# Time Value Explained

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Contents

## What Is Time Value?

In options trading, time value refers to the portion of an option’s premium that is attributable to the amount of time remaining until the expiration of the option contract. The premium of any option consists of two components: its intrinsic value and its time value. The total premium of an option is equal to the intrinsic value plus the option’s time value.

Time value is also known as extrinsic value.

## The Basics of Time Value

The price (or cost) of an option is an amount of money known as the premium. An option buyer pays this premium to an option seller in exchange for the right granted by the option: the choice to exercise the option to buy or sell an asset or to allow it to expire worthless.

The intrinsic value is the difference between the price of the underlying asset (for example, the stock or commodity or whatever the option is being taken out on) and the strike price of the option. The intrinsic value for a call option (the right but not the obligation to buy an asset) is equal to the underlying price minus the strike price; the intrinsic value for a put option (the right to sell an asset) is equal to the strike price minus the underlying price. So, an option’s time value is equal to its premium (the cost of the option) minus its intrinsic value (the difference between the strike price and the price of the underlying asset).

As an equation, time value might be expressed as:

• Option Premium – Intrinsic Value = Time Value

Or, to put it another way: The amount of a premium that is in excess of the option’s intrinsic value is referred to as its time value. For example, if Alphabet Inc. (GOOG) stock is priced at \$1,044 per share and the Alphabet Inc. \$950 call option is trading at \$97, then the option has an intrinsic value of \$94 (\$1,044 – \$950) and a time value of \$3 (\$97 – \$94).

### Key Takeaways

• Time value is one of two key components that comprise an option’s premium, or price.
• As an equation, time value is expressed as Option Premium – Intrinsic Value = Time Value.
• Generally, the more time that remains until the option expires, the greater the time value of the option.

## The Significance of Time Value

As a general rule, the more time that remains until expiration, the greater the time value of the option. The rationale is simple: Investors are willing to pay a higher premium for more time since the contract will have longer to become profitable due to a favorable move in the underlying asset. Conversely, the less time that remains on an option, the less of a premium investors are willing to pay, because the probability of the option having the chance to be profitable is shrinking.

In general, an option loses one-third of its time value during the first half of its life, and the remaining two-thirds of its time value during the second half. Time value decreases over time at an accelerating pace, a phenomenon known as time decay or time-value decay.

Along with the countdown to expiration, another factor can influence an option’s time value – implied volatility, or the amount an underlying asset is likely to move over a specified time period. If the implied volatility increases, the time value will also rise. For example, if an investor purchases a call option with an annualized implied volatility of 30 percent and the implied volatility jumps to 45 percent the next day, the option’s time value would increase. Investors would figure that dramatic moves bode well for their chances for the asset to move their way.

Whatever the influences, an option’s time value eventually decays to zero at its expiration date.

## What Is the Time Value of Money (TVM)?

The time value of money (TVM) is the concept that money you have now is worth more than the identical sum in the future due to its potential earning capacity. This core principle of finance holds that provided money can earn interest, any amount of money is worth more the sooner it is received. TVM is also sometimes referred to as present discounted value.

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## Understanding Time Value of Money (TVM)

The time value of money draws from the idea that rational investors prefer to receive money today rather than the same amount of money in the future because of money’s potential to grow in value over a given period of time. For example, money deposited into a savings account earns a certain interest rate and is therefore said to be compounding in value.

### Key Takeaways

• Time value of money is based on the idea that people would rather have money today than in the future.
• Given that money can earn compound interest, it is more valuable in the present rather than the future.
• The formula for computing time value of money considers the payment now, the future value, the interest rate, and the time frame.
• The number of compounding periods during each time frame is an important determinant in the time value of money formula as well.

Further illustrating the rational investor’s preference, assume you have the option to choose between receiving \$10,000 now versus \$10,000 in two years. It’s reasonable to assume most people would choose the first option. Despite the equal value at the time of disbursement, receiving the \$10,000 today has more value and utility to the beneficiary than receiving it in the future due to the opportunity costs associated with the wait. Such opportunity costs could include the potential gain on interest were that money received today and held in a savings account for two years.

## Time Value of Money Formula

Depending on the exact situation in question, the time value of money formula may change slightly. For example, in the case of annuity or perpetuity payments, the generalized formula has additional or less factors. But in general, the most fundamental TVM formula takes into account the following variables:

• FV = Future value of money
• PV = Present value of money
• i = interest rate
• n = number of compounding periods per year
• t = number of years

Based on these variables, the formula for TVM is:

FV = PV x [ 1 + (i / n) ] (n x t)

## Time Value of Money Examples

Assume a sum of \$10,000 is invested for one year at 10% interest. The future value of that money is:

FV = \$10,000 x (1 + (10% / 1) ^ (1 x 1) = \$11,000

The formula can also be rearranged to find the value of the future sum in present day dollars. For example, the value of \$5,000 one year from today, compounded at 7% interest, is:

PV = \$5,000 / (1 + (7% / 1) ^ (1 x 1) = \$4,673

## Effect of Compounding Periods on Future Value

The number of compounding periods can have a drastic effect on the TVM calculations. Taking the \$10,000 example above, if the number of compounding periods is increased to quarterly, monthly, or daily, the ending future value calculations are:

• Quarterly Compounding: FV = \$10,000 x (1 + (10% / 4) ^ (4 x 1) = \$11,038
• Monthly Compounding: FV = \$10,000 x (1 + (10% / 12) ^ (12 x 1) = \$11,047
• Daily Compounding: FV = \$10,000 x (1 + (10% / 365) ^ (365 x 1) = \$11,052

This shows TVM depends not only on interest rate and time horizon, but also on how many times the compounding calculations are computed each year.

