Financials

What Is Arbitrage? Arbitrage describes the act of buying a security in one market and simultaneously selling it in another market at a higher price, thereby enabling investors to profit from the temporary difference in cost per share. Arbitrage is a widely used trading strategy and probably one of the oldest trading strategies to exist. Traders who engage in the strategy are called arbitrageurs. Let me tell you a story about a “Chaiwala”! He was truly chaalu or shall we say, “Extra Smart”!! He would provide tea at ₹ 5 per cup and his cost of preparing the same was ₹ 4. Thus, he made a profit of ₹ 1. But he was not happy with making a profit of just ₹ 1. So he thought about how he could increase his profit. It was then that he had a brainwave out of the blue! He identified a Government canteen which offered tea at ₹ 2. BIG IDEA! Wasn’t it?  He could now simply buy tea for ₹ 2 and sell it for ₹ 5 and make a much better gain of ₹ 3 This buying of a thing in one market and selling in another market at a higher price is known as “Arbitrage”. Similarly, if arbitrage opportunities exist, stocks too can be purchased in one market at a lower cost and sold in another at a higher cost. So, for the next few days, our Chaiwala had a field day earning happily as he served his daily chai. But Alas! Such arbitrage opportunities do not last long. As information flow increases and the arbitrage opportunity gets known, it soon starts to disappear. And this is exactly what happened in the case of our “chaiwala”. The chaiwala had an assistant who one day spilled the beans about the “arbitrage” advantage being enjoyed by the chaiwala. Soon after that, the chaiwala was rounded up and he confessed about the arbitrage opportunity he had spotted. Since his customers, in a sense, had been paying a fair price all this while since ₹ 5 had been the standard retail price in all canteens, the chaiwala was forgiven but was warned against adopting this practice again. So, the arbitrage opportunity too vanished in thin air as the very next day, he was back in his own canteen making tea at ₹ 4 and selling it at ₹ 5. Thus, it’s important to understand that “arbitrage” opportunities are short-lived. It is essentially a short window of opportunity that can be exploited by taking action at the right time. As information flow gets efficient, this opportunity vanishes as we saw in the case of the chaiwala. KEY TAKEAWAYS Arbitrage occurs when a security is purchased in one market and simultaneously sold in another market, for a higher price. The temporary price difference of the same asset between the two markets lets traders lock in profits. Traders frequently attempt to exploit the arbitrage opportunity by buying a stock on a foreign exchange where the share price hasn\’t yet been adjusted for the fluctuating exchange rate. An arbitrage trade is considered to be a relatively low-risk exercise.

How do interest rate work…? An interest rate is the cost of borrowing money. A borrower pays interest for the ability to spend money now, rather than wait until he has saved the same amount. FOR EXAMPLE….. If you borrow Rs 200 at an annual interest rate of 5%, at the end of the year you\’ll owe Rs 205. The interest a lender receives is his compensation for taking a risk. How…? With every loan, there is a risk that the borrower will not be able to pay it back. The higher the risk that the borrower will default (fail to repay the loan), higher is the interest rate. That\’s why maintaining a good credit score will help lower the interest rates offered to you by lenders. Interest rates work both ways. Banks, governments and other large financial institutions need cash and they are willing to pay for it. If you put money into a savings account at a bank, the bank will pay you interest for the temporary use of that money. Governments sell bonds and other securities for the same reason. In this case, you are the lender to the government and the interest rate is your compensation for temporarily giving up the ability of spending your cash. Government-issued bonds pay relatively low interest rates as the risk of default is close to zero. Interest rates for Unsecured credit will always be higher than secured credit. Secured credit is backed by collateral. A home loan is a classic example of secured credit, because if the borrower defaults on the loan, the bank can always take the house. Credit cards are unsecured credit because there is no collateral backing the loan, only the cardholder\’s credit score. Long-term loans also carry higher interest rates than short-term loans, because the more time a borrower has to pay back a loan, the more time there is for things to possibly go bad financially, causing the borrower to default. Another factor that makes long-term loans less attractive to lenders is inflation. In a healthy economy, inflation almost always rises, meaning the same rupee amount today is worth less in a few years from now. Lenders know that the longer it takes the borrower to pay back a loan, the less that money is going to be worth. For example, if you take out a home loan with a nominal interest rate of 12%, but the annual rate of inflation is 4%, then the bank is only really collecting 8 % on the loan. So how do interest rates affect the rise and fall of inflation? Well, lower interest rates put more borrowing power in the hands of consumers. And when consumers spend more, the economy grows, creating inflation. And If the RBI decides that the economy is growing too fast, then it can raise interest rates, slowing the amount of cash entering the economy.

