Market-Determined Interest Rates, and the Time Value of Money

Abstract

For any application the discount rate that is used is the market-determined rate. This rate is used to value capital market instruments. The rate of discount reflects the fact that cash has a current value and any decision to forgo consumption of cash today must be compensated at some point in the future. So when a cash-rich individual or entity decides to invest in another entity, whether by purchasing the latter’s equity or debt, he is forgoing the benefits of consuming a known value of cash today for an unknown value at some point in the future. That is, he is sacrificing consumption today for the (hopefully) greater benefits of consumption later. The investor will require compensation for two things; first, for the period of time that his cash is invested and therefore unusable, and secondly for the risk that his cash may fall in value or be lost entirely during this time. The beneficiary of the investment, who has issued shares or bonds, must therefore compensate the investor for bearing these two risks. This makes sense, as if compensation was not forthcoming the investor would not be prepared to part with his cash.