07. Time value of money

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Understanding Time Value of Money (TVM)

The concept of Time Value of Money (TVM) explains why money today is more valuable than the same sum in the future, due to interest earnings.

  • Immediate Payment Advantage

    • Paying $2 today allows the recipient to earn three months of interest.
    • Delaying payment means losing out on potential interest earnings.

  • Example Scenario

    • A $2 payment due in three months has a present value less than $2 today.
    • Calculation with a 5% annual interest rate and continuous compounding results in this amount being worth only $1.975 now.

  • Discount Factor & Fair Price

    • The fair price of a financial instrument today is determined by discounting its future payout.
    • The discount factor is calculated as the exponential of negative interest rate times time.

  • Application to Financial Instruments

    • This same discount principle applies when calculating the fair price of European options.

Further exploration of this topic will be covered in upcoming content.

A British company has issued a bond that pays its holder 1 GBP in 2 years. Assume the risk-free and continuously compounded interest rate is 5% and will remain at this rate in the next 2 years. Also assume the company is in a good shape and won't default. The bond is being sold at 0.95 GBP. What would you say about the current bond price as a potential investor?
SOLUTION: unfair and too expensive

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