Some financial terms can be quite overwhelming and downright confusing (test: is coefficient of variation the same or different to correlation coefficient?) so the following terms are the most relevant in understanding basic finance and more importantly this sites material. I have done by best to find a balance in content and too much detail. I will elaborate on some of the terms more in posts at a future date.

Glossary

Present Value (PV)

The value of your money as of today

Present Value (PV) in relation to Future Value (FV)

The value of your money as of today but, given by discounting a future value by a factor (referred to as rate of return or interest rate)

Future Value (FV) of a Present Value

The present value projected into the future using an interest factor and compounding.




Compounding

The accumulation of a value over multiple periods of time when the principle and interest are fully invested. It’s the combination of compounding and time that truly creates value, in your case financial wealth. To demonstrate the power of compounding, a term often used in financial references, assume you had $10,000 today in a bank savings account that was earning on average a nominal 6% per annum (pa). Let us look at the situation without the inclusion of compounding first, at the end of year 1 you would have $10,600, this would be your initial (principle) amount of $10,000 plus the interest paid by the bank of $600. You then remove the $600 earned and go buy those Jimmy Choo Pumps or that Dewalt Hammer Drill you have been salivating over recently. You begin year 2 with the same initial amount of $10,000 and assuming the interest rate remains consistent you could expect the same return experienced in year 1, $600. Now, let us assume at the end of year 1 you decide not to remove the interest earned and you begin year 2 with $10,600. At the end of year 2 you will have $11,236 because $10,600 had the 6% interest rate applied against it rather than $10,000. The reality of this is a gain of $36 through the process of compounding (no compounding – total interest $1,200 from two years, with compounding – total interest $1,236).

Compound Frequency

Usually occurs on an annual or semi-annual (twice a year) basis but, can occur as frequently as quarterly, monthly, weekly, daily or even continuously. It refers to the frequency that the interest rate is calculated and subsequent interest is added to the balance figure at the end of the period. The higher the frequency the greater the result, both negatively and positively depending on whether we are discussing debt or savings. This is not to be confused with the payment frequency.
Eg. You have $10,000 today in a savings account with Bank A. They claim a nominal interest rate of 2.5% annually (“nominal” – meaning what they state but, not necessary what you get) and paid monthly. Assuming the bank compounds annually, at the end of the first year you could expect to have accrued $10,250 in your account with an interest component of $250. This interest component is divided and paid to you over 12 monthly payments. Now, taking the opposite end of the spectrum let’s say they were to compound daily and still pay monthly. At the end of the first year you will have $10,253.14 – an increase of $3.14. Doesn’t sound like much but, for people handling large sums over long periods it can be significant.

Discount Rate

This is a term often used in reference to a future value. It is a factor that the future value is reduced by over a period of time.
Eg. Assume you have projected through calculation that you will have $10,000 in 10 years from today. You have decided on a discount rate of 10%, so counting backwards from year 10 you would reduce the figure by a given factor each year. Essentially, $10,000 at the close of year 10 would be multiplied by a discount factor of 0.909 to arrive at $9,090 for the close of year 9.

Common Stock

Refers to ordinary shares in a company.

Per Annum (pa)

Same as per year. Used to describe an occurrence with an annual frequency

Principle

The portion of the investment or loaned amount that is not the interest component. This is the initial capital invested or loan payable depending on which context it applies to.

Interest Rate

This can have both a negative or positive context. It is a percentage (%) that is added to the principle as compensation to the lender of the funds.

Eg. If you are investing your money then you are loaning your money to another party for use and you require compensation for this. The compensation is for the lost opportunity you incur by not having these funds to invest elsewhere (opportunity cost). The compensation usually comes in the form of an interest payment receipt.

On the other hand, if you are the borrowerer of the funds like in the case of a homeloan then you will need to pay compensation (interest) to the lender.

Rate of Return

Often interchanged with “interest” this term is used to identify your perceived required return in the form of a percentage (%) and to elaborate more, what you expect as compensation for your invested money (capital)

Eg. You invest $10,000 in Pacific Rim LLC and expect to be compensated $1,000 in interest during the first year. The rate of return would be 10%.




Inflation

Inflation can be defined by an effect on the purchasing power of money. It is an increase in the general (average) price level of goods and services in the economy as measured by the Consumer Price Index (CPI).

Inflation is influenced by economic conditions and controlled by government monetary policy. The rate of inflation typically increases in times of economic strength and decreases in times of depression. As the economy grows, production outputs and spending increase. Demand for goods and services outpace supply and prices rises for the scarce resources. Governments seek to control increasing inflation by adopting a tight monetary policy which involves decreasing the cash supply in the market through the buying back of government securities.