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The Interest Rate: An Exchange Rate Across Time

The rate at which we can exchange money today for money in the future via the financial markets is determined by the current interest rate.

Suppose the current annual risk free interest rate is 5%. By investing or borrowing at this rate, we can exchange (trade) $1.05 in one year for $1 today.

Risk Free Interest Rate (Discount Rate), rf: The interest rate at which money can be borrowed or lent without risk.

Interest Rate Factor = 1 + rf = 1.05 ($s tomorrow/$ today)

Discount Factor = 1 / (1 + rf) = 1/1.05 = $0.9524 ($s today/$ tomorrow)

Investors are compensated for surrendering capital.

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