TimeValueOfMoney 07082006

Its all about money, honey!!
Jaikumar L
07-08-2006
Misys International Banking Systems

What is money?
• Money is the set of assets in

the economy that people
regularly use to buy goods
and services from other
people.
“something generally accepted as a medium of exchange, a measure of value,

or a means of payment.”

In other words…
Characteristics of The Functions of

Money Money
– Portable – Medium of
– Divisible Exchange
– Durable – Store of Value
– Stable – Unit of Account

A Brief History of Money
I. Physical
Goods
Money Electronic barter
Barter V. Electronic
Money E-money
Commodity money
Cybermoney
II. Coins IV. Electronic

Transfers
Creditcards EFT
Bank money
III. Paper &
Accounting
Money
Development of Money
Monetary History:
• Barter (direct exchange of goods)
• Medium of exchange (arrowheads, salt) ABSTRACTION
• Coins (gold, silver)

• Tokens (paper)
• Notational money (bank accounts)
NEED
• Dematerialized schemes (pure information)
BANKS

Barter
• Direct exchange of goods and services -- possible
when production exceeds individual needs
• Problem: “double coincidence of wants”
– Trade a bicycle for a cow
– Alice must have a bicycle and want a cow
– Bob must have a cow and want a bicycle UNLIKELY
• But: Internet allows rapid discovery of wants

• Problem: remote barter requires an escrow (or risk)
• Problem: outside the monetary and tax systems
• When money is not trusted, barter returns
• Electronic barter systems exist

Types of Money:
Fiduciary vs. Scriptural
• Fiduciary money (fiat money, legal tender)
– Issued by a central (government) bank
– Has real “discharging power” (to discharge debts)
– Cannot be refused
• Scriptural money
– Money not issued by a central bank
– Examples: bank accounts, travelers checks, gift certificates,
scrips
– Discharging power based on trust in issuer
• Commodity Money
– something that performs the function of money and has
alternative, nonmonetary uses.
– Examples: Gold, silver, cigarettes

Types of Money:
Token vs. Notational
• Token money
– Represented by a physical article (e.g. cash)
– Can be lost
• Notational money
– Examples: bank accounts, frequent flyer miles
– Electronic (scriptural) money: wide recognition
– Jeton = electronic token with limited recognition
• Hybrid money
– Check
– Telephone card (carries jetons for future service)

The Money Matrix
TOKEN NOTATIONAL HYBRID
FIDUCIARY • CASH • ACCOUNT WITH • GOVERNMENT

• GOVERNMENT CENTRAL BANK CHECK
BEARER BOND
SCRIPTURAL • CERTIFIED • BANK ACCOUNT • PERSONAL

CHECK • FREQUENT CHECK
• TRAVELER’S FLYER MILES • GIFT
CHECK CERTIFICATE

Money creation
First National Bank

Assets Liabilities
Reserves Deposits
$10.00 $100.00
Loans
$90.00
Total Assets Total Liabilities
$100.00 $100.00

Money creation
• When a bank makes a loan (from it’s reserves)

the money supply increases. When banks hold
only a fraction of deposits in reserve, banks
create money.
• The creation of money through loans does not
create any wealth, but allows banks to charge
interest several times on the same bit of wealth.

The Money Multiplier
• When one bank loans money, that money is

generally deposited into another or the same
bank thus creating more deposits and more
reserves to be lent out.
• The Money Multiplier is the amount of money
that the banking system generates with each
dollar of reserves.

First National Bank

Assets Liabilities
Reserves Deposits
$10.00 $100.00
Loans
$90.00
Total Assets Total Liabilities

$100.00 $100.00

First National Bank Second National Bank

Assets Liabilities Assets Liabilities
Reserves Deposits Reserves Deposits

$10.00 $100.00 $9.00 $90.00
Loans Loans
$90.00 $81.00
Total Assets Total Liabilities Total Assets Total Liabilities

$100.00 $100.00 $90.00 $90.00



$10.00 $100.00 $9.00 $90.00
Loans Loans
$90.00 $81.00

$100.00 $100.00 $90.00 $90.00



Total Money Supply = $190.00!
$10.00 $100.00 $9.00 $90.00
Loans Loans
$90.00 $81.00

$100.00 $100.00 $90.00 $90.00

Query to ALL
There are two options available.

