What is Time Value of Money?

The world is filled up with the ample number of things like food, clothes, car, books, mobile, tangibles, intangibles and an endless number of things and the money we need to buy these items because these items do have a price. However, you know the money we pay to buy things itself also has a price, yes, it does and it's called Interest rate. You heard it right interest rate is the price of money we pay to buy items and the price of money is directly proportional to the time. The longer the time is higher the price of money. Now dive straight into it and figure it out how.

Why do we pay or charge interest? Because when you lend your money to someone to use, you could have consumed that money in buying anything. By giving that money to someone, you are sacrificing your current consumption of that amount and to compensate the same you charge interest rate as a price of money. Interest rate generally consists three components viz.

• Real risk-free rate
• Inflation risk premium
• Maturity risk premium

The real risk-free rate is the price you charge as an opportunity cost for the sacrifice of current consumption i.e. the price you are charging for not consuming the amount and giving the same to someone to use. We charge only real risk-free rate from borrower like Banks and Treasury whose probability of default is almost nil. In addition, we charge inflation premium as a compensation required for the expected loss of purchasing power. Example: If we lend someone Rs.100 for one year to consume but by the end of one year, you found the goods prices have been increased to Rs.101 so due to inflation the price of goods inflated by 1%, which reduces the purchasing power of the lender. This is the reason we charge inflation premium. Generally, the bank provides to their saving bank account holders the interest rate consisting real risk-free rate and inflation risk premium.

Finally, the Maturity risk premium is charged because of the risk associated with the borrower. The risk associated with the borrower can be in three shapes.

1. Default risk premium: The premium charged because of the borrower's probability of getting a default.
2. Liquidity risk premium: Liquidity refers to the pace at which you can offload the security without substantial loss of value. Investors like liquidity. Treasury securities are the most-liquid security.
3. Maturity risk premium: Maturity risk premium refers to the premium charged because of the securities having long-term maturity. As security can be redeemed only at maturity, so longer the maturity investors get back their money after a long period of time so they ask for maturity risk premium for the same.