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Financial Engineering Lecture Notes

This document provides an overview of modern finance structures and cash flows. It discusses key concepts such as: - Cash flows having specific attributes of payment/receipt amount, time, currency, and credit risk. - Examples of default-free and defaultable cash flows to illustrate these attributes. - The importance of considering the time value of money when evaluating cash flows, using concepts like net present value and discount factors. - Worked examples are provided to demonstrate calculating the net present value of cash flows and identifying the internal rate of return for an investment project.

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Mehmet Zirek
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Download as PDF, TXT or read online on Scribd
867 views

Financial Engineering Lecture Notes

This document provides an overview of modern finance structures and cash flows. It discusses key concepts such as: - Cash flows having specific attributes of payment/receipt amount, time, currency, and credit risk. - Examples of default-free and defaultable cash flows to illustrate these attributes. - The importance of considering the time value of money when evaluating cash flows, using concepts like net present value and discount factors. - Worked examples are provided to demonstrate calculating the net present value of cash flows and identifying the internal rate of return for an investment project.

Uploaded by

Mehmet Zirek
Copyright
© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
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UMT FACULTY OF ECONOMICS

MSc Program of Financial Engineering and


Risk Management

Financial Engineering Lecture 2


Modern Finance Structure
Modern Finance Structure – Cash Flows

Cash Flow:
• a payment or receipt of cash
• at a specific time,
• in a specific currency,
• with a certain credit risk
Modern Finance Structure – A visual Tool 1
Cash Flow:
• a payment or receipt of cash
• at a specific time,
• in a specific currency,
• with a certain credit risk

Ex1: Default-Free cash flows

• Cash: 100
• Time: t0 (received) t1 (paid)
• Currency: USD
• Credit Risk = 0 (No default)
• Interest: [t0, t1] is 5%
Modern Finance Structure – A visual Tool 2
Cash Flow:
• a payment or receipt of cash
• at a specific time,
• in a specific currency,
• with a certain credit risk

Ex2: Defaultable Deposit

• Cash: 100
• Time: t0 (paid) t1 (received/defaulted)
• Currency: USD
• Credit Risk > 0
• Interest: [t0, t1] is 5%
Modern Finance Structure – A visual Tool 3

Cash Flows with Different Attributes

pays USD100 at time t0 and receives


100et0 units of Euro at the same time

FX: Foreign Exchange


et0 : Spot exchange rate
(#Euros paid for 1 USD)
A spot FX deal
Net Present Value
Value of money varies with time due to the interest

Time of the actual cash flow must be taken into account to obtain a realistic measure of
the profitability of the investment.

If €100 were invested in a bank earning an interest of 5%

The value in 1 year would be €100×1.05 = €105


The value in 2 years would be €100×1.05×1.05 = €110.25
The value in 3 years would be €100×1.05×1.05×1.05 = €115.76

It can be seen therefore that, today, to obtain €115.76 in 3 years it would cost €100. In
other words,

present value of €115.76 = €100.


Discount Factors
Net Present Value Example 1
Net Present Value Example 2

There are two options of receiving the yearly income.


Take discount factor as 8%
Which one has higher NPV?
Net Present Value Example 2 solution
Internal Rate of Return
IRR is discount factor that makes NPV = 0

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