Time Value of Money Essay
Interest rate pertains to the earning which is made over clip ( Valentino. 2002 ) . Two of import parties are engaged in this scenario – the borrower and the loaner. The borrower incurs the losingss while the investor has the involvement. the net income. after the term is fulfilled. There are two chief types of involvement rates harmonizing to their nature:nominalinvolvement rate and theexistentinvolvement rate.
Nominal involvement rates are fixed and usually contract edge for a given term. While existent involvement rate takes rising prices into history. therefore the involvement rate is capable to alter over clip. depending on the economic conditions ( Dr. Johnson. 1994-2005 ) . For illustration. a $ 10. 000 loan with an involvement rate of 20 % collectible for 2 old ages will hold the same involvement rate until the 2-year term ends under a nominal involvement rate puting while the involvement rate is likely to alter after the 1sttwelvemonth under a existent involvement rate scene.
Interest rates can besides be classified harmonizing to their gaining power:simpleinvolvement andcompoundinvolvement. In simple involvement. merely the chief sum additions involvement. While in compound involvement. the current sum ( chief + the old involvement incurred ) will derive the involvement ( Valentino. 2002 ) . For illustration. if Mr. X borrowed $ 10. 000 from a bank with a simple involvement rate of 10 % yearly.
The involvement will be equal to $ 10. 000 Ten 0. 10 Ten 2 which is equal to $ 2. 000. Hence. the accrued value will be equal to $ 10. 000 plus $ 2. 000 which is equal to $ 12. 000 after the 2-year term. While under compound involvement. after the first twelvemonth. the involvement would be $ 10. 000 Ten 0. 10 = $ 1. 000 and the accumulated value will be $ 11. 000. This will go the new principal. After the 2nd twelvemonth. the involvement would be $ 11. 000 Ten 0. 10 = $ 1. 100 and so the accrued value would be $ 12. 100 at the terminal of the 2-year term ( TVM 1. 2. 2 Java Bean. 2007 )
Discount rate is non much different from the involvement rate. Actually. it is besides governed by the same rule. The lone difference between the two is that the involvement is paid at the terminal of the term under an involvement rate. but under a price reduction rate. the involvement is paid instantly or at the beginning of the period ( Dr. Johnson. 1994-2005 ) .
Using the old illustration. under a simple price reduction rate of 10 % if Mr. X would hold to borrowed the same sum so. the bank would non give him $ 10. 000. but less the involvement. Since the involvement must be discounted at the beginning. so the bank will merely impart him $ 8. 000 but he has to pay $ 10. 000 at the terminal of the 2-year term ( TVM 1. 2. 2 Java Bean. 2007 ) .
Clearly. the involvement and price reduction rate are some of the most of import economic indexs. Proper calculation and informations would give economic experts a step of how much an involvement rate would be. Therefore. to continue the value of money through clip. analysts should accurately mensurate the current economic tendencies and implement the most accurate rates as possible.
Valentino P. ( 2002 ) . Interest Rates. Retrieved August 17. 2007. from Economics Web Institute. Website: hypertext transfer protocol: //www. economicswebinstitute. org/glossary/interest. htm.
Dr. Johnson. P. M. ( 1994-2005 ) . A Glossary of Political Economy Footings: Discount rate. Retrieved August 17. 2007. from Auburn University. Website: hypertext transfer protocol: //www. auburn. edu/~johnspm/gloss/discount_rate.
TVM 1. 2. 2 Java Bean. Retrieved August 17. 2007 from: hypertext transfer protocol: //www. getobjects. com/Components/Finance/TVM/tvm. hypertext markup language.