Money Market Instruments

Corporations and government organizations are continually buying and lending money. Often, they borrow money by issuing bonds, but in many cases, they will raise money through money market instruments (aka cash equivalents), which consists of shortterm, very low risk securities. The money market is the market for buying and selling short-term loans and securities. The buyer of the money market instrument is the lender of money and the seller is the borrower of money. Capital markets are the other part of the financial markets, which consists of longer term or riskier securities, such as stocks, bonds, currencies, and derivatives. While money market instruments are diverse, they have several features in common. All have terms of less than 1 year, with most less than 6 months. Many money market instruments have terms of 270 days or less, because any instruments with longer maturities would have to be registered with the SEC under the 1933 Act. They are very low risk securities, and, because of their short terms, they are usually issued at a discount interest is paid when the holder of the money market instrument is paid par at maturity. Because money market instruments are discounted, their yield is quoted using the bond equivalent yield, which is the yield that is equivalent to the discount, and allows an investor to easily compare yields among different instruments and securities.

Bond Equivalent Yield (BEY)

Sometimes the yields listed for short-term discount instruments have simply been annualized without compounding the interest. This simplifies the math and can be calculated using a calculator that doesn't have a root or exponential function. This uncompounded annual interest rate is simply called the annual interest rate to distinguish it from the effective annual yield, but, most often, it is called the bond equivalent yield (BEY) (aka investment rate yield, equivalent coupon yield). The simplified formula appears below: BEY = Interest Rate per Term x Number of Terms per Year Below is the formula relating BEY to the face value, price paid for the instrument, and days left to maturity: Formula for Calculating Bond Equivalent Yield (BEY) Interest Rate Per Term Number of Terms per Year Face Value - Price Paid Actual Number of Days in Year BEY = x Price Paid Days Till Maturity Note that this yield is not compounded, but is the simple interest rate annualized. However, if you only have the simple interest rate of a discount instrument, then this rate can be converted directly to any compounded rate of interest by using the formula for the

present and future value of a dollar. (See Calculating the Interest Rate of a Discounted Financial Instrument for more info.)
Example Calculating the Bond Equivalent Yield of a T-Bill

If you buy a 4-week T-bill with a face value of $1,000 for $996.50, what is the bond equivalent yield, assuming it is not a leap year? ($1,000-$996.50)/$996.50 x 365/28 = 4.58% (rounded)
ExampleFormula for Finding the Annualized Effective Compounded Rate of Interest for a Discounted Note

To find the compounded rate of interest for a discounted money market instrument: 1. Divide the par value by the discounted price. 2. Raise the result by the number of terms in 1 year, then subtract 1. So if you bought a 4-week T-bill for $996.50 and receive $1,000 4 weeks later, what is the effective annual compounded interest rate earned? Solution: 1. $1,000/$996.50 = 1.0035 (rounded) Since there are 13 4-week periods in a year, this T-bill rate compounded 13 times would equal: 2. (1.0035)13 - 1 = 1.046 - 1 = 4.6% (rounded) (See how the future value of a dollar is calculated to understand the reasoning better.) You can use this formula for calculating the yields of any money market instrument sold at a discount.

U.S. Treasury Bills (aka T-bills)

Treasury bills are issued by the federal government and have terms of 28, 91, or 182 days, and are virtually free of credit risk. They are the most actively traded money market securities with very low bid/ask spreads due to their liquidity, and they are also except from state or municipal taxes. Retail investors can buy T-bills directly from the Treasury at http://treasurydirect.gov/.

Federal Funds
The Federal Reserve requires each bank of the Federal Reserve System to maintain a minimum amount of money on deposit at a Federal Reserve bank to insure that the bank has enough reserves to meet customer obligations. Federal funds (aka Fed funds) is the money that banks deposit at the Federal Reserve bank to maintain the amount of deposits required. However, some banks, especially in the large financial centers of major cities like New York, Chicago, and San Francisco, have greater loan requirements than most other banks, and often do not have enough to maintain their reserve requirements. So these banks borrow from other banks that have an excess amount of money over the requirement. Banks will lend their excess reserves to other banks, or borrow $1 million and up, if they are short, paying the federal funds rate of interest, usually for 1 day, since most of these loans are overnight loans. Some banks that are always short on money may borrow for longer termsfrom 1 week to 6 months or, in rare cases, longerfrom banks that usually have excess reserves. These longer term Fed funds are called term Fed funds. The federal funds rate is extremely volatile, and is regulated by the Federal Reserve to some extent as a means to control the supply and demand of money.

The London Interbank Offered Rate (LIBOR) Market

Similar to the Fed funds rate is the LIBOR rate, which is the interbank lending rate that banks charge to each other. Many financial instruments and contracts are based on the LIBOR rate.

