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Discounting

• The present value calculation takes into account the fact that you will receive interest on interest. The process of calculating present value is called discounting. Discounted cash flow equals future cash flow divided by one plus the discount rate.

• Calculating the present value of a future amount. The process is opposite to compounding.

 
 Embedded terms in definition
 Cash flow
Cash
Compounding
Discount rate
Discounted cash flow
Discount
Future
Interest on interest
Interest
Plus
Present value
Will
 
 Referenced Terms
 Discount rate: Is the interest rate used for adjusting for the time value of money for Net Present Value, Option Pricing or other Market Models. It can also refer to the rate that the Federal Reserve charges its members.Also known as the Capitalization Rate. The interest rate charged by the twelve Federal Reserve Banks for short-term loans made to member banks. This is the rate used in Discounting future cash flows.The interest rate that the Federal Reserve charges a bank to borrow funds when a bank is temporarily short of funds. Collateral is necessary to borrow, and such borrowing is quite limited because the Fed views it as a privilege to be used to meet short-term liquidity needs, and not a device to increase earnings.In corporate finance this is the rate by which you divide the cash flows to obtain present value. Other names for discount rate would be hurdle rate, market rate of capitalization, and opportunity cost of capital. In banking, this is the rate of interest charged by the Fed to member banks that borrow at the discount window. The discount rate is an add-on interest rate.

 Market efficiency hypotheses: Refer to theories which try to explain financial market behavior. Some hypotheses state that the markets are rigorously efficient and operate by an immediate Discounting of perfect information. Other theories state that the markets are relatively inefficient, particularly when socially-oriented goals are also to be considered. Other hypotheses state that information is good or even very good but not perfect. Also, not all market participants believe or simultaneously act on new data or information. The latter theorists believe that the markets try to attain pure efficiency. However, they also recognize that competition breeds asymmetrical change and this influences the discounting and adaption processes. A simple example will highlight this view. While improvements in technology are reducing costs and communication times, not everyone updates their systems given each and every change in chip speeds and processing power. To do so would be too expensive and this creates one of example of a marketplace paradox.

 Option models: Are evaluation tools to determine the price, the premium, or the volatility for a put, call, or complex position or strategy. Sometimes, the list for option models includes: convertible securities, mortgage and asset backed securities, and warrants. Option models may be categorized as credit, currency, equity, index, futures, and physical or cash oriented. The basic factors for an option model are: the underlying market price, the strike or exercise price, the interest rate for Discounting purposes, the volatility, and the time to expiration. Some models require expected dividends, coupons and foreign exchange considerations. Some of these models are: Binomial, Black, Black Scholes, Cox, Ingersoll, and Ross (CIR), Gastineau-Madansky, Heath, Jarrow, and Morton (HJM), Ho and Lee, Hull and White, Jamshidian, Rendleman and Bartter, Vasicek, and Whaley. Often these models have modifications. Usually, the modifications are at the practices level in order to expedite calculations.

 Settlement rate: The rate suggested in Financial Accounting Standard Board (FASB) 87 for Discounting the obligations of a pension plan. The rate at which the pension benefits could be effectively settled off the pension plan wished to terminate its pension obligation.

 
 Related Terms
 Discounting cash flows

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