Money, Financial Assets, Bonds, and the Time Value of Money

Chapter 12 companion lesson

A one-year bond promising a future payment has a price today. If market interest rates change, that promised payment does not—but the price investors are willing to pay does. This link joins money, bonds, and present value.

Why does functions of money, liquidity, and monetary aggregates matter?

Money consists of assets generally accepted as payment for goods, services, and debts. As a medium of exchange, it removes the need for a double coincidence of wants. A baker can sell bread for money and later use money to pay a mechanic; the mechanic need not want bread at the moment of exchange.

As a unit of account, money provides a common measure for prices, contracts, and financial records. Comparing a bicycle at 500 with a computer at 1,000 is easier than maintaining a separate barter price between every pair of goods. As a store of value, money transfers purchasing power across time, though inflation can erode that value and other assets may provide a better long-run return.

Liquidity is the ease with which an asset can be used for payment without significant loss. Currency and checkable deposits are highly liquid. A house can store substantial value but is costly and slow to sell. A bond may be marketable yet fluctuate in price. Liquidity is a spectrum, not a simple money/nonmoney divide.

Why does financial assets: risk, return, liquidity, and ownership matter?

A financial asset is one party's claim on another party's future payment or income. The issuer records a liability or equity obligation; the holder records an asset. Financial claims help transfer funds from savers to borrowers and share risk, but purchasing an existing claim is not itself current GDP investment.

A bond is debt. Its issuer promises specified payments, often coupons during the bond's life and face value at maturity. A share of stock is equity ownership and can provide dividends and capital gains, but its payments are not fixed contractual debt payments. A bank deposit is an asset to the depositor and a liability to the bank.

Expected return compensates an investor for delaying consumption and bearing risk. Default risk is the chance promised payments will not be made. Interest-rate risk is the chance market-rate changes alter a fixed-income asset's price. Inflation risk is uncertainty about purchasing power. Liquidity risk concerns difficulty selling quickly without loss.

How does the CLEP test bond prices, coupons, and market interest rates?

A bond's coupon is its stated periodic payment. Its yield relates promised payments to the price an investor pays. For a simple perpetual bond paying 50 each year, a 1,000 price implies a current yield of 5 percent. If the market requires 10 percent for comparable risk, the price must fall toward 500 so the 50 payment represents 10 percent.

This is the inverse bond-price/interest-rate relationship. Existing fixed payments do not change when market rates rise, so the price falls until the return is competitive. When market rates fall, the old fixed payment becomes attractive and the price rises. A distractor claiming higher rates make existing bonds more valuable reverses the adjustment.

For a one-period bond paying face value F next period, price is P=F/(1+i). A 1,050 payment discounted at 5 percent is worth 1,000 today. If the discount rate rises to 10 percent, present price falls to about 954.55. Longer bonds require discounting each coupon and the face value separately.

What should you know about present and future value, nominal interest, real interest, and inflation?

Present value converts future payment into today's equivalent: PV=(FV)/((1+i)^n). The discount rate i is the relevant return per period and n the number of periods. A higher rate or longer wait lowers present value because today's funds have more time or a better opportunity to earn a return.

Future value runs the same comparison forward rather than backward: FV=PV(1+i)^n. Compounding means that each period's return earns a return in later periods. If 1,000 earns 5 percent annually for three years, its future value is 1,000(1.05)^3=1,157.63. Multiplying by 1+3(0.05) would produce simple interest and miss the interest earned on earlier interest. The two answers are close over a short horizon at a low rate, which is precisely why that incorrect method is a plausible distractor.

The formulas are inverses. If the question gives today's amount and asks what it becomes, compound forward. If it gives a later payment and asks what it is worth today, discount backward. A timeline makes the direction visible: PV stands at date zero, FV at date n, and every step to the right multiplies by (1+i) while every step to the left divides by it.

What is the CLEP likely to ask?

Expect functions of money, M1/M2 classification, liquidity comparisons, the inverse bond-price/interest-rate relation, present- and future-value arithmetic, and nominal-real interest calculations. Read the definition supplied if a question uses a historical monetary aggregate.

A useful check is to name the model before doing arithmetic. Then write the first change, the intermediate market response, and the final macroeconomic result. This keeps a plausible distractor from borrowing one true step and attaching it to the wrong conclusion.

Can you do these without notes?

1. Explain the three functions of money, distinguish money from liquidity, and classify currency, checking, savings, a small time deposit, a retail money market fund, a credit-card limit, and a house under current M1/M2 definitions.
2. Compare a deposit, bond, stock, and house by claim type, liquidity, expected return, and risk. Explain why buying an existing stock is not GDP investment even though it is a financial investment.
3. Explain the inverse relation without memorized arrows. Then calculate the price of a one-year 1,100 payment at 10 percent and predict what happens to price if the required rate falls.

For each prompt, say why the tempting wrong answer fails. That extra sentence is often the difference between recognizing a term and being able to use it under time pressure.