# Posts Tagged rate

### Compounding, Discounting and Effective Annual Rate

Compounding:

The process of going from today’s value (Present Value; denoted by PV) to Future Value (denoted by FV) is called Compounding. If i is the Interest Rate, then Interest Amount (INT) can be calculated as:

INT (\$) = PV x i

The Future Value will be the Present Value plus the amount of Interest, so:

FV = PV + INT

FV = PV + PV x i

FV = PV (1 + i)

If the amount is deposited or invested for n periods, the same formula can be written as:

FVn = PVn (1 + i) n

The term (1 + i)n is known as Future Value Interest Factor and is denoted by FVIFi,n, so:

FVn = PVn (1 + i)n = PV (FVIFi,n)

In some cases, Interest is paid semiannually, which means Interest is paid twice a year. Similarly Interest payment 4 times a year means Interest is paid quarterly. For such cases, the above formula can be more generalized:

Where m is the number of times Interest Payment is made in a year. However, in such case, i is taken as Nominal Rate of Interest.

Discounting:

The process of calculating Present Value (PV) from Future Value (FV) is called Discounting. As we know:

FVn = PVn (1 + i) n

Solving for PV, we have:

Or we can write it as under:

PVn = FVn (1 + i)-n

The term (1 + i)-n is called Present Value Interest Factor, and is denoted by PVIFi,n; therefore:

PVn = FVn (1 + i)-n = FV (PVIFi,n)

Same as previous case, if the Interest is paid semiannually or quarterly, a more general formula is applicable:

Where i is taken as Nominal Rate of Interest.

Effective Annual Rate (EAR):

Effective Annual Rate is defined as the rate which would produce the same Future Value, if annual Compounding had been used. It is also called Equivalent Annual Rate, and can be calculated as:

As we have taken Annual Compounding, therefore n is not shown in the formula, and i will be taken as Nominal Rate of Interest.

References:

Financial Management – Theory & Practice by Eugene F. Brigham & Michael C. Ehrhardt

Investment Analysis & Portfolio Management – Lectures

### Market or Investment Portfolio, Investors, Securities, Time Value of Money Concepts

Investment/Market Portfolio:

When an investor invests in multiple
stocks/securities, it is called Investment Portfolio. Maintaining a Portfolio
is a very important step taken by investors. By maintaining a Portfolio, Risk
can be mitigated / minimized by maintaining a portfolio and higher margins of
profits can be earned. In this case, if one stock/security defaults, it does
not necessarily mean Investor is also in loss. Instead, investor can compensate
the loss of one stock from other stocks/securities. Fig. 5 shows how
maintaining a Portfolio minimizes the Portfolio Risk. Fig shows that Portfolio
size is taken on x-axis and portfolio risk on y-axis, which results a curved
graph.

Classification of Investors:

Investors can be classified on the basis of their risk-taking/bearing capacity. How much risk an investor bears, depends on investor’s personal capacity, attitude, interest and behavior. For example:

1. 1.      Risk Seekers

Risk seekers seek for riskier investment. They are capable of assuming a higher risk and have strong and healthy financial position.

1. 2.      Risk Avoiders

They avoid riskier investments, because they have not strong and healthy financial position. They choose those instruments, which have less variation in returns.

1. 3.      Risk Bearers

Risk bearers fall in between the above categories. They choose moderate levels of risk they can bear according to their capacity.

Hedging:

Risk reduction is known as Hedging. They do it by using Derivative Instruments.

Security:

A Security refers to a publicly traded financial instrument, as opposed to a privately placed instrument. Securities have greater liquidity than otherwise similar instruments, which are not traded in Open Market. Security is considered to be an insurance against an emergency, according to banking definitions.

Classification of Securities:

The securities have been classified according to the functional operation aspects as under:

1. 1.      Intangible Securities

These are personal exclusive undertakings by a party to pay the amount of advances outstanding against a borrower. Examples of such securities are Demand Promissory Note, bill of exchange or a Bond, Guarantee and Indemnity etc.

1. 2.      Tangible Securities

These are the securities which can be realized from sale or transfer. Examples of such securities are Shares, Stock, Land, Building and Goods.

1. 3.      Prime Securities

These are also called Primary Securities. Such securities are main covers for an advance and are deposited by the borrower himself. When a depositor of term deposits offers his Term Deposit Receipt to cover and advance, it is the Primary Security according to banking term.

1. 4.      Collateral Securities

These are the securities provided as an additional cover for an advance, where either he security is not very stable in value, or where the realization of the security to cover the outstanding amount of balance is difficult. In case of the default by borrower, bank has the authority to sell these shares of security and adjust the advance.

1. 5.      Movable Securities

These are the securities, which are legally and physically both in possession of the lending bank. Examples are Term Deposit Receipts, Goods, Vehicles and Merchandise etc.

