CFA Level 1 Time Value of Money LO a: Various Interpretation of Interest Rates

Hello and welcome back. 

In this blog, we will start talking about Time Value of Money, which is the first reading of Quantitative methods Study Session for the CFA Level 1 exam. The concepts discussed in this reading are not only important for the CFA exam but as a finance professional, you will be using these tools regularly.

I hope you have seen our previous blogs 0C. Introduction to Time Value of Money (TVM) Calculations for CFA Level 1 (with Examples) and 0D. Introduction to Cash Flow (CF) Calculations for CFA Level 1 (with Examples). If you haven’t done so, I will strongly advise that you read these 2 blogs first and get familiar with basic concepts before we move ahead in this study session. 

So, let’s start talking about Time Value of Money. What exactly is the meaning of Time Value of money? 

Let’s say I offer you a 1000$ and I give you two options: you could either have it today or you could have it after a year. 

Which option would you choose?

Of course Option 1, right! 

This is because you know that you could either invest those 1000$ today to get a higher amount of money after a year or you could buy/spend that 1000$ to buy something that may be more expensive in future. So, as you can see a 1000$ today is much more valuable than a 1000$ one year from now, i.e. money has a time value: the sooner we get, the more valuable it is.

Now let’s talk about the first Learning Outcome which states “Interpret interest rates as required rates of return, discount rates, or opportunity costs”. Interest rate signifies how quickly your money grows (if you are an investor). In simple terms, a higher interest rate implies a quicker growth of your money. Now interest rates can be interpreted in a number of ways and CFA curriculum requires you to understand these 3 interpretations:-

1. Required rates of return: Every investor needs some “financial motivation” to invest his money. The required rate of return is the interest rate that an investor requires to loan/invest his money for a particular investment (considering the “risk” involved in investing). 

Let’s say I have a 1000$ and you want to borrow it from me for a year. Now, I need to have some financial motivation to give my money to you. Let’s say I want at least 1100$ after a year to give my money to you. Now, this additional 100$ is my financial motivation to loan the money to you. In simple terms, I am making 100$ on my investment of 1000$ in a year. So, my rate of return is 10%. 

The required rate of return is the minimum interest rate that will convince an investor to invest his money for any particular investment. As can be expected, the required rate of return will vary for different investments.

2. Discount rates:  Interest rates can also be called discount rates as the future payments are “discounted” at this rate to arrive at the present value of the future payments. 

For our previous example, the discount rate is 10% as the future payment of 1100$ at the end of one year, when discounted at 10% yields 1000$ today. 

Required rate of return and discount rate are terms that are used interchangeably, they imply the same interest rate.

3. Opportunity costs: Opportunity cost is the cost of spending the money now, rather than investing. This is the lost value that the money could have earned if it was invested rather than spending it today and is given in terms of the interest rate as well. 

For our previous example, the opportunity cost of current consumption will be 10% as the investor would lose the benefit of earning 10% if he spends the money today.

Please note that all these 3 terms represent interest rate, but they explain interest rate from different perspective. Required rate of return is the interest rate from an investor’s perspective, discount rate is the interest rate from a borrower’s perspective and opportunity cost is the interest rate from a consumer’s perspective.

You can watch a video explaining the points discussed in this blog here:-

In the next blog, we will talk about the 2^nd learning outcome: various components of interest rate.

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