Important concepts to understand Finances

By December 28, 2018

If you get to study finance you’ll see that the thing can be quite complicated. As we want to start at the beginning and consolidate concepts, we show you the most important ones for the understanding of finances. Sean St John Toronto has around 25 years of experience in finance sector. Sean St John currently serves as the Executive Vice President and Co-Head of Fixed Income, Currencies & Commodities at National Bank Financial in Toronto, Canada.

Time value of money:

Imagine that you can have a certain amount of money to invest and that money you have to pay. The concept of the time value of money is that it is preferable to receive a payment today instead of at a future date.

If today you receive money and invest it, it will produce interest from now on. But if you receive it later, you will lose purchasing power due to the effect of inflation.

Risk premium:

The risk premium is the difference between the return on an investment and the interest rate of the securities that are considered safe.

Investors always move in the same way: they act in the markets trying to get the best possible return for their money and at the same time they try to make that investment as risk free as possible. It is clear that the higher returns there will be greater risk, investors have to weigh that and this is one of the data offered by the capital market.

Given this, it is clear what the data of the risk premium is for, which was heard so much ago in the news.

Interest rate:

The interest rate is defined as the amount paid in a unit of time per unit of capital invested. Interest rates affect investment, trade and consumption. This is because many of the purchases we make every day are paid with debit or credit cards. Also, the businesses have to buy the products that are going to sell to us and they usually do it on credit. Regarding investments, these are supported by debt issuance through bonds or bank loans.

All this network works in the following way: when the interest rate goes up, consumption and investment decrease because it is more difficult to pay. If the interest rate goes down, consumption and investment are encouraged. It is very important to understand this because it is what people engaged in macroeconomic policies use.

Those responsible for macroeconomic policies are the central banks of the countries. They induce an increase in the interest rate to lower inflation. The tool they use to move inflation is called the discount rate, which is nothing more than the interest rate at which banks lend money.

Inflation:

We go with a concept that, luckily or unfortunately, accompanies everywhere. Inflation consists of a continuous increase in prices, which leads to the loss of the value of money in order to acquire the products and services that we need.

There is nothing that influences a country’s economy more than inflation, since it determines the cost of living. It is also related to interest rates because inflation decreases the value of money. Then, the higher the inflation rate, the higher the interest rate needed.

Opportunity cost: You are an investor, you are interested in two options and you decide to invest all the money that you thought in one of the options. The opportunity cost is what you give up because you have discarded one of the possibilities you were weighing.

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