Repurchase Agreements (aka Repos, Sale-Repurchase Agreements)

Repurchase agreements (aka repos) are contracts that are sold, often for 1 day or a few days, with a minimum denomination of $1,000,000, with the stipulation that they will be repurchased for a price that is higher by the amount of the interest, called the repo rate. Government security dealers typically use repos to finance the purchase of government debt, especially Treasuries. For instance, if a government bond dealer wanted to buy $1 billion worth of Treasuries, he may submit a winning bid for that amount, but pay only $300,000,000 and finance the rest by promising the U.S. Treasury that he will pay for the rest later, after he has customer orders for the rest of the purchase, usually by the next day (an overnight repo). The Treasury will charge daily interest on all issues bid, but not yet paid for. If the bond dealer can sell the Treasuries for more money than he paid, then the dealer makes a profit; if he sells the Treasuries for less, then the dealer will suffer a loss. In a reverse repo, the dealer buys the securities with the stipulation that the dealer can sell them back for a higher pricethe additional interest. The dealer is, in effect, lending the seller money and keeping the securities as collateral. Term repos have longer maturities of a week to a few months. The market for term repos is larger than the market for overnight repos.

Sometimes a dealer will have an open repo contract with a lender to provide funds on a continuing basis, and that allows the dealer the right of substitutionto substitute securities of equal or greater value for the loans. Either party may cancel the contract at any time. Repos are considered safer than Fed funds because they are collateralized, so the repo rate ranges from 10 to 200 basis points below the Fed funds rate. Because repurchase agreements are private agreements between 2 parties, there is no secondary market for repos, especially considering their very short terms of 1 or more days.

Bankers' Acceptance
A banker's acceptance is a commercial bank draft requiring the bank to pay the holder of the instrument a specified amount on a specified date, which is typically 90 days from the date of issue, but can range from 1 to 180 days. The banker's acceptance is issued at a discount, and paid in full when it becomes duethe difference between the value at maturity and the value when issued is the interest. If the banker's acceptance is presented for payment before the due date, then the amount paid is less by the amount of the interest that would have been earned if held to maturity. A banker's acceptance is used for international trade as means of verifying payment. For instance, if an importer wants to import a product from a foreign country, he will often get a letter of credit from his bank and send it to the exporter. The letter of credit is a document issued by a bank that guarantees the payment of the importer's draft for a specified amount and time. Thus, the exporter can rely on the bank's credit rather than the importer's. The exporter presents the shipping documents and the letter of credit to his domestic bank, which pays for the letter of credit at a discount, because the exporter's bank won't receive the money from the importer's bank until later. The domestic bank then sends a time draft to the importer's bank, which then stamps it "accepted" and, thus, converting the time draft into a banker's acceptance. This negotiable instrument is backed by the importer's promise to pay, the imported goods, and the bank's guarantee of payment.

Commercial Paper
Creditworthy corporations can borrow from banks for the prime rate of interest, but they may be able to borrow at a lower rate by selling commercial paper to institutional investors and the publicusually banks, pension funds, and other corporations. Commercial paper are unsecured promissory notes for a specified amount to be paid at a specified date, and are issued by corporations with excellent credit instead of borrowing money from a bank. They are issued at a discount, with minimum denominations of $100,000. The main purchasers are other corporations, insurance companies, commercial

banks, and mutual funds. Terms range from 1 to 270 days. Commercial paper is the least traded money market instrument in the secondary market. Finance companies sell 2/3 of the total commercial paper, and sell their issues directly to the public. But corporations that borrow less frequently sell their commercial paper called industrial paperto paper dealers, who then sell them at a markup to other investors. A round lot for a paper dealer is $250,000.

Negotiable Certificates of Deposit

Before 1986, the Federal Reserve Board restricted the amount of interest that banks could pay for savings or other time deposits. Often, corporations would have money available for lending, but banks couldn't compete for this money because of the interest rate restriction. Negotiable CDs were a means around the restrictions. Negotiable certificates of deposit (aka jumbo certificates of deposits, jumbo CDs) are tradable certificates issued by commercial banks as unsecured time deposits. Terms range from a minimum of 14 days to 1 year or more. Most have terms of 1 to 3 months, but some can have maturities of 3 to 5 years, or longer. They have a minimum denomination of $100,000, but usually are issued in denominations of $1,000,000 or more. Most CDs have a fixed rate of interest, although there are some that pay a variable rate of interest. CDs are actively traded in the secondary market in round lots of $5,000,000.

