Interest rate (discount factor) in Derivative discount, difference, between, correct, example

malbec

Hi, I am confused between how to use correct method to get Present Value of a number.

As you see as below, there are two methods to calculate the PV discount factor.

Do you know what is the difference?

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RFR= Risk Free Rate
For example, T=20 days ; Annual RFR Rate=5% or 0.05

1) 1 + 0.05 (20/360) = 1.002778 <--- This is used to calculate PV factor of swap

2) 1.05 ^ (20/360) =1.002714 <--- Put Call Parity: eg: C + X/(1 + RFR)^T = P + S

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Edited 1 time(s). Last edit at Friday, May 13, 2011 at 09:49AM by shinki.

chandsingh

Your #1 is simple interest (a discrete, day-by-day measurement), and your #2 is compound interest (althought I would guess you'd use 365 as the demoninator, unless it's a t-bill).

Honestly, sometimes you just have to know which to use in a given situation. I would hope if it's not defined by a formula (like for bonds and t-bills), you are told simple, compound, or continuous.

firat

Many thanks for your explanation!!!

comp_sci_kid

I'm pretty sure we're almost always using compound interest unless we're specifically talking about the LIBOR, which our plain vanilla swaps are based on (hence using the simple interest)