…is worth more than two in the bush. Where did this saying come from and what does it mean?
The phrase is thought to date back to the 1700s and its meaning is based upon a view that it is better to receive a small advantage today than the chance of something better at a later date. For example, would you take 10 bags of corn today, or you can come back and I can offer you 20 bags next month, the best time for harvesting, for the same price? This dilemma conjures up all sorts of issues. What if the weather changes or the crop gets infected? What if corn is in big demand and prices surge?
The phrase has a meaning that is absolutely fundamental and core to the financial world and relates to the time value of money or any unit of payment. Unless we are experiencing deflation instead of inflation, receiving £100 today is more beneficial than receiving £100 next year.
Let’s take a look at the dynamics that affect the time value of money.
Real Rate of Interest
Financial markets consist of borrowers, lenders and intermediaries
If I lend you £100 for one year I will expect my £100 back, but with some money on top to make it worth my while lending it. This is known as the real interest rate and represents the loan principle plus some compensation, and inflation, I am paid because you have my money and I can’t invest it or do as I like with it.
The real interest rate is affected by the economy, just like with any supply and demand relationship. If there is a demand for money and there isn’t much of it about; a spending boom; then real interest rises. In times when there is plenty of money about, interest rates are low and borrowing goes up. What is happening to our economy now, and as it did in the 1980s, is a very good example of the extremes of this concept.
The real rate of interest is therefore dependent upon inflation
Expected inflation rate
Inflation can be dramatic in change from say 20% in the 1970s and early 1980s to around 1% now. Some countries may be a high as 200%!
Therefore the lender will expect their real interest, plus compensation to cater for the effects of inflation. Let’s look at an example:
I want to save £100 and I have seen an account that will pay me 3% interest. This is known as the nominal interest rate and it excludes the effects of inflation. Let’s assume that inflation is currently at 1%. So, in one year, my £100 savings will be worth £103. However, inflation will have a negative effect on my savings to the tune of £1. So in real terms, I am £2 better off.
Let’s represent the theory with an equation:
1 + nominal interest (%) is equal to (1+ real interest rate (%) )
multiplied by (1+ expected inflation rate (%) )
Therefore, 1 + 0.03 = (1 + real interest) X (1 + 0.01)
Or
1.03 / 1.01 = 1 + real interest = 1.02 = 1 + 2%
This can also be written:
Real Interest Rate = Nominal Interest Rate – expected inflation
Real Interest Rate = 0.03 – 0.01 = 0.02 = 2%
Risk Premium
Some loans can be riskier than others. For example if I lend to a developing country using their weak currency, this will be far riskier than lending UK currency to the UK government. Similarly lending against debt to a company, rather than in shares, is less risky because debt is recovered (or at least they try) before shares are recovered in a case when companies become insolvent.
Therefore, a risk element is added to the real rate of interest. Many credit card loan rates could be considered excessive when comparing to high street banks. However, they tend to lend at the drop of a hat and with no collateral backing requirements on the borrower. Therefore, the risk that the borrower will default, or not be able to pay the loan, is greater.