Which one would you prefer –
$10,000 today
or
$10,000 in 3 years?
years

Learning Objectives
• Time Value of Money

• Future Value
• Present Value
• Concepts of Compounding / Discounting
• Types of Interest
– Simple
– Compound
• Interest calculation

Query to ALL
There are two options available.

Which one would you prefer –
$10,000 today
or
$10,000 in 3 years?
years
Most of us would prefer $10,000 today.
today
We already recognize that there is
TIME VALUE TO MONEY!!

MONEY

Why Time ?
Why is TIME such an important element in our

decision?
TIME allows us the opportunity
to postpone consumption and earn INTEREST.

INTEREST

Future Value
If you choose option A and invest the total amount at an annual rate
of 4.5%, the future value of your investment at the end of the first
year is $10,450.
This is calculated by multiplying the principal amount of $10,000 by
the interest rate of 4.5% and then adding the interest gained to the
principal amount:
Future value of investment at end of first year:
= ($10,000 x 0.045) + $10,000
= $10,450

Future Value
You can also calculate the total amount of a one-year investment

with a simple manipulation of the above equation:
Original equation: ($10,000 x 0.045) + $10,000 = $10,450
Manipulation: $10,000 x [(1 x 0.045) + 1] = $10,450
Final equation: $10,000 x (0.045 + 1) = $10,450
The manipulated equation above is simply a removal of the like-
variable $10,000 (the principal amount) by dividing the entire
original equation by $10,000.

Future Value
If the $10,450 left in your investment account at the end of the first
year is left untouched and you invested it at 4.5% for another year,
how much would you have?
To calculate this, you would take the $10,450 and multiply it again by
1.045 (0.045 +1). Future value of investment at end of second
year:
= $10,450 x (1+0.045)
= $10,920.25
The above calculation, then, is equivalent to the following equation:
Future Value = $10,000 x (1+0.045) x (1+0.045)

Future Value
Using rule of exponents, the equation can be represented as the

following:
Future value = $10,000 x (1+0.045) (1 + 1)
= $10,000 x (1+0.045) 2
= $10,920.25
We can see that the exponent is equal to the number of years for
which the money is earning interest in an investment. So, the
equation for calculating the three-year future value of the
investment would look like this:
Future value = $10,000 x (1+0.045) (1 + 1 + 1)
= $10,000 x (1+0.045) 3
= $11,411.66

Future Value
This calculation shows us that we don' t need to calculate the future

value after the first year, then the second year, then the third year,
and so on. If you know how many years you would like to hold a
present amount of money in an investment, the future value of that
amount is calculated by the following equation:
Future Value
= Original Amount X (1 + Interest Rate per Period) (No. of periods)
= P * (1 + i) n

Future Value
Future Value is the Amount to which an

investment will grow after earning interest.
FV = PV (1 + i)^n
Where FV = Future Value
PV = Present Value
n = number of periods
i = interest rate per period

Future Value
What is the future value of $34 in 5 years if the

interest rate is 5%?
FV= PV ( 1 + i ) ^n
FV= $ 34 ( 1+ .05 ) ^5
FV= $ 34 (1.2762815)
FV= $43.39.

Present Value
If you received $10,000 today, the present value would of course be

$10,000 because present value is what your investment gives you
now if you were to spend it today.
If $10,000 were to be received in a year, the present value of the
amount would not be $10,000 because you do not have it in your
hand now, in the present.
To find the present value of the $10,000 you will receive in the future,
you need to pretend that the $10,000 is the total future value of an
amount that you invested today.
In other words, to find the present value of the future $10,000, we
need to find out how much we would have to invest today in order
to receive that $10,000 in the future.

