2 - The time value of money: The key to the valuation of financial markets

Abstract

A dollar in hand today is worth more than a dollar to be received tomorrow because of the interest it may earn if it is put into a savings account. This process of earning interest on money called compounding. Compound interest is the term for the kind of interest that itself earns interest. Present value is the present worth of future sums of money. The process of calculating present values or discounting is actually the opposite of finding the compounded future value of money. The process of determining security valuation involves finding the present value of an asset's expected future cash flows through the investor's required rate of return. The valuation process for a bond requires knowledge of three basic elements: (1) the amount of cash flows to be received by an investor, which is equal to the periodic interest to be received and the par value to be paid at maturity; (2) the maturity date of a loan; and (3) the investor's required rate of return. The periodic interest can be received annually or semiannually. The value of a bond is simply the present value of these cash flows.