Present Value
Overview
The Discount Curve
The above calculations gloss over the issue of choosing the appropriate discount rate. The key to recognize is that the rate will
in general be dependent on the chosen period. The rate of return on money invested over a 1 year period will be different than the rate
that can be obtained over a 2 year period. If one imagines plotting the market rate against the loan period on the x-axis, one
obtains a curve, and one often refers to the set of interest rates as the curve.
For information about interest rate curves, please see:
yield curve
There are various theories as to why the rate depends on the tenor. For the most
common, see
curve theories
Regardless of the reasons for the varying interest rates, in order to be able to do present value calucations for a set of
cash flows, one needs to be able to get the appropriate for each cash flow. This is tougher than just finding the current rate
being traded in the market. For any given period, there may be multiple instruments, with different tax treatments and credit
characteristics, or they may be none, requiring an extrapolation of some kind. For information about estimating a yield curve,
please see:
