-Period Example uppose you have the opportunity to invest $100 for one year at 10% interest. At the end of the year, your investment is worth $110: the $100 you invested plus (0.1)(100) interest: $110 = $100(1 + 0.10) Here, $110 is called the future value of $100 invested at 10% today. Now, what is the value today of $110 in one year? The answer is called the present value of $110 in one year discounted at 10%. It is calculated by rearranging the future value equation:

Next, ask the following question: If the present value of $110 in one year is $100, what is the interest rate? The answer, of course, is 10%, again calculated by rearranging the future value equation:

To describe these valuation principles more generally, let FV = future value, PV = present value, and r = interest rate. Then, the relationship among these variables is:

Therefore, if you know the future value (FV) and the interest rate (r), you can calculate the present value (PV). Similarly, you can calculate the future value from the present value and the interest rate, or the interest rate from the other two variables. A Two-Period Example Now, suppose an investment opportunity will pay you $121 at the end of two years. What is the value today (i.e., the present value) of this opportunity? To work out the answer, we work backward by solving two one-period problems. First, suppose you are at the end of Year 1. What is the value of $121 in one year? As you know, the answer depends on the interest rate between Year 1 and Year 2. If this is 10%, then the value at the end of Year 1 is

Second, what is the value today of $110 in one year? You already know that the answer is $100:

Note that you have to discount the $121 twice, once for each period. If the interest rate is r per year, then the relationship between the future value and the present value is

You can easily deduce the general principle. If the interest rate is r per year, and you receive FV in t years, then the present value is

An example of a fixed-income security that has only one future payment is a zerocoupon bond. You will encounter these in much more detail throughout this text. A Three-Period Example In the two-period example, you started with the future value and worked back to the present value. You can also start with the present value and work forward. Suppose you can invest $100 for three years at 10% per year. This means that each year, you will earn 10% on whatever you invest that year. You already know that your

$100 will be worth $110 in one year. If you reinvest the $110 at the end of the year, the value at the end of Year 2 will be $110(1 + 0.10) = $121. Equivalently, this equals:

If you reinvest the $121, then at the end of Year 3 you will have:

The value of your investment over time is shown in Figure 1.1.

Figure 1.1 Value over Time

The relationship between present and future values in this example can be summarized by noting that as an investor, you are indifferent among: 1. $100 now, 2. $110 in one years time, 3. $121 in two years time, or 4. $133.10 in three years time. We state this as:

More generally, if you invest PV now at interest rate r per year, then the value at the end of year t is

A Sequence of Cash Flows: A Two-Period Example

So far, we have valued single payments in the future. We now examine a sequence of future payments. Suppose there is an investment opportunity that pays $50 at the end of Year 1 and $100 at the end of Year 2. If the interest rate is 8%, what is the present value of the future cash flows from the investment? The answer is obtained by discounting each part separately and then adding present values, a principle known as value additivity:

The important point to remember is that money received at different times cannot be added together; a dollar today is very different from a dollar to be received one year later. However, you can add present values together, as we have done. In fact, you can add the value of dollars together whenever they are expressed with respect to any common time, present or future. When the price of a fixed-income security is determined in the market, investors are in this same position; they are valuing cash flows that occur at different times. From value additivity, the price of the security is the sum of the present values of the future cash flows. Given the price at which investors buy or sell a security, we can ask the question: What is the interest rate that investors are implicitly using to discount cash flows? In our current example, suppose that the market price is $138.32. You can calculate the implied interest rate, r, from the following:

You can verify that r = 0.05, which is the rate that equates the present value to the sum of the discounted future cash flows. In the next topic, we apply time value of money concepts to value a particular type of fixed-income security called a bond.

1.2.1 EXAMPLE: ANNUITY Lotto Winnings: Lump Sum or an Annuity


n March 2007, the Mega Millions lottery had a $390 million jackpot, the largest in the world at the time. The lottery winners had the choice of taking the payments over time (an Annual Payout) or taking a single lump sum payment (the Cash Option). The annual payout was $15 million every year for 26 years. The Cash Option was to receive an immediate payment of $233 million. If you were the winner, what would you do, take the Annual Payout or the Cash Option? Answering this question requires understanding the time value of money and taxes. In this topic we will ignore taxes and instead focus on the time value of money as captured by interest rates and the annuities. An annuity is a series of fixed payments over time, such as the Annual Payout from a lottery. There are two types of annuities: ordinary annuities and annuities in-advance. In an ordinary annuity, you receive the payments at the end of the period, e.g. at the end of the year. With an annuity in-advance, you receive the payment at the beginning of the period. Lottery payouts are annuities in-advance; if you choose the Annual Payout option, you get the first payment right away, the next payment one year later, and so on. The present value of the Annual Payout is given by the annuity formula (a derivation is in the appendix to this chapter). The formula says if you receive a constant payment C for t periods and the interest rate is r, then the present value P(C,t), of an ordinary annuity is

The present value of an annuity-in-advance is C+P(C,t-1) since you get C immediately and then for t-1 more periods.

