73Promises, promises
Thirty-ve, thirty-six, thirty-seven. Please Brenda, I was silently
begging, keep your jacket on. Jerry bared his teeth, keeping his
gaze xed on head of compliance. ‘Come on,’ he muttered, ‘it
must be eighty degrees in there.’
Forty seconds. I’d been holding my breath because of the tension.
My maximum exposure was £400, which was £20 multiplied by
twenty seconds. And after that, my upside was unlimited.
Forty-nine seconds in and disaster struck. No! Brenda picked up
a manila le and fanned herself. ‘Looks like you’ll be making a
visit to the cash point soon.’
‘Don’t be so sure, Jerry. In six – no, ve – seconds I’ll be in the
kill zone.’
‘Don’t think so, mate.’ And, immediately he’d nished, Brenda
suddenly stood up and struggled to slip her green jacket from her
bulky shoulders.
‘Stop the clock!’ Jerry shouted out. ‘I make that four seconds. You
owe me eighty quid. Cash only, I’m afraid.’
But I’d stopped listening. A woman with long black hair elegantly
waved her manicured hands in front of her beautiful face. The
rst time I saw Perrine’s face was while I was losing money.
Sad to say, this was to prove an omen.
The time value of money
Perrine had been brought up in Paris, Madrid and Milan. She’d
studied art history in Turin and philosophy at Columbia. From a
purely rational point of view, it wasn’t entirely clear what Perrine
brought to Saiwai in terms of hard business skills. But I – like 90
per cent of Saiwai’s male staff – had fallen head over heels in love.
I smiled every time she mangled English, which was her third
or fourth language. Jerry was playing devil’s avocado with the
market. Old-time risk-averse investors were dinosaurs voting for
Christmas.
Welcome to the jungle74
Jerry – who never missed a trick – teased me mercilessly. But his
cruellest trick was to assign me to be Perrine’s mentor. I blushed
at the very thought of her and stammered in her presence. I
bought a book called The Time Value of Money Made Easy and
prepared our rst lesson.
‘This topic is much easier than you think.’ I imagined that would
be a good opening: it showed I was condent and it was designed
to relax Perrine.
‘No it isn’t,’ she said. You know you’ve got it bad when you nd
a girl’s sulking attractive.
‘All you need to do is imagine you lend €10 to a friend for a year.’
I thought Euros would make me seem more Continental in her
eyes. The currency hadn’t even been invented at this stage so I
thought I’d also look pretty cutting-edge. ‘Why does your friend
need to pay back more than he borrowed?’
‘What’s my friend called?’
‘Eh?’ The question threw me. ‘Anything you like.’
‘Good. I will call him Armin.’
It sounds stupid but I was jealous of this imaginary Armin. In
fact, it sounds really pathetic, doesn’t it?
The promise of money is not worth the same as money today
I went on. ‘There are three reasons why Armin will need to pay
you back more.’
1. Inflation
This erodes the value of money. Suppose ination is very low at
2 per cent. If Armin gives you €10 after a year, you’ll really only
receive €9.80. What’s happened to the 20c? Ination has bitten
off a chunk.
Ination erodes the value of savings and hyper-ination
can destroy a country’s economy. In 2008 ination reached
75Promises, promises
231,150,888 per cent per year in Zimbabwe. (That was the ofcial
estimate, which probably understated the real gure.)
2. Opportunity cost
Armin has borrowed your €10 for a year, and that stopped you
from doing anything with the money. You need a reward for
renting your money out to Armin. How about the interest you
would have made if you’d tied up the money in a bank deposit
for twelve months? Perhaps 3 per cent would be enough?
3. Risk of the borrower
This is a very variable factor. A lender will charge more if they
think the borrower is risky.
What are the signs of a bad bet?
Not long in a new job? (Perrine ticked that one).
Already got big debts (tick).
Credit cards that can’t be paid off within a month (tick).
But Armin has none of these problems. His individual risk as a
borrower was only 5 per cent. This number reects the riskiness
of the borrower. It varies from one borrower to another, and will
be much higher if the lender has doubts about being paid back.
After my explanation, Perrine added these three elements
together.
She begins with inflation . . . 2%
. . . then adds opportunity cost . . . 3%
. . . and the risk of the borrower. 5%
The total is the cost of borrowing 10%
Armin was going to pay interest at the rate of 10 per cent per
annum.
It’s just the same as compounding. If you lend €10 and think
Armin is a 10 per cent risk, he will need to pay back €11 next
year. That’s the initial €10 multiplied by 1.1, because Armin’s
Welcome to the jungle76
going to have to pay you 10 per cent interest for borrowing your
money.
Compounding
A Money borrowed €10
B Interest rate 10%
C 5 A 3 (11B) Amount to pay back €11.00
‘Perrine, let me ask you a question. You can have €10 now, cash
in your hands. Or you can have the promise of €10 in exactly one
year’s time. Which option do you prefer?’
She considered for a second. ‘Everyone
should choose the cash now. It’s certain,
you’ve got it, there’s no chance of the
borrower not paying. The promise is just
that. It’s not guaranteed, and your borrower
may go bust, go on the run, spend all their
cash on drink or just plain die. The lender
needs compensation because of these added
risks. And the longer you lend the money, the more compen-
sation you will demand because there is more time for bad things
to happen.’
‘So what does this mean for bankers?’
Perrine delicately chewed the top of her pen.
‘€10 today does not have the same value as the promise of €10 in
one year. Since all of us prefer to take €10 today, it must follow
that €10 next year is worth less than €10 today.’
‘How much less?’
‘I don’t know.’
‘Well, let me tell you.’ She smiled at me. Perrine actually smiled
at me! This teaching lark was better than I had ever imagined.
‘‘
your borrower
may go bust, go on
the run, spend all
their cash on drink
or just plain die
’’
77Promises, promises
Discounting is compounding in reverse
Perrine was determined to get the next bit done and dusted. She
knew that the total risk of lending money was worth a return of
10 per cent. She also knew she would be paid €10 in one year’s
time. But what was that future payment worth to her today?
She divided the payment of €10 by 1.1 to discount the value of the
repayment in the future. Why 1.1? Because it’s 1 plus 10 per cent.
The 10 per cent is called the discount rate. And 1 divided by 1.1,
which is 90.9 per cent, is the discount factor. It’s like saying the
promise of €10 in one year is only worth 90.9 per cent. It follows
that €10 in one year is only worth €9.09 today.
Discounting
A Cash fl ow at the end of Year 1 €10
B Discount rate 10%
C 5 1/(1 1 B) Discount factor 90.9%
D 5 A 3 C Value of cash fl ow to us now €9.09
She sketched out a couple of simple diagrams. In the rst, Armin
borrows €10 and has to pay back €11. The difference (€1) is the
interest. As you move from today (on the left) to the future (the
right) the value of the amount to repay increases.
Compounding
Borrow
€10
€10
Today Last day of
the year
Interest €1
Principal €10
Repay
€11
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