Broker's Loans and Call Loans

Broker's loans are loans from commercial banks to brokers so that the broker's customers can finance stock purchases. The broker uses the stocks, held in street name, for collateral for the loans. Time notes are loans that must be paid by a specific date for a specified interest rate, with terms of 6 months or less. A demand note (aka call loan) is a loan that is payable on demand the next day at 1 day's interest. If the note is not demanded, then the term is extended by another day, and so on, up to 90 days. The interest rate for each day varies with the prevailing interest rate.

Eurodollars, Eurocurrency
Eurodollars usually refers to U.S. dollars deposited in banks outside of the United States. Eurocurrency is a more general term that can refer to any currency that is deposited in banks whose domestic currency is different from the deposited currency, and it can involve any country, including the Far East and the Cayman Islands. Eurodollars or Eurocurrency does not necessarily involve either Europe or the Euro. Multi-national corporations deposit their domestic currency in foreign banks because they can often get better terms trading their currency with the locals than by exchanging domestic currency for foreign currency at a bank. The interest paid on these deposits is usually equal to the

London Interbank Offer Rate (LIBOR), which is slightly higher than the yield for 3month Treasuries. This is a sample of key money rates that were published in the Wall Street Journal on April 20, 2007. Note that because many of these rates are negotiated between private parties, and the rates fluctuate throughout the day, these rates are mostly averages that do not necessarily reflect individual transactions. Note also how the yields of the various money market instruments compare with the key interest rates.

onds - Table of Contents

Bond Fundamentals
Interest Rates The Present Value and Future Value of Money The Present Value and Future Value of an Annuity Bonds - An Introduction Bond Indentures Bond Yields Bond Pricing Bond Risks Bond Ratings and Credit Risk Volatility of Bond Prices in the Secondary Market Primary Bond Market Term Structure of Interest Rates Interest Rate Risk Duration and Convexity Bond Income Taxation

Types of Bonds
International Bonds Convertible Bonds Preferred Stock Fixed Rate Capital Securities (FRCS)

Money Market Instruments

Money Market Instruments Current Document Certificates of Deposit Commercial Paper Repurchase Agreements (Repos) Federal Funds Bankers Acceptances Medium-Term Notes

Government Securities
Municipal Bonds United States Savings Bonds Treasury Securities: Bills, Notes, Bonds, TIPS, and STRIPS Primary and Secondary Markets for Treasury Securities United States Treasury Auctions

Corporate Bonds
Corporate Bonds - An Introduction Corporate Bond Types: Mortgage Bonds, Collateral Trust Bonds, Equipment Trust Certificates (ETCs), Debentures, and Guaranteed Bonds High-Yield Bonds (Junk Bonds)

Asset-Backed Securities
Asset-Backed Securities (ABS) Asset-Backed Securities: Structure Prepayment Models Asset-Backed Securities: An Overview of Credit Ratings Asset-Backed Securities: Credit Analysis Special Purpose Entity (SPE) Credit Enhancements Credit Card Asset-Backed Securities Credit Card Asset-Backed Securities: Structure and Cash Flow Allocation Auto Asset-Backed Securities Auto Lease Asset-Backed Securities Mortgage-Backed Securities Collaterized Mortgage Obligations Collateralized Debt Obligations (CDOs) Covered Bonds

Derivatives
Derivatives - An Overview Death Bonds Interest Rate Swaps Credit Default Swaps Overnight Index Swaps Derivatives Resources

Bond Resources
Bond Blog Bond Formulas

Interest and Interest Rates

Interest rates are the rate of growth of money per unit of time. It is one of the most fundamental factors in investments, since so many financial assets depend on its value. It is used to determine the present and future value of money and annuities. Many securities either pay interest or the payoff depends on the interest rate. Whether a business will invest in capital or issue securities depends on the interest rate. Hence, the interest rate allocates economic resources more efficiently. Governments control their economies by adjusting key interest rates through monetary and fiscal policies. Interest is the cost of money, and like the price of virtually everything else, it is determined by supply and demand. In the United States and most other developed countries, the government has a major influence on the interest rate, adjusting it higher to cool the economy and adjusting it lower to stimulate it. The government can also increase the money supply by printing money, or through monetary and fiscal policies. Another source of supply is the savings of people, businesses, and other organizations. The main demand for money is for loans by people and businesses. Demand can also be affected by the monetary policies of the government. Charging interest on a loan is sometimes called usury, although in more recent times, it has acquired a negative connotation of excessively high or illegal interest rates being charged. In fact, when the usury rate is limited by law, the rate is referred to as a usury ceiling. However, at least 2 states in the United States do not have usury limits: Delaware and South Dakota, which is why many credit card issuers are located in those states. The concept of interest has a long history. Aristotle thought interest was evil, and according to the Koran, God condemned the charging of interest. The earliest known examples of interest were in ancient Mesopotamia, beginning in the 3rd millennium B.C., when an interest rate of either 20% or 33% was charged depending on whether the loan was paid in silver or barley. However, the interest rate did not depend on the amount of time. [No doubt this simplified calculations that required using a sexagesimal (base 60) numbering system and pressing wedge-shaped (cuneiform) styles into wet clay tablets.]

