Relevant Accounting and Financial Concepts

Paul Newson

This article was first published as a chapter in Interest Rate Risk in the Banking Book, by Risk Books.

Although this book attempts to address the area of interest rate and other market risks from first principles as far as is possible, and presumes little or no prior knowledge on the part of the reader, there are nevertheless a few underlying accounting and financial concepts about which some knowledge is assumed. This chapter therefore aims to inform those readers who are new to these concepts or wish to re-familiarise themselves with the main issues involved.

The chapter will provide a brief overview of:

• • the meaning of discounted cashflow (DCF) and its use to compute the present value (PV) of a future cashflow;
• • the difference between accrual accounting and mark-to-market (MTM) accounting;
• • what determines the level of interest rates for different maturities, and hence the shape of the yield curve; and
• • some of the principal wholesale financial instruments that are mentioned in later chapters.

DCF AND NPV

Consider a situation in which you are offered the choice between receiving £1,000 in one year’s time or £960 now. Assume that the