FINANCIAL MARKET – MIDTERMS – TIME VALUE OF MONEY

CONCEPT OF TIME VALUE OF MONEY

 Time value of money denotes the value d money over time. This means that money changes its
value over time. P1 today no longer be P1 after a year.
 Time value of money is central to the concept of finance.
 Inflation is an economic disorder characterized by continuous increase in the price level of goods
and services without the corresponding increase in the production of these goods and services.
- Inflation erosion of purchasing power of currency associated with investment.
 The concept of the value of money is based on the notion that peso received today is worth more
than a peso received in the future.
INTEREST RATES AND THEIR ROLE IN FINANCE
 Interest rate denotes percentage earning or yield on investment.
 It is the cost of using money expressed as a percentage of the principle for a given period of time
which is usually per year.
TERM STRUCTURE OF INTEREST RATE - (reflect in the financial instrument and give advice to
investors to what is the right financial instrument to sell in the market)
 UPWARD SLOPING – it happens when the long-term securities interest rate is higher than interest
rate of short-term securities. The company expects expansion. Possible boom period of economy or
the economy is good. Good to invest. Normal curve yield.
 DOWNWARD SLOPING – the interest rate of short-term securities is higher than the interest rate
of long-term securities. Inverted yield curve. The economy is experiencing recession. Beware in
handling financial instrument.
 FLAT – market uncertainty. Flat curve yield.
TYPES OF INTEREST
Real Interest Rate - Named because it state the "real" rate that the lender or investor receives, or a
borrower pays after considering inflation. Interest rate that is adjusted for expected changes in the
price level to accurately reflect the true cost of borrowing. Provide interest in financial instrument when
we get the inflation rate premium.
Fixed Interest Rate - Interest rate that you will be charged over the term of your loan will not change,
no matter how high or low the market my drive the interest rate. Constant regardless the state of the
economy.
Variable Interest Rate - Also called floating rate. Interest you are charged changes as whatever index
your loans is based on changes. The index can be the rate on t-bills, the prime lending rates of banks,
or the LIBOR. London Interbank Offer Trade – benchmark of all country since the Europe country,
the exchange currency is high.
INTEREST RATE THEORIES
1. Classical theory:
✓ Oldest theories concerning the determination of the pure or risk-free Interest rate developed during
the eighteenth and nineteenth centuries by a number of British economists, refined an Australian
economist Bahra Bawerk, and elaborated by Irving Fisher early in the 20th century.
 This theory posits that the rate of interest is determined by o factors: 1. supply of saving, 2 demand
for capital investment.
 Saving generally carried on by individuals and families households) and for these households, they
are simply abstinence from consumption spending.
✓ Consumption spending means spending for both durable and non-durable goods and services.
2. Loan Funds Theory
✓ Used for forecasting interest rate.
✓ This theory is based on the premise that the interest rate is the price paid for the right to borrow or
use loanable funds.
 Borrower and lender and meet as a price taker. Price taker – accepts the market price of a
particular country.
3. Liquidity Preference Theory
 In 1930, John Maynard Keynes introduced the concept of money demand and used the term
"Liquidity preference" for demand.
 This theory stipulates that the interest rate us determined in the money market by the money
demand and money supply.
 Interest rate is the point where the money demand is equal to money supply
4. Rational Expectation Theory
 theory came out in the advent of the information age.
 Based on the precise that the financial markets are highly efficient.
 institution in digesting new information affecting interest rate and security prices.
 We came up with interest rate because the past outcome affects/influence the future outcome. And
because of knowledge and information of past outcome.
Determinants of interest rates
 Inflation expectation – anticipate of the rate of the market.
 Monetary policy – actions taken by central bank to monitor the money supply.
 Business cycle – construction and expansion of economic aggregate because of boom period or
recession.
 Government budget deficits – when the expenses of the government exceeds the government
income.

Simple and Compound interest

Interest, in financial parlance, is the money paid for the use of money lent. Interest is measured by a
certain percentage commonly known as interest rate. With interest, the value of money after some
period of time grows.
Two basic type of interest measurement
1. Simple interest
2. Compound interest
Simple Interest
Interest=Principal × Rate × Time
Interest
Principal = P=
rate x time
Interest
Rate = R¿
principal x time
Interest
Time = T¿
principal x rate
P=PRINCIPAL
R-INTEREST RATE
T-TIME PERIOD MONEY IS BORROWED/INVESTED

Nominal and Effectives rates

A nominal rate is rate of interest that is compounded more often than once a year such as semi-
annually, quarterly or monthly.
An effective rate is that rate when compounded annually, produce the same compound amount each
year as the nominal rate (compounded (m) times a year.
Nominal Rate Effective Rate

j = is the nominal interest rate

u = is the effective interest rate
m = is the number of compounding periods per year

Varying interest rate

When the interest rate of an investment changes during its term then is called investment with varying
interest rate.
SAMPLE QUESTIONS/PRACTICES:

SIMPLE INTEREST

NOMINAL AND EFFECTIVE RATE

SAMPLE:
1. What is the effective interest rate equivalent to 8% compounded quarterly?
2. A nominal rate is compounded monthly and is equivalent to an effective rate of 7.5% Find the
nominal rate.
3. A bank offers a nominal interest rate of 10% compounded semi-annually. What is the corresponding
effective annual rate?
4. If an investment has an effective rate of 5.2% per year, what is the nominal rate compounded
quarterly?
5. What is the nominal interest rate compounded semi-annually that is equivalent to an effective rate
of 12%?
VARYING INTEREST RATE
Ex:
1. A principal of P 40,000.00 is invested for 18 years under the following conditions:
o First 6 years: 9% compounded semi-annually
o Next 6 years: 8% compounded quarterly
o Last 6 years: 7% compounded monthly
Find the maturity value.
2. P 60,000.00 is invested for 25 years under different compounding rates:
o First 10 years: 5% compounded quarterly
o Next 8 years: 6% compounded semi-annually
o Final 7 years: 7% compounded annually
Determine the final amount.
3. A person invests P 35,000.00 for 12 years with the following interest rates:
o First 4 years: 10% compounded semi-annually
o Next 4 years: 9% compounded quarterly
o Last 4 years: 8% compounded monthly
How much will be in the account at the end of 12 years?
4. Find the compound amount of P 55,000.00 invested for 15 years under these conditions:
o First 5 years: 6% compounded monthly
o Next 5 years: 7% compounded quarterly
o Last 5 years: 8% compounded annually
5. P 45,000.00 is invested for 22 years in a bank under the following interest schemes:
o First 8 years: 4.5% compounded quarterly
o Next 7 years: 5.5% compounded semi-annually
o Final 7 years: 6.5% compounded annually
Find the maturity value.