Nominal and Real Interest Rates

The nominal interest rate is the stated interest rate. If a bank pays 5% annually on a savings account, then 5% is the nominal interest rate. So if you deposit $100 for 1 year, you will receive $5 in interest. However, that $5 will probably be worth less at the end of the year than it would have been at the beginning. This is because inflation lowers the

value of money. As goods, services, and assets, such as real estate, rise in price, it takes more money to buy them. The real interest rate is the nominal rate of interest minus inflation, which can be expressed approximately by the following formula: Real Interest Rate = Nominal Interest Rate Inflation Rate = Growth of Purchasing Power. For low rates of inflation, the above equation is fairly accurate. However, the actual growth of your purchasing power is equal to the nominal interest rate divided by the inflation rate: Formula Relating the Real Interest Rate, Nominal Interest Rate, and Inflation Rate 1+N R = Real Interest Rate 1 + R = N = Nominal Interest Rate 1+I I = Inflation Rate The above equation can be solved for the real interest rate. Solving for the Real Interest Rate (1+R)(1+I) = 1+N Multiply both sides by (1+I). 1+I+R+RI = 1+N Multiply out left-hand side to get terms. R+RI = R(1+I) = N-I Subtract 1 and I from both sides. R = (N-I)/(1+I) Divide both sides by 1 + I. Real Interest Rate Formula N - I R = Real Interest Rate R = N = Nominal Interest Rate 1 + I I = Inflation Rate Because people invest to earn more purchasing power, they will only invest or lend money that pays more than the expected inflation rate. In this case, the nominal rate equals the real interest rate plus the expected inflation.

Nominal Interest Rate Equilibrium

Although there are many different interest rates, their differences result mainly from risk, but they all move up or down along with the prevailing rates. Thus, these rates can be abstracted as a single interest ratethe prevailing interest rate. Generally, as interest rates increase, saving increases and borrowing decreases, and vice versa. If investments pay higher interest, then more people, businesses, and other organizations will invest to earn more money. If interest rates decline, then the motivation to invest declines also, but borrowing increases, which increases demand for money. There is a point where supply equals demandthis is the observed or nominal interest rate.

Irving Fisher looked at interest rate equilibrium as the desire for a specific real rate of return plus the expected inflation rate: Nominal Interest Rate = Real Interest Rate + Expected Inflation Rate. If the expected inflation rate was high, then people would demand a higher nominal rate for their investments; for why would anyone invest if they did not expect a real return? Although no one can really know what future interest rates will be, the nominal interest rate can be somewhat indicative of the expected interest rates.

The Taxation of Nominal Interest Rates

Most earned interest, or any positive return from investments, is taxed. However, taxes currently apply to the nominal rate of return, not the real ratethus, the tax rate on the real rate of return is greater than the published tax rate. Real Rate of Return = Nominal Interest Rate x (1 Your Tax Bracket) - Inflation Rate
Example Calculating the Real Interest Rate after taxes

If you earned 5% nominal interest on your money with 3% inflation, and you are in the 25% tax bracket, what is your real interest rate after taxes? Solution: Using the above formula: Real Rate of Return = 5% x .75 - 3%. = .75% As you can see from the above, if you are in a high tax bracket, you will have to earn significantly more than 5% to earn a decent real return. If you are in the 35% bracket, given the above nominal interest rate and inflation rate, your real interest rate would be 0! You can see why the wealthy invest in tax-free municipal bonds.

Simple Interest
Simple interest, often called the nominal annual percentage rate (APR), is uncompounded interest, which is calculated by multiplying the principal times the interest rate. The earned interest is not added to the principal, so the amount of interest earned is always the same for a given interest rate. Interest = Principal x Interest Rate A good example of simple interest is the interest earned by bonds. Most bonds pay a coupon rate, which is simply the stated interest rate of the bond when it is first issued. When the interest is earned, it is sent to the bondholderit is not added to the bond's

principal and the interest earns no additional interest unless the bondholder reinvests the interest in another investment, such as a savings account.