Refer now to the interactive calculator below and assume that the interest rate is 6%. Now you can compute the present value of $15m for 26 years, for an in-advance annuity.

Online, using the calculator above you can check how changing the interest rate from 6% to a rate that is lower and then higher than 6% changes the present value of the prize.

1.3 BONDS
In the fixed-income security markets of the world, prices (or values) are being determined constantly. The largest and most liquid security market in the world is the market for U.S. Treasury securities. In this market, traders around the world trade Treasury obligations to pay cash over many different times -- up to 30 years into the future. In particular, simple Treasury obligations called strips (or zero-coupon bonds) are traded for a wide range of different maturities. These maturities can range from a few days to 30 years. If you buy a Treasury strip, you receive a fixed payment (the face value) at a fixed date in the future (the maturity date). As you will see, zero-coupon bonds such as strips are fundamentally important because they allow us to deduce the values of many other types of fixed-income securities. A common feature of any fixed-income security is that it can be represented on a timeline. This is a graphing concept illustrated by Figure 1.2. This timeline displays both the timing and the amount of cash flows that the buyer of a fixed-income security will receive. For example, often a fixed-income security is defined in terms of some face value plus the promised interest rate, or coupon rate, that is paid for the amount of the face value. In this case, the security is called a "coupon bond," and its cash flows are defined by the coupon rate times the face value over time plus the face value at the end of its life. Consider a 30-year bond with a face value equal to $10,000. Suppose that it pays simple interest on the face value two times a year (i.e., semiannually) at a coupon interest rate equal to 10% per year. Because interest is paid semiannually, we divide 10% per year by two to express it relative to six months. This means that every six months, the bond pays $500 = $10,000(0.10/2) in interest payments. Finally, at the time of maturity, this bond pays the $10,000 face value in addition to the final interest payment. The cash flows from this security can be represented on a timeline as shown in Figure 1.2. Figure 1.2 Coupon Bond

This 30-year example is easily solved using the Time Value of Money subject in Bond Tutor. Suppose the market rate of interest equals 8% per year. Online, you enter this problem as follows: Graphically, both the present value at the end of every six months and the nominal total dollar value are graphed as follows: The top bar chart represents the total cash flows accruing from the current coupon period until the time to maturity. At Coupon Period 1, the cumulative, undiscounted cash flows are $40,000; at Coupon Period 2, these cash flows are $39,500 and so on. Coupon Period 1 is 60 times $500, plus $10,000. This equals $40,000. Online, the remaining undiscounted and present values are provided by clicking on the Numeric button at the bottom of the Bond Tutor screen. You should click on Numeric in the above live screen and the popup grid with undiscounted and discounted values will appear. The bottom bar chart (yellow in default colors) graphs the present value at each coupon period. This value declines from above the face value. The reason for this is that the promised or coupon rate is greater than the market's required rate of return. Therefore, the market will bid the price up above the face value, which is equivalent to lowering the expected return from the bond. Now consider this same example using a market rate of interest equal to 12% per year. The market rate of interest exceeds the coupon rate for the bond. This implies that investors want a higher return than is provided by coupon payments alone. As a result, the market will let the price fall below the face value, to increase the return from this issue. Online, you can repeat this example by entering 12% into the Interest Rate cell as follows:

The nominal values remain the same because the cash flows specified by the Bond indenture have not changed. What has changed, however, is the discount rate. As a result, the present value declines relative to the 12% market interest rate example. The following graph shows both the nominal and the present values over time. Because the coupon rate is less than the market's required rate of interest, the present value of the bond increases over time from below $10,000, the face amount. Click on the Numeric button to see the undiscounted and discounted values per coupon period. Cash Flows and Present Values In the current example, the cash flows accruing to the bondholder can be viewed online by clicking on the Cash Flows option:

Graphically, this is displayed as follows: Click on the Numeric button above to verify that the discounted and undiscounted cash flows for each Coupon Period. As you can see, the coupon bond is made up of two types of cash flows. The first is a stream of coupon payments (or cash flows) of equal size which occurs at the end of each time period. This type of cash flow is known as an ordinary annuity or an annuity in-arrears. The second component is a one-time cash flow, equal to the face value, which occurs at the end of the bonds life. The cash flows from most fixed-income securities can be described by these two types of cash flows. For example, home mortgage agreements, car loans, and leases are

often specified in terms of an equal series of cash flows (i.e., an annuity). If the first component of the cash flow series occurs at the beginning of the period (rather than the end of the period), then the annuity is called an annuity in-advance. Other types of fixed-income securities are defined only in terms of the second component of a coupon bond, the face amount. This special case of a coupon bond is called a "pure discount" or "zero-coupon bond." This is a fixed-income security that makes no promised coupon payments over its life. Instead, its issuer is obliged to pay the face value of the bond at the time of its maturity. This is the most primitive form of a fixed-income security, in the sense that all other types can be viewed as some bundle of zero-coupon bonds that vary by face amount and maturity. The U.S. Treasury issues a zero-coupon bond, called a Treasury bill. It is sold as a pure discount bond with face values ranging from $10,000 to $1,000,000. Suppose you buy a Treasury bill with a face value equal to $10,000 at a Treasury auction. Your time-line is represented in Figure 1.3.

