A tiny primer on principles of finance

While finance is a vast and multifaceted industry, there are certain principles that underpin every decision or transaction made by it. This post is an explanation of these principles.

Time Value of Money (TVM)¹ ² ³
This principle says that money available earlier is worth more than an identical sum available at a later time; so money in the past was worth more than the same amount today, and any amount today is worth more than the same amount at a later date.

The reason this happens is threefold:
1. Interest:⁴ ⁵ money available at an earlier date can be invested to earn an interest that increases that total quantity of money available at the later date. Interest is a fee paid to any entity (such as an individual, a group, or an organisation) when that entity allows another entity to use its money. For example, if a person deposits their salary in a savings account, the bank pays them interest for keeping the money and making it available for use by the bank. Conversely, if an organisation gives another organisation a loan, the borrower pays the lender interest as a fee for being able to access and use those funds.

2. Compounding:⁶ ⁷ in finance, interest is of two types- simple interest and compound interest. If money is invested so that it earns simple interest, it will earn interest on the original sum that is invested, and only on that amount. Let’s say an individual invests INR 1,000 for 5 years at a simple interest of 10% per annum, they will get an interest amount of INR 100 per annum for 5 years if they do not withdraw any of the original money they deposited (the INR 1,000 which is called the “Principal” in finance). Therefore at the end of their investment period, they will receive INR 1,000 + INR 100 + INR 100 + INR 100 + INR 100 + INR 100 = INR 1,500.

Compound interest pays a higher rate of interest, because as long as the interest amount earned at the end of the first year was not withdrawn, that INR 100 of interest would also earn an interest (unlike SI which only pays interest on the principal amount of INR 1,000). So, if the individual who invested the INR 1,000 had invested at a rate of 10% compound interest annually, at the end of Year 1, they would receive the same amount as with SI- INR 100, but at the end of Year 2, they would receive 10% interest on INR 1,000 + 10% interest on the INR 100 interest amount that was added to the investment at the end of Year 1. Therefore at the end of Year 2, they would have a total amount of INR 1,000 + INR 100 + INR 100 + INR 10 in their account.

Here’s a table to help explain this better:

Year	Simple Interest: Year-end Total (INR)⁷	Compound Interest: Year-end Total (INR)⁶
1	1,100 (Principal 1,000 + Interest: 10% × 1,000 = 100)	1,100 (Principal 1,000 + 10% of 1,000 = 100)
2	1,200 (Last year total 1,100 + Next 100 interest)	1,210 (Last year total 1,100 × 10% = 110; 1,100 + 110)
3	1,300 (Last year total 1,200 + Next 100 interest)	1,331 (Last year total 1,210 × 10% = 121; 1,210 + 121)
4	1,400 (Last year total 1,300 + Next 100 interest)	1,464.10 (Last year total 1,331 × 10% = 133.10; 1,331 + 133.10)
5	1,500 (Last year total 1,400 + Next 100 interest)	1,610.51 (Last year total 1,464.10 × 10% = 146.41; 1,464.10 + 146.41)

Tabular explanation of the difference between calculations for simple interest and compound interest

Therefore in SI, each year the interest is always INR 100 (just 10% of 1,000), added without change, but in compound interest, each year new year interest is calculated on a bigger amount (previous year’s total), so the yearly interest keeps growing. Notice the difference- via compounding, the investor would have earned INR 110.51 more after the five year period of investment.

3. Inflation:⁸ The final reason is something called inflation, which is the rise in the general price levels in the economy (that is, in general, the prices rise or the amount you can buy for a certain amount of money reduces, even if some things remain static in price or may have even reduced in per unit price), which makes it so that the same amount of money will purchase fewer goods and services at a later date, since they have become more expensive in comparison to an earlier date.

Materiality
More here.

Risk
In finance, “risk” means the uncertainty or variability of returns associated with an investment.⁹ ¹⁰

There are multiple types of risk in finance. Some risks affect everything, and they simply cannot be avoided, but others can be minimised.

1. Systematic (or sometimes called systemic) Risk:¹¹ those risks that affect the entire national economy, or in these interconnected times, affect most of the world at the same time. The 2008 subprime financial crisis was an example of one such issue. Imagine somebody, may it never be so, lives in a country that is at war- most sectors in the economy of such a country are likely to be affected by the war. It is unlikely that they could invest in a sector that is not affected at all, not even indirectly. Such risks are simply impossible to minimise. How to know if something is a systemic risk- ask, can the risks be avoided? No? It’s systemic.

2. Unsystematic (unsystemic) Risk:¹¹ those risks that affect only one sector in the entire economy, or an industry, or even one company. Imagine a corruption scandal erupts at a particular company- the risk will be limited to the company, or at most the industry the company belongs to, rather than spread through the entire national economy. Can the risks avoided? Yes, easily.