Present Value
The future value equation can be rewritten by replacing the P variable

with present value (PV) and manipulated as follows:
Original equation: FV = PV * (1 + i) n
Manipulation: Divide both sides by (1 + i) n
Final equation: PV = FV / (1 + i) n or PV = FV * (1 + i) -n
Present value for three year investment = $10,000 x (1+0.045) -3

= $8762.97

Present Value
Let’s walk backwards from the $10,000 offered in option B.

Remember, the $10,000 to be received in three years is really the
same as the future value of an investment.
If today we were at the two-year mark, we would discount the
payment back one year. At the two-year mark, the present value
of the $10,000 to be received in one year is represented as the
following:
Present value of future payment of $10,000 at end of year two
= $10,000 x (1+0.045) -1
= $9569.38

Present Value
Note that if today we were at the one-year mark, the above $9,569.38
would be considered the future value of our investment one year
from now.
Continuing on, at the end of the first year we would be expecting to
receive the payment of $10,000 in two years. At an interest rate of
4.5%, the calculation for the present value of a $10,000 payment
expected in two years would be the following:
Present value of $10,000 in two years
= $10,000 x (1+0.045) -2
= $9157.30

Present Value
Using the rule of exponents, we don' t have to calculate the future

value of the investment every year counting back from the
$10,000 investment at the third year.
We could put the equation more concisely and use the $10,000 as
FV. So, here is how you can calculate today'
s present value of the
$10,000 expected from a three-year investment earning 4.5%:
Present value for three year investment = $10,000 x (1+0.045) -3
= $8762.97

Evaluation of query
So the present value of a future payment of $10,000 is worth

$8,762.97 today if interest rates are 4.5% per year.
In other words, choosing option B is like taking $8,762.97 now and
then investing it for three years.
The equations above illustrate that option A is better not only
because it offers you money right now but because it offers you
$1,237.03 ($10,000 - $8,762.97) more in cash!
Furthermore, if you invest the $10,000 that you receive from option A,
your choice gives you a future value that is $1,411.66 ($11,411.66
- $10,000) greater than the future value of option B.

Present Value
How much you have now is the Present Value.

PV = FV (1 + i)^-n
Where
PV = Present Value
FV = Future Value
n = number of periods
i = interest rate per period

Present Value
What is the present value of $1000 in 5 years if

the interest rate is 6%?
PV = FV (1 + i)^-n
= 1000 (1 + 0.06)^ -5
= 1000 (0.74726)
= 747.26

Time Value of Money
• It is a concept in interest rates.

• It implies that the value of one rupee
today is not equal to one rupee
tomorrow.
• It may be more or less depending upon
the interest rates. If interest rates
are positive, we get more money on a
future date in return for letting
someone else use our money today.
• All products offered by the financial
services industry which involve
interest calculations are based on
this concept

Time Value of Money
• Translating a value to the present is referred

to as Discounting.
• Translating a value to the future is referred to
as Compounding.

Types of Interest
• Simple Interest
– Interest earned only on the original investment.
• Compound Interest
- Interest earned on interest. Interest earned on the previous
period’s balance.

Types of Interest
• Simple Interest
– Interest paid (earned) on only the original amount, or principal
borrowed (lent).
– It is used in financial institutions for interest periods of less
than one year.
– If the rate is expressed as an annual rate (normal practice),
then the time period (t) must be a fraction of a year.

Simple Interest
In its most basic form, interest is calculated by multiplying

principal (amount invested) by rate (percent of interest)
multiplied by time (number of periods the interest is
calculated). This is called simple interest.
Simple interest formula
I = PRT
where
I = Interest
P = Principal
R = Percentage Interest Rate
T = Time in years

Simple Interest
Interest earned at a rate of 6% for five years on

a principal balance of $100.
Interest Earned Per Year = (100 x 6 X 1)/(100)
= $6
Today Future Years
1 2 3 4 5
Interest Earned 6 6 6 6 6
Value 100 106 112 118 124 130
– Value at the end of Year 5 = $130

Simple Interest
Example1: A $10,000 deposit at 8% per year for three

years'simple interest.
Principal = 10,000
Rate = 8%
Time = 3 years
I = PRT
Giving
I = (10000)(.08)(3) = 2400
A $10000 deposit at 8% simple interest for three years earns $2400 interest.

