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The curve describing this relationship between risk and return is a hyperbole connecting one and the other. Logically and economically, this also makes sense: if the investor is willing to assume more risks, he is also likely to potentially discover more alternatives and solutions in which to invest his money and open his investment to a greater impact from the market, in a positive sense.
Additionally, spending more money on the open market can even involve the investor in the decision making process, essential in determining the way the business is likely to evolve in the future. Putting your money at more risk than another investor will bring about higher returns.
The investments in securities or in a business are just as much subjected to the impact of inflation as the time deposits are. There are however important temporal differences. With the investment in a business or in securities, the rate of return is higher and able to compensate the potential inflationary pressures.
At the same time, investing in securities is sometimes much more flexible than a time deposit. With a time deposit, the investor will have his money blocked in the deposit for as long as 18 months as a precondition of receiving the pay (the cost of money). With the securities, this is much more flexible and they can virtually be purchased and sold during the same day.
In terms of cost of money, there are several ways in which one can classify the interest rate or cost of money. The interest rate can be categorized as either simple or compounded. The simple interest rate functions after the http://upload.wikimedia.org/math/6/6/3/6639fdfc415ab212504287e2dad7abd1.png where r is the period interest rate, B0 the initial balance and m the number of time periods elapsed after the money was placed in the deposit.
With compounded interest, the formula takes into consideration the fact that the more the investors places his money within a deposit, the higher the cost of that money should be and, thus, the higher the interest rate. If the interest rate is compounded, this is likely to reflect the fact that the investor was willing to block his funds for a longer period of time in a deposit.
Compounded interest can be calculated according to the http://upload.wikimedia.org/math/4/e/7/4e7b10f4c70d9264d80f7c66bfbf640f.png where Icomp is the compound interest, B0 the initial balance, Bn the balance after n periods and r the period rate (Gelinas, 2006-2008).
The cost of money can also be categorized as either fixed or floating. A fixed interest rate will mean that the interest rate for a certain deposit will be the same throughout the timeframe during which the investor decide to keep his money in the bank. A floating interest rate will take into consideration a reference rate, which is floating, to which a fixed percentage will be added. Usually, LIBOR, the London Interbanking Rate is used, although there are other reference rates that are common to practice as well.
Interest rates are usually left to float freely on the market, but, in some situations, it is potentially possible for the central bank to intervene in order to either increase or decrease the official interest rate, as previously mentioned in this paper.
This artificial adjustment affects the cost of money and reflects a macroeconomic situation in the country at that respective period of time, usually either periods when the economy is overheating or periods when the threat of economic recession forces the government to decrease interest rates so as to lower the cost of credit and encourage companies and individuals to spend their money and invest in businesses rather than stick the funds in deposits with the banks. Again, this reflects well the perception that the cost of money is in fact an opportunity cost: what is the bank willing to pay (or the investor in a business if he takes credit from the bank) if it wants the investor's money as an alternative to him investing this in other ventures.
In conclusion, the cost of money is actually an opportunity cost that a bank or another borrowing entity is willing to offer the investor in exchanging for him not investing his money in other ventures, such as a business or the stock exchange through securities. In this sense, it is simpler to understand this as the interest rate paid for a time deposit, but, at the same time, also as the cost of credit that an investor is willing to undertake in the case he decides for securities or investing in a business.
1. Keown, Arthur; Martin, John; Petty, William. Foundations of Finance. Pearson Prentice Hall. 2006. 5th Edition
2. Gelinas, Mark. White Paper: The Lost Art of Interest Calculation. 2006-2008. On the Internet at http://www.margill.com/white-paper-interest.htm.Last retrieved on November 26, 2008
3. Campbell, R. McConnell. Microeconomics. McGraw-Hill Professional. 2004.[continue]
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