At its core, finance is concerned with the value of money now versus what it could be worth in the future. Here’s a thought experiment: would you rather have $100 now or wait 10 years for $100? Most people would answer now. Humans have an innate sense that money now is worth more than the promise of money in the future, but why is that?
There are actually a few reasons:
- If I have $100 now, I can spend it now and satisfy some desire sooner rather than later.
- If I have $100 now, I can invest it, and earn some return on it before that 10 year mark hits. That means my $100 now will amount to more than $100 in 10 years.
- There’s a risk that I might not ever receive that $100 in the future. Maybe you won’t pay. Maybe the US monetary system collapses. Or maybe the value of that $100 is eaten away by rampant inflation.
So, a dollar received today is worth more than a dollar received tomorrow. But how much more?
In a perfectly predictable world, if you know some information like the interest rate you’ll receive on your money and how often it will be compounded over what time period, you can use a formula to understand how valuable that $100 would be in the future. Conversely, you can use the same data points to discount the value of a future $100 to its present value. The interest rate used for an almost perfectly predictable world is called the risk-free rate. Usually the return on 3-month US Treasury bills is used as a stand-in for the risk-free rate. Compensation for the opportunity cost of missing out on the risk-free return is ultimately where the time value of money comes from.
But what if the world isn’t perfectly predictable. What if you have to worry about things like inflation, trust in institutions, or unpredictable returns? That’s where things get tricky, but it all comes down to risk.