Time Value of Money and Interest Rate Risk

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Time Value of Money and Interest Rate Risk

Time Value of Money

Time value of money (TVM) is a financial concept, which implies that money available to an individual or a company at the present time is much more valuable. The same amount of money is worth more in the present than it will be worth in the future because of the potential earning capacity attributed to it (Investopedia, n.d.). Also referred to as present discounted value, this financial principle contends that because money has the capacity to earn interest, even the smallest amount is worth more the sooner it is received by someone. To better understand this idea, it is important to look at the following formula of TVM:

FV=PV * (1+(i/n)) ^ (n * t) (Investopedia, n.d.).

In this formula, FV is the future value while PV is the present value of money; i is the interest rate, t is the number of years of withheld money, and n is the number of compounding periods per year (Investopedia, n.d.). For instance, if the present value of money is $10,000 was invested at a ten percent interest for one year, the future value will be:

$10,000 * (1+(10%/1)) ^ (1 * 1) = $11,000

Based on the example given above, if an individual decides to invest money at the present time, this money will earn a certain percentage due to its growth in value. Therefore, there is no point in taking home less money today but getting a bigger lump sum in the future, especially when it comes to tax refunds. Essentially, tax refunds are loans to the government that have no interest rate, so every cent a person withheld from a paycheck brings no value. It is far more beneficial to take the money without waiting for April to get a refund. Instead, the time value of money suggests investing any sum at the present moment and getting a percentage of the interest.

Interest Rate Risk

The interest rate risk is a term that implies a certain risk associated with the change of the value of the investment, which is influenced by any shift in the interest rate relationship. It is worth mentioning that interest rate risks predominantly impact bonds, so there is a need for bondholders to make certain adjustments in order to secure themselves from being influenced by the changes in the interest rates (FINRA, 2016). With the fall of bond prices, interest rates rise, and vice versa. This occurs because the increase in interest rates decreases the opportunity cost of bond holding as the majority of investors quickly switch to other investments that have high-interest rates.

To secure themselves and their businesses from interest rate risks, bondholders prefer two methods: hedging and diversification. Hedging can be achieved through the swap of interest rates while diversification is implemented by companies investing in fixed-income securities. If the interest rates fall, this means that the prices on corporate bonds will increase. Therefore, it is advised for the companys manager to invest in fixed-income securities that will bring the corporation regular income as well as eliminate the majority of risks associated with the fluctuations of the portfolio.

Companies can predominantly appreciate such investments because fixed-income corporate bonds are much more likely to be repaid in the case if a company becomes bankrupt. With the fall in the interest rates, the company is in an advantageous position and should capture all opportunities with regards to selling some bonds and earning a profit, which further should be invested in fixed-income bonds that will provide some guarantees and secure the business from future interest rate risks.

References

FINRA. (2016). Understanding bond risk.

Investopedia. (n.d.). Time value of money TMV.

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