Compounding Interest
Compounded interest is calculated using the principal plus previously earned interest. For instance, if you deposit $100 in a savings account that pays 6% interest, compounded semiannually, then this means that you are actually earning 3% every 6 months, so that at the end of 6 months, you would have $103. But in the next 6 months, there would be $103 earning interest instead of just $100, so $103 x 3% = $3.09. Add this to the 1st $3 already earned will yield a total of $6.09 for the 1st year, which is 9 cents more than if the interest rate was simple interest. This would be equivalent to a simple interest rate of 6.09% per year. Because money earns interest, it has a future value that is greater than its present value by the amount of the interest earnedthis is referred to as the future value of money or the future value of a dollar. The future value can be expressed as: Future Value = Principal x (1 + Interest Rate per Compounding Period)Number of Compounding
Periods

or Future Value of a Dollar (FVD) FV = Future Value P = Principal i = interest rate per compounding period n = number of compounding periods

FV = P(1+i)n

Using the above example: $100 x (1+.03)2 = $106.09. Interest rates are often used to compare investments, but not all investments have the same compounding period, or it may not be compounded at all, as is the case for a zero coupon bond, which pays no interest. The interest is earned by buying the bond at a discount and receiving face value at maturity. However, an effective compounded interest rate can be found even for a discounted bond, because it is possible to convert compounding interest rates into other rates with different periods of compounding. Most investments that pay interest normalize the interest rate to an annual ratethe APR. Thus, using the above example, a savings deposit that pays 6% compounded semiannually is approximately equivalent to 6.09% compounded annually. By normalizing interest rates to an effective annual percentage rate, different investments can be easily compared.

Rule of 70 Quick Method to Find Doubling Time

The Rule of 70 is a simple method to find how quickly a principal that is earning a compounding interest rate will take to double: divide 70 by the interest rate for the compounding period.

Time to Double = 70 / Interest Rate Examples: How long will a savings account paying 5% compounded annually take to double? 70/5 = 14 years. As a check, using part of the formula for future value listed above, (1.05)14 1.98, so the Rule of 70 is a close approximation. Note, however, that the Rule of 70 approximation becomes less accurate for higher interest rates. For instance, if the interest rate is 14%, then 70/14 = 5, but (1.14)5 1.93

Continuous Compounding Interest

Many portfolio simulations and pricing models for derivatives use a continuously compounded interest rate formula. If a savings account paid a nominal interest rate of 6%, that was compounded semiannually, the real compounded rate can be found using the following formula: 1. Formula For Finding the Compounded Interest Rate from a Nominal Interest Rate n 2 C = Compounded Interest Rate R .06 - 1 = 0.0609 = R = Nominal Interest Rate C= (1+) -1=(1+ ) 6.09% n = number of compounding n 2 periods To find the daily compounded rate for a nominal annual interest rate of 6%, divide the interest rate by 365, and raise the quantity in parentheses to the 365th power. We note that as n increases, the increase in the 1st term becomes less and less, reaching a limit as n increases to infinity. This limit is the natural logarithm base e: 2. Formula For Finding the Natural Logarithm Base e 1 n As n , ( 1 + ) e = 2.718281828... n = number of compounding periods n As a corollary of the above equation, we arrive at formula 3: R n R = Rate of growth or interest rate As n , ( 1 + ) eR n = number of compounding periods n Thus, by substituting the result of formula 3 into formula 1, we see that: Continuous Compounded Interest Rate = eR - 1
Example Calculating the Continuously Compounded Interest Rate or the Effective Annual Percentage Rate

If a bank advertises a savings account that pays a 6% nominal interest rate that is compounded continuously, what is the effective annual percentage rate? Solution: Using the above formula: Continuously Compounded Interest Rate = e.06 - 1 = 1.061837 - 1 6.1837% Although it sounds like you'll make a lot of money by having it continuously compounded, it's not much more than the daily compounded rate of: 6% Compounded Daily = (1 + .06/365)365 0.061831 6.1831% Note that since 1 + Growth Factor = e(Growth Factor), we can simplify the 1st formula relating real interest rates, nominal interest rates, and inflation rates by the following equation: Formula Relating the Real Interest Rate, Nominal Interest Rate, and Inflation Rate Using Continuously Compounded Rates eN R = Real Interest Rate R e = = e(N-I) N = Nominal Interest Rate I e I = Inflation Rate Taking the natural logarithm of both sides, simplies the above equation even further: R=N-I Thus, for continuously compounded rates, the approximation formula for relating the real interest rate to the nominal interest rate and inflation rate becomes exact.

The Present Value and Future Value of Money

< prev: Interest Rates How would you like to make more than 100% interest compounded annually, virtually guaranteed, and with very little risk? This is not a misprint, and it is not a lure to sell you something. I have nothing to sell. Read on. When you learn about the present value of a dollar and the future value of a dollar, you can see things that might not be so obvious at first.

