Friday, December 23, 2005

The time value of money
The present value of a dollar to be received in a year is less than the present value of that dollar if it were received today. We call this the time value of money. Financial markets use spot curves, forward curves, discount curves and yield curves to describe the time value of money. These are referred to collectively as the fixed income term structure. This article defines these notions.

A cash loan is a loan that commences immediately. A spot loan is a loan that commences spot. A forward loan is one that commences on some date later than spot. For example, in the Eurodollar markets a three-month spot loan commences in two business days (spot) and matures three months after that. A 27 forward loan commences two months from the spot date and lasts for five months. With either type of loan, interest can be paid periodically or it can be accumulated and paid at maturity.

A spot interest rate for maturity m is an interest rate payable on a spot loan of maturity m that accumulates interest to maturity. Spot rates are sometimes called zero-coupon rates because they are the rates of interest payable on obligations that accumulate all interest to maturity. Libor rates for maturities of a week or more are spot rates.

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