Question

1. THE TIME VALUE OF MONEY Some financial advisors recommend you increase the amount of federal income taxes withheld from your paycheck each month so that you will get a larger refund come April 15th. That is, you take home less today but get a bigger lump sum when you get your refund. Based on your knowledge of the time value of money, what do you think of this idea? Explain.

2. INTEREST RATE RISK Define what is meant by interest rate risk. Assume you are the manager of a $100 million portfolio of corporate bonds and you believe interest rates will fall. What adjustments should you make to your portfolio based on your beliefs?

Answer 1

1. Time Value of Money is the effect of application of interest. An amount received today is worth more than the same amount received on a future date. Because the money received or paid today will earn interest for the interim period and will grow in volume during that period. Inversely, the amount received or paid on a future date is equivalent to a lesser amount today, the difference being interest during this period.

In the given case, the idea of higher deductions as income tax  every month and refund of the same in April next is not beneficial.for the person subjected to it. This is because of the operation of time value of money explained above. The refund receivable later in April next is not worth of the amount deducted every month., the difference being the amount of interest involved.

2. Interest Rate Risk is the risk of fixed income securities being affected by change in the market. It is also known as Market Risk. When the market interest rate (or consequently the market expectation of yield) increases, price of the bond gets reduced so that the fixed amount of income at the coupon rate corresponds to the higher yield expectation on. (In cases where the investments are to be marked to market at the intervals as stipulated by the regulators, the reduction in market value of the securities will result in booking losses in the books of the investor)

The reverse process takes place in case the market interest rates decrease after making the investment. In such a situation, price of the security increase when the market interest rate decreases.

In the given case, the expectation is that interest rates will fall. As a result, price of the bonds will increase. It is true that there is a risk of lower yields on re-investment of the periodical interest received. The manager can opt to take advantage of the price increase by selling the bonds, once the change in rates takes place, in case there is a need to book profit. But the sale proceeds will yield only at lesser rate on re-investment. Still this is the best choice in case there is a chance interest rates going up later on.