Time Value of Money, Risk and Return

Transcription

1 Time Value of Money, Risk and Return Introduction Time Value of Money and Risk and Return A simple illustration of a bank deposit is used to explain simple interest. Next a compound interest rate application is shown. The concepts of Present Value and Future Value are explained to you as these concepts form the basis of understanding cash flows in equity and fixed-income investments. The basic concept of risk and return, the continuum of investment products ranging from very low risk to high risk products and their implications are discussed.

2 Introduction to Time Value of Money Money is a scarce commodity that has value over time Suppliers (depositors or lenders) of money are being paid to part with their money by those who demand or need the money (borrowers) The payment for the use of money is in the form of interest Simple and compound interest calculations are then used to compute interest amounts in 2 separate illustrations Lastly, the concepts of Present Value (PV) and Future Value (FV) and their significance are explained Time Value of Money Illustration of a Simple Interest Calculation Let us illustrate a simple interest rate calculation based on a fixed deposit of $1,000 placed with a bank Principal Amount S$ 1, Interest Rate Tenure (Period of deposit) 6 % per annum 6 months (½ year) Interestpayable at maturity (S$1,000 x 6% x 6/12 ) = $30 Principal + Interest at maturity S$ 1,000 + S$ 30 = S$ 1,030 The simple interest rate earned in the above deposit is the true rate of interest

3 Time Value of Money Illustration of Compound Interest Calculation Compound interest rate is calculated when the interest paid on the initial principal amount also attracts further interest payments in subsequent period of the deposit renewal or rollover Initial Principal S$ 1, New Principal S$ 1, Interest rate 6% p.a. Interest Rate 6 % p.a. Initial Tenure (1 st Period) Interest payableat maturity Total Amount (Principal + Interest) 6 months Next tenure (2 nd Period) S$30 Interest payable at Maturity (2 nd Period) S$1, Total Amount (Principal + Interest) 6 months S$30.90 S$ 1, Note that the 2 nd interest payment of S$30.90 received is greater than the 1 st interest payment of S$30 due to the compounding effect Understanding Simple and Compound Interest Calculations Investors need to understand the concept of simple and compound interests as these concepts and calculations are often used in valuing investment returns (such as equities and bonds which generate dividend and interest incomes) over a period of time The effects of compounding are such that an asset that is able to achieve a consistent rate of return of 8% per annumyear after year will be able to almost double in size after only 9 years The basic assumption of compound interest computation is that the interest rate remains constant throughout the tenure, which may not be a realistic assumption for most investments

4 Time Value of Money Present Value (PV) and Future Value (FV) Present Value (PV) : Is the current value of a future amount that is yet to be received Answers the question of what amount is needed NOW that will grow to become X amount in the future Uses an interest rate calculation called the discount rate, which is applied consistently throughout the period of calculation Future Value (FV) : Refers to the amount that will be available when a current known amount grows at a compound rate over a period of time Is an extension of the compounding effects on interest rates which become accumulative over a period of time Investors need to fully understand PV and FV when calculating streams of future cash flow in relation to various investments that provide dividends or interest payments to investors. Introduction to Risk and Return Investors undertake investments to generate returns in the form of : INCOMEwhich can be dividends or interest or other cash payments CAPITAL GAINS or appreciation when the investments are sold or liquidated (This does not mean that capital losses cannot occur) RISK is defined as the degree of certainty in which an investment is able to generate the returns (comprising capital gains and income as mentioned above) over a given period of time There will always be risk in investments as long as there is uncertainty over the future income or capital returns The more uncertain the returns are, the higher the investor s expectation of the future returns to compensate or reward him for the added risk taken Investors need to analyse past returns in terms of volatility (where available) to ascertain the attractiveness and suitability of the investments

5 Risk and Return Trade Offs Investors need to evaluate the following trade-off considerations between risk and return when evaluating the suitability of each investment: The higher the risk an investor bears for an investment, the greater will be his demand for higher expected return in order to compensate for the higher risk bearing Conversely, risk is increased when there is concentration of investments into very limited types of securities or asset classes in a portfolio Risk in investments can be reduced through diversification and asset allocation into different asset classes or types Concept of Risk and Return Asset Classes Represented in a Continuum Graph showing a continuum of asset classes (groups of investment products/instruments) ranging from very low risk (cash/bank deposits) to very high risk (commodities, derivatives) Level of Expected Returns Commodities / Derivatives High ( Futures / Options ) Stocks and Shares Real Estate / Properties Moderate Mutual Funds Real Estate Investment Trusts Low Bonds ( Fixed Income ) Cash / Bank Deposits Low Moderate High Level of Risk

6 Risk and Return From the above chart, you can see that the asset class with the lowest risk is cash and bank deposits which usually also generates the least return As investors move into asset classes further to the right, the risk level as well as the expected levels of return increase This means that an investor who chooses to invest in stocks and shares instead of bonds is prepared to accept the stocks greater level of risks while at the same time expecting to be compensated by the higher returns to be potentially generated from owning stocks instead of bonds The above chart is only a general rendering of the risk return tradeoffs between different classes or types of investment products. Specific securities in an asset class can be of higher or lower risk and reward when compared to other securities in another asset class Summary The concept of time value of money, including understanding how simple and compound interest rates are computed The roles of Present Value and Future Value in evaluating the returns of equity and fixed-income instruments The concept of risk return trade-offs is examined in detail when we look at the various asset classes presented in a continuum

7 References Gitman, Joehnkand Smart, Fundamentals of Investing, 2011 Appendix 4 A The Time Value of Money Chapter 4 Return and Risk Websites :