Figure 1.3 Zero-Coupon Bond

Suppose, as in the previous example, that the time to maturity is 30 years and the market interest rate is 8%. The difference now is that there are zero-coupon payments (i.e., Coupon Frequency and Coupon Rate are set to zero). Online, the undiscounted and discounted values for this example are computed as follows:

You can see that, over time, the value of the zero-coupon bond increases from below the face amount because the payment of the face amount is drawing closer. This is displayed as follows:

Again click on the Numeric button to see the Undiscounted and Discounted Values per coupon per coupon payment period. Observe that the undiscounted value remains the same over the zero-coupon bond's life and the present value increases. Long-term zero-coupon bonds are very sensitive to shifts in interest rates. For example, at a market rate of interest equal to 8%, you can see that the present value at the beginning of Coupon Period 1 equals $993.773. Suppose that interest rates jumped by 75 basis points (where a basis point is 0.01 of 1%). The present value of the zero coupon bond will decline to $807.462.

This can be computed online by entering the numbers as above and clicking on OK and then Numeric to see the undiscounted and discounted values. The initial outlay on the timeline of any fixed-income security is its price. In Topic 1.5, The Lotto Case we will discuss what an arbitrage-free price is. Then, in Chapter 2 we discuss how it is determined. Before moving on, however, you may find it useful to review the distinction between simple and compound interest in the topic titled The Calculation of Interest.

1.4 THE CALCULATION OF INTEREST


nterest rates are quoted two ways: as simple interest and compound interest. Simple Interest Suppose you borrow $1,000 for 1 year, and the bank charges you simple interest of 10%. At the end of the year, you will have to repay $1,100. If you borrow $1,000 for three years, your total repayment will be $1,000 + $100 x 3. Here, the simple interest is the principal ($1,000) times the interest rate (10%) times the number of periods (3). If you repay the loan in equal annual installments, you will make three payments of $433.33.

Given the principal P (the amount borrowed), the interest rate, r, and the term of the loan, T, simple interest on the loan is

If you repay the loan in n installments, your payment per installment is

Note that every period, the interest is calculated relative to the original amount borrowed. Simple Interest Example The simple interest on $10,000 for six months at 8% per year is calculated in the following way. In one year, the simple interest is $10,000 x 0.08 = $800. As a result, in 6 months, the simple interest is $10,000 x 0.08/2 = $400. In some cases, simple interest is computed for some specified number of days. Suppose you want to find out the simple interest for 137 days. In this case, you need to know the number of days in one year (or the "day count"). A bankers year typically has 360 days. In some cases, the day count is 365 days or 364 days. Once the convention is known, the computation of simple interest is straightforward. With a day count of 360, the simple interest for 137 days is: Simple interest = $10,000 x 0.08 x (137/360) Compound Interest Suppose you borrow $1,000 for 1 year and the bank charges you interest of 10%. At the end of the year, you will have to pay $1,100. This is no different from simple interest. The difference between simple and compound interest arises with multiple periods. Consider a two-year loan in which you only pay back the loan at the end of two years. Then, you would have to pay $1,000 (1 + 0.10)2, which is $1,210. What happens here is that at the end of one year, your new principal is $1,100 = $1,000 (1 + 0.10). The interest for the second year is calculated on this new principal. Table 1.1 summarizes the repayment if you make only one payment on the loan. As you can see, you pay more if interest is compounded. This is because in Period 2, interest is charged on both the original principal and on the Period 1 interest. Simple Interest Compound Interest

Principal Year 2 Payment

$1,000 $1,200

$1,000 $1,210

Table 1.1 Simple versus Compound Interest Therefore, compounding works against you if you pay off a loan only at the end. Compounding works in your favor, however, if you make intermediate payments. With simple interest, you would pay $600 at the end of Year 1 and $600 at the end of Year 2. With compound interest, the story is more complicated, and involves the concept of amortization. Suppose you pay C at the end of each year. The interest on P is rP, so the amount C - rP is applied toward reducing the principal. Therefore, your principal remaining after one payment is P1 = P - (C - rP). The second years interest is now calculated on P1 , and is rP1, which is less than rP. Here, you are paying less interest in the second year than you would with simple interest if C > rP. You may be asking, what is C? It is determined by applying the principle of discounting future cash flows. For the bank, P today must equal the present value of C in one year and C in two years:

For our example, P = $1000 and r = 0.10, so C = $576.19. You can see immediately that C is less than the $600 you would pay with simple interest. Let us check our calculations at the end of Period 1. At this point, we have a one-period loan with principal amount P1 = P - (C - rP) = $523.81. At the end of Period 2, C must cover this principal plus the interest on this principal (i.e. it must be the case that C = P1 (1 + r) = $523.81(1.01) = $576.19). The process of recalculating the principal every time you make a payment is called amortization. The Compounding Frequency With compound interest, you have to be careful to consider not only the quoted interest but also the compounding frequency. Interest is usually quoted on an annualized basis with the compounding frequency stated separately (e.g. daily, monthly, quarterly, semi-annually, or annually).

