Cash Flow
Table of Contents
Summary
A cash flow is a real or virtual movement of money (see Wikipedia: Cash flow) – a vector quantity carrying both a magnitude (an amount in a given currency) and a direction (an inflow to, or an outflow from, a reference entity). By convention, outflows are signed negative and inflows positive, relative to whichever entity is under discussion. Cash flows are the fundamental building block from which financial assets are constructed: any financial asset can, at least in principle, be decomposed into, or replicated by, a stream of cash flows.
Detail
Magnitude, direction, and sign convention
A cash flow's magnitude is its notional, or principal, amount – the face amount used to calculate payments, which generally stays fixed over the life of the instrument even as the payments it generates vary from period to period. Its direction is relative: the same physical payment is an outflow for the payer and an inflow for the payee, and by convention outflows are recorded as negative and inflows as positive from the perspective of whichever single entity's cash flows are being described.
Cash flow streams and legs
A related group of cash flows sharing a common purpose is a cash flow stream, sometimes called a leg depending on context – an interest-rate swap's fixed leg, for instance, is the stream of fixed cash flows one counterparty pays across the life of the swap. Naming the grouping matters because most instruments are better understood as a small number of streams than as an undifferentiated list of individual payments.
The building block of financial assets
Cash flows are treated as the fundamental unit financial assets are built from: in principle, any financial asset can be decomposed into, or equivalently replicated by, a stream of cash flows with the right amounts, currencies, and dates. This is what makes cash flow the right level of abstraction for valuing and comparing otherwise very different instruments – a bond, a swap, and a deposit all reduce, at bottom, to streams of cash flows that can be discounted and compared on the same basis.
See also
- Wikipedia: Cash flow – the general definition this note follows.
- Currency – hub note; the currency a cash flow's magnitude is denominated in.
- Assets – financial assets, which cash flows compose.
- Cash – what a cash flow is ultimately a movement of.