Simple Interest
The future value (FV) of a simple interest calculation is

derived by adding the original principal back to the
interest earned.
In example 1, FV = Principal + Interest
= $10,000 + $2400 = $12,400
Expressed as a formula:
FV = Principal + Principal * Rate * Time

FV = P(1 + RT)

Simple Interest
Example 2
Principal = 10,000
Rate = 10% (annual)
Time = 6 months (hint: convert into years)
I = (10,000 * 10 * 6) / (12 * 100) = 500

Simple Interest
Example3: We invest $10,000 in an 8% , 90-day

certificate of deposit.
Principal = 10,000
Rate = 8%
Time = 90 days
I = (10000 * 8 * 90) / (365 * 100) = 197.26
Our total proceeds at the end of the CD period are:
FV = (10000)+(10000)(.08)(90/365) = $10,197.26

Simple Interest
The present value (PV)
PV = FV /(1+RT)
Example: If the bank loans out $10,000 for 90 days at

8% simple interest, the PV is:
PV = 10000 / [1 + (.08)(90/365)]
= 10000/ 1.019726
= $9,806.56

Types of Interest
• Compound Interest
Interest paid (earned) on any previous interest earned, as well as
on the principal borrowed (lent).
Interest earned on interest. Interest earned on the previous
period’s balance.

Compound Interest
If interest is left in the account to accumulate for a longer

period (usually longer than one year) common practice
(and usually state law!) requires that after interest is
earned and credited for a given period, the new sum of
principal + interest must now earn interest for the next
period, etc. This is compound interest.
To distinguish from simple interest, we use "n" to refer to
the number of "periods" in which the interest is
compounded and added to principal.
FV = PV (1+r)^n

Compound Interest
Suppose we invest our original $1,000 for three years

at 8%, compounded quarterly: (The rate per
quarterly period is 8% / 4 or 2%. The number of
periods (n) is 3 x 4 = 12 quarterly periods.)
FV = PV(1 + i)^n
FV = (1000)(1.02)12 = $1,268.24

Compound Interest
If we wanted to know how much we'

d have to invest
now (PV) at 8% compounded quarterly to earn
$10,000 in three years:
PV = FV / (1 + i)^n
PV = 10000 / (1.02)12 = $7,884.93

Comparison
Simple & Compound Interest

INTEREST - Interest rate structures
Simple rates
A single rate applicable to all of the balance
Example 1
Rate of 12%
Balance of 25,000
Rate used is 12%

Simple tiered
A set of balance thresholds and associated rates
The rate used depends on where balance falls within the
thresholds or tiers
The rate applied to the full balance

Simple tiered
Example 1
Rate structure is
5% up to 25,000
6.25 up to 50,000
7.75 up 100,000
8% from 100,000 upwards
Balance is 47,000 - what’s the rate?
It’s 6.25%

Simple tiered
Example 2
Rate structure is
5% up to 25,000
6.25 up to 50,000
7.75 up 100,000
It’s 5%

Banded tiered rates

A set of balance thresholds and associated rates
The balance is apportioned over the tiers
Each portion of the balance accrues interest at the rate
assigned to each tier

Banded tiered
Example 1
Rate structure is
5% up to 25,000
6.25% up to 50,000
7.75% up 100,000
It’s 5% on the first 25,000 and 6.25% on 22,000

Banded tiered
Example 2
Rate structure is
5% up to 25,000
6.25% up to 50,000
7.75% up 100,000

Banded tiered
Example 2 - answer
5% on the first 25,000
6.25% on the next 25,000 !!!
7.75% on the next 50,000 !!!
8% on the remaining 400,000 upwards

PV & FV tables
• Because raising interest factors to an exponent of "n"

was a difficult calculation before calculators, some
mathematicians used logarithmic functions to calculate
the exponent factor.
• Financial professionals acquired tables of these
functions so that either of the above problems could
be calculated simply by looking up a FV factor (or to
discount, a PV factor) based on the interest rate and
number of compounding periods and multiplying the
principal by the interest factor.
• Now, computerized spreadsheets can build in these
financial functions and easily do the work for us.

