1294410427589_Chapter4_Instructor_Notes

1294410427589_Chapter4_Instructor_Notes - CHAPTER 4: FUTURE...

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______________________________________________________________________________________ 55 CHAPTER 4: FUTURE VALUE, PRESENT VALUE AND INTEREST RATES A. T HE B ASICS The primary focus in this chapter is on Core Principle 1: time has value. It is likely that your success in this part of the course, and in many aspects of your financial life far beyond this course, depend crucially on understanding this chapter. If you learn the concepts, and how to implement them, you will earn huge rewards. Chapter 4 is organized around three topics. First, the ideas of future and present values are presented. You will start with the notion of future values, and in the process highlight the notion of compound interest. You will also see that the idea of the present value is one that is closely related to future value. In fact, much as division “undoes” multiplication (take a number, double it, and then divide by two), present value and future value are really concepts where one “undoes” the other. Second, in the process of discovering the ideas of present and future value, you will at the same time be learning about the proper measure of the interest rate as a way to correctly measure the time value of money. Third, it is absolutely imperative for you to learn to distinguish between what economists call the nominal interest rate and the real interest rate. This distinction arises whenever the rate of price change is not zero. In many important ways the real interest rate is the focus of monetary policy, as you will begin learning at the end of the chapter. B. S OLIDIFY Y OUR K NOWLEDGE DISCUSSION/EXTENSIONS OF THE BASICS The Key Equation : Text equation (3) on page 74 is the most important expression in the chapter. It states: PV = FV n / (1+i) n . Note that an algebraic equivalent, FV n = PV * (1+i) n on text page 72, is similarly important. These expressions show explicitly and precisely the value of time. The expression in terms of FV n helps understand the concept of compounding. The expression in terms of PV helps you grasp how financial assets, which often provide promises to make payments in the future, are priced today. The Real Interest Rate . The real interest rate is a key concept. For a sense of its importance, take a quick look ahead at Your Financial World : It’s the Real Interest Rate that Matters on text page 558 in chapter 21. The “nominal” interest rate tells how much you will receive later in dollars if you make a loan today. For example, lend someone $1 at 5%, and in a year you will have
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Chapter 4: Future Value, Present Value and Interest Rates ______________________________________________________________________________________ 56 $1.05. Similarly, the nominal rate tells you the dollar amount you will owe later if you take out a loan today. Borrow $1 at 5% and next year you will owe $1.05. In contrast, the real interest rate tells how much you will earn (or pay) in terms of goods (and services) rather than in terms of dollars. Lend someone a “bundle” of goods today and receive back
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This note was uploaded on 09/07/2011 for the course ECO 412 taught by Professor Staff during the Spring '05 term at Kentucky.

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1294410427589_Chapter4_Instructor_Notes - CHAPTER 4: FUTURE...

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