Understanding risk helps individuals make better decisions. There are several specific types of risk that are explained briefly in the table.

Type	Meaning (Simple Words)	Example For Beginners
Market Risk	Prices move because of the whole market	Stocks fall when economy dips
Credit Risk	Borrower may not repay money	Person takes a loan and can’t pay it back
Liquidity Risk	Can’t sell asset quickly for fair price	You own a rare toy, but no one wants to buy it today
Operational Risk	Failure inside a company (mistake, fraud)	Computer glitch at a bank
Inflation Risk	Money loses buying power over time	Prices of groceries go up, money buys less
Currency Risk	Foreign money value changes	INR to USD exchange rate changes
Reputational Risk	Bad publicity affects business	News breaks that a company did something unethical

Types of risk

Risk and Return Tradeoff¹² ¹³
Now, in the example in the Time Value of Money section, we knew exactly how much interest would be earned by the investment. However, there are many avenues of investment that do not guarantee any returns, and may even lead to losses.

Generally speaking, the higher the risk any investor takes, the higher their expectations of returns for that risky investment. Think about it- if they could achieve the same returns for a lower amount of perceived or actual risk, then would they not opt for getting the same returns for the lower returns? In this way, each percentage point of higher risk taken must reward the risk taker with greater returns, or they would have no incentive to take the extra risk at all.

This is called also called the Efficient Frontier. It is a graph where the x-axis maps the risk taken, and the y-axis represents the returns for each point of risk taken. Points to keep in mind:
1. For any given level of risk, the aim is to receive the highest possible expected return; and
2. For any given expected return, the aim is to take the lowest possible risk.

Any investment that doesn’t meet these conditions is inefficient: either the investment involves too much risk for the amount of returns they are offering, or too few returns for the amount of risk being taken.

But what is “too much risk”?

Every individual has a particular “Risk Tolerance”, or their personal capacity to withstand losses in case something goes wrong with their investments. Investors must always understand what their personal capability is to stomach losses, and this is also why investments must be risk efficient, so that on the occasion of a loss, that loss is not more than they can tolerate. This is a matter of personal comfort with loss.

Risk tolerance is determined for each individual via multiple factors, such as how soon they need the money invested- those with long investment horizons (let’s say 50 years for example), may invest and easily tolerate shorter term losses since their investment has the time to build back up (this may never happen, but they still have the time to see if it will). Another factor is how much money they have outside of the particular risky investment in question. Those with a large nest egg will naturally feel safe even if the entire amount invested in the riskier investment were to disappear.

Every individual has a different personal relationship with financial risk, which they must understand thoroughly and stay within their own limits.

Diversification¹⁴ ¹⁵ ¹⁶ ¹⁷
Diversification is the risk management strategy of spreading investments across various assets to reduce exposure to any single investment (an asset is anything that will earn you returns in the future, this post has other such definitions). Diversification is best explained as not putting all your eggs in one basket. By spreading investments across multiple assets classes, geographies, and industries, an investor gains the benefit of never leaving their entire investible corpus or all their savings at the mercy of an unsystematic risk event. If there is an event that affects the entire economy, diversification will not help for any asset classes that are based (fully or partially) in that region, but this too can be diversified against these days- it is now possible to invest in other countries, and this works against the kind of systematic risk that spreads only within the boundaries of a particular nation. In case the risk event has spread across the globe… well, that’s you done for the moment.

Efficient Market Hypothesis¹⁸ ¹⁹ ²⁰ ²¹
Imagine if an individual wanted to buy a house, and the only thing they know is the area they wish to purchase the house in, and what their own budget is. They find out that in that area, no house sales have taken place at all in the last few years (even though it is a residential area with 100s of houses). How would such a person determine what buying the house in the locality would cost them?

They won’t, because there is no historic price or volume data available at all, and they may withdraw from buying in the area. It is also possible that they decide to pay whatever they are asked for as long as it is within their budget, but there is no way for them to know whether they are receiving the correct value for the money they are being asked to pay, since there is no comparison available.

Now imagine two houses are sold in the same area- let’s say one for INR 30,00,000 and another for INR 35,00,000: so now the buyer has price data and volume data both- two houses, and around INR 30-35,00,000. Are they likely to offer somewhere in the vicinity of these numbers for any house they may wish to buy, or are they likely to offer much less or more than the established price level? In case the buyer chooses to offer less than the established price level, they are unlikely to get any sellers, correct? And why would they offer much more than the established price level?

