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