Money makes money. And the money that money makes makes more money. Benjamin Franklin Money has a time value because it can be invested to make more money. Thus, a dollar received in the future has lesser value than a dollar received today. Conversely, a dollar received today is more valuable than a dollar received in the future because it can be invested to make more money. Formulas for the present value and future value of money quantify this time value, so that different investments can be compared. If a saver deposits $100 in a savings account today, and it pays 5% interest, what will it be worth 5 years from now, or 10 years from now? If an investor buys stock for $25, then sells it 3 years later for $45, what was its rate of return? A business has money and many ways to spend or invest it. What is the best use of that money? The present value and future value of money, and the related concepts of the present value and future value of an annuity, allow an individual or business to quantify and minimize its opportunity costs in the use of money. Opportunity cost, in terms of the use of money, is the benefit forfeited by using the money in a particular way. For instance, if I spend $100 instead of depositing it in a bank that pays 5% interest, I forego the interest that I would have earned in the savings account by spending it instead of saving it, and if I would have saved it, then I forfeit the benefit of what I purchased. Of course, it might be possible to buy some stock, instead, that may double or triple, incurring an even greater opportunity cost. However, the future value of a stock is unpredictable, and the true opportunity cost of anything is really not knowable. However, the opportunity cost can be compared among specific investments where the rate of return is dependent on an interest rate that is either known or can be reasonable estimated by using the formulas for the present value and future value of money. Or a reasonable interest rate can be assumed simply to compare different investments.

The Future Value of a Dollar

The future value of a dollar is considered first because the formula is a little simpler. The future value of a dollar is simply what the dollar, or any amount of money, will be worth if it earns interest for a specific period of time. If $100 is deposited in a savings account that pays 5% interest annually, with interest paid at the end of the year, then after the 1st year, $5 of interest will be added to the $100 of principal for a total of $105. In the 2nd year, interest will be earned not only on the principal of $100, but also on the $5 of interest earned. Thus, at the end of the 2nd year, there will be 5 more dollars of interest earned from the principal added to the account, plus 25 earned from the previous year's interest of $5. Thus, at the end of the 2nd year there will be $105 + $5 + $.25 = $110.25 total in the account. This is an example of compounding interest, interest that is paid on interest previously earned. This process can be continued for any number of years.

Expressing this as an equation, if P = principal and i = interest rate per year, then the amount of money in the account after the 1st year can be expressed by the equation P (1 + i) = P + i*P = $100 + .05 * 100 = $100 + $5 = $105. To find the amount after the 2nd year multiply 105 by the same factor(1 + i). This equation can be expressed in terms of the 1st equation: P (1 + i) (1 + i), which reduces to P (1 + i)2. This equation can be extended to P (1 + i)n, with the superscript n equal to the number of years. Thus, the amount of money in the account after 3 years is P (1 + i)3. For this example, 100 (1 + . 05)3 = 100 (1.05)3 = 100 * 1.157625 = $115.76, rounded to 2 decimal places. Future Value of a Dollar (FVD) FV = Future Value of a Dollar P = Principal FV = P(1+i)n i = interest rate per year n = number of years Using a calculator to determine future value: If you have a calculator that has the exponential functionusually designated by the yx keythen this equation is easy to solve. Add the interest rate in decimal form to 1, then press yx, then enter 3, then press the = key. Take this product, the interest factor, and multiply it by the principal. So for our example, enter 1.05, then press yx, then enter 3, then press = to arrive at the interest factor 1.157625. Multiply this by 100 to get $115.76, the amount of money in the account after 3 years. Because exponentiation has priority over multiplication, you can also enter it this way: 100 X 1.05 yx 3 = $115.76.

Comp0unding Interest
In all formulas that compute either the present value or future value of money or annuities, there is an interest rate that is compounded at certain intervals of time. This interval of time is assumed to be 1 year, but, if it is less than 1 year, as it frequently is, then there are 2 adjustments that must be made to the formulas: 1. The number of time periods must be changed to represent the number of times that interest is compounded. The number of years must be multiplied by the number of compounding periods within a year. 2. The interest rate itself must be changed to reflect the interest rate per time period. The annual interest rate must be divided by the number of compoundings in a year. Note also that most of the solutions to these formulas are rounded.

Example Adjusting a Formula for Non-annual Compounding of Interest

If you put $100 in a savings account that pays 5% interest annually, but is compounded daily, how much will be in the account after 10 years? Solution: This is finding the future value of a savings account, but since this account is compounded daily, the formula will have to be adjusted as follows: FV = Future Value of Savings Account i P = Principal n*c FV = P(1+ ) i = interest rate per year c n = number of years c = number of compounding periods in a year Thus, we find the solution by plugging the values into the formula: .05 FV= 100 * (1+ )10*365=$164.87 365 Note that with compounding interest, doubling either the interest rate or the amount of time more than doubles the amount of interest earned. For instance, $100 earning 5% interest that is paid yearly would equal $62.89 of earned interest after 10 years; after 20 years, earned interest would equal $165.33. Thus, the future value of a dollar is the value that it will have after a specific time earning a specific interest rate.

The Present Value of a Dollar

Suppose you buy a zero coupon bond that matures in 10 years, then pays $1,000. How much is that future payment of $1,000 worth today at a 5% interest rate? In other words, if the prevailing interest rate is 5%, how much should you pay for a zero coupon bond that is sold at a discount to its par value? In determining the future value of money, we know how much money we are starting with, and we want to know how much it will be worth at some point in the future at a specific interest rate. When we know how much a future payment will be, then we want to determine what its value is today at a given interest rate. The present value is the current value of a payment that will be received in the future. Discounting is the process of determining the present value of a payment from a known future payment, or future value. This is the reverse of determining the future value of a

payment, because in this case, we already know the future value. It is found by dividing the future value by the same interest factor, (1 + i)n, used to determine future value. The Present Value of a Dollar (PVD) PVD = Present Value of a Dollar FVD FVD = Future Value of a Dollar PVD = i = interest rate per time period (1+i)n n = number of time periods

Example Calculating the Worth of a Zero Coupon Bond

How much would a zero coupon bond sell today, that pays $1,000 in 10 years, assuming an interest rate of 5% that is compounded and paid annually? Solution: The zero coupon bond pays $1,000 in 10 years, so that is its future value in 10 years. If the prevailing interest rate is 5%, then to find the present value of the zero: 1,000 PVD = = $613.91 (1+.05)10 Using a calculator to determine present value: Enter 1,000, press the divide key, enter 1.05, then press the exponential key, yx, then enter 10, then the = key. The calculator should do the exponentiation 1st, because exponentiation has priority over division, then the division to arrive at the correct answer of $613.91, rounded to 2 places. Summary: 1,000 1.05 yx 10 = $613.91.

Calculating the Interest Rate of a Discounted Financial Instrument

To find the present value, we need to know the future value and the interest rate; to find the future value, we need to know the present value and the interest rate. But sometimes, both the present value and the future value are known, but not the interest rate. A good example of this problem is the zero coupon bond. A zero coupon bond pays no interest during its term, but is bought at a discount to its par value. Thus, in this case, the purchase price is known, which is its present value, and its future value is the par value of the bond, usually $1,000, which is paid when the bond matures. But what is the equivalent interest rate? As we will see below, even though a zero pays no interest, it still has an equivalent interest rate, which can be calculated and compared to other investments. How would it compare to a savings account that pays 5% interest compounded annually, for instance?

To find the equivalent interest rate, i, we transpose the equation for the future value of money to equal i. The equation for future value is: Present Value * (1 + i)n = Future Value First, divide both sides by the Present Value: (1 + i)n = Future Payment/Present Value. Take the nth root of both sides: 1 + i = (Future Payment/Present Value)1/n. Then subtract 1 from both sides, to arrive at i, the interest rate for the discount: The Interest Rate of a Discount (IRD) i = Interest Rate of Discount per time period FV n = number of time periods -1 FV = Future Value PV PV = Present Value

i=

or

Example Calculating the Interest Rate of a Zero Coupon Bond

What interest rate is a zero coupon bond paying, that costs $600 and pays $1,000 in 10 years, assuming an interest rate that compounds annually? Solution: Future Value = $1,000 par value, Present Value = $600 purchase price, n = 10 years (1,000/600)1/10 - 1 = 5.24% Using a scientific calculator: 1000 600 = xy 10 - 1 = .0524 = 5.24% Note that if the interest is compounded at different intervals, such as quarterly or daily, then the interest rate i and the number of compounding periods must be adjusted. But if compounding of interest is not specified, as with the zero coupon bond, what value do we use? We use the value that allows us to compare it to another investment. We can specify that the interest rate be compounded daily instead of annually, which will result in a lower interest rate. We would do this to compare the zero, for instance, to a savings account that is paying interest compounded daily. So how would our zero coupon bond example compare with a savings account that paid 5%, compounded daily? In other

words, if we put $600 in the savings account instead of buying the bond, would we have more or less than $1,000 after 10 years? We can solve this problem in 2 ways. We can solve the problem either by calculating the future value of $600 earning 5% compounded daily, or we can calculate the equivalent interest rate for the zero coupon bond when compounded daily. In either case, we need to know how many compounding periods there are. Since there is 365 days to a year, there is 3,650 compounding periods in 10 years. However, because the interest rate is listed as 5% per year, compounded daily, we need to find that .05/365 = .000136986 = the daily interest rate. Substituting these values into the IRD formula, the future value of the savings account is: Future Value = 600 * (1 + .000136986)3650 = $989.20 We can already see that the zero coupon bond pays better, but let's see what the interest rate of the bond would be if compounded daily, like the savings account. (1,000/600)1/3650 - 1 = .000139962 (daily interest rate) * 365 = .0511 = 5.11% annual interest rate.

