IA Time Value of Money

Sidney Homer,

author of A History of Interest Rates, wrote,

“$1,000 invested at a mere 8 percent for 400 years would grow to $23 quadrillion—$5 million for every human on earth. But the first 100 years are the hardest.”

This startling quote highlights the power of time and compounding interest on money.

The Interest rate

“the price, or cost, of debt capital”

Factors affect the cost of money?

1. Production opportunities
2. Time preferences for consumption
3. Risk
4. Expected inflation

Calculating Interest Rates

• r*= Real risk-free rate.
• r = Any nominal rate.
• r = r* + IP + DRP + LP + MRP

Here:

• r = Required rate of return on a debt security.
• r* = Real risk-free rate.
• IP = Inflation premium.
• DRP = Default risk premium.
• LP = Liquidity premium.
• MRP = Maturity risk premium.