EMI Calculation
Loan Payment Formula

MS EXCEL - Future Value
Returns the future value of an investment based on periodic, constant
payments and a constant interest rate.
Syntax
FV(rate,nper,pmt,pv,type)
Rate is the interest rate per period.
Nper is the total number of payment periods in an annuity.
Pmt is the payment made each period; it cannot change over the life of
the annuity. Typically, pmt contains principal and interest but no other
fees or taxes.
Pv is the present value, or the lump-sum amount that a series of future
payments is worth right now. If pv is omitted, it is assumed to be 0
(zero).
Type is the number 0 or 1 and indicates when payments are due. If
type is omitted, it is assumed to be 0.

Try this problem in Excel:

Invest $1,000 (present value) at 8% annual interest
compounded quarterly for three years to see how
much we can receive (future value) (hint: use the
=FV function)
1. Invest $1,000 at 8% compounded quarterly for 3 years:
Principal -1000 (enter as negative)

Rate 2% (8% / 4 qtrs)
Nper 12 (3 yrs x 4 qtrs)
Fut. Val $1,268.24 =FV

You deposit $1,000 into a savings account that

earns 4 percent annual interest compounded
monthly (monthly interest of 4%/12, or 0.33%).
You plan to deposit $100 at the beginning of
every month for the next 12 months. How
much money will be in the account at the end
of 12 months?
FV (0.0033, 12, -100, -1000, 1) = $2266.38

MS EXCEL - Present Value
Returns the present value of an investment. The present value is the
total amount that a series of future payments is worth now. For
example, when you borrow money, the loan amount is the present
value to the lender.
Syntax
PV(rate,nper,pmt,fv,type)
Rate is the interest rate per period.
Nper is the total number of payment periods in an annuity.
Pmt is the payment made each period; it cannot change over the life of
the annuity. Typically, pmt contains principal and interest but no other
fees or taxes.
Fv is the future value, or the cash balance you want to attain after the
last payment is made. If fv is omitted, it is assumed to be 0 (zero).
Type is the number 0 or 1 and indicates when payments are due. If
type is omitted, it is assumed to be 0.
Now the reverse—how much would we have to invest

now (present value) at 8% compounded quarterly to
receive $10,000 (future value) in three years? (use
the =PV function)
PV (0.02,12, ,-10000,0) = -$7884.93
Excel displays the PV amount as negative

IF you wish to buy an insurance annuity that pays 1000 at the end of
every month for the next 20 years. The cost of the annuity is
110,000, and the money paid out will earn 8 percent. You want to
determine whether this would be a good investment. Using the
PV function, you find that the present value of the annuity is:
PV(0.08/12, 12*20, -1000, , 0) equals -119,199.29
The result is negative because it represents money that you would
pay, an outgoing cash flow. The present value of the annuity
(119,199.29) is more than what you are asked to pay (110,000).
Therefore, you determine this would be a good investment.

MS EXCEL - PMT function
Calculates the payment for a loan based on constant payments and a
constant interest rate.
Syntax
PMT(rate,nper,pv,fv,type)
Rate is the interest rate for the loan.

Nper is the total number of payments for the loan.
Pv is the present value, or the total amount that a series of future payments
is worth now; also known as the principal.
Fv is the future value, or a cash balance you want to attain after the last
payment is made. If fv is omitted, it is assumed to be 0 (zero), that is, the
future value of a loan is 0.
Type is the number 0 (zero) or 1 and indicates when payments are due.

