Vaughan Reid's blog

What is present value?

Present value is an important calculation across a bank as its use to calculate a traders positions total mark-to-market. ie: How much are all their trades worth?

So the idea is actually quite simple. The value of an instrument is the combined value of all the future cash flows of the instrument. So for example if you buy a bond, its contract will say when and how much will be paid at a future date in time. An important concept in finance is the future value of money. So $100 today in your bank account is worth more to you today than $100 in your bank account in a years time. The idea is that you could invest that $100 at a “risk free” rate for a year and are “guaranteed” a bigger value in your account in 1 years time. (the quotes are for the cynics). So its then intuitive that the $100 in a years time is worth less than $100 to me now. The common practice is to discount that value to get an equivalent value for today. So maybe my calculation will say that the $100 in a year is actually worth $90 to me right now.

It can actually be argued that all traded instruments derive their value from the predicted future cash flows of the instrument. Even a stock which has no predefined cashflows in theory gets its value from the predicted future dividends.