If the quoted interest rate is r, compounded n times a year, interest per period is computed using the rate r / n. Therefore, if you invested $1,000 for one year at 12% compounded monthly, at the end of the first month your investment would be worth $1,000 x (1 + 0.01). At the end of two months, it would be $1,000 x (1 + 0.01) 2 . At the end of the year, it would be worth $1,000 x (1 + 0.01)12 = $1,126.825. Table 1.2 shows the effect of the compounding frequency on your investment. Compounding Frequency Daily Weekly Monthly Semi-Annually Annually Value $1127.48 $1127.34 $1126.82 $1123.60 $1120.00

Table 1.2 Effect of Compounding Frequency As you can see, the greater the compounding frequency, the greater the final value, even though the quoted interest rate is the same. The moral of the story is: If you are investing money, then you want frequent compounding. If you are borrowing money, you want the frequency to be as small as possible. The General Form If interest is compounded t times per year, the investment lasts for n years, then in general, if P is the principal, then at the end of n years, the value is

In the limit, as t approaches infinity, the compounding interval approaches zero. This is called continuous compounding. This limit is:

where e is the transcendental number = 2.718... . A $1,000 investment continuously compounded at 12% leads to a value of $1,127.50 at the end of one year, which is only slightly greater than the value with daily compounding.

For most bonds, interest is calculated using compound interest, rather than continuously compounded interest. The Annuity Formula Many financial transactions involve a constant stream of payments over time. An ordinary annuity is a sequence of equal cash flows occurring regularly, say, every month or every year. Coupon payments from a bond and mortgage payments on a fixed-interest loan are examples of ordinary annuities. The present value of an annuity is given by the annuity formula. This formula says that if you receive C every period for t periods, and the interest rate is r, then the present value of the annuity, P, is

You can see the derivation of the annuity formula in the Appendix to this chapter. Ordinary annuity tables are often constructed for the case where C = $1. These tables present the numbers pre-computed for this case in a table of interest rates r, by life t. To value a t-period annuity in-advance, you add C and subtract one period from t in the ordinary annuity formula. To see why, consider the following example. In Pennsylvania, the major winner in a Lotto game receives the cash prize as an annuity in-advance. For marketing purposes, the prize is quoted in total nominal dollars (e.g., $21 million), but this prize is paid over 21 years. Quoting prizes in nominal dollars clearly sounds more favorable than quoting prizes in present dollars. Suppose you are lucky enough to win $21 million dollars paid at the rate of $1,000,000 per year starting from the present. What is the present value of this prize (before tax)? You can value your win by breaking the prize into two parts: $1,000,000 today and an ordinary annuity of $1,000,000 for 20 years. The present value of the first part is $1,000,000, because $1 today is worth $1. If the market rate of interest is 8.15%, then by applying the annuity formula, the present value of this ordinary annuity component is worth $9,709,515. Therefore, the present value of this annuity in-advance is the sum of the two parts, which equals $10,709,515. This is a lot less than the nominal dollar quote of $21,000,000, but you might argue that "If I won the lottery I wouldnt care about nominal versus present values!" After you work through The Lotto Case presented in the next topic, however, you may want to reevaluate this argument.

1.5 THE LOTTO CASE


The following story was reported by The Pittsburgh Press Wednesday, June 14, 1989. Willa T. shared in the Lotto jackpot on February 10, 1986. She won $454,389.63. At first she found winning thrilling, but at her age, she found that "the thrill wears off when the prize comes in 21 installments." Mrs. T. was entitled to receive $21,638.03, or $17,310.43 after federal withholding tax. After collecting four installments, Mrs. T. decided to sell her remaining 17 installments for an immediate payment of $111,000. Mrs. T. hired an attorney to sell the remaining installments. At a dinner party, the attorney ran into the financial consultant. The financial consultant was reported to have said that buying the annuity "fits right into my portfolio." How do you think each of the parties fared in this transaction? The answer to this depends upon how you would value Mrs. T.'s lotto annuity. We will now apply Bond Tutor to work through this example. First we make several simplifying assumptions: Taxes: For incremental cash income less than $30,000 per year, let the assumed tax rate be 20%. For incremental cash income greater than $100,000 let the tax rate be 35%. Market Information: At the time of this story, the yield to maturity on a long-term Government bond was 8.40%. Annuity Assumption: Remaining annuity is an ordinary annuity from the present time of June 14, 1989. Mrs. T.'s annuity of $21,638.03 for 17 years is virtually a riskless sequence of cash flows. The state of Pennsylvania has invested in a trust account an endowment to cover cash payments. As a result, in a perfect market, with no taxes, transaction costs, or liquidity problems, Mrs. T. would receive the present value discounted at 8.40 using interest rates in 1989. Online in the calculator below set up the problem as follows.

