Getting even with Inflation

Getting even with Inflation

Let us get to briefly know the terms- Saver,Borrower and Investor.

Saver, like many of us, saves now to consume at a later date, when he may not have an income to meet his various needs. Hence, he saves for the rainy day.

Borrower, on the other hand, spends more than his means allow at a given point of time. He hopes that he will earn enough in future, when he will not only repay his creditor(s) but will also have enough money left to spend on food and other necessities.

Investor is the person with a glint in his eyes. He invests in a business that is essential to us all. He hopes to sell his products year after year. Of course, we figured out that he is the one who takes the big bets.

Interestingly, all of us keep switching roles from Saver to Borrower or even Investor.

We have made another discovery - the 'purchasing power of money' declines with time, thanks to the monster called Inflation.

Interestingly, Inflation bares its fangs only at Saver. It is a saviour of Borrower and a boon to Investor.

We have also learnt an important lesson: Investing is a good way to offset Inflation.

After understanding all this, we stopped ourselves to ask if it is worth saving.

We realised that something was missing from the picture.

And then, a bolt from the blue told us that it is 'Interest' that completes the big picture.

Question hour again
So, what is Interest? Why do we need it? How does it tilt the balance in favour of Saver?

Let’s get to the Answer
Let us first assume you have $500 to spare. You have two options as to what to do with it - you can either buy a shirt today or you can save the money and buy a shirt six months later, during Diwali. Mind you, the same shirt will cost you $550 by Diwali time. So, what do you do?

You are obviously muttering: "what a stupid question!" After all, it will make a whole lot of sense to buy the shirt now as your $500 will not be able to fetch you the same shirt six months down the line. And why save anyway?

Hold your horses while we add another twist to the options that you have.
Assume a friend of yours needs $500 urgently. He is willing to return $550 six months hence. What will you do then?

Well, if he is a very good friend you will give him the money and postpone your plan to buy a shirt. After all, you can buy the shirt once your friend returns your money.

Another twist: what if your friend promises to repay $600 (instead of $550) six months down the line?

You will lend him that $500 without any second thoughts, as you will not only be able to buy the shirt six months down the line, but also have $50 to spare.

Lessons:
1. It does not make sense to save if you have not been compensated for Inflation.
2. In order to boost your saving instinct, you need to be compensated at least for the loss of your purchasing power. That is you need to be compensated for Inflation.
In our examples, we have seen that a borrower is willing to repay a higher sum in order to compensate the lender for the loss of his purchasing power.

Some very basic arithmetic now
In the first example, you lend your friend $500 but he returns $550 six months later. That is your friend gives you $50 extra when he returns your money. In the second case, he returns $100 extra. The money that you lent him is called 'Principal'. The extra money that your friend gives is called 'Interest'.

'Interest' defined the textbook style
"Interest is the price paid for money lent by one person for the use of others." In other words, Interest is in no way different from wages that are paid as a price for the use of labour.

What is Interest Rate then?
Interest paid on principal expressed as a percentage of the principal. Hence, in our second poser, Interest Rate was 10% ($50 interest on a $500 principal). While Interest Rate in the other example was 20%.

Now we know what Interest Rate is.

The battle lines have been drawn
Interest Rate aids Saver by compensating for the ravages caused by Inflation. On the other hand, Borrower has to think twice before borrowing since he needs to pay a price.

What about Investor?

Investor now starts having second thoughts too.

He uses money to set up a business. Last time, we discovered how uncertain investing can be, as many things can go wrong with the business. However, the expected rewards (profit) offset the risk (uncertainty) and hence, Investor goes ahead.

However, now he has the option of earning Interest on his money if lends it to Borrower. Which is why he needs to make at least as much profit as he would have earned as Interest if he had given the money to Borrower.

The cycle is complete now.

When Inflation rises, Borrower and Investor have a distinct advantage.

Borrower rushes to borrow more to spend now while Investor smells higher profit from its business. Saver knows that he is at the receiving end and insists on higher Interest Rate, reestablishing the balance.

