Question

Would you rather have $100 today or $105 in one year? What does your answer depend on? What happens to your choice as the interest rate rises? As the interest rate falls?

Answer #1

a) Our answer would depend upon the current market interest rates.

Rate at which I will be indifferent between both the choices will make the PV of future $105 equal to current $ 100.

i.e. 105/((1+i)^1) = 100, solving for i =5%

So, if currently the market interest rate is :

- below 5%, I will choose $105 in 1 year as the FV of $100 today would be lower than the $105 in one year's time.
- above 5%, I will choose $100 today as the FV of $100 today would be higher than the $105 in one year's time.

b) If the interest rates rises, the present value of any future amount decreases. Thus, PV of $105 would be lower than $100 if interes rate increases over 5%

c) If the interest rates falls, the present value of any future amount increases. Thus, PV of $105 would be higher than $100 if interes rate falls below 5%.

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