LOS 1.aQuantitative Methods · Time Value of Money
Interpreting interest rates and discounting
Difficulty
Candidate-reported: Moderate
Exam frequency
High — appears on essentially every Level I sitting
An interest rate can be read three ways at once: as a required rate of return, as a discount rate, and as an opportunity cost. The same number does all three jobs — which reading you use depends on the question being asked.
Key points
- The nominal risk-free rate ≈ real risk-free rate + expected inflation; adding default, liquidity, and maturity premiums builds it up to a required return.
- Present value discounts a future cash flow; future value compounds a present one. They are the same equation rearranged.
- More frequent compounding raises the effective annual rate (EAR) for a given stated rate — EAR = (1 + periodic rate)^m − 1.
Common pitfalls
- Mixing the compounding frequency of the rate with the frequency of the cash flows — always match periods first.
- Quoting a stated annual rate where the question wants the effective annual rate.
Source: CFA Program Curriculum, Level I — Quantitative Methods, Time Value of Money.