Pack up time
We have learnt how Interest swings the balance of power back in Saver's favour. Interest induces saving.

What is Inflation

What is Inflation

This story explains Inflation in a very basic but informative manner for all of us to understand.

I love my grandfather's stories. Who doesn't? We won't get into the ones that my grandma loves to scoff at. Like his brave encounters with tigers. Or the one about the milk that needed boiling.
But you must listen to this one. My dear grandpa used to buy 10l of milk for 50p and 40kg of rice for Re1 a good fifty years ago!
Don't believe me? Then sample this. In those days, there were coins of 1p and even less! Incredible, eh? But I have seen those with my own eyes in my father's collection of old coins.
What more, I also remember seeing and transacting in 5p and 10p coins in my childhood. Alas! my son won't get to see those currencies. Except in an collection of old coins perhaps!

Wondering why I am rambling about 1p coins and getting into the generation business?
If you have an eye for detail you will have noticed the common thread that runs through these anecdotes. The point that I have been trying to make is how expensive things have become over the years.

My grandfather used to buy 40kg of rice for Re1 and today a kilo of rice costs $20! 10l of milk cost 50p in his days but today you need at least $120 to purchase the same amount.

See what the passage of time has done. It has eroded the value of money. Having $800 today is equivalent to having Re1 fifty years ago!

Economists call it a decline in the purchasing power of money. Remember we encountered this term while getting acquainted with saving, borrowing and investing? The 'purchasing power of money' is the amount of merchandise that a unit of money (say a rupee) can buy.

And the term 'inflation' has its roots right there. When the purchasing power of money dwindles with time, the phenomenon is called 'inflation'. This is manifested in a general rise in prices of goods and services.

But why do prices rise?

Let us understand why this happens with the help of a simple example:
Onions are an integral part of any food preparation in our country. Can you think of having a meal without having a dish that contains onion? Why, onion and chapattis constitute the staple diet for many people.
Let us assume the onion crop fails in a particular year, for whatever reasons.
What happens then? The supply of onions in the market drops. However, people still need onions. Inevitably, the price of onion shoots up as people scramble to buy the limited supply of onions.
Remember November 1998? Such a situation actually happened in several parts of the country. It nearly brought down the government! The price of onions rose to as high as $40 per kg or more.
But how does a simple thing like a one-off drop in onion supply cause prices to rise across the board in sutained fashion?.
In the winter of 1998, the dabbawallas and restaurants were forced to hike their prices in response to the rising prices of onions. Even your local barber and maidservant demanded a higher pay to meet their higher daily expenses. All thanks to the (mighty?) onion. And this set off a chain reaction.

How?

Think again. It is not only onions that we consume in the course of a day. There is a whole basket of products and services that we draw on, on a day-to-day basis.
Hence, some of you decide to use more of garlic to make up for the lack of onion. The demand for garlic goes up. A few who eat raw onions decide to substitute it with more of tomato and cucumber. The local sabjiwala senses this shift in consumption happening. The smart businessman that he is, he hikes prices of all vegetables. He starts earning more money. Now his children demand that he should get them a new 21" TV with 100 channels.
And with all sabjiwalas rushing to the nearest TV shop, the sales for TV picks up. The TV company makes more money. Noticing the ballooning profits, the employees of the company demand a hike in their salaries. You are lucky to be working for one such company. You have more money in your pocket. And you have always wanted to buy a car...
We could go on and on, but you get the idea,don't you? The price rise is here to stay. Any guesses on who actually benefits and who loses from this rise? Can 'inflation' lead to prosperity?
We are posing a lot of questions. Do not worry we will come back to answer them later. Write in at school@sharekhan.com to tell us. Maybe we will use your response itself!
But, for now we just need to understand the concept of inflation. After all, the main objective is to figure out how inflation affects the three friends we met last time - saver, borrower and investor.
Last time we understood how important it is for all of us to save. We all need to save for the day when we will not be earning but will still need to spend money on food, clothing and the occasional movie.
What would have happened if my grandfather had saved a rupee fifty years back to buy rice now? Oh boy! It would have been a total rip-off. He would receive a few grains of rice in exchange for that amount.
In short, inflation is one BIG enemy of savers.

