Posts Tagged nominal
Author: Awais Ahmad (email@example.com)
The process of going from today’s value (Present Value; denoted by PV) to Future Value (denoted by FV) is called Compounding. If i is the Interest Rate, then Interest Amount (INT) can be calculated as:
INT ($) = PV x i
The Future Value will be the Present Value plus the amount of Interest, so:
FV = PV + INT
FV = PV + PV x i
FV = PV (1 + i)
If the amount is deposited or invested for n periods, the same formula can be written as:
FVn = PVn (1 + i) n
The term (1 + i)n is known as Future Value Interest Factor and is denoted by FVIFi,n, so:
FVn = PVn (1 + i)n = PV (FVIFi,n)
In some cases, Interest is paid semiannually, which means Interest is paid twice a year. Similarly Interest payment 4 times a year means Interest is paid quarterly. For such cases, the above formula can be more generalized:
Where m is the number of times Interest Payment is made in a year. However, in such case, i is taken as Nominal Rate of Interest.
The process of calculating Present Value (PV) from Future Value (FV) is called Discounting. As we know:
FVn = PVn (1 + i) n
Solving for PV, we have:
Or we can write it as under:
PVn = FVn (1 + i)-n
The term (1 + i)-n is called Present Value Interest Factor, and is denoted by PVIFi,n; therefore:
PVn = FVn (1 + i)-n = FV (PVIFi,n)
Same as previous case, if the Interest is paid semiannually or quarterly, a more general formula is applicable:
Where i is taken as Nominal Rate of Interest.
Effective Annual Rate (EAR):
Effective Annual Rate is defined as the rate which would produce the same Future Value, if annual Compounding had been used. It is also called Equivalent Annual Rate, and can be calculated as:
As we have taken Annual Compounding, therefore n is not shown in the formula, and i will be taken as Nominal Rate of Interest.
Financial Management – Theory & Practice by Eugene F. Brigham & Michael C. Ehrhardt
Investment Analysis & Portfolio Management – Lectures
Author: Awais Ahmad (firstname.lastname@example.org)
When an investor invests in multiple
stocks/securities, it is called Investment Portfolio. Maintaining a Portfolio
is a very important step taken by investors. By maintaining a Portfolio, Risk
can be mitigated / minimized by maintaining a portfolio and higher margins of
profits can be earned. In this case, if one stock/security defaults, it does
not necessarily mean Investor is also in loss. Instead, investor can compensate
the loss of one stock from other stocks/securities. Fig. 5 shows how
maintaining a Portfolio minimizes the Portfolio Risk. Fig shows that Portfolio
size is taken on x-axis and portfolio risk on y-axis, which results a curved
Classification of Investors:
Investors can be classified on the basis of their risk-taking/bearing capacity. How much risk an investor bears, depends on investor’s personal capacity, attitude, interest and behavior. For example:
- 1. Risk Seekers
Risk seekers seek for riskier investment. They are capable of assuming a higher risk and have strong and healthy financial position.
- 2. Risk Avoiders
They avoid riskier investments, because they have not strong and healthy financial position. They choose those instruments, which have less variation in returns.
- 3. Risk Bearers
Risk bearers fall in between the above categories. They choose moderate levels of risk they can bear according to their capacity.
Risk reduction is known as Hedging. They do it by using Derivative Instruments.
A Security refers to a publicly traded financial instrument, as opposed to a privately placed instrument. Securities have greater liquidity than otherwise similar instruments, which are not traded in Open Market. Security is considered to be an insurance against an emergency, according to banking definitions.
Classification of Securities:
The securities have been classified according to the functional operation aspects as under:
- 1. Intangible Securities
These are personal exclusive undertakings by a party to pay the amount of advances outstanding against a borrower. Examples of such securities are Demand Promissory Note, bill of exchange or a Bond, Guarantee and Indemnity etc.
- 2. Tangible Securities
These are the securities which can be realized from sale or transfer. Examples of such securities are Shares, Stock, Land, Building and Goods.
- 3. Prime Securities
These are also called Primary Securities. Such securities are main covers for an advance and are deposited by the borrower himself. When a depositor of term deposits offers his Term Deposit Receipt to cover and advance, it is the Primary Security according to banking term.
- 4. Collateral Securities
These are the securities provided as an additional cover for an advance, where either he security is not very stable in value, or where the realization of the security to cover the outstanding amount of balance is difficult. In case of the default by borrower, bank has the authority to sell these shares of security and adjust the advance.
- 5. Movable Securities
These are the securities, which are legally and physically both in possession of the lending bank. Examples are Term Deposit Receipts, Goods, Vehicles and Merchandise etc.
- 6. Immovable Securities
These are the securities, where the legal possession or right to takeover is entrusted to the lending bank, but the physical possession remains with borrowers.
- 7. Government Securities
These are the long-term securities issued by the government for financing social programs. They are perceived as Risk-free, are highly liquid and carry attractive coupon rates. Like T-bills (Treasury Bills), government securities are sold through auctions and are actively traded in secondary markets.
Time Value of Money:
The theory of Time Value of Money states that the value of money decreases with the passage of time. This concept can be described as “A Dollar in hand today is more worth of a Dollar tomorrow”. This happens because of Inflation. Inflation is a situation, where the prices as a whole are increasing. The rate at which the prices are increase is known as Inflation Rate. Two terms are necessary to explain while discussing Inflation and theory of Time Value of Money:
- 1. Nominal Interest Rate/Quoted Interest Rate:
Nominal Interest Rate is a rate at which money invested grows. Banks generally offer Nominal Rate of Interest to the depositors.
- 2. Real Interest Rate
Real Interest is a rate, at which the purchasing power of an investment increases. Market Interest Rates are Nominal Interest Rates.
Relationship of Inflation, Nominal and Real Interest Rates:
Real Interest Rates, Nominal Interested Rates and Inflation Rates have strong relationship with each other, which can be expressed in the form of an equation:
The above equation shows that if Inflation Rate increases, then Real Interest Rate decreases and vice versa.
Another approximate relationship also exists between the three rates:
It means, by subtracting Inflation Rate from Nominal Interest Rate, the approximate Real Interest Rate can be calculated.
Financial Management – Theory & Practice by Eugene F. Brigham, Michael C. Ehrhardt
Management of Banking and Financial Services by Padmalatha Suresh & Justin Paul
Handouts Investment Analysis and Portfolio Management
Lectures on Financial Investment and Portfolio