Increasing Complexity of Financial Products

“You can fool some of the people all of the time, and all of the people some of the time, but you cannot fool all of the people all of the time.” -Abraham Lincoln

Financial Innovation: What Happens When You Believe in Things You Don't Understand- Robert Shiller

Absolutely wrong! Just go and ask any CEO of a bank, mutual fund house or an insurance company. They can tell how easy it is to fool all of the people all of the time. The ULIP programs launched by government (e.g. LIC Market Plus I, II, SBI Life - ULIP etc) is the latest example of this growing phenomenon where people rushed around to get the product without full understanding of pros & cons.

In today’s scenario you have many options to invest & manage your money/assets in financial products. However, the root question is: why the financial products such as loans, credit cards, insurance or mutual funds are getting more and more complex with each passing day? Is the complexity for the benefit of consumer / investor, or is there something else behind it?

Answer is confusology. Confusology means to confuse the customer to such an extent that it’s not worth the time & effort involved to decipher the product or service and virtually impossible to make a comparison with other similar product or services.

To quote Scott Adams, from his recent blog post Government efficiency

“A confusopoly is a situation in which companies pretend to compete on price, service and features but in fact they are just trying to confuse customers so no one can do comparison shopping.

Cell phone companies are the best examples of confusopolies. The average customer finds it impossible to decipher which carrier has the best deal, so carriers don’t have normal market pressure to lower prices. It’s a virtual cartel without the illegal part.”

Read more about Confusology in the following articles:

1.       Confusopoly, or Scott Adams, Prophet of Finance

2.       Rise of the Confusopoly

Confusology not only applies for financial products, indeed applies to all scenarios where sales come into picture. Have you also encountered confusopoly while buying financial products & services? Air your views by posting a comment.

Many appear to think that the increasing complexity of financial products is the source of the world financial crisis. In response to it, many argue that regulators should actively discourage complexity. ... They do have a point. Unnecessary complexity can be a problem ... if the complexity is used to obfuscate and deceive, or if people do not have good advice on how to use them properly. ...

But any effort to deal with these problems has to recognize that increased complexity offers potential rewards as well as risks. New products must have an interface with a consumer that is simple enough to make them comprehensible, so that they will want these products and use them correctly. But the products themselves do not have to be simple.

Ultimately everyone wants simplicity in their life…J

Simple v/s Compound Interest

Interest is what you earn when you let people borrow your money.  Some call it the price of renting your money.  Obviously how much you will rent it for will depend on many things and mainly on the differences between simple and compound interest.

Simple Interest is, well, the simplest and most basic kind of interest out there. You can calculate simple interest by multiplying Principal by Rate by Time, given by the following formula:

Simple Interest (SI) = (P * R * T)/100

P = principal amount (the amount that was borrowed)
r = rate of interest (for one period)
t = time duration for which the money is borrowed (number of periods)

Here, principal (P) is the amount to begin with, whether it's invested, lent, or borrowed. This amount increases by the given interest rate (r) over a period of time (t). To calculate not just the accrual but the resulting amount to which interest is applied, you can use the amount function:

A(t) = A₀ x (1 + t x r)

In the given formula, A₀ is the principal, while r and t are the interest rate and period of time, respectively.

Because simple interest is a linear function, it is quite easy to see how a loan or an investment will turn out in the future.

Compound Interest is a bit more tricky to calculate. Interest is periodically added to the current amount, and the amount you get (or owe) is computed from the following formula:

Compound Interest (CI) = P(1+r/n)^nt

P = principal amount, (either borrowed or deposited)
r = rate of interest (annual/quarterly/half yearly)
n = numbers of times the interest is compounded every year
t = number of years (period) the amount is deposited for

To calculate the resulting amount to which interest is applied, you can use the amount function:

A(t) = A₀ x (1 + r/n)n x t

The principal (A₀) increases by an amount that is dependent on both the given interest rate (r) and the number of compounding periods (n) within a given time period. This time (t) is usually expressed in years. So if a starting amount, Rs 500 were to be compounded at a monthly rate of 5% for five years, n would be equal to 12 and t would be equal to 5. The equation would be: A(t) = 500 x (1 + 0.05/12)5 x 12 and amounts to Rs 641.68.

Instead of a linear rate being applied, we see an exponential growth: notice that each time the amount A(t) is compounded by an interest rate dependent on that current amount A(t). In investing, that sounds like a good way to make your money grow. In borrowing, however, that doesn't sound that great.

It is tricky to figure out the additional amount added to the principal in a compounded interest scheme, calculating the annual percentage yield or APY can be a helpful method in calculating the yield, or the extra amount, and not the total resulting amount. You can get your APY through the following equation:

APY = (1 + r/n)n – 1

Again, r stands for the interest rate and n is the frequency of compounding that occurs in a year. Calculating APY gives you a better idea of how much you earn or how much more you owe in relation to the principal.

The difference between simple and compound interest is the difference between night and day. You will want to remember this simple rule: simple interest grows slowly, compounding speeds up the process. 

Simple interest is interest on the principle amount while compound interest is when your principle and any earned interest earned interest. If you have invested money into an account you always want compound interest. Moreover, the relative advantages of compound interest escalate as your holding period increases.

Therefore, before investing your money, you should double check with your local bank if compound interest will be used.

Having said that if you have a credit card and you owe money on it, you will pay less interest if the credit card company uses simple interest. However, they will never do something so foolish!

I hope simple vs compound interest is well understood now... :-)

The Time Value of Money

What Does Time Value of Money Mean?

The idea that money available at the present time is worth more than the same amount in the future due to its potential earning capacity. This core principle of finance holds that, provided money can earn interest, any amount of money is worth more the sooner it is received. Also referred to as "present discounted value".