1. 6.      Immovable Securities

These are the securities, where the legal possession or right to takeover is entrusted to the lending bank, but the physical possession remains with borrowers.

1. 7.      Government Securities

These are the long-term securities issued by the government for financing social programs. They are perceived as Risk-free, are highly liquid and carry attractive coupon rates. Like T-bills (Treasury Bills), government securities are sold through auctions and are actively traded in secondary markets.

Time Value of Money:

The theory of Time Value of Money states that the value of money decreases with the passage of time. This concept can be described as “A Dollar in hand today is more worth of a Dollar tomorrow”. This happens because of Inflation. Inflation is a situation, where the prices as a whole are increasing. The rate at which the prices are increase is known as Inflation Rate. Two terms are necessary to explain while discussing Inflation and theory of Time Value of Money:

1. 1.      Nominal Interest Rate/Quoted Interest Rate:

Nominal Interest Rate is a rate at which money invested grows. Banks generally offer Nominal Rate of Interest to the depositors.

1. 2.      Real Interest Rate

Real Interest is a rate, at which the purchasing power of an investment increases. Market Interest Rates are Nominal Interest Rates.

Relationship of Inflation, Nominal and Real Interest Rates:

Real Interest Rates, Nominal Interested Rates and Inflation Rates have strong relationship with each other, which can be expressed in the form of an equation:

The above equation shows that if Inflation Rate increases, then Real Interest Rate decreases and vice versa.

Another approximate relationship also exists between the three rates:

It means, by subtracting Inflation Rate from Nominal Interest Rate, the approximate Real Interest Rate can be calculated.

References:

Financial Management – Theory & Practice by Eugene F. Brigham, Michael C. Ehrhardt

Management of Banking and Financial Services by Padmalatha Suresh & Justin Paul

Handouts Investment Analysis and Portfolio Management

Lectures on Financial Investment and Portfolio

### Investments, Risk and Return

Investment:

Investment may be defined as an activity that commits funds in any financial/physical form in the present with an expectation of receiving additional return in the future. The expectation brings with it a probability that the quantum of return may vary from a minimum to maximum. This possibility of variation in the actual return is known as Investment Risk. Thus every investment involves a Return and Risk.

Investment is an activity that is undertaken by those who have Savings. Savings can be defined as the excess of Income over Expenditure. Two important characteristics of Investment are Return and Risk.

Return:

Every Investment has and expectation of Return, which is the margin earned by investor in future by investing at present. The margin earned reflects the concept of Time Value of Money, which describes that a Dollar currently held will be less worth tomorrow. Investors take advantage from this saving, which is called Return (denoted by kor r)

Risk:

Risk is the chance of uncertainty that may rise after investment. It is the event that may arise by affecting the Return of the Investment. Every investor should forecast the Return and Risk while investing and should keep into account all possible events that may occur in future. It is denoted by d and is the Standard Deviation, which reflects the deviation from the Expected Rate of Return.

The formulae for Risk and Return of and Investments are:

Relationship between Risk and Return:

Risk and Return have positive relation to each other (Direct Relationship):

Risk µ Return

The relationship shows that if an investment is tied with high expectation of Return, it will have high Risk and vice versa. This relationship is also shown in the diagram:

Types of Risk:

There are various types of Risk, among which, following are the most important to describe:

Business Risk is one which is tied to a particular business. Such risk arises when the investor is not sure whether the business will successful or not in which he/she has invested.

1. 2.      Financial Risk:

Financial Risk is the additional risk placed on the common stockholders as a result of the decisions to finance with debt. The use of debt, also called Financial Leverage also concentrates the firm’s business risk on its stockholders. Financial Risk arises, when to decide whether the firm should be Levered (50% debt and a portion of equity) or Unlevered (All Equity). In this way, it makes the Capital Structure of a firm.

1. 3.      Country Risk:

Country Risk is one that arises from a particular country. A country’s environment may be favourable for investors, who want to invest in that country. Investors need to forecast such risk before making the investment decision.

1. 4.      Diversifiable Risk/Unsystematic/Idiosyncratic:

The part of a stock’s risk, that can be minimized/neglected is called Diversifiable Risk. Such Risk is caused by some random events like lawsuits, strikes, successful and unsuccessful marketing programs etc. This type of risk can be minimized while investing in multiple stocks; a phenomenon known as Diversification Principle.

1. 5.      Non-diversifiable/Systematic/Market Risk:

The part of stock’s risk, that cannot be minimized or neglected is known as Non-diversifiable Risk. This type of risk stems from factors that systematically affect most firms; such as war, inflation, recessions and high interest rates. Such risk remains constant even when investing in multiple stocks. It is measured in terms of Beta (β).

