Thursday, June 19, 2008

Inflation and Expenses

Everybody has variably heard of the word inflation. As a matter of fact, any educated person would like to rattle off his/her knowledge on inflation, and with the current market news (maybe I follow it a bit too much) its all over. So here's a small peek into what is it and how it affects us.

Inflation: In simple terms it is the phenomenon due to which the little orange candies which used to cost 10paise each back when I was a kid at school, now cost more than 50paise (on a conservative estimate). Or the onion butter masala dosa a south Indian delicacy that used to cost a mere Rs 13, would now cost somewhere in the region of Rs 20 to Rs 25.

How does inflation affect me: Due to inflation the cost of every goods or service that you buy goes up. And you are not spared, whether you are spending in dollar, euro, yen or the rupee. It affects all commodities and makes them dearer every year. So in general the price of petrol/ diesel you buy at the pump goes up every year.

The amount of real return earned by keeping money in the bank goes down. For example, given the current real scenario in India, the interest rate offered in a normal savings account hovers around 3.5%. While with the recent released figures, the inflation hovers around 5% and above. If we were to assume that today you have Rs. 100 which would purchase you a cake at the Barista, then due to inflation next year the same cake would cost you Rs. 105. But since you chose to eat the cake next year, and kept the money in the bank, your money grew to only Rs. 103.5. And so you don't have enough money to purchase the cake anymore.

Are there any standard measures: In India, inflation is measured by the Wholesale Price Index (or the WPI) released by the Reserve Bank of India(or RBI) every Friday. Check under the Database -> Weekly Statistical Supplement and select "Index Numbers of Wholesale Prices". The WPI is a more broad based measure than the variably used Consumer Price Index (or CPI) used by other countries, or many other measures. The WPI numbers released for India include on the upwards of 435 item prices and give a good picture of the overall price rises.

What is the extent of the affect it has on us: Year to year, there is hardly any effect that an individual may feel. In fact with increasing efficiency in some spaces, prices may actually go down in some categories of goods, most notably technology products. But in the long run we all get hurt by inflation. Even if we assume a modest average inflation figure of 5% per year, in 20 years the cost of any good is bound to grow by 2.65 times. So we need to plan our savings in such a manner that we beat atleast that figure.

Why is there inflation: Economists vary regarding all the possible factors affecting inflation. But some of the most common reasons are
  • Increase in the price of goods due to increase in demand in excess of supply available. This also gives rise to ocassional black market.
  • Increase in money supply due to government/ central bank policy. Sometimes if the government sees that there is not much spending by the consumer, it may reduce interest rates to encourage the consumer to borrow and spend. This decreases the value of money, and companies increase the selling price to keep the value that they earn the same. This in turn pushes up prices.
  • Higher interest rates. Due to this the cost of purchase of raw materials or labor increases for the business which may be passed onto the consumer. This effect may not be seen immediately, but is over the long term prices rise/fall to match interest rates.
Any other information: Yes. There are two more terms that be mentioned in the context. They are deflation and stagflation. Plus there are other terms like disinflation, reinflation and hyperinflation, but of lesser significance.

Wednesday, June 18, 2008

Currency Carry Trade

The recent and ongoing global financial crisis was precipitated due to a lot of factors, a few of which I actually know about and all of which I am sure no single person knows about. Albeit everybody would agree a part of it was due to the collapse of the American consumer market, especially the housing market where individuals could no longer afford the monthly payments on the houses they purchased on loan.

The other factor that I am aware about is the effect of the Yen Carry Trade. Today I read an article in Investopedia, which pretty much explains in basic terms what it means with an example.

What does it mean
A strategy in which an investor sells a certain currency with a relatively low interest rate and uses the funds to purchase a different currency yielding a higher interest rate. A trader using this strategy attempts to capture the difference between the rates - which can often be substantial, depending on the amount of leverage the investor chooses to use.

Here's an example of a "yen carry trade": a trader borrows 1,000 yen from a Japanese bank, converts the funds into U.S. dollars and buys a bond for the equivalent amount. Let's assume that the bond pays 4.5% and the Japanese interest rate is set at 0%. The trader stands to make a profit of 4.5% (4.5% - 0%), as long as the exchange rate between the countries does not change. Many professional traders use this trade because the gains can become very large when leverage is taken into consideration. If the trader in our example uses a common leverage factor of 10:1, then she can stand to make a profit of 45%.

The big risk in a carry trade is the uncertainty of exchange rates. Using the example above, if the U.S. dollar was to fall in value relative to the Japanese yen, then the trader would run the risk of losing money. Also, these transactions are generally done with a lot of leverage, so a small movement in exchange rates can result in huge losses unless hedged appropriately.