Calculation of the present day value of a cash flow that will or might occur at some time in the future
Detail
Suppose I offered to give you £1,000 right now - you'd be pretty pleased (wouldn't you?! If not imagine it's £10,000,000)
Suppose I guarantee to give you £1,000 in one year's time - you'd also be pleased I guess, but less pleased of course...
Why?
Well, for starters if you got it today you could use right away
Even if you wanted to use it in a year's time you'd rather have it now because you could put it in the bank and earn some interest over the next year
Conversely, if you really needed some money now, you could borrow it from a bank and then repay it when I paid you in a year's time
But if you borrowed £1,000 now you'd have to pay interest over the year, so you'd actually end up owing a bit more than £1,000, let's say £1,050
So if you worked out how much interest you would pay, and borrowed an amount, such that the initial amount plus the interest over the next year came to £1,000, then the £1,000 would exactly pay it off
Let's say you did the calculation and it came out that you could borrow £965, the interest on that over the year coming to £35
We could then say that £1,000 in a year's time is equivalent to £965 right now
We call that £965 the discounted value of the £1,000 in a year's time
You can see that the general principle is the discounted value is worked back from the actual value from the expected payment date to today using the expected interest rates
In order to calculate a discounted cash value we need:
The payment date - usually available from the contract terms, or the master agreement
The interest rate curve (for the payment currency or an alternative hedging currency)