The annuity value of the remaining 17 payments, measured in both nominal and present values, declines over time as follows: Numerically this equals where the undiscounted value in period 1 equals $21,638.03*17=$367846.51. Online click on the Numeric button to see the undiscounted and discounted values per year. Thus, in a perfect market the present value is $192,216.20 when discounted at 8.40% compounded annually. Unfortunately, Mrs. T. faces several types of market imperfections: taxes, no organized market for Lotto payments, and legal fees. Ignoring legal fees, Mrs. T. received $111,000 from the financial analyst. Now suppose Mrs. T. pays 35% in tax. This leaves $72,150 -- and even less after legal fees. As a result, Mrs. T. has lost a lot due to market imperfections. With your acquired knowledge from Chapter 1 to date about the time value of money, can you improve on the reported result? The attorney was quoted as saying that he first contacted several financial institutions. These institutions were not interested because the prize was not large enough. However, by framing the question in terms of the bank's regular business, the following deal could potentially be struck. Deal I: A Simple Solution Mrs. T. takes out a standard 5-year personal loan for $62,400. In return, Mrs. T. assigns (recall that the courts approved the sale) the after-tax lotto revenues ($17,310.42) to the bank for 5 years. Structuring the settlement this way requires no additional cash outlay by Mrs. T. and lets Mrs. T. keep the lotto annuity for Years 6 - 17. She could repeat the transaction on February 10, 1994. At the time of the article, the personal loan rate was 12%. The bank is strictly better off with this loan because the cash flows are riskless, whereas personal loans are risky. As a result, a better-than 12% rate should be negotiated by Mrs. T.

If the bank booked a 6-year personal loan at 12%, then Mrs. T. could borrow $71,170.19 in the same way. This amount approximately equals her after-tax settlement, but once again, Mrs. T. can repeat the transaction on February, 10, 1995! In fact, Mrs. T. would have received $138,856.50 if the bank had booked a 17-year loan at 10%. The bank is strictly better off in this case because the repayments have zero default risk and at the time of the article, the 17-year Government bond rate was 8.40%. Mrs. T. is clearly better off she receives $138,856.50 now and faces no future liabilities. That is, her loan repayments are covered by assigning the after-tax Lotto receipts to the bank. In the solution reported by the newspaper, an arbitrage opportunity exists. That is, an opportunity exists for an investor with zero cash outlay to generate strictly positive cash flows. Deal II: Highlighting a Pure Arbitrage Opportunity Suppose some outside party had sufficient equity in his/her home or other real estate to take out either a first or second mortgage to cover the $111,000. At the reported settled amounts, a pure arbitrage opportunity exists by paying Mrs. T. $111,000 for the Lotto annuity. To see why, suppose the third party buys the Lotto annuity from Mrs. T. and finances this investment by borrowing the entire amount of $111,000 against some property. Assume that the mortgage loan is booked at a fixed rate equal to 10%. Online, we can work out the arbitrage opportunity. The first part of the problem is to compute the cash outflows from borrowing $111,000 over a ten-year period at 10%. To simplify the problem, assume that all cash payments are annual. Click on Amortization and Cash Flows as follows:

Online enter the above numbers and click on OK. Then click on the Numeric button and you will see for this mortgage loan the cash repayments as well as the part of these repayments that service the interest expense: You can open a spreadsheet and cut and paste these numbers from Bond Tutor in order to complete this analysis. First, online reset the calculator above as follows:

That is, enter the Lotto payments. Click on the Numeric button to get the Lotto unity payments and then click on the Copy button. Second, open your spreadsheet and paste in the raw Lotto numbers from above:

Online change the inputs to the calculator to the parameters for Deal II (funding from a equity in the home mortgage at the time of this case). Select Amortization and Cash Flows and then click on OK and Numeric as illustrated below.

Again from the popup grid containing the numbers for Constant Payment and Interest Expense. Click on Copy and then paste into cell D1 in the above spreadsheet.

