in one direction or another. An example of this bias is the British Telecom shares illustrated in Figure 1-2. The market thought that all things telecom would be highly profitable.
❯❯ Markets can influence the events that they anticipate. Financial markets can be stabilising. If a recession is anticipated and the currency declines, this situation should boost exports and help prevent a recession.
George Soros’s ideas are controversial, but they help to explain some major market distortions. He’s been proven correct on enough occasions to have been successful using his insights.
Cash is the most fundamental of all financial assets. Economists write that money has three functions. It serves as a:
❯❯ Store of value
❯❯ Means of exchange
❯❯ Unit of account
These three functions are familiar to anyone with a savings account (store of value) who has done some shopping (means of exchange) and carefully compared prices (unit of account). Whether in the form of nickel, plastic or paper, cash is the key.
❯❯ Gold has been used for thousands of years as a store of value and also as a means of exchange. Most central banks in the world hold substantial quantities in vaults. This practice is partly a relic of the time when paper money could be exchanged for gold at the central bank. Although this ended in the United States in 1971, many investors still hold gold as part of their investment portfolios.
❯❯ Like gold, the bitcoin is a currency not under the control of any government. However, bitcoin isn’t physical. It’s been described as a cryptocurrency because bitcoin is completely digital and relies heavily on encryption techniques for security. It can be used for payments just like other forms of cash, but at the moment these transactions are small compared with, say, the volume of credit card transactions.
One of the appeals of both gold and bitcoin is that they’re not under government control. In the past, governments have used their power to print money, which undermined the value of the currency. The currencies then no longer function well as a store of value. By investing in gold, which is limited in supply, this undermining can’t happen.
Cash exists in the form of many currencies such as the US dollar, the Japanese Yen and the Chinese renminbi. These countries all have their own central banks, and one of the key functions of these banks is to set the interest rate for the currency. This interest is money that you earn by depositing cash at the central bank. Normally, only other banks are permitted to use central banks in this way, but these interests rates are one of the key parameters in quantitative finance. The interest rate at a central bank is often called the risk-free rate because the assumption is that a central bank can’t go bankrupt. Chapter 4 has some of the maths involved with interest rates that’s the basis behind lots of quantitative finance calculations.
If you take out a loan to buy a house or expand your business, the loan is said to be a floating-rate loan if the interest rate changes when the central bank in your country changes its interest rate. The load is fixed-rate if it stays the same when the central bank changes the interest rate. However, given that the period over which loans are repaid can be long, locking into one type of loan gives you no flexibility. If you have a floating-rate loan, you may decide that you want to keep the interest payments fixed in future. That may help you sleep at night. The solution to this fixing is called an interest-rate swap. This instrument allows you to swap from a fixed-rate loan to a floating-rate loan or vice versa. Chapter 4 has a section which gives you the maths behind this.
Interest-rate swaps are one of the most important instruments used by banks to manage risk. They also use more sophisticated tools as well and Chapter 12 provides an introduction to some of the most common interest-rate derivatives. These derivatives have proved very popular with real-estate investors who typically borrow large sums of money and want to put limits on interest payments.
Because different currencies have different interest rates, you can potentially make money by
❯❯ Selling a currency with a low interest rate
❯❯ Buying currency with a high interest rate
❯❯ Earning a high interest rate
Such transactions are called the carry trade and are a big factor in influencing foreign exchange rates.
Going beyond cash
Borrowing money from a bank to expand a business is fine, but other ways are possible too:
❯❯ Bonds are a form of loan to a business. The borrower (or business owner) receives the principal from the lender and in return promises to pay a regular interest payment called a coupon. On the bond’s maturity date, the lender gets her principal back. The clever bit, though, is that this bond is a financial instrument. This means that the lender can sell it to someone else. Then the buyer is entitled to the coupon payments and the principal repayment on maturity.
❯❯ Owning stocks or shares in a business means you’re a part owner of the business, are entitled to dividend payments and can vote at the annual general meeting in support (or otherwise) of the managers.
Businesses issue shares in exchange for cash from investors but they have no fixed repayment date as a bond does. Dividend payments are at the discretion of the management and can vary and, in fact, be non-existent. Because of this, shares are often considered riskier than bonds.
Bonds and shares are the building blocks for most investment portfolios. Bonds are risky because the borrower can default and fail to pay her coupons. Shares are risky because the company may be unable to pay a dividend. Shareholders have no right to any repayment of capital so are more likely to lose everything. Chapter 4 gives you the lowdown on the bond and stock markets.
If you’re thinking that you’re never going to invest in shares or bonds because you may never get your money back, then you’re not alone. However, the financial markets have created a solution to this, using two instruments, options and futures that can be used to control and manage the risk of investing in the stock and bond markets. They’re both flexible contracts that I cover in great detail in Chapters 5 and 6, respectively. Quantitative finance developed rapidly in the 1980s after people figured out a mathematical way to price options. You can find out about pricing in Chapters 10 and 11.
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