1. 6.      Inflation Risk:

Technically speaking, this type of risk is a subtype of Systematic Risk. This risk stems from variation in inflation rate. When inflation rate increases, it reduces the Real Interest Rate and vice versa. More detail about the relationship between Inflation Rate and Real Interest Rate will be explained in related articles.

1. 7.      Interest Rate Risk:

Interest Rate Risk can be said to be a subtype of Systematic Risk. This type of risk arises with the fluctuation on Interest Rate in market. The more is the market Interest Rate, the more will be Interest Rate Risk tied to a particular stock (will be explained in later articles).

1. 8.      Exchange Rate Risk:

Exchange Rate Risk stems from changes in Exchange Rate or currency fluctuations. The more is the currency fluctuation in market, the more will be the Exchange Rate Risk for and Investor.

1. 9.      Liquidity/Marketability Risk:

Liquidity Risks generally arise when one business acquires another business. Liquidity refers to a condition when a firm is not generating enough profit from its operations, that can meet the overall cost of a business. By doing so, investors of one organization purchase the stocks of Liquidating Firm, but are not sure whether their decision to purchase the stocks of such firm will benefit at a future date or not. Such uncertain factors are called Liquidity Risk, when combine together.

1. 10.  Political Risk:

Political Risk arise from the political environment of an economy. If a country’s political environment is uncertain and unfavourable, the investors are called facing Political Risk while investing in such country.

1. 11.  Stand-alone Risk:

If an investor has only one investment, the risk tied to that particular investment is known as Stand-alone Risk. If an investor has only one investment, it is highly risky for him/her, as he/she cannot compensate his/her loss from alternative stocks, in case the stock hald by him/her is losing its value.

1. 12.  Portfolio Risk:

If an investor has invested in multiple stocks/securities, the risk tied to all of those stocks/securities (combined together) is called Portfolio Risk. If a security defaults, the investor still has a chance to earn profit from other stocks/securities held by him/her. Portfolio Risk can be measured by the following formula.

References:

Investment Analysis and Portfolio Management (handouts)

Lectures by Mr. Wasim Anwar

Financial Management – Theory & Practice; 10e by Eugene F. Brigham & Michael C. Ehrhardt

### FINANCIAL MARKETS AND THEIR CLASSIFICATION

Financial Markets are places, where Financial Instruments or Financial Assets are exchanged. Financial Markets can be classified on the basis of the nature of instruments exchanged in the economy.

Classification of Financial Markets:

The following are different types of Financial Markets:

1.      Securities Market

Security Markets are the Financial Markets, where securities are exchanged. Securities are financial instruments that have been created to represent a legal obligation to pay a sum in future in return for the current receipt of vlue. Securities, thus represent the cash or cash equivalent received from another person. Security Markets can be further classified into National Market and International Market.

1.1              National Market

National Markets (also called Local Markets) are those within the boundaries of a nation. National Markets cater to the financial requirements of the local players. Players from the foreign countries are permitted to bring their financial instruments into the National Market, subject to their following the rules and regulations imposed by the nation. Each nation has a regulatory authority, under whose scrutiny financial instruments are exchanged in that country. National/Local Market can also be classified into Domestic Segment and Foreign Segment.

1.1.1        Domestic Segment

The Domestic Segment caters exclusively to firms registered in a country. The country’s regulatory authority controls the domestic market. Based on the economic performance of the country, the Domestic Markets are also called Advanced Markets and Emerging Markets. Advanced Markets are usually markets in nations that are economically sound and have also progressed technologically. Emerging Markets are those in developing countries, whose economic progress is forward looking. Domestic Market can also be subdivided into Money Market and Capital Market.

i.      Money Market

Money Markets are short term Debt markets. Debt is a fixed income security and represents the borrowing of a market player. Money Markets are mostly wholesale markets for financial instruments. Money Market can be classified into the following types:

a)      Call Market

Call Market is a money market, and is one, where Call/Notice Money is borrowed or lent for a very short period. If the money is lent or borrowed for a period of up to 14 days, it is called Notice Money. On the other hand, if the money is borrowed or lent for a period more than 14 days, it is called Call Money. Intervening Holidays and/or Sundays are excluded for computing the holiday duration. No Collateral Security is required to cover these transactions.

b)     T-Bill Market

The Treasury Bill or T-Bill Market is one, where Treasury Bills are exchanged. Treasury/T-Bills are short term (up to one year) borrowing instruments of the government. They are the lowest risk category instruments, maturing in a short duration. A considerable part of the government’s borrowings happen through T-Bills of various maturities.

c)      Inter-Bank Market

The Inter-Bank Market is usually for deposits of maturity beyond 14 days and up to three months. The specified entities are not allowed to lend beyond 14 days.

