Part 1: Introduction to Financial Markets and Institutions

The goal of this blog is to teach people basic financial concepts that can be applied to their every day spending and management of money. I will start with my first blog here explaining the basics.

First off why do people invest? People invest to save for the future. They are giving up some consumption today to allow for greater consumption at a future date. Investors have excess funds that they are willing to risk in order to allow the funds to grow. When we talk about risk, we mean two things. First, there is a risk that the investment will not be profitable and you may lose money. Second there is a risk that you may lock in the funds for a certain period of time and may need the funds before that period is over.

There are many types of investments and levels of risk. Some investments, such as government bonds and GICs have virtually no risk. They have time periods that they are locked in for and pay a specific amount of interest at specified dates. They amount of time that your money is locked in for is called its maturity. Your original investment is called the principal. The money you make on top of the principle is called interest.

For example, if you have a 5 year GIC paying 6% interest annually worth $100 000:
Principal: $100 000
Maturity: 5 years
Interest: 6 percent per year, or $6000 of your original investment of $100 000

Using a simple interest method, your investment will be worth $130 000 in five years when it matures. Again, these are just basic concepts but I will get into greater detail in my later blogs.

Just about any bank may offer investment opportunities similar to the one i just explained. GICs and term deposits usually have a maturity of 1 to 5 years. As a general rule, the longer you lock in your money for, the higher interest rate the bank will be willing to offer you.

So how do banks make money? They make money by lending money in the form of loans and mortgages at higher rates than they are paying on their deposits. They normally offer these loans and mortgages on 1-5 year terms, just like GICs. They do this on purpose so that they can match the cash inflows of interest they receive on loans and mortgages with the cash outflows they give out on deposits. Many people may complain that banks do not pay enough interest on their checking, savings, and GIC accounts, however if you compare those rates to the rates on loans and mortgages you will notice that they are only slightly higher. Banks are a business, and they need to make a profit just as any other company does.

Thank you for reading my first blog on this subject. I know it is very basic but I will get go more complex topics in finance very soon. Check back to learn about things such as stocks, bonds, mortgages, derivatives, the stock market, economics, and the economy. Any questions? Leave a comment and I will get back to you!