Interest Rates and Time Value of Money – CFA Level I

Welcome to the first lesson of the CFA Level 1 Quantitative Methods course. We’ll start with the time value of money, a crucial concept in finance. If you’re already a pro, feel free to jump to the next lesson.

In this lesson, we’ll define interest rate and explore two key aspects: how interest rates are determined from a risk compensation perspective and how they can be interpreted in three different ways.

Interest Rates: Risk Compensation and Risk Premiums

Imagine a stranger asking to borrow $10,000 from you, promising to return it in a year. What interest rate should you charge?

You might think of Treasury bills, providing a risk-free interest rate in the US. But you’ll want more than that for taking on the risk of lending to a stranger! That extra interest is called the risk premium.

Interest rates can be broken down into five components, consisting of risk premium components and risk-free components. Let’s examine each of them:

1. Default Risk Premium: How likely is the borrower to repay? Consider their financials and credit rating. The lower their credit rating, the higher the default risk premium.
2. Liquidity Premium: How easily can you convert the debt to cash? If there isn’t a ready market or high transaction costs are involved, you’ll want a higher liquidity premium.
3. Maturity Risk Premium: How long will it take for repayment? The longer the timeframe, the higher the chances of things going wrong, and the higher the maturity risk premium.
4. Nominal Risk-Free Rate: The minimum return expected for any investment. This can be broken down into two components: inflation premium and the “real” risk-free rate.
5. Inflation Premium: Compensates you for expected inflation over the loan period to preserve your money’s purchasing power.

Interpreting Interest Rates: Three Perspectives

The 10% interest rate in this case is your required rate of return, the minimum return you’d accept for this investment. There are other valid interpretations of interest rates:

1. Discount Rate: The rate used to discount the future value of cash flows to determine the present value.
2. Opportunity Cost: The return you’d give up if you spent the money now. In this case, 10% is the opportunity cost of current consumption.

Key Takeaways

Remember, interest rates consist of the real risk-free rate, inflation premium, maturity risk premium, liquidity premium, and default risk premium. Interest rates can be interpreted as the required rate of return, discount rate, or opportunity cost. These three terms appear frequently throughout the CFA curriculum, and most of the time, they refer to the same concept: interest rate.