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Understanding Interest Rate and the Time Value of Money

Updated on May 8, 2017

Can a Financial System Exist Without The Concept of Interest?

Yes, but to be successful, this system has to be heavily dependent on a uniform set of morals that allows lenders to trust that borrowers and investors will act within the confines of certain covenants. These moral disciplines eliminate the need for collateral or interest. The Islamic financial system and Jewish financial system are present and historical examples that have applied these methods successfully.

According to Investopedia, Islamic banks make money through profit-sharing on their business loans. However, considering that each and every financial system has an expectation of yielding an increase at the maturity of a loan then interest is always present no matter what the system claims. According to Frederic Mishkin, an Alfred Lerner professor of Banking and Financial Institutions at the Graduate School of Business, Columbia University, yield to maturity is the most accurate way to measure interest.

Interest provides the incentive necessary for depositors, investors, and banks to expose themselves to risk. The typical financial system needs to provide an incentive to attract sufficient savers and investors to provide deposits which are then made available to borrowers who have a productive opportunity to use that money to generate returns.

The Time Value of Money

Money today is worth more than money in the future.
Money today is worth more than money in the future. | Source

It is Hard to Imagine an Economy in Which Money Has No Time Value

Risk, inflation and the opportunity to use today's money to produce returns make it impossible to imagine an economy in which money has no time value. A dollar today is worth more than a dollar in the future. Think about it, there is no risk of losing or having problems getting back the money you already hold. According to blogger Robert Schmidt of propertymetric.com, money today has a higher purchasing power than in the future.

Because of inflation, $100,000 can be exchanged for more goods and services today than $100,000 in 100 years. Put another way, just think back to what $100,000 could buy you 100 years ago.

Factors that Underlie Interest Rate Changes

Amercian economist Frederic Mishkin teaches that the supply-and-demand analysis for bonds forms the apparatus that explains how interest rates are determined. It identifies the factors that affect interest rates and forecast rates will change when there is a shift in demand because of fluctuations in wealth, expected returns, risk, liquidity or when there is a change in supply due to changes in the size of government spending or speculations about inflation, consumer confidence and the profitability of investments. The video below provides a short lesson showing the relationship between bond and interest rates.

Is the Efficient Market Hypothesis a Satisfactory Explanation for Financial Market Behavior?

The efficient market hypothesis is unable to completely explain every phenomenon in the financial market but forms a reasonable foundation for understanding the behavior of the financial market. The ultimate take away from the efficient market hypothesis is that an efficient market does not depend on all its participants to be well informed. Frederic Mishkin states that when you accept this tenet then you cannot use the existence of market crashes and bubbles as an argument for dismissing the efficient market hypothesis. I have mixed feelings about the hypothesis because information can be cornered and selectively distributed and I believe there are market over-performers who are able to predict and influence stock prices. However I also, believe this hypothesis offers sound advice i.e. to pursue a buy and hold strategy - mutual funds and pensions usual provide a reasonable return in the long run.

The Evidence For and Against the Applicability of the Hypothesis

Supporting Efficient Market Hypothesis:

  1. Stock prices change base on information that is publically available.
  2. Stocks outperform technical analysts. Showing that it is not possible to time the market 100% of the time.

Past performance of randomly selected stocks performing equal to top advisors in conjunction with mutual funds not performing above market average supports the efficient market hypothesis in that they were unable to predict future prices and beat the market. If information is publicly available, then announcements on earnings do not impact stock prices. Technology is unable to utilize predictive analytics to identify future prices based on past trends. The random walk should guide stock prices, as future values are indeterminable, so should stock prices be. (Mishkin & Eakins, 2016).

Disproving Efficient Market Hypothesis:

  1. Small firm effect.
  2. January Effect.
  3. Market Over-Reaction.
  4. Excessive Volatility.
  5. Mean reversion.
  6. New information is not always incorporated in prices.

The size of a firm has an apparent correlation with the size of return on investment. Smaller firms may have higher returns over the course of time. From December through January it is predictable that stock prices will rise, negating random-walker behavior. Market overreaction has occurred where stocks do react to public information after an earnings announcement. Fluctuations in stock prices might be larger than their intrinsic value. The impact of new information becoming available is not always immediately impactful. (Mishkin & Eakins, 2016).

What Investment Methods Should You Select to Develop Your Own Portfolio?

A well-diversified portfolio is the best way to spread your risk and successfully pursue wealth creation. Consider the following for building a portfolio under the Trump Administration.

  1. U.S. Treasury bills – are highly liquid, responds positively to tax cuts, consumer confidence, and increased wealth.
  2. Precious Minerals – silver, platinum, etc. can make both functional and luxury items which keep demand high.
  3. Dividend paying stocks – companies within several industries most of which are top performers are highly desirable.
  4. Real estate – offers significant tax benefits, land appreciates as it becomes more densely occupied.

References

Mishkin, F. S., & Eakins, S. G. (2016). Financial Markets and Institutions. 9th Edition. Boston. Pearson

Staff, I. (2006). Islamic Banking. Investopedia. Retrieved 17 March 2017, from http://www.investopedia.com/terms/i/islamicbanking.asp

Schmidt, R. (2014). What You Should Know About The Time Value of Money. Propertymetrics.com. Retrieved 16 March 2017, from https://www.propertymetrics.com/blog/2014/06/17/time-value-of-money/

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