## What Is Time Value Of Money? Time Value Of Money Explained

Time value of money (TVM) is a financial concept concept widely used in businesses and investing and it is used to estimate the value of money over time. This concept states that the value of money changes over time.

What does this mean? It is simple, the value of money is not static, it changes and this it does over time. It can increase or decrease depending on various economic factors. Take, for example, the money you have at hand right now. Say you have \$100. This money can buy you more petrol today then few months or years down the line because of surging fuel prices. Same goes for your housing. Housing was pretty cheap a few decades back but is it cheap today? That’s the effect of Time value of money.

To put it simply, economic factors like inflation can affect your purchasing power now and in the future. This is because the value of your money will have likely decreased over the one-year period, in the case of inflation. Time value of money is not always negative.

Let’s say you buy land for \$50,000 that might be worth \$55,000 in the next year. In this case, TVM will have had a positive effect on your investments because its appreciated its value by 20%.

Understanding the time value of money requires that you also understand the two elements that are intrinsic to TVM; the present value of money and future value

## The present value of money vs the Future value of Money

It refers to how much worth money is today while the future value is the worth of money at a later time. This is quite straightforward, simply think about it regarding purchasing power.

In our example above, for instance, the present value of \$50, 000 can buy you land today, but it won’t buy you the same piece of land in a year or two to come. Why? Because in a year’s time your purchasing value would have diminished based on the future value of \$55,000.

So basically, the money you have or are to get today is more valuable than if received in the future. Therefore, you can invest whatever money you have today and enjoy more of it in the future. Otherwise, you can also choose to spend it right away, if you opt to spend it and you don’t have the money needed for this, you can borrow and pay back in future with accumulated interest.

Moreover, while investing money can gain you more money at a later time, the chances are that that money might not gain in value; this happens when factors such inflation creep and decrease the value of money in the future. In an inflated economy, the further into the future you invest your money, the less valuable it is.

This correlation between the present and future value is the reason most financial experts advise that investors should regard the timing of receipts from their investments with great importance, at least more valuable than the sum received. That is, because of TVM, given a chance to gather money in a shorter time could be shrewder that collecting a bigger entirety of cash in the future.

Ideally, discount rates tend to determine the amount by which the value of money diminishes over time. This is proportionate to an interest rate. If the rate is high, then the present value of money in the future is low and vice versa. In other words, discount rates vary from time to time and from one person to the other. If alternative investment opportunities are great, the rate will be high.

In case the individual giving a loan has no quick prerequisite for the money, the rate will be lower. Risk likewise increases the rate. In case the possibility of repayment is uncertain, then the lender will demand a higher interest rate.

Compound interest significantly impacts investment returns as it increases investment returns in most cases. Compounding in this regard implies that additional interest is paid on the accrued interest and left on deposit. So when interest is accrued and then plowed back, it tends to multiply together with the original principal amount. In actuality, the interest earned in this case thus becomes the principal.

Understanding time value of money, along these lines, is vital for investors and those seeking financial success. You need to understand all the tenets of TVM, and that implies to it. It is this knowledge that attempts to explain why we endeavor so earnestly to quantify and comprehend for those progressions with so many components as internal rate of return (IRR) and net present value (NPV). When attempting to measure an investor’s rate of return, you ought to do so with the concept of TVM in mind.

To further explain the time value of money and why it is better to receive money now than in the future, consider the accompanying case.

## Example of Time value of Money

Example; If you own a parcel of land now, you should take note of its present value today; let’s say the present value is \$50,000. You can opt to sell the property today and spend the money on things that need immediate cash. On the other hand, you can choose to invest in the property to increase its value in future. You can, for instance, develop rental properties on the land or whatever venture you see fit. You can also cash out now and loan that money to someone else who will pay back with interest in the future.

These investments will put you in a position of enjoying greater returns in the future. Unfortunately, not everyone acknowledges the value of money in consideration for time. Most people will want to cash out money today rather than wait for it to appreciate in value or invest the money for profit. They find cashing out a more viable option as it saves them the heartaches of having to deal with late payments or no payments at all.

## Calculation for Time Value of Money

Here is how to calculate the change in the value of money over time. We will use our present value of \$50,000, a period of 1 year and a return rate of 10%.

FV= future value

PV = present value

n = period of investment

FV = (50,000) x (1 + 10%) ^ 1

FV = (50,000) x (1.1) ^1

Summarily, understanding the time value of money can significantly help you to make better assessments on the value of money presently compared to in the future. This way you can make wise investments decisions thus being able to achieve your much desired financial success.

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