Finance - Risk and Return (Rate)

In finance field, it is common for people to hear this phrase: higher risk compensated with higher return (take note; there is not necessary in vice-versa form). Well, what is risk then? Let’s look at an example: If you are going to lend a sum of money to two of your friends, A and B, and you know that A had a stable income, while B still being unemployed, who do you think will have the higher probability of failure in return back your money? In common sense, you should assume that B will more probably to default in his/her payment, hence, the lending to B will be more riskier than A. So, from the above example, we can define that risk is the uncertainty of something, and which out of our control extension.

When we said that proportion of risk have to be compensated by equivalence proportion of return, then how to determine the form of return? In finance, people use different rates to measure different risk. Loan risk compensated by loan rate, deposit has a return based on deposit rate, and so on. Before further the discussion on different types of rates, I would like to show you the impact of rate on value of money first. To understand the effect, there are few terms that you should know: Time Value of Money (TVM), Compounding Effect, Present Value (PV), Future Value (FV) and Discount/Interest Rate (i).

Assume that you are holding RM1 now (PV = 1), with annual interest rate of 5% (i = 0.05), and we make an assumption that the rate will be remain the same in next 10 years. So, what is your RM1 value after 10 years if it is value added by 5% interest rate annually? Now, to calculate the value, we have to consider compounding effect, compounding effect is occur when interest rate is build on principle value + previous accumulated interest. To make it simple, let’s look at below calculation example.

Compounding Effect:

Value of RM1 after 1st year: RM1 + RM1 x 0.05 = RM1.05

Value of RM1 after 2nd year: RM1.05 + RM1.05 x 0.05 = RM1.1025

Without Compounding Effect:

Value of RM1 after 1st year: RM1 + RM1 x 0.05 = RM1.05

Value of RM1 after 2nd year: RM1.05 + RM1 x 0.05 = RM1.1

See the difference? In common, we only multiply directly the interest rate on principle value, but we had ignored the previous accumulated interest on principle.

We discuss this far till here, next post I will continue on the various calculations of Time Value of Money, have a nice day~!