A Quick Intro to Finance: Opportunity Costs

In this third and final part on our series on interest rates, we look at opportunity costs. In the first two posts, we defined interest rates as 1) return for risk taken, and 2) discount rates used to evaluate cash flows.

Interest rates can also be viewed as opportunity costs, or, in other words, the highest-value action foregone.

"King Lear" (ink and acrylic, 53.7x38.6 cm)

“King Lear” (ink and acrylic, 53.7×38.6 cm)

Think of it this way. Imagine you have $5 in your pocket and you are deciding whether to spend it or save it. You decide to spend it. If you had decided to put it in a savings account, that would have given you, say, 4% annually, then that 4% is your opportunity cost, because that is your highest-value action foregone.

Why would we need this third definition for interest rates? In my opinion, it is largely useful for conceptualizing what is happening with your money, regardless of what you decide to do with it. Let’s go back to the concept of the time value of money.

Since we know that money is worth more today than it is in the future, you are making a tradeoff when you decide to either spend it or save it. If you spend it, you trade off the interest you may have earned. If you save it, you trade off spending the money today. Either way, you have to make a tradeoff.

You have to make tradeoffs because resources are scarce. In our next post, we will use the concepts of opportunity costs and scarce resources as starting point for learning about microeconomics.

Ramon Rodrigo Cuenca, CFA
Equities Analyst
Artandfinance.net

Source: CFA Program Curriculum Level I, 2009, vol. 1: Ethical and Professional Standards and Quantitative Methods, pp. 172-173

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