In a financial market, when the historical price and volume data is known, that market is considered to be at the first level of market efficiency, called Weak Efficiency. It is data without which no fair transactions are possible.

Now, let us say the buyer decides on a few houses they really like, and to find out more about them, they go and ask neighbours about whether those houses are well built, or have any issues. etc. This information is publicly available, and is likely to shape their opinions about the properties in their shopping cart. Let us imagine one of the houses has a well known termite problem- is this new publicly available information likely to change the buyer’s valuation of the product? Then they find out another house in the locality that they have their eyes on has built in parking space for 5 cars- even if they themselves don’t have five cars yourself, are they more likely to look at this house more favourably? Perhaps offer a little more for it in comparison to other houses?

In a financial market, this is the second level of market efficiency. It is called Semi-Strong Efficiency. All publicly available information is known to everyone.

And now back to 1984: Strong form market efficiency, where there is no private information- all information, no matter how seemingly private, is known publicly. Clearly (thankfully), such a world does not exist. In the context of markets, this means that there will always be insiders who will know more than outsiders.

One thing to note here before we move on- since we’re talking about financial markets, the theory is about stock prices.

Information Asymmetry²² ²³ ²⁴
Information asymmetry is the situation where one party in a transaction possesses more or better information than other parties, which leads to outcomes that are optimal only for the party with the good information.

Information problems have significant implications for financial markets. For example, because borrowers know their own financial conditions better than lenders, lenders may not be able to assess the potential borrowers true creditworthiness. Assets may also be priced wrongly due to information asymmetry, again causing inefficiency in the market.

There are several market intermediaries that help lower information asymmetry, such as credit rating agencies that assess an individual or organisation’s creditworthiness so that lenders may have a level playing field; auditors, who provide independent verification of organisation’s financial claims, and even IPO grading agencies (IPO = Initial Public Offering) that independently evaluate a company’s financial credentials when it is issuing shares to help investors make more informed decisions before subscribing to that IPO.

Agency²⁵ ²⁶ ²⁷
A Principle-Agent relationship is the relationship between the owners, or Principals, and the people who work for them, such as managers, or Agents.

The larger an organisation, the more agents there will be, and the more information asymmetry there will be between the owners and their agents. Add to that the fact that Agents and Principals have very different inherent motivations, and it’s easy to see conflicts of interests arising between these parties.

The Principal-Agent problem can manifest in a number of ways, for example, managers may be more interested in short term profits while shareholders may wish to build their organisation up to ensure long term value; or managers may avoid risky but profitable projects over the worry that if it goes wrong they may lose their job even if the shareholders would prefer to go for the project, etc. Information asymmetry exacerbates these issues, as managers typically know more about what is happening in the company and the decisions being taken than shareholders.

Several mechanisms exist to counter agency problems. Monitoring agent behaviour and decisions through audits and oversight as well as strong corporate governance helps ensure management acts appropriately. Aligning the incentives of the management and the shareholders can be done through compensation packages that include profit-sharing with employees.

Stakeholders²⁸ ²⁹
All those individuals, or groups of individuals, who are affected by the activities of the company are stakeholders of that company. Stakeholders may be internal or external. The table below has examples:

Type	Example	How They’re Impacted
Internal	Employees	Their jobs, pay, and stability depend on the business.
Internal	Management	Make decisions and want success for their own reputation and bonuses.
Internal	Board of Directors	Set the company’s big-picture vision, provide oversight, and uphold good governance.
Internal	Shareholders	Invested money in the company, want profits and growth.
External	Customers	Use the products or services produced by the company, seek quality, safety, and value.
External	Suppliers	Sell goods and supplies, need reliable buyers and prompt payments.
External	Lenders	The company owes them money.
External	Debtors	They owe money to the company.
External	Community	Care about jobs, environment, local development.
External	Government	Collect taxes, set regulations, interested in company compliance and economic contribution.

Every stakeholder benefits in some way when the company succeeds, and can be hurt if things go badly. In finance, all decisions were made earlier from the perspective and for the benefits of shareholders only. This is now changing towards more holistic stakeholder management which balances (or attempts to) the shareholders’ requirement for profits while also making sure that other stakeholder’s points of views are incorporated into decision making. This is called Stakeholder Capitalism (as opposed to regular capitalism), and it aims to create long term value for everyone affected by the company rather than just prioritising shareholders.

These are a web of financial concepts that build all financial logic. All higher financial concepts are based on one or an interaction of these concepts. I’ve explained the very basics of these concepts here from my own understanding, but please use all the sources provided through the post as a further reading library.

Sources

Author: Finrod Bites Wolves

A blogger. View all posts by Finrod Bites Wolves

A tiny primer on principles of finance

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