Reading Topic - Time Value of Money

Note - CFA level 1 is divided into 18 study sessions => each study session has Readings => Readings have LOS i.e. learning outcome statementsInterest rate has 3 interpretation(s):1. If you are buying a 0 coupon bond(a bond which will not pay any coupon in between;it will be issued at a discount and redeemed at par) with face value say 1000 and maturity 1 year. So for that bond what amount are we ready to pay today which will be the present value of 1000 which is (1000/1+R). So here are we compounding or discounting?Obviously discounting for which we need interest rate R which is the Discount Rate. Interest rate is the discount rate here.Any asset produces future cash flows and to get the cash flows we are willing to pay some amount today which is the PV of the cash flows. To do the PV(present value) of the cash flows we need to define what is discount rate for the cash flows.To calculate the discount rate we need the required rate of return e.g you will say you need 20% return which means you are willing to pay 1 Re now and will get 1.2 Re after one year. So to get 1000 after 1 year you are willing to pay 1000/1+1.2. 20% is the required rate of return. First interpretation of Interest rate - It is the discount rate used to pull cash flows.2. Second interpretation is that it is the required rate of return whenever we are making an investment.Now how to decide upon the required rate of return. It actually depends on the opportunity cost. As a result of buying this bond I am losing the opportunity to investing elsewhere.3. Third interpretation is that it is the opportunity cost of capital.Summary - Any asset generates future cash flows. The price of the asset would be the PV of the cash flows, and for calculating the PV you need to discount them (not compound). The rate at which you discount them is called the Discount Rate. This discount rate is actually your Required Rate of Return. Finally how do you decide upon what rate of return you want by looking at the Opportunity Cost.Example - We buy a govt bond at 900 (outflow) today and get return of 1000 after a year. In that case the PV of 1000 is 900. This process is called discounting.this security is a Security Note or Security Bond issued by a company.