Everyone knows that money deposited in a savings account will earn interest. Because of this universal fact, we would prefer to receive money today rather than the same amount in the future.

For example, assuming a 5% interest rate, 100 invested today will be worth 105 in one year (100 multiplied by 1.05). Conversely, 100 received one year from now is only worth 95.24 today (100 divided by 1.05), assuming a 5% interest rate.

I give you 100 rupees. You take it to the bank. They will give you 10% interest per year for 2 year.

• The Present Value = 100
• Future Value = 121.

Time Value of Money is an important concept in financial management. It can be used to compare investment alternatives and to solve problems involving loans, mortgages, leases, savings, and annuities.

Time Value of Money is based on the concept that a rupee that you have today is worth more than the promise or expectation that you will receive a rupee in the future. Money that you hold today is worth more because you can invest it and earn interest. After all, you should receive some compensation for foregoing spending. For instance, you can invest your rupee for one year at a 6% annual interest rate and accumulate 1.06 at the end of the year. You can say that the future value of the rupee is 1.06 given a 6% interest rate and a one-year period. It follows that the present value of the 1.06 you expect to receive in one year is only 1.

A key concept of Time Value of Money is that a single sum of money or a series of equal, evenly-spaced payments or receipts promised in the future can be converted to an equivalent value today. Conversely, you can determine the value to which a single sum or a series of future payments will grow to at some future date.

You can calculate the fifth value if you are given any four of: Interest Rate, Number of Periods, Payments, Present Value, and Future Value.

FV= PV (1 + i )N

• FV = Future Value
• PV = Present Value
• i = the interest rate per period
• n= the number of compounding periods

Determine Future Value Compounded Annually
What is the future value of 34 in 5 years if the interest rate is 5%? (i=.05)

• FV= PV ( 1 + i ) ^N
• FV= 34 ( 1+ .05 ) ⁵
• FV= 34 (1.2762815)
• FV= 43.39.

Determine Future Value Compounded Monthly
What is the future value of 34 in 5 years if the interest rate is 5%? (i equals .05 divided by 12, because there are 12 months per year. So 0.05/12=.004166, so i=.004166)

• FV= PV ( 1 + i ) ^N
• FV= 34 ( 1+ .004166 ) ⁶⁰
• FV= 34 (1.283307)
• FV= 43.63.

Determine Present Value Compounded Annually
You can go backwards too. I will give you 1000 in 5 years. How much money should you give me now to make it fair to me. You think a good interest rate would be 6% ( You just made that number up). (i=.06)

• FV= PV ( 1 + i ) ^N
• 1000 = PV ( 1 + .06) ⁵
• 1000 = PV (1.338)
• 1000 / 1.338 = PV
• 747.38 = PV

O.K. so you give me 747.38 today and in 5 years I'll give you 1000. Sound fair?? You will get 6% interest on your money.

Determine Present Value Compounded Monthly
Here's that last one again, but with monthly compounding instead of annual compounding. (i equals .06 divided by 12, because there are 12 months per year so 0.06/12=.005 so i=.005)

• FV= PV ( 1 + i ) ^N
• 1000 = PV ( 1 + .005) ⁶⁰
• 1000 = PV (1.348)
• 1000 / 1.348= PV
• 741.37 = PV

So in simple terms we can say:

Present Value: How much you got now.

Future Value: How much what you got now grows to when compounded at a given rate.

What is Finance?

We all have a general idea of what Finance is, but to make sure we are on the same page, let's let others define Finance for us. Webster's New World dictionary defines it as:

1. Money resources, income, etc
2. The science of managing money.

Finance is a branch of economics concerned with resource allocation as well as resource management, acquisition and investment. Simply, finance deals with matters related to money and the markets.

Used in this context it is a noun. It can also be used as a verb in which case it is to supply or get money for a project.

Of these I like the definition as the management of money. Finance is the most encompassing of all business enterprises. To understand finance you must know about the entire business, indeed the entire economy. So for a few minutes lets step back and pretend that we never took economics and are new to this earth.

The Financial system (or the economy, your choice) is composed of consumers, manufacturers, retailers, distributors. These groups need money to purchase products and services. One way of looking at Finance is that it is getting the money to purchase these goods and services.

Many economists assume that households have excess money and corporations need money. (This is obviously a gross simplification. At any given point some individuals have excess money to invest where others need to borrow. The same is true for corporations and other organizations, but the simplified model makes things easier for the moment.)

The purpose of the Financial System is to make sure that the money flows to those who value it the highest (that is those who can put it to the "best" use).

Now

Corporations « Households

(Need money) $ (have money to invest)

Now, these households are not going to just give corporations money. They will demand their money back at some time in the future and a bit more for the use of their money and risks incurred etc.

Future

Corporations >> Households

(have money) $ (Want money back)

Everything else we study in finance is just looking at this model in more detail. Let's make it personal

I remember being asked in second or third grade the key to understanding a book. My immediate response to put yourself into the book. The same is true here. If we take a few seconds now to internalize the subject it will pay large dividends (don't you love finance humour :-)) in the future.

If I ask to borrow money from you what do you say? Yes? No? It depends doesn't it? What does it depend on? A million things! For example: how much do I want to borrow, what are the prospects of me being able to repay it, what is my reputation, what am I going to do with the money, whether you have anything better to do with the money....can you think of anything else?

The same ideas are true in the financial world. People will not lend, or will require a larger repayment if they do decide to lend, if there are many things to do with their money, or if the borrower is going to do something risky with it, or if the borrower has an unsavory reputation.

If you get that, you will have fun in finance. If you do not understand the example, please reread it and imagine people asking you for money :-)