Time Value of Money

By admin
Feb 15th, 2012
1 Comment
Time Value of MoneyThe most basic concept but a very important one. It is one of the essentials to know before stepping into the world of finance. It is of utmost importance in pricing of every other instrument. We will see about pricing sometime later but for now let’s understand Time Value of Money.

Time Value of Money: Let’s take an example from our day to day life.

You expect some amount of cash from a party in the near future, say Rs 10,000/-. The party offers to pay the money either today or after a month. Which option would you choose? There is no telling the answer, obviously the former one. The reason behind that is Time Value of Money. Money received sooner is always worth more than money received later. But why is it so?
Answer: It is so because if you have the money today you can earn interest over that money in a given period of time. Money kept in your pocket is losing its value with every passing day. 🙂
But what an interest is? Why somebody borrowing from you now would after some time return you more than what he actually borrowed? The answer to this is pretty straight forward.

An interest is the compensation paid by the borrower to the lender, as the lender forgoes his right to use his money now and lends it to the borrower and let him use the money now.

This interest can be calculated as:
  • Simple Interest
  • Compound Interest
We will not discuss the two methods here as they are too simple to be elaborated.

What does money losing its value with time means? It simply means that with a particular amount of money you will be able to buy lesser quantity of a particular thing after some time than what you are currently able to. The buying capacity of money decreases because of inflation.

Inflation: It is the increase in price of all the goods and services. If in a year the prices go up by 3 % from the level they were during the same period last year, then the inflation is said to be 3%.

It is not necessary that prices of all the goods increase by the same level, rather prices for some might decrease during the period, but overall you will be required to shell out 3% more than what you were spending the previous year.

Causes of Inflation:
  • Long term inflation occurs when there is more money supply in the market than the rate at which goods are produced. When there is more money available in the market to purchase goods or services which are not produced at the same rate at which the money supply grows, inflation tends to rise. It is a simple demand and supply thing. Inflation rises when the consumers want to consume more goods than what can be produced with the current resources as this puts an upward pressure on the prices of these goods as they are high in demand.
  • Short term inflation occurs when prices of a particular essential shots up causing a rise in other prices as well, e.g. oil. Whenever oil prices shoot up prices of other goods and services show a rise as oil is a major cost in any mode of transportation.
Control Measures: For now we will briefly speak about them but will discuss them in detail in the coming posts.
  • Decreasing money supply in the market, monetary policy.
  • Introducing new taxes or increasing the old ones or changing the government’s spending, fiscal policy.

The first measure can be achieved by increasing the interest rates which will squeeze out some money from the market and thus balance the money supply and the goods and services produced.

The second measure will put extra burden on the tax payer and will force him to cut down his spending to balance his budget due to increased pressure of higher taxes.

Hence, we see that interest rates tend to go up in a high inflation period. When you invest your money you would always like to beat inflation. Otherwise your buying power will be reduced as the value of money will go down with higher inflation.

So, now we can define Time Value of Money. It will be the building blocks for the coming posts in which we discuss different market instruments and where we refer to time value of money time and again.

One Response to “Time Value of Money”

  1. Another addition to your list of two, would be real interest. The rate of return, after accounting for the rate of inflation. I think it’s the most practical way to determine the future value of any amount of money. 🙂

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