So, why should we save?

A good and important question. But we will come back to it later. We need to find out how this monster they call 'inflation' impacts our two other friends that is savings and investments.
We have already discovered that 'borrowing is the opposite of saving'. So if the saver is losing, our borrower must be winning.
Yes, of course. After all, the borrower borrows to spend today and repay later. Imagine if my grandfather had saved a rupee fifty years ago and my grandfather's neighbour had borrowed it from him. The neighbour could have bought 40kg of rice then and had a feast. In case he repaid the money to my grandfather now, all that my grandfather would have been able to buy is a few grains of rice!
To top it all, the borrower spends NOW and adds to the inflation effect, doesn't he? And compounds the misery of our saver.
What about our last friend, investor, the slightly difficult one to understand?
Imagine once again (just one last time, we promise) that my grandfather's friend had invested a rupee in a paddy field, that is bought a paddy field with a rupee. The smart guy would have been raking in money today, selling a kg of rice at $20!
Our investor friend seems a lot better off than even our borrower who benefits from inflation.
No wonder investing is always considered as a good thing to do to beat inflation. It is what textbooks call 'hedging inflation'.
Hey, but what is happening? Last time we understood that the saver, borrower and investor are good friends who complement each other. The saver meets the needs of the borrower and the investor. Life is in perfect harmony.
Now you are saying that 'inflation' upsets this balance completely. That the 'saver' is at a complete disadvantage while the other two benefit from this poor guy.
Is life so very unfair? Should we all stop saving? Or have we missed something very fundamental?

Time value of money

Time value of money

We have three friends - Saver, Borrower and Investor and their tryst with Inflation?

Inflation is detrimental to Saver but favourable to Borrower and Investor.

But this lop-sided scenario can't last forever. Saver can't always be the 'poor guy'. And Borrower and Investor can't benefit endlessly at his expense.

We surely know why. If things continue as they are, then all of us would want to be borrowers and investors! And nobody would bother to save!

So, the stage is set for a new character, who would balance the disequilibrium. Enter Interest, the great balancer.

Interest tilts the balance in favour of our friend Saver, thereby levelling the playing field for our three friends. But how does he do that? Saver demands interest for postponing his consumption while Borrower and Investor have to pay up Interest for using Saver's surplus.

Hence, what Saver loses owing to Inflation, he gains through Interest.
Now that we have seen how Interest restores the balance, it is time for us to move on...

Assume that your friend calls and offers you $1000. He says that you can have it either now or tomorrow. What would you choose?

Pretty simple, eh? Your voice is loud and clear as you say, "I want now."


So, why did you choose to have the $1000 NOW?
You obviously are thinking of the many things that you can do with that money. You can buy a couple CDs or a pair of new jeans or even the pair of shoes teasingly displayed at the shoe shop on the way home. After much deliberation, you decide to go for the pair of shoes. With the cash in your pocket, all you need to do now is go to the shop and buy.

However, your friend is too busy and is unable to give you the money today, but he promises that you will get it a month later. You are sorely disappointed. All your plans of buying that pair of shoes lie shattered.


"Or what if somebody else buys those pair of shoes, which may well be the last such pair on earth?"

"Or what if your friend delays his gift by another month?"

'If' - the root of all uncertainties! What we commonly term as 'Risk' and what can ruin all your well laid plans...
Hence, if you have a choice, you would rather go to see this friend at his office and collect your money today.

Why would you do that?

This brings us to a fundamental truth: Time has value.
We all know that the value of a rupee does not stay the same across time horizons. Due to Risk and Inflation, a rupee today is worth more than a rupee tomorrow on the time line.

