Question

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 states that the money has interest earning capacity. It means that if one has $100 today than it will become $105 a year latter (assuming 5% interest rate).

Here advice is given that allow more deduction now and get refund latter. In this case one will not get interest as we discussed above. Thus in effect one is lossing interest on the money. Hence the advice given should not be followed

2) interest rate risknis the risk that the portfolio might suffer loss due to change in interest rate. For example if interest rate rises than prices of the bond will decrease resulting in loss

If one is managing 100$ million portfolio of bond and believes that interest rate might increase, he shall reduce holding of long term bonds. This is becase long duration bonds are more sensitive to interest rate change. Allocation to short duration bonds should be increased