Inflation: a general increase in prices and fall in the purchasing value of money.
Deflation: decrease in the general level of prices in an economy. deflation can turn a recession into a depression. reasons housing 2008,1992
Creeping mild Inflation
3 percent a year or less
between 3-10 percent a year. economy growing fast
buy more than they need, just to avoid tomorrow’s much higher prices
inflation rises to 10 percent or more
than 50 percent a month. It is very rare.
money printed got in war situations, Zimbabwe 2000, 2010 Venezuela
price increase without demand
except for food & energy
wage inflation: more than the cost of living
political uncertainty in the oil-exporting countries
inflation rate and stock market Warren Buffett
SAVING = INCOME – EXPENSES
What can you do with your saving?
Hold as cash/deposit in savings bank account (Retain the Saving)
Invest the Saving (Deploy the saving in physical or financial products with a view to gain a return on your investment)
What happens to the Saving that remains uninvested?
Inflation eats the Uninvested Saving
inflation risk represents the risk that the money received on an investment may be worthless when adjusted for inflation.
Inflation risk is also known as purchasing power risk.
Eg. On 1st Jan 2016, Asha had Rs 8 Lacs. She invested this money in a 6% Bank FD for 1 year. So she will be getting Rs 8.48 Lacs* on 31st Dec 2016.
The general rise in prices in India was 7% over the same time period.
This means that what Asha could buy with Rs 8 Lacs on Jan 1, 2016, she will need Rs 8.56 Lacs for the same purchase on 31st Dec 2016.
But her investment has yielded her Rs 8.48 lacs only.
This has happened because her investment was exposed to inflation risk. Her purchasing power has decreased.
*Assuming no compounding
inflation risk is highest in fixed return instruments, such as bonds, deposits, and debentures.
This can be explained with the concept of Real Rate of Return
The return from the investment is the Nominal Rate.
Real Rate of Return = Nominal Rate – Inflation Rate
For Eg. Coupon of a Bond is 8% (Nominal Rate)
Rate of Inflation is 7%, The Real Rate of Return is 1%
Rate of Inflation is 8%, The Real Rate of Return is 0
Rate of Inflation is 9%, The Real Rate of Return is -1%
The Nominal Rate is always +ve. But the Real Rate of Return can be +ve,0 or even -ve.
Effective Real Rate of Return
When the Real Rate of Return is adjusted to include the impact of Time Value of Money, it is called Effective Real Rate of Return
If an investment earns a nominal rate of return, that is the rate at which money is being compounded. However, if inflation reduces the value of those investment cash flows, the value of those returns is discounted by the rate of inflation
Effective Real Rate of Return =
((1 + Nominal Rate) / (1+ Inflation Rate)) – 1
So, if the coupon of the bond is 8% and Rate of Inflation is 6%Effective Real Rate of Return = ((1.08) / (1.06)) – 1 = 1.89%
How much would be the expense, if it were incurred today?
A = P X (1 + i)^n
A = Rupee requirement in future or Future value
P = Cost in today’s terms
i = inflation,
n = Number of years into the future when the expense will be incurred.
Mr. A wants to plan for his child’s education. Assuming that he wants his child to be a doctor. Let’s assume that the current expenditure of medical education is Rs. 15,00,000. His child is 3 years old and would require fees when he is 18 years. Find out the expenditure required at the child is 18 years old.
P = 15,00,000
N = 15 years (18 -3)
I = 8% ( It is inflation rate – Assumed)
A = 1500000*(1.08)^15 = Rs. 47,58,253
^ symbol meaning in maths raised to a power.
For example, 4^3 = 4 to the 3rd power = 4 x 4 x 4 = 64
present value is, P = A / (1+R) ^ N (R is return expected)
Future value is, A= P*(1+ I)^ N (A = is future value, P is present value, I is inflation and N is