d)     Certificates of Deposit Market

After T-Bills, the lowest risk category investment option is the Certificate of Deposit (CD) issued by banks and financial institutions. A CD is a negotiable promissory note, secure and short term (up to one year) in nature. They are issued and purchased in CD Markets and for a purpose to augment funds by attracting deposits from corporations, high net worth individuals, trusts and others.

e)      Ready Forward Contracts (Repo) Market

Repo (abbreviated from Repurchase Agreement) Market is one, where the same securities are sold and repurchased by two parties. This type of transaction is called Repo Transaction according to seller’s point of view and Reverse Repo Transaction from the buyer’s point of view of the security. When seller sells the security with the objective of repurchasing it, it is called Repo. On the other hand, when the buyer of the same security purchases it with a view to resell it, it is called Reverse Repo. This phenomenon can be described as in the following:

Repo = Seller sells the same security + Commitment to Repurchase it

Reverse Repo = Buyer buys the same security + Commitment to resell it

The Future Date and Price are mutually decided by buyer and seller of the same security. Whether the transaction is Repo or Reverse Repo depends on which party initiated it. Two terms are necessary to define while discussing Repo Transactions. Repo Period is the period mutually decided by buyer and seller of the security for which the money is borrowed by the seller by selling it. Repo Rate is the Rate of Interest mutually agreed by seller and buyer for the selling and repurchasing of the same security for a time period (Repo Period) in Repo Market. Repos help banks to invest surplus cash. It helps the investors to achieve money market surplus with sovereign risk. It helps the borrower to raise funds at better rates.

f)       Commercial Paper (CP) Market

Commercial Paper (CP) is an unsecured money market instrument issued in the form of a promissory note. CP enables highly rated corporate entities to obtain sources of short-term borrowings and provides and additional instrument to investors. Such instruments are traded in CP markets.

g)      Inter-corporate Deposit (ICD) Market

Inter-Corporate Deposit (ICD) is an unsecured load, extended by one corporate to another. Existing mainly as a refuge for low-rated corporations, this market allows a fund-surplus corporate to lend to another corporate.

h)     Commercial Bill Market

Bills of Exchange are negotiable instruments drawn by seller (drawer) of goods on the on the buyer (drawee) of the goods for the value of the goods delivered. These bills are called Trade Bills. Trade Bills are called Commercial Bills when they are accepted by commercial banks and are traded in Commercial Bill Market.

ii.      Capital Markets

Capital Markets exchange both long-term fixed claim securities and residual/equity claim securities. The main economic role of a Capital Market is to match players, who have excess funds to players, who are in need of funds. These markets can be classified into Debt Markets and Equity Markets.

a)      Debt Market

Financial Instruments that have a fixed income claim and have a maturity of more than one year are traded in Debt Market. Debt Market can also be classified into Primary and Secondary Markets.

b)     Equity Market

Equity Instrument bestows ownership on the holder of the security. Equity hence implies ownership rights in the corporate entity that has issued the instruments to the public. Equity Market can also be subdivided into Primary Markets and Secondary Markets.

Primary Markets

The Primary Markets are the doorway for corporate enterprises to enter the Capital Market. The issues of new/fresh/subsequent securities are offered to the public through the primary markets.

Secondary Markets

The Secondary Market refers to the exchange of securities that have been listed through the Primary Market. Such markets offer tradability to the financial instruments. Secondary Markets can be subdivided into Spot Markets and Derivative Markets.

Spot Market

Spot Markets denote the currency trading price of financial instruments. In the context of time, the Spot Markets may range between one day, two days or a week. The transactions in the Spot Markets are settled are settled immediately, that is, on the immediate settlement date.

Derivative Markets

Unlike the Spot Markets, Derivative Markets are Futures Market. Trade takes place here with the intention to settle it at a later date. The trade in Derivative Markets is based on Futures Contract, which is an agreement by one participant to either buy or sell a financial instrument at a predetermined date in the future at a predetermined price.

1.1.2        Foreign Segment

Each nation, besides its exclusive domestic market allows firms registered outside the country to participate in its economic activities. This is termed as Globalization or Opening Up of the Economy. This is known as Foreign Participation in a National Market.

1.2              International Market

International Markets are usually referred to as Offshore Markets. This concept includes opening the National Market to other group countries.

2.      Currency/Forex Market

The Foreign Exchange or Forex Market is on international currency exchange market. It caters the need of International Mobility of funds. The main players in Forex Market are dealers, who are regulated by the specific regulatory authority of the country. Fig. 3 shows the classification of Financial Markets.

References:

Handouts – Investment Analysis and Portfolio Management

Lecutres by Mr. Wasim Anwar regarding Financial Management