In pricing the value of a security, we consider that humans discount future returns.

def. Discounted Cash Flows (DCF) are used to price assets.

  • Each cash flow is discounted by the discount rate. They are summed to get the present value of all the cash flows
  • We always want asset price↑, risk↓
  • rate of return volatility ← knowing how to trade off these two is important

To calculate the DCF of some future cash flow ’s current present value :

  • is the Annual Percentage Rate [= quoted rate]
  • is how many times to compound every year
    • → thus is the interest rate per compound period (=)
  • is the number of years
    • → thus is the number of **total compounding periods (=)

You can calculate the present value of multiple identical cash flows of amount :

What is the value of interest rate ?

  • In individual investments/loans, determined usually by looking at similar assets in the market
  • inflation; if inflation is high, money isn’t worth much in the future, so lender demands more interest rate

Net Present Value