Changing Value of money with time - time value concept

Regularly on television, we see an ad on pension plan, where the lead actor says whether the funds you invest  in the mutual fund today will be enough in future. We can associate the same with our daily life. During my childhood day, a plate of chicken biryani at my favorite restaurant was RS 50(some 10-15 years back). I visited the same restaurant few days back, the price of chicken biryani was Rs 200. So the purchasing power of Rs 200 has reduced from what it was ten years ago and it is much higher than what it will be ten years from now. 10-15 years ago, I would have brought four plates of chicken biryani for Rs 200, but now only one L

In this article, I will try to understand and share, why the purchasing power of money changes with time. We will try to understand the time value of money.  The basic concept behind time value of money is “a given sum of money is more valuable the sooner it is received” due to the potential of earning interest from the money.

Let us take another example. Suppose I had Rs 100 with me and invest it in some government bank under a fixed deposit plan which is giving me almost risk free 10% of interest rate (Please do not ask which bank is offering such interest rate, I have taken 10% for ease of my calculation).

Suppose I invested the money in the fixed deposit for 5 years. The value of the investment at different time will be:

The relation between Present value, future value and the interest rate is as follows:

FV = PV * (1+r)ⁿ

As shown in the calculation above, the future value depends on the rate of interest. Next let us understand how the interest rate is calculated.

Interest rate depends on following factors or components:

a. Risk-Free Rate – A risk free investment is one in which the actual return over a tenure are always equal to the expected return over the period. For e.g.  Government securities can be considered risk free investment and the rate they provide can be considered as risk free rate.

b. Expected Inflation - Inflation refers to the rate at which prices for goods and services rises. Any investment should beat the rate of inflation to make it profit.  

c. Default-Risk Premium – When we invest money in some instrument, we are actually lending money to another party. One component of interest is to consider the capacity of counterparty to repay the investment. This component will be high or low depending on the creditworthiness of the person or entity involved, i.e. what is the probability of the counterparty to default. That is the reason why the bonds of private institutions provide higher interest rates compared to government bonds. Rating provided by rating agency to the instrument is an indication of the risk of default for the instrument.

d. Liquidity Premium- Liquidity of an instrument is considered to be low if the instrument cannot be converted to cash easily. For e.g. Consider there are two bonds, a bond with higher liquidity will have low premium compared to another bond with low liquidity. Higher liquidity means the instrument will be easily convertible to cash and will follow the fair price for the stock. A less liquid instrument should offer a higher interest rate to compensate as liquidity premium.

e. Maturity Premium - Maturity risk premium applies to any investment that pays a fixed rate of interest and has a fixed maturity date. Buying any investment with a longer time to maturity increases the probability that interest rates could rise within the period between today and maturity.

Summarizing the time value of money increases with time based on the interest rate. The future value of any investment depends on the interest rate. Interest rate is directly proportional to risk free interest, increase in inflation rate, and time to maturity of the instrument and the probability of default by the counterparty, and illiquidity in the instrument.

Key Indicators defining the monetary policy

Today I was watching a news channel and heard that Repo Rate has been reduced by the Reserve bank of India Governor. So I thought of investing some time on the concept of Repo rate, Reverse Repo Rate and CRR and what they mean to a layman like me.

So when I start reading, I get to know including these, there are some more key indicators defined in the monetary policy for the country defined by the central bank of country. In India monetary policies are defined by the Reserve bank of India and are presented from time to time by the RBI governor.

Below are the key indicators defined by the RBI.

Repo Rate is defined as the rate at which the Reserve bank lends money to commercial banks. Repo means Repurchase Obligation agreement. In a repo transaction, a holder of securities (e.g.: the commercial bank) sells the securities to an investor (e.g.: the reserve bank of India), with an agreement to repurchase at a predetermined date and rate. So Repo Rate is the rate at which RBI purchases the securities from the commercial bank with obligation on commercial bank to repurchase the securities at the prevailing repo rate at the agreed rate. This is an interesting topic and deserves a separate article for detailed discussion. Lowering of Repo rate implies banks can now borrow money from the reserve bank at a lower rate. Reverse Repo Rate is the rate at which RBI borrows money from commercial bank. 

Another term we hear regularly during policy commentary is CRR (cash reserve ratio). Cash reserve ratio is the minimum amount of funds that the banks have to keep with the Reserve bank. 

Reverse repo rate and repo rate are used as instrument to keep a check on inflation. The flow of supply from central bank to commercial banks will reduce in case if the repo rate is increased or reverse repo rate is decreased. 

Statutory liquidity ratio (SLR)  is the percentage of money that commercial banks needs to maintain as reserve in the form of gold, cash or government securities before providing any credit to loans. This again is determined and maintained by Reserve bank or central bank

SLR restricts the bank’s leverage in pumping more money into the economy and keeps a check on minimum amount maintained to pay the liabilities that are deposits maintained with the bank. CRR is maintained in cash form with central bank and is used to manage inflation

Bank Rate is the rate at which RBI in India or Central bank of a country allows finance to commercial banks. In case the reserve bank increases/decreases the bank rate, it is an indication of the banks to make changes to interest rates and lending rates.

 In case reserve bank wants more money to flow in the system, it reduces the repo rate. This reverse repo rate is always lower than the repo rate. Reverse repo rate can be increased to reduce flow of money in the system.