Suppose that a risk-free investment will make three future...

Suppose that a risk-free investment will make three future payments of $100$dollars in one year, $100$dollars in two years, and $100$dollars in three years. If the Federal Reserve has set the risk-free interest rate at 8 percent, what is the proper current price of this investment? What if the Federal Reserve raises the riskfree interest rate to 10 percent?

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Key Concepts

Risk-Free Rate

The risk-free rate is the interest rate associated with an investment that is considered free of credit risk, typically represented by government securities. It serves as the benchmark for discounting future cash flows in financial calculations and helps in assessing the value of investments relative to a guaranteed return.

Present Value

Present value is the concept of determining the current worth of a future sum of money or stream of cash flows given a specific rate of return. It embodies the idea that a dollar today is worth more than a dollar in the future due to its potential earning capacity, and it is essential for evaluating investment decisions.

Discounting Cash Flows

Discounting cash flows involves applying a discount rate to future cash inflows to convert them into present values. This technique accounts for the time value of money, ensuring that future payments are evaluated in terms of today’s dollars, which is crucial for pricing investments.

Time Value of Money

The time value of money is a fundamental financial concept that implies money available now is worth more than the same amount in the future due to its earning potential. This principle underlies many finance decisions and is operationalized through discounting future cash flows at an appropriate interest rate.

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