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THE TIME VALUE OF MONEY, r: periodic rate
m: the number of periods in N…
THE TIME VALUE OF MONEY
INTEREST
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DEFINITION
Opportunity cost: the cost of taking one specific option compared to other ones (most popular one is putting money into saving account)
Required rate of return: the minimum rate of return that an investor expects when making investment decision
Required rate of return = Nominal risk free rate + Default risk premium + Liquidity risk premium + Maturity risk premium
Liquidity risk premium: the risk related to the time/possibility it took for an investor to exchange an asset into cash
The less liquidity, the higher risk
Maturity risk premium: the risk related to the maturity of an investment
The longer the maturity, the higher risk
Default risk premium: the risk when borrowers go into bankruptcy
The higher default possibility, the higher risk
Nominal risk free rate = real risk free rate + expected inflation
Investors usually see US treasury bonds interest as real risk free rate
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PV & FV
Annuity
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Ordinary annuity: first PMT is in one period
FVordinary = PMT**[(1+r)^m - 1] / r
PVordinary = PMT**[1 - (1+r)^(-m)] / r
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