Now the above cash flows can be matched to illustrate the arbitrage: First, the interest expense on the mortgage loan is tax deductible and serves to reduce the Lotto receipts. In the spreadsheet below the taxable lotto payments are in column G (Column B - Column F) and the cash tax expense equals the numbers in column H. This is illustrated below:

Finally we need to account for the cash Mortgage repayments which are in the above spreadsheet in Column E. Thus the after tax cash flows can be calculated as follows in Column I as Col B - Col E - Col H:

The pure arbitrage opportunity is revealed from the realized net positive cash flows in every year except Years 9 and 10 in Column G. The positive cash flows from earlier years easily eliminate these two negative years. This Lotto case illustrates that with zero cash outlay, a strictly positive return is earned. This is an arbitrage opportunity. Clearly, the arbitrage-free value of the Lotto winnings is significantly higher than what Mrs. T. received. In Chapter 2, we further develop the no-arbitrage arguments to the problem of valuing bonds.

Appendix 1A DERIVATION OF THE ANNUITY FORMULA


he present value of a constant cash flow, C, for t periods is:

Define the discount factor:

Substituting a into the formula, we get

To simplify the present value formula, we need to simplify the expression in the brackets:

To simplify this formula, we first add at+1,at+2, and so on, and then subtract all the terms we added:

We can rewrite this as:

Note that the infinite number of terms in each of the brackets is the same. Define:

+ Now, observe that V = 1 + aV, which means that

Therefore, the expression

Now, replace a with the discount factor 1/(1 + r) and simplify to get:

We can now simplify the present value formula as follows:

Replacing the expression in square brackets with what we derived, we get:

which is the annuity formula. Given the interest rate, r, this formula can be used to compute the present value of the future cash flows. Given the present value, it can be used to compute the interest rate or yield. Finally, given the present value and the interest rate, it can be used to determine the cash flow. You can use the formula in different ways as you go through Bond Tutor. The topic Time Value of Money in this chapter lets you calculate the present value of each cash flow for an annuity and also lets you see the annuity value through time. In The Term Structure of Interest Rates topic, you can see how the present value is affected by the interest rate and also calculate the interest rate given the present value.

http://www.bondtutor.com/btchp1/topic7/topic7.htm

CHAPTER 2: Bond Prices and Interest Rates

2.1 Introduction any of the principles for valuing fixed-income securities depend on arbitrage arguments. For there to be no arbitrage, it must be the case that no investor can receive a positive (risk-free) return without investing any money. In this chapter, we will identify the arbitrage-free value of bonds. The argument is first developed in Topic 2.2, ArbitrageFree Prices: Single-Period Cases. In Topic 2.3, this is extended to Arbitrage-Free Prices: Multi-Period Case. Generally, when fixed-income securities are traded in the marketplace, the buyer pays the price in cash and receives a legal claim to the future cash flows from the security. However, it is possible to trade fixed-income securities where this is not the case. That is, no cash is exchanged at the time of the trade. In this type of trade, a forward contract is entered into where both parties are obligated to settle at some time in the future for a price agreed upon now. Therefore, in the case of forward contracts, investors are concerned not only with the arbitrage-free value of securities today, but also with the arbitrage-free value of the position at some time in the future. In Topic 2.4, Future Value, we consider develop this concept further. 2.2 Bond Prices: Single-Period Case he present value of a bond can be derived, given interest rates, by applying the principle of discounting and assuming that no arbitrage opportunity exists. We argue here that this value must equal the price of the bond. Otherwise, there is an arbitrage opportunity. Let us apply these arguments first to a zero-coupon, or pure-discount, bond. Suppose the bond pays its face value, F, in one period's time. Let the bond's price equal P and suppose that r is the one-period interest rate at which investors can borrow or lend in the market. If there is no arbitrage, then the price of the bond must satisfy: P(1+r) = F or

To see why, suppose P(1 + r) < C. Now you should borrow P at interest rate r and buy the bond. In the next period, you will owe P(1 + r) but will get F > P(1 + r) and will have made a pure arbitrage profit. Therefore, at least P(1 + r) > F. However, if P(1 + r) > F, you should sell the bond and invest the proceeds at interest rate r. In the next period, you will owe F but your investment will be worth P(1 + r) > F. This implies P(1 + r) < F. Taken together,

Example 1: Determining the Arbitrage-Free Price of a Bond If the face value of a zero-coupon bond equals $100, and the interest rate is 5%, then the arbitrage-free price of the bond is:

Alternatively, suppose you observe that the price of a one-period bond is P. Now, you can use the formula to determine the interest rate implicit in the price. This interest rate is the return (or yield) you would get if you bought the bond today at price P and held it to maturity. In one period, the price of the bond must equal its face value, F. To determine your return, you have to ask: At what interest rate would I have to invest P in order to get F in one period ? The answer is the number y, such that P(1 + y) = F. If you rearrange this, the yield is

which simplifies to

Of course, because the one-period borrowing and lending rate is r, the yield must equal r, otherwise there is an arbitrage opportunity. If the yield is y > r, then this can immediately be exploited by borrowing at r and buying the discount bond. If y < r, you should sell the discount bond and lend the proceeds at rate r. Example II: Determining the Arbitrage-Free Price of a Bond If the face value of a bond equals $100 and the price is $95.24, then the yield from this investment is approximately (rounding to two decimal places):

