Ch08 - Chapter 8 Time Value of Money Road Map Part A...

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Chapter 8 Time Value of Money Road Map Part A Introduction to Finance. Part B Valuation of assets, given discount rates. Part C Determination of discount rates. Historical asset returns. Time value of money. Risk. Portfolio theory. Capital Asset Pricing Model (CAPM). Arbitrage Pricing Theory (APT). Part D Introduction to corporate. Main Issues Theroy of Real Interest Rates Nominal Interest Rates Term Structure Hypotheses
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8-2 Time Value of Money Chapter 8 Contents 1 Th e o r yo fR e a lIn t e r e s tR a t e s ................. 8 - 3 2 N om in a t e r e s a t e s..................... 8 - 7 3 T e rmS t ru c tu r eH ypo th e s e s .................. 8 - 8 3 . 1 E x p e c t a t i o n sH y p o t h e s i s ...................... 8 - 8 3 . 2 L i q u i d i t yP r e f e r e n c y p o t h e s i s................... 8 - 1 0 4 H ew o r k ........................... 8 - 1 3 15.407 Lecture Notes Fall 2003 c ° Jiang Wang
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Chapter 8 Time Value of Money 8-3 1 Theory of Real Interest Rates Real interest rates are determined by supply and demand of funds in the economy. Three factors in determining real interest rates: 1. Aggregate endowments 2. Aggregate investment opportunities 3. Aggregate preferences for diFerent consumption path. Dollars, date 0 Dollars, date 1 e 1 e 0 ( e 0 ,e 1 ) payoF 6 invest (1+ r ) u ( c 0 ,c 1 ) u H H H H H H H H H H H H H H H H H H H H H H H H H H H H H c ° Jiang Wang ±all 2003 15.407 Lecture Notes
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8-4 Time Value of Money Chapter 8 Consider a representative investor: has endowment of ( e 0 ,e 1 ) faces a bond market with interest rate r . He maximizes his utility over his consumption now and later: max u ( c 0 )+ ρu ( c 1 ) s.t. c 0 = e 0 b c 1 = e 1 +(1+ r ) b where b is his bond holding, u 0 > 0 and u 0 < 0 . The optimality condition is u 0 ( c 0 )=(1+ r ) ρu 0 ( c 1 ) or (for c 1 = c 0 + dc ) r = u 0 ( c 0 ) ρu 0 ( c 1 ) 1 µ 1 ρ 1 1 ρ c 0 u 0 ( c 0 ) u 0 ( c 0 ) dc c 0 . 15.407 Lecture Notes Fall 2003 c ° Jiang Wang
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Chapter 8 Time Value of Money 8-5 Thus, the real interest rate is given by r = µ 1 ρ 1 + 1 ρ · c 0 u 0 ( c 0 ) u 0 ( c 0 ) ¸µ dc c 0 .
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Ch08 - Chapter 8 Time Value of Money Road Map Part A...

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