Example Calculating the Interest Rate of a Fluorescent Bulb

What did you say? Fluorescent bulbs don't pay interest! Let's see. You have a light bulb in your house, that's on quite a bit, and it's a 100 watt bulb. You typically go through 13 bulbs in 5 years, for a total of 10,000 hours of light. But, what if you buy a 23-watt fluorescent bulb, instead, which gives off almost the same amount of light, and it last 13 times longer than a typical 100-watt bulb. And let's say that your electric rate is 10 a kilowatt hour. Let's also assume that you pay about 33% of your income in federal, state, and local taxes. 100-watt bulbs generally cost about .25 per bulb, so 13 will cost $3.25. A 23-watt fluorescent bulb can be bought for nearly the same price as the 13 incandescent bulbs. Yes, fluorescent bulbs are more expensive than incandescents, but wait! The amount of electricity consumed by a series of 100-watt bulbs in 10,000 hours is 1,000 kilowatts (100 x 10,000 = 1,000,000 watts or 1,000 kilowatts, since a kilowatt is 1,000 watts). At 10 a kilowatt hour, that's $100 worth of electricity needed for incandescent bulbs. The fluorescent bulb consumes 230 kilowatts of electricity for the same amount of light (23 x 10,000 = 230,000 watts = 230 kilowatts). At 10 a kilowatt hour, that's $23 worth of electricity for a savings of $77 over the incandescents. So, in 5 years, for this one light socket, you would save $77 over a period of 5 years. But, to save $77 is the same thing as earning $77 tax-free! So you paid $3.25 to earn $77 tax-free over a period of 5 years. So what is the equivalent interest rate that is compounded annually of this? Solution: Future Value = $77 saved, Present Value = $3.25 purchase price, n = 5 years

(77/3.25)1/5 - 1 = 88.33% Using a calculator: 77 3.25 = xy 5 - 1 = .883308... = 88.33% That's a pretty impressive rate of returna tax-free rate of returnand not only that, it's virtually guaranteed! Your only small risk is that the bulb breaks or turns out to be defective, in which case, you can probably return it to the store for another one. Note that the $77 is real money, even though you only saved it and didn't really earn it. It's real, however, because if you had bought the incandescent bulbs instead, that would be $77 less than you would have had over the 5 years. Granted, these savings aren't going to allow you to buy a Lamborghini for your next car, but it's something that not only saves you money, but saves you time as well, since you won't have to change the bulb 12 times during those 5 years! Multiply that by the number of bulbs in your house. Or if you have a business! Even a small business like a medical center could have a hundred or more light bulbs which are on all day during business hours. The savings could be quite substantial. Not only that, but you help to conserve energy and protect the world from global warming! Since this money is earned free of all taxes, we can also calculate a taxable equivalent yield. The formula for this is: Taxable Equivalent Yield = (Tax-free yield)/(100% - Tax%) We assumed that you pay 33% of your income in federal, state, and local taxes. This yields: 88.33%/(100% - 33%) = 88.33%/67%= .8833/.67 = 1.318358... = 131.84% For a more detailed discussion of taxable equivalent yields, see Bond Yields: Nominal Yield, Current Yield, Yield to Maturity, Yield to Call, True Yield, Taxable Equivalent Yield. That's a taxable equivalent yield of 131.84%, compounded every year, for 5 years. In other words, you would have to earn that rate of return to equal the tax-free yield of 88.33%. Compare that to a savings account! Obviously, this rate of return will vary depending on the actual value of the variables. For instance, if the light bulb was not on so much, and it lasted 10 years, then obviously this will lower the equivalent interest rate, but it will still be substantial.

Conclusion
Here we can see that, even though a zero and a fluorescent bulb pay no actual interest, we can find an equivalent interest rate that's compounded daily, weekly, quarterly, or

whatever, so we can compare it to investments that do pay interest. This is the value of the formulas for the present value and the future value of money! The present value and future value of a dollar is a lump sum payment. A series of equal lump sum payments over equal periods of time is called an annuity. This is a more general concept than the insurance product that most people think of when they see the word annuity; it includes loans, interest payments from bonds, and so oneven the annuity insurance product. Like the present value and future value of a dollar, the present value and future value of an annuity allows you compare investments, or the costs of loans. For instance, you can answer questions such as, How much would my payments be on a $200,000 mortgage with a 6% interest rate? or How much of a mortgage could I get, if the interest rate is 5%, but I can only afford to pay $1,000 per month? next: The Present Value and Future Value of an Annuity