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Introduction to Finance

29 April, 2015 - 15:13

Finance is a field of study of the relationship of three things; time, risk and money.

The Time Value of Money is one of three fundamental ideas that shape finance.

The Time Value of Money explains why, "A dollar today is worth more than a dollar tomorrow". This is primarily due to the market for loanable funds and inflation. If someone has a dollar today then they also have the opportunity to loan/invest that dollar at some interest rate. Therefore, a dollar today in time t, would be worth $1.00 plus some interest rate, i. That is more than a dollar by itself in the future. An example for inflation would be, let's say you have $1 and you can buy 10 candies today. For the same 10 candies tomorrow you have to pay $1.20. So, due to inflation for the same 10 candies today you pay less than you would pay tomorrow

Inflation refers to the decrease in the purchasing power. Deflation refers to the increase in the purchasing power. In layman terms, inflation causes not the value of money to decrease but the amount of consumables/items that you can now purchase to decline in quantity. Look at the example above. $1 is still $1 but after inflation the individual can probably buy only 8 candies for the same $1 amount.

There are two values of money. One is the Present Value of Money and the other is the Future Value of Money.

Second is the concept of "opportunity cost"; i.e. if a person deploys his money on one item or investment then he has given up the opportunity to do something else with it.

Third is the concept of risk. Let us say, I have earmarked $10,000 towards investments and I decide that I will invest in Microsoft. I put all my money in Microsoft(MSFT) all $10,000 of it. As on 5th Oct., 2006 each share of Microsoft trades at $27.94. So, I would be able to purchase 357.91 shares of MSFT. My returns are completely dependent on how MSFT stock performs in the market and this means that if a Microsoft product(i.e. Vista), fails in the marketplace, MSFT stock goes tumbling down and reduces my investment in MSFT.

Thus, Risk can be defined as the probability of my investment eroding its own self.

In equity, the risk factor is higher than in debt financing and hence as an investor I look for equity to give me higher returns as I have taken higher risk. If I buy US Treasury notes for that value, the investment is almost risk free as the US Govt. stands to guarantee it and hence the return (typically, expressed as the rate of interest) is low. The difference between the returns from equity and from debt(US Treasury, etc) is the Risk Premium.

Risk Premium is the reward given to an investor to take more risk.