In both of the above examples, it is straightforward to construct the arbitrage-free, pure discount bond price given the one-year interest rate, r. The next topic, Arbitrage-Free Prices: Multi-Period Case, extends the above analysis.
2.3 Bond Prices: Multi-Period Case

he cash flows from most fixed-income securities extend beyond one period. The valuation of these cash flows uses two principles: that of discounting and that of value additivity. Value additivity says that you can simply add up the different discounted cash flows. The discounting principles you have learned say that you must be careful to add together only present values at the same time. With these principles in mind, it is easy to move to multiple periods and to multiple cash flows. One complication that arises is that different interest rates may be used to discount cash flows at different periods. For example, you may be willing to lend money for one year at 7%, but may require a higher interest rate, say, 8% per year, to lend money for two years. The extra return would compensate you for not being able to use the money for that extra year. The interest rate used to discount cash flows in period t, rt , is called the spot interest rate for t periods. We will quote interest rates relative to one period (which is generally one year). That is, rt per period means that interest accrues (or is paid) at the rate of rt% per period for t periods. For example, consider a zero-coupon bond that pays its face value, F, in two years. You can value this bond given the two-year spot interest rate. The arbitrage-free price of this pure discount bond is the present value of the face amount F discounted at the two-year spot interest rate.

Example: Present Value using Spot Rates of Interest The present value of $100 at the end of two years when two-year spot interest rates are 6% per year is:

As you can see, the only differences between a cash flow in one period and a cash flow in two periods are (1) we use the two-period interest rate, and (2) we discount the cash flows "twice." If the cash flow occurs in t periods, we use the t-period spot interest rate and discount the cash flow for t periods. With many periods, however, you can also receive intermediate payments. For example, a coupon bond makes a payment every period in addition to the face value, which is paid at maturity.

These more complex cash flows can also be valued using what you have learned in Chapter 1. First, you know how to discount each cash flow. Second, you know that you can add up the discounted cash flows, as in the derivation of the derivation of the annuity formula (see appendix A, in chapter 1). For example, consider the timeline in Figure 2.1 for a newly issued 30-year Treasury bond with a face value of $10,000 and a coupon rate equal to 10% compounded semiannually. Figure 2.1 30-Year Coupon Bond

Here, we know the present value of each cash flow. Value additivity says that the value of the bond must equal the sum of all the present values, so we also know the value of the bond. There is another way to see why value additivity must hold, and this comes from arbitrage. The cash flows from the 30-year Treasury bond are exactly the same as a portfolio of 59 zero-coupon bonds with face values equal to $500 plus one zero-coupon bond with a face value equal to $10,500. The first zero-coupon bond has maturity equal to 6 months, the second 12 months, and so on. Since it is possible to reconstruct the Treasury bond from the zero-coupon bonds, the value of the Treasury bond must equal the value of the collection (or portfolio) of zerocoupon bonds. If the Treasury bond had a higher price, you would sell it and buy all the necessary zero-coupon bonds, giving you a pure arbitrage profit. You can calculate the value of this bond using the procedure in Chapter 1, in the Time Value of Money topic 1.2. You should be able to verify that if the interest rate is 7%, the value of the bond is $13,741.71. Example: Coupon Bond Suppose you want to value a 10-year U.S. Treasury bond with a face value of $10,000 and a coupon rate equal to 6% payable semiannually. The bond is issued today. With a face value of $10,000 and a coupon rate equal to 6% per year, the bond will pay $300 ( = 10,000 x 0.06 x 1/2 ) every six months for ten years and then pay the face value of $10,000 at the end of ten years. The cash flows are shown in the time-line in Figure 2.2.

Figure 2.2 10-Year Coupon Bond

In other words, the holder of this bond receives 20 separate cash payments of $300 each and one cash payment of $10,000 over the ten years. The arbitrage-free price of each coupon payment (denoted by C = $300 for the tth coupon payment) is:

The arbitrage-free price of the face value is:

Value additivity (or lack of arbitrage) then says that the price of this bond is:

in the above each rt is the six-month interest rate. The stream of coupon payments makes up an ordinary annuity, so the value of the bond equals the value of an ordinary annuity plus the present value of the face value. However, you cannot apply the annuity formula directly because it assumes that all the spot interest rates are the same. In Chapter 3, (see Overview (Topic 3.1)), you will see how to value bonds when interest rates for maturities differ. For now, if we make the simplifying assumption that all interest rates are constant, we can apply the annuity formula. You can use the software in Bond Tutor to calculate the value of any annuity. Example: Present Value of a Coupon Bond Assume for the bond in Figure 2.2 that each spot interest rate is 6%. What is the value of this coupon bond?