Asset Allocation Asset Allocation is at the heart of personal finance What is asset allocation all about…..? If asset allocation means diversification, then may I ask what is diversification……? What is Diversification..? Let’s look at the example of “Emirates”. It is one of the finest airlines. It also provides a very unique service. The different air-hostesses in the air-craft are proficient in different languages. Some speak French, some speak Mandarin, some speak Spanish, some speak Swahili, some speak Hindi depending upon the sector they fly. How does this help…? Since it is an international airlines, it flies across the world and has passengers from all over the world. On some sectors knowing English alone does not work. Perhaps only French works in that sector. Hence the hostesses who speak French ensure that all is well. On some other sector perhaps knowing “Hindi” is essential and so on and so forth. Clearly different languages work in different sectors and having a staff knowing different languages ensures that all is well all the time. Similarly in investments, not all asset classes work at all the time. Hence if one were to invest all his savings in a single asset class then certainly it won’t be “all is well” all the time. It is prudent to invest in several asset classes such as equity, fixed income assets, gold, other commodities, real estate, etc. because some asset class or the other will work for you by giving reasonable returns at all times, and all would be well at all times. Asset Allocation is therefore at the heart of “Financial Planning” . It is the starting point towards designing your portfolio.

TIME VALUE OF MONEY Some people put their money in a bank account; some make investments in stocks and bonds. Different people follow different strategies to keep their money on the move. All of them consciously or unconsciously realize time is the biggest enemy of idle money. But what makes a rupee in our hands today worth more than a rupee tomorrow? What is so different about currencies made of paper that the value of the same amount of money diminishes with time….? So, the concept of time value of money always influences our decision about what we intend to do with our money. Well… You need not be a philosopher to understand the concept of time value of money. A ₹2000 note today in our pocket is worth more than a ₹2000 note that we may get after five years. All of us intuitively know that. But let’s try to understand what actually makes the present value of money worth more than the value of the same amount of money after five years. Remember… Money is just another name for new opportunities. The money that you have now can open the doors for many opportunities. Different uses of money may have different advantages. Some of these opportunities may look very small but some of them might really put you on the fastest track to the future. Here’s a new term for you to know! If you invest your money now, you would earn a return which would make your money grow in the next five years. But the problem is you can choose only one of the many equally advantageous opportunities. All of us try to use our money for the best possible opportunity. The advantage that we forego by not putting our money in another possible opportunity is what is called the Opportunity Cost of Money. For example… So, if you are investing your money in a 10 year bond that pays you 9% interest, then you are foregoing an opportunity of putting the same money in a 10 year term deposit that pays you 7% interest. In this case, your actual advantage is only the 2 percentage points more interest that you earn on your investment in bonds. But always remember that different opportunities have different risks. Investment in bonds may be riskier than investment in term deposits. So you should always compare the risk adjusted return to find out whether you are gaining or losing in making a particular use of money. It is better to eat your breakfast before inflation eats your money! Today you can buy two pizza’s for ₹300, but maybe after five years you would be able to buy only one with the same amount. So you have to think if I give you an option of either taking two pizza’s today or one pizza after five years, which option would you choose…? How can you use the concept of time value of money to make intelligent decisions about your money…? The first thing you must keep in mind is that you should never keep your present money idle. Money has to grow with time. Invest it in stocks or bonds so that the return is good enough to at least preserve its present value. And still better, take the mutual funds route to take advantage of professional fund management services. To Sum Up If you invest Rs. 5 lakhs now, what should its worth be after 30 years if you are earning 10% return per annum compounded annually? For your knowledge, let me tell you that Rs. 5 lakhs would be worth Rs. 87.24 lakhs after 30 years. Almost appreciated by 16 times. The concept of time value of money says that the value of money at present is worth more than the same amount of money in the future. By making appropriate investment decisions, we can make money grow with the passage of time.