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Time Value of Money Terminology

In: Business and Management

Submitted By Lessynz
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Time Value of Money Terminology
Terminology (AKA jargon) can be a major impediment to understanding the concepts of finance. Fortunately, the vocabulary of time value of money concepts is pretty straightforward. Here are the basic definitions that you will need to understand to get started (calculator key abbreviations are in parentheses where appropriate):
Banker's Year
A banker's year is 12 months, each of which contains 30 days. Therefore, there are 360 (not 365) days in a banker's year. This is a convention that goes back to the days when "calculator" and "computer" were job descriptions instead of electronic devices. Using 360 days for a year made calculations easier to do. This convention is still used today in some calculations such as the Bank Discount Rate that is used for discount (money market) securities.
Compound Interest
This refers to the situation where, in future periods, interest is earned not only on the original principal amount, but also on the previously earned interest. This is a very powerful concept that means money can grow at an exponential rate.
Compounding Frequency
This refers to how often interest is credited to the account. Once interest is credited it becomes, in effect, principal. Note that the compounding frequency and the frequency of cash flows are not always the same. In that case, the interest rate is typically adjusted to an effective rate that is of the same periodicity as the cash flows. For example, if we have quarterly cash flows with monthly compounding, we would typically convert the monthly rate into an effective quarterly rate to solve the problem.
Discount Rate
This is the interest rate that is used to convert between future values and present values. Note that the process of calculating present values is often referred to as “discounting” because present values are generally less than future values....

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