In simpler words, we are saying that the value of the same rupee differs at different points of time. This difference in value arises due to the passage of time. Hence, it is called the 'Time Value of Money'.

Expressing this in numbers, if you believe that you can buy the same pair of shoes with $1100 a month later, then the time value of money for you is $100 for a month.

Twist in the tale
Now, let us assume that your friend actually turns up and gives you $1000. But while on the way to the shoe shop you meet your old classmate who badly needs $1000. In that case, will you part with the money?

You would, provided he promises to return at least $1100 a month down the line, so that you can buy the same pair of shoes. (We know that, in real life, you would not take a penny more than what you have lent to your classmate, but just for academic purposes!)

So, what do you call this extra payment that you demand over and above the amount you have lent?

If the answer is 'Interest', you are right. But then what is Interest? And why is it charged?
Let me explain. When you are lending the money to your friend, you forego an opportunity to buy the shoes and use them when you wanted. Hence,you would charge the cost of losing this opportunity, commonly termed as 'Opportunity Cost', to your friend in the form of Interest.

One last exercise before we bid goodbye to 'Time Value of money' and 'Opportunity Cost' for now.

What is the Opportunity Cost for our friends, Saver, Borrower and Investor?

Saver:
Saver is a lot like you. He needs to get compensated for the erosion in his purchasing power with time as also the risk associated with postponing consumption.

Borrower:
Now that Saver has an ace up his sleeves in the form of Interest, Borrower needs to evaluate his decision to borrow and consume now. Why? Now there is interest to contend with.

Lost? If your classmate is borrowing $1000 from you today to meet his needs and is repaying $1100 a month later. Then, he is better off fulfilling a need of his that will be worth at least $100 more a month later.

Investor:
Our most enigmatic friend, Investor has several opportunities knocking at his door. He can set up a beer factory or open a restaurant among other things. We could actually exhaust this page writing about the options that he has staring at him. As we all know, our clever friend hopes to maximise his profits and minimise his risks.

In case he decides to set up a beer factory, the profits he would have earned by setting up a restaurant are considered as his 'Opportunity Cost'!

He also has a very basic 'Opportunity Cost'. He can opt to lend his money to Borrower in return for Interest payment. Thus his investment needs to fetch him enough profits to compensate for all this.

Hence, Investor needs to know the value of his future profits in today's terms for all the investment opportunities. Only then can he make the best choice.

Structured Settlements

Structured Settlements

Structured Settlements is an agreement through which an insurance company agrees to pay an individual a predetermined amount of cash for a fixed length of time if the individual meets an accident. Structured Settlements is designed to help the people to get the most money for their structured settlements and annuity payments by matching with the best possible choices of financial institutions.

Structured Settlements Documents

The documents for Structured Settlement include an agreement, a qualified assignment, an annuity application, a court order if a claim is made by a minor and an annuity policy. Structured Settlements is useful for the individuals who need money quickly for a financial emergency or lifestyle change. These reasons may include paying bills, the purchase of a home, children going to college or starting a new business.

With Structured Settlements one can have the control to proceed as they wish with their settlements. It only works with the finest direct funding sources, weeding out expensive brokers and fly-by-night companies.

Steps to get money by Structured Settlements:

• Firstly we need to evaluate what type of structured settlement or annuity we have.
• Secondly package all the information together in a way it will be pleasing to the investor. This deals with several outstanding investors both private and institutional which pay the best prices in the country. This will give more than 3 quotes and makes us decide which terms and financial offers best suit for our needs.
• Lastly if we would decide to accept an offer, it takes from 2 to 3 months due to the paperwork and court processes involved.

Structured Settlements also includes assisting with the paperwork when we sell annuity payments. The qualified representative will review the specific needs and match us with one of our select partners who can help us in giving much cash for your structured settlement. The information which we give must be confidential as it will not be shared by anyone outsiders. The funding company commences payment after acknowledging the assignment and receiving a court order. The payments starts after we receive the receipt from court orders.

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