Buying Cash

I'm the kind of guy who laughs at a funeral
Can't understand what I mean? You soon will
I have a tendency to wear my mind on my sleeve
I have a history of losing my shirt
--Barenaked Ladies

A friend offers you a dollar bill right now. How much should you pay for it today? Assuming there's nothing special about the bill, such as it being a rare silver certificate, then you should pay face value of $1.00. Simple enough.

Suppose this same person offers to give you a dollar bill exactly one year from now in exchange for a cash payment today. How much is that future dollar worth today? If you pay face value today you're likely overpaying, since there's opportunity cost associated with the dollar you currently have. At the very least, that buck could be earning interest in at a bank account somewhere. Plus, inflation may eat away at its purchasing power.

You estimate that the buck in your pocket will net you 5% over the next 365 days. If so, then you'll need to pay your buddy 1/(1+.05) = $.95 in order to be indifferent on the deal. If you pay something less, then this transaction should be a good deal for you. If you pay more than 95 cents, then you're better off keeping that dollar in your pocket.

Now, let's say your friend proposes a longer term deal. Exactly one year from now, he/she will pay you one dollar on this day for each of the next 10 calendar years.

Assuming the same 5% 'discount rate' you employed earlier, how much is this stream of future dollars worth today?

We'll look at this in a future missive.