The principle of time value of money - the notion that a given sum of money is more valuable the sooner it is received, due to its capacity to earn interest - is the foundation for numerous applications in investment finance.

Central to the time value principle is the concept of interest rates. A borrower who receives money today for consumption must pay back the principal plus an interest rate that compensates the lender. Interest rates are set in the marketplace and allow for equivalent relationships to be determined by forces of supply and demand. In other words, in an environment where the market-determined rate is 10%, we would say that borrowing (or lending) $1,000 today is equivalent to paying back (or receiving) $1,100 a year from now. Here it is stated another way: enough borrowers are out there who demand $1,000 today and are willing to pay back $1,100 in a year, and enough investors are out there willing to supply $1,000 now and who will require $1,100 in a year, so that market equivalence on rates is reached.

Exam Tips and Tricks
The CFA exam question authors frequently test knowledge of FV, PV and annuity cash flow streams within questions on mortgage loans or planning for college tuition or retirement savings. Problems with uneven cash flows will eliminate the use of the annuity factor formula, and require that the present value of each cash flow be calculated individually, and the resulting values added together.


The Five Components Of Interest Rates

Related Articles
  1. Markets

    Calculating the Present Value of an Annuity

    The present value of an annuity is the current, lump sum value of periodic future payments as calculated using a specific rate.
  2. Markets

    Forces Behind Interest Rates

    Get a deeper understanding of the importance of interest rates and what makes them change.
  3. Markets

    What are Cash Equivalents?

    Cash equivalents are money market instruments.
  4. Markets

    How Does Money Supply Affect Interest Rates?

    A larger money supply lowers market interest rates, while a smaller supply tends to raise them.
  5. Trading

    Guide To Excel For Finance: PV And FV Functions

    The Present Value or "PV Function" in Excel helps the user determine the current value of a financial asset. For instance, analysts can value a stock by forecasting its future profits, or cash ...
  6. Investing

    Understanding The Time Value Of Money

    Find out why time really is money by learning to calculate present and future value.
  7. Markets

    Calculating Future Value

    Future value is the value of an asset or cash at a specified date in the future that is equivalent in value to a specified sum today.
  8. Markets

    Macroeconomics: Money And Banking

    By Stephen Simpson TMoney can be thought of as any good that is widely used or accepted in the transfer of goods and services. Today, there are three common forms of money in use. Commodity ...
  9. Investing

    Calculating Net Present Value at Different Points Using Excel

    Calculating the net present value (NPV) of your investment projects using Excel.
  10. Retirement

    Immediate Annuities: Guaranteed Payout At A Price?

    This vehicle can have very low, or even negative, rates. Find out when it pays to invest.
Trading Center