To compute this value you calculate the present value of the coupon payments and add to this number the present value of the bonds face value. The coupon payments form an ordinary annuity. Using Bond Tutor, you can calculate that the present value of $1 for ten periods at 6% compounded twice per period is 14.8775:

The present value of all future coupon payments for this bond (to the nearest dollar) is then: $4,463 = $300 x 14.8775 The present value of $1 at the end of 20 periods at 3% per period is $0.5537, which is computed as follows:

Thus, the present value of the face amount is: $5,537 = $10,000 x 0.5537 As a result, the value of the bond is $10,000. Note that this equals the face value. If a bonds price equals its face value, it is said to be trading "at par." Otherwise, it may trade at a "discount from par" or at a "premium to par." What happens if the market interest rate falls below or rises above 6%? In the Bond Tutor subject two titled, Bond Values and Interest Rates, you can see what happens in each of these cases. For example, suppose we want to see how the value of the bond is altered when exposed to a range of interest rates from 1% to 10%, with a step size of 1%. In the interactive calculator below, enter the following values:

You want to look at a sensitivity analysis in step sizes of 1% (i.e., 10 steps between 1% to 10%). The exposure profile is the following: Click on numeric button and verify the following bond values:

You can see that the bond value declines as interest rates increase. When the interest rate equals the coupon rate, the value equals the face amount of $10,000. You can also see the principle of value additivity at work, by selecting to plot Cash Flows

and viewing the components both numerically and graphically. For example, for the first ten coupon payments, the present value of each component is:

To see the relative weighting of coupon versus face value, click on the Composition button to view Period 0 (i.e., present time) :

The display appears as follows: The numbers supporting the above graph for Time 0 are:

That is, the present value of the face value is $5,536.76 and the present value of the future coupon payments is $4,463.24. The valuation principles developed thus far apply to any point in time. In the next topic, we calculate the future value of a fixed-income security.

2.4 Future Value

any cases, investors are concerned not only with the value of securities today but also with the value of a position at some time in the future. For example, you may want to know: If I invest $1,000 today at 7% for five years (compounded annually), what will my investment be worth after five years? This is the future value of your investment. The future value of an investment also provides important "risk management" information. It lets you answer "what if" questions such as: What will be the value of my investment six months from now if spot interest rates increase? To calculate future values, we continue with the assumption that all spot interest rates are equal. In Chapter 3, you will see how to perform similar calculations with different spot rates for each maturity. Calculating a future value requires us to replace "discounting" with "compounding." That is, instead of discounting future values to the present, we compound present values to the future. If P0 is the arbitrage-free price relative to the current set of spot interest rates, r, then the future value at time t is:

Computation of this future value actually requires some cash flows to be discounted and some to be compounded, but all aspects are always measured at a common time. To see this, consider Figure 2.3, where we want to determine the value of the bond at the end of Year 1. Figure 2.3 Computation of a Future Value

If you want to compute the future value of the coupon bond as of the end of Year 1, you must first compute the future value of the coupon payment at the end of six months, add this to the coupon value as of the end of Year 1, and then add the present value of each of the subsequent coupon payments and the face value. Of course, you neither discount nor compound cash flows occurring at the end of Year 1.

As a result, in Figure 2.3 the future value at the end of Year 1 equals the sum of: 1. The future value of the $300 paid at the end of six months. 2. The $300 paid at the end of Year 1. 3. The present value of an ordinary annuity of $300 per period for 18 six-month periods. 4. The present value of the $10,000 face value paid at the end of Year 10 (18 periods from the end of Year 1). If the interest rate is 8% per year compounded semiannually, then you can verify that the future value at the end of Year 1 for this ten-year bond is: $9,349.70 = ($300 x 1.04) + $300 + ($300 x 12.659) + (0.494 x $10,000) You can use Bond Tutor to verify these figures and step through time using the interactive calculator below. You can enter the current problem by changing the Interest Rate to 8% and scrolling the View Period to 2, as follows:

In this form, we have first chosen to consume (i.e., not to reinvest) the realized coupon payments. Equivalently, this is consistent with the perspective of investors in the market at the end of Period 2 (immediately prior to the realization of the current coupon payment). These investors are trading claims to current and future cash flows only. Online, selecting Composition lets you choose the period you want to view. For the current example, this is one year's time (i.e., View Period 2). Your display screen appears as follows: At this point in time, the face value makes up 54.6% of the bonds value. Numerically, these figures are:

Alternatively, you can repeat the exercise assuming that realized coupon payments are reinvested at the market interest rate. To do this, click on the option Reinvest Coupons in the above interactive calculator.

Numerically, this is:

By scrolling the view period, you can take a journey through bond value time. For example, scroll to after 16 periods, above

and verify that the bond value with reinvestment breaks down as follows:

In Chapter 3, The Term Structure of Interest Rates, you will learn how to value fixedincome securities for the case that relaxes the assumption of a constant market interest rate over different time to maturities.

WEITERMACHEN chapter 3 - 5

You might also like