In my opinion, the easiest way to understand the fundamentals of Finance is to look at investing as a tradeoff between risk and reward. For example, when you consider a particular investment, the amount of money you could lose can be seen as a risk, and the amount of money you could earn from bearing that risk can be seen as a reward.
Even if you invest in the seemingly safest of investments, you are still taking on some risk for which you have to be compensated. Let’s look at the interest you earn on a savings account.
When you put money into a savings account, you’re basically lending money to a bank. In return, the bank pays you an interest rate as compensation for the risk you take in lending your money. Specifically, you are compensated for:
- Real risk-free interest rate – The actual interest rate you earn from lending the bank money. The bank has to pay you this amount because you could have used this money for other purposes.
- Inflation premium – In addition to the actual interest rate described above, the bank also has to compensate you for expected inflation (we’ll discuss inflation later on).
- Default risk premium – The bank further compensates you for the risk that it can’t make a promised payment to you.
- Liquidity premium – This compensates for the risk that it may cost you extra if you need to convert your investment into cash quickly.
- Maturity premium – This premium pays you for the risk that market interest rates may change while the interest rate you pay remains the same. It’s called a “maturity” premium because the longer it takes for a borrower to pay back your principal (which means a longer time for your investment to mature), the larger the risk is that market interest rates will change in the meantime.
These are all added up to give you the interest rate your savings account earns. From your perspective, this interest rate is the rate of return on your investment.
Note that the interest rate amount could vary depending on the risks outlined by the five components above. But for something generally considered low-risk like a savings account, the rate likely to be small.
In the following post, we will take these concepts one step further and see how rates of return are used to compare different cash flows across time.
Ramon Rodrigo Cuenca, CFA
Source: CFA Program Curriculum Level I, 2009, vol. 1: Ethical and Professional Standards and Quantitative Methods, pp. 172-173