The Time Value of Money

As you read, consider the concept of the time value of money and why that is important.

The merchant bankers of Antwerp quickly saw how using money layers, and creatively at that, could improve money as a technology for human progress. What exactly was their secret? The answer lies in one of the foundational concepts of modern finance: discounting. Let's walk through a basic example of discounting in order to illustrate the time value of money and see precisely what the bankers in Antwerp added to our monetary system.

You purchase a bill from a banker today for $98 that can be exchanged for $100 in a month. You do this because the $2 that you accrue during the month is worth the time you have to wait. This is commonly called the time value of money because the time you wait has value associated with it: you're paid to wait. Before the dawn of the money market in sixteenth century Antwerp, you were forced to wait a month before presenting the bill to collect your cash. In the interim, you have a piece of paper with a principal amount and a maturity date. Even though it has a maturity date in the future, this piece of paper still has value associated with it. If, after two weeks, you require liquidity from this bill and must convert it to cash, where do you go? You need a banker willing to purchase the bill for cash before it matures. The banker would split the difference between your purchase price ($98) and the face value ($100) and pay you $99. This process of a banker buying the bill at a price of $99, which is "discounted" from the $100 par value upon maturity, is called discounting. You walk away with cash today, and the banker will collect $100 at the end of the month. This type of discounting by money market traders in Antwerp brought alive the time value of money on a daily basis. Paper money finally had a price for the world to see. In fact, the birth of the financial press occurred in Antwerp during this period, not due to stock or government bond markets, but to detail daily price changes of commodities traded by merchants and second-layer money traded by bankers.

The last piece of the puzzle to Antwerp's success in launching the modern-day money market was the invention of promissory notes. Promissory notes brought full circle the money market's transition from a haphazard and quarterly smorgasbord to a continuous state. At the Bourse, in order to settle any outstanding balances at the end of the day, bankers issued yet another form of credit, a new second-layer money called promissory notes or notes. These notes were promises to pay the bearer, meaning that whoever held the piece of paper was due the promise. These instruments were the direct predecessors to what we consider paper cash today, currency notes. They were groundbreaking in their lack of specificity; previous versions of second-layer money always had people's names on them. Notes, like cash today, were completely free of this construct. They were used as a settlement tool but evolved into their innate role as cash and became extremely useful as mediums of exchange. Figure 5 shows the layers of money in Antwerp during the sixteenth century.

Figure 5

In Antwerp, the interest rate arbitrageur had arrived. Arbitrage is when you buy apples for $1 in one town because you know you can sell them in the next town over for $2. The art of arbitrage is as old as business itself, and medieval money changers that converted one coin into another were themselves engaged in a form of it. But arbitrage opportunities never existed in second-layer money until the Antwerp Bourse. As dealers discounted and traded bills and notes year-round in the Bourse, paper money found liquidity on any occasion, slowly moving the international monetary system away from an over-dependence on metal. The second layer of money itself became an asset class with prices quoted by the world's first financial newspapers. The way to compare all second-layer instruments was not in terms of their individual prices but based on the interest rate one could earn from holding that paper. Interest rates were a complementary way to express the price of money, and one that allowed traders to exploit differences in the value of paper. Every piece of paper in the Bourse had an interest rate, presenting arbitrage opportunities for bankers. This modernization in liquidity ultimately shifted the primary perception of money from metal to paper. Precious metal couldn't fulfill the multitude of properties commanded from a monetary system. Accounting, paper, and a network of bankers could.

Source: Nik Bhatia: Layered Money
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Last modified: Monday, March 4, 2024, 10:24 AM