What is the monthly payment on a $10,00,000

loan at an annual rate of 8 percent that you
must pay off in 10 years
PMT(8%/12, 10*12, 1000000) equals - $12,153.91
You need to pay Rs. $12,153.91 every month for the loan of Rs.
10,00,000 @ 8% for 10 years.

You can use PMT to determine payments to annuities other than
loans. E.g. Public Provident Fund For example, if you want to
save Rs. 500,000 in 15 years by saving a constant amount each
month, you can use PMT to determine how much you must save.
If you assume you' ll be able to earn 9 percent interest on your
savings, you can use PMT to determine how much to save each
month.
PMT(9%/12, 15*12, 0, 500000) equals -1321.33

If you pay Rs. 1321.33 into a 9 percent savings account every
month for 15 years, you will have Rs. 500,000

Exercise
You have two options –

You could receive either $15,000 today
or
$18,000 in four years.
Which option would you choose ?
Lets assume that Interest rate is 4%.
FV for Option1 - FV(0.0033,48,,-15000) = $17569.94

PV for option 2 - PV(0.0033,48,,18000,0) = -$15,367.16.
Hence, Option 2 is better.

Exercise
You have two options –

You could receive either $15,000 today
or
$17,000 in four years.
Which option would you choose ?
Lets assume that Interest rate is 5%.
FV for Option 1 - FV(5%/12,4*12,,-15000) = $18,342.63

PV for option 2 - PV(5%/12,4*12,,18000) = - $14719.81
Hence option 1 is better.

Exercise
What is the monthly payment on a $10,00,000

loan at an annual rate of 9 percent that you
must pay off in 15 years
PMT(9%/12, 15*12, 1000000) equals - $10,142.66
You need to pay Rs. $10,142.66 every month for the loan of Rs.
10,00,000 @ 9% for 15 years.

Example: Cash Transaction
1. CENTRAL BANK ISSUES CENTRAL

FIDUCIARY MONEY 7. SELLER’S BANK
(ANTI-FORGERY) + BANK SENDS CASH TO
(SERIAL NUMBERS) CENTRAL BANK 6. SELLER’S BANK
CREDITS SELLER’S
BANK ACCOUNT
2. CENTRAL BANK SELLS BUYER’S SELLER’S

CASH TO BUYER’S BANK
BANK BANK
5. SELLER DEPOSITS
CASH IN SELLER’S
BANK ACCOUNT
3. BUYER’S BANK ALLOWS

BUYER TO DRAW CASH BUYER SELLER
FROM BUYER’S ACCOUNT
4. BUYER PHYSICALLY
GIVES CASH TO SELLER

Thank you

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Its all about money, honey!!

Misys International Banking Systems

• Money is the set of assets in

“something generally accepted as a medium of exchange, a measure of value,

Misys International Banking Systems

Characteristics of The Functions of

Misys International Banking Systems

II. Coins IV. Electronic

• Coins (gold, silver)

Misys International Banking Systems

• But: Internet allows rapid discovery of wants

Misys International Banking Systems

Misys International Banking Systems

Misys International Banking Systems

TOKEN NOTATIONAL HYBRID

FIDUCIARY • CASH • ACCOUNT WITH • GOVERNMENT

SCRIPTURAL • CERTIFIED • BANK ACCOUNT • PERSONAL

Misys International Banking Systems

First National Bank

Misys International Banking Systems

• When a bank makes a loan (from it’s reserves)

Misys International Banking Systems

• When one bank loans money, that money is

Misys International Banking Systems

First National Bank

Total Assets Total Liabilities

Misys International Banking Systems

First National Bank Second National Bank

Reserves Deposits Reserves Deposits

Total Assets Total Liabilities Total Assets Total Liabilities

Misys International Banking Systems

First National Bank Second National Bank

Reserves Deposits Reserves Deposits

Total Assets Total Liabilities Total Assets Total Liabilities

Misys International Banking Systems

First National Bank Second National Bank

Reserves Deposits Reserves Deposits

Total Assets Total Liabilities Total Assets Total Liabilities

Misys International Banking Systems

There are two options available.

Misys International Banking Systems