1. What is time value of money and its importance. Explain the relationship of d

Question

1. What is time value of money and its importance. Explain the relationship of discounting and compounding. Suppose you were considering depositing your savings in one of three banks, all of which pay 5 percent interest; bank A compounds annually, bank B compounds semiannually, and bank C compounds daily. Which bank would you choose? Why?

2. Discuss investor’s required rate of return, and how the riskiness of an asset is measured and interpreted. Assess how diversifying investments would affect the riskiness and expected rate of return of a portfolio or combination of assets. Discuss unsystematic risk, systematic risk, characteristic line, beta, portfolio beta, and asset allocation.

Explanation / Answer

Solution:

Time Value of Money-

Time Value of Money is an approach provided or introduced to explain that, the worth of money available at the present time is more than the same amount in the future due to its potential earning capacity.Because money can earn interest.

Suppose, today we have 1 $, and market rate of interest is 10 % say. If we deposit the same amount in bank which provides interest 10 %, that 1 $ we turn upto $ 1.1, but the present value would not be $ 1, it will be calculated as

                                         $ 1 / $ 1.1 = $ 0.9090

Just the difference of 1 year, that $ 1 will have a worth of 0.909 next year. It means, present value of $ 1 will be $ 0.909. The same $ 1 will lose its worth to $ 0.909. It is time value of money.

Importance of time value of money is that, it helps in making financial decisions for the future, like investing in any proposal, purchaing of securities like shares bonds etc. by calculating the return we want.

Relation of discounting and compounding-

Discounting can be defined as the calculating the present value of future cashflows with a required rate of return where as compounding can be defined as finding the value of of a current sum of money in future money. And the rleation of compounding and discounting can be shown by the equation too

                                      Future value = Present Value ( 1 + required rate of interest ) number of period

For caculating future values of present values, both discounting and compounding is used.

Further, The bank which will give higher interest will be choosen, and the bank C which compounds daily will give higher interest, becausing of its daily compounding. So, it will be choosen among the three provided atlernates.

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