 Okay, cool. We are online. How's it guys? It's MJ the student's act tree and what I'm going to be doing in these videos is Just going through finance. I haven't prepared for these videos. This is me actually studying at the moment So what I'm doing is I'm going through subject F105 Which is also known as the specialist finance subject and I'm doing this in preparation for the fellowship in finance So what I need to do is I need to go through the entire syllabus and the very first thing that the syllabus asks is it says State what is meant by a risk-free rate of return? Now when you go into the notes, I mean you can get a very nice definition that the risk-free rate of return is Well can be defined at as the rate at which money can be borrowed or lent Lent at when there is no credit risk so that the money is certain to be repaid. So if we have to Just write this out the risk-free rate of return is the rate at which money can be borrowed or Lent when repayment is Certain i.e. No risk and I mean that should be no surprise to you because I mean the very name of the concept is risk-free rate of return Now it's a little bit problematic because this is the very first thing in the syllabus and I have a problem with it because I don't think that the risk-free rate of return is Something that actually exists. I think it's it's hypothetical and This is quite problematic because a lot of the course builds up on this risk-free rate of return It's one of the core concepts and it doesn't exist So what I mean by the fact that it doesn't exist is because of this word here certain repayment is certain and Also, what do we mean by saying that there is no risk? Traditionally we see government lending as risk-free because the government can always go and print more money so Government lends you you know you lend your money to the government's government spends it if they cannot repay it Then they can always either you know raise taxes Or they can just print more money the problem though is Raising taxes can cause a little bit of political unrest the people can get angry The people might refuse to pay or they might be frictional cost and taking up the taxes So it's not as easily said as done and also when it comes to say printing more money Well, there's two problems. What happens if you're using a shared currency such as the euro we've seen this with Greece or More importantly with even currencies that have their their own well countries that have their own currency What happens is if you print more then I mean it's kind of like supply and demand and the currency value decreases and That is a risk that that's a risk that you're the real value of your investment has gone down so for instance if you had to lend a hundred 100 rand to the South African government and the South African government cannot afford to pay it so what they go and do and they They print lots and lots of money and they're able to give you back your hundred rand back However, because there's so much more money that has been printed your hundred rand can no longer buy you as many goods And services as it could before so hold on. Let me maybe let me write this out So today, okay, let's pretend today a hundred rand can get you five cooks Okay, and what you decide to do is you decide to lend that hundred rand to the government Okay, and let's say the government Can't or you know wants to default but instead they they print a whole bunch of money and they pay you back your 100 rand So government then pays you back your 100 rand tomorrow, but by doing so They have By doing so they have released more more money into the system supply and demand. There's more supply of money Which means that the price then comes down. So which means your hundred rands tomorrow can only buy you say four cooks and This is a little bit problematic because You can see that the purchasing power of the currency Decreases when the government prints more of it and that is a risk because if I'm lending a hundred rand I'm forgoing the five cooks and when I get my hundred rand back is only four cooks So there is that risk and this is why we have a while we charge interest rates We say to the government we will only give you a hundred rand if you give us back a hundred rand plus an amount Okay, this amount being interest this amount can be 10 rand This amount can be 20 rand and the higher the amount should correspond to the higher of the risk taken so If there's a chance that the government is just going to repay The amount using their own money and it will be five cooks You know if that's that's a high chance then the amount will be quite low But if there's a chance that they're going to print lots of money and then I can only buy four cooks Well, then I'm going to need a substantially more amount to compensate myself for that risk And that's the thing is that there is always risk and The problem is when we look at this risk-free rate of return The textbook or what the notes are referring to is a closed economy and Again, this is rubbish because the closed economy Doesn't really exist today, you know, we've got globalization We've got all these foreign investors who are you know pushing money into a country but then they can pull the money out of the country and you know, this can fluctuates the prices and Introduce a lot of volatility and when we have volatility we have risk Now so that that's my first point my first point is that the risk-free rates of return does not exist Okay, so point one it doesn't exist and Point two is If it did exist Its value should be well, yeah, what should its value be? Okay, should the value maybe be zero? Because think about it if there's no risk, why should you be getting a reward? You know that comes down to the whole One of the you know the things in finance is the greater the risk the greater the reward Well, if there's no risk Then how can there be a reward? So maybe the value should be zero Because This doesn't I guess very confusing. I mean like I said, I haven't prepared for this video So I'm still trying to think this whole thing through because then what what is the value of money? You know, it comes down to that very first subject. We study in actual science, you know the time value of money and We always saw that, you know, you'd rather have ten rent today Then ten rent tomorrow because of the uncertainty that maybe you don't get that ten rent tomorrow so The question though it comes down to is what what would you be in difference about so let's say let me maybe find some more space Today you could either have ten rent or tomorrow You know, what amount should you have? You know, if it was if it was ten rent, then you would choose today If it was a hundred rent tomorrow, you would choose tomorrow but what value in between ten and say a hundred grand do you become indifferent about it and I Think that is the only way to determine what this risk-free rate of return value should be The problem comes is that it's different for for everyone So for instance, if I had to go and I decided people You know, who would do the following deal and let's go 12 rent You know, who would do this following deal here? You go to a whole bunch of varsity students and you you asked them this question you might find that like almost They say 99% Choose today When it's ten rent versus ten rent when it's ten rent versus eleven rent you might find only 80% choose it when it's ten rent to twelve rent, you know, we might only find say 75% of people Choose that one over the other one and and this is the thing is that it's very much subjective For instance, if you're someone who has a lot of money then waiting tomorrow to get more money is The more logical thing to do But if you're somebody who desperately needs money now Well, then you're rather gonna choose the money today, even if the amount tomorrow is greater So it's all comes down to its subjective and it's the demand for money Now you might think oh everybody's got the same demand for money, you know, everybody likes money But I would disagree I would say some people want money more than others say for instance You've got rent to be paid the next day and you don't have any money Then your demand for money is going to be much higher Then say a multimillionaire who's got unlimited funds, you know And you're gonna be doing you're gonna be prepared to do a much more labor-intensive job Or a much uglier job in order to get that a thousand rent to pay your rent Then what the multimillionaire would do so one thing we can see with the demand of money is that the more money? We have the less we demand it although not always because you know, there's that thing known as greed and This gets a little bit shaky because now we're moving away from pure finance and we're entering the realm of behavioral finance and When we enter behavioral finance We get really really confused because in order to work up behavioral finance is you need data you need to do experiments you need to look at you know the various observations and The problem with that type of stuff is that there hasn't been enough done or the science of experiments are very very small You know the sample stats are you know you can't really draw significant results from it yet So it's still early days, but we're seeing behavioral finance is a big portion To to say the theoretical finance Which means that there definitely is gonna be I can never spell this word psychology Psycho, I know there's like a wire somewhere Psychological, I don't know that I spelled that correctly. There's you know, but there's definitely a psychological Logical element to finance when it comes to say the demand and stuff like that And that's why when we say the risk-free rate of return You know what what should it be? It very much is well, we don't know and This gets a little bit problematic. I mean, how can we we not know what the interest rate should be if there's no risk return? You know, what what do we do? Fortunately for us well, some people might say it fortunately other people might say this is a little bit scary But the central bank sets the interest rate so the central bank which is An in well a party that were or an organization that we're gonna look at maybe in some other later videos the central bank sets the interest rate Okay, and this interest rate that they set is supposed to have a bit of the risk-free Component and a risk component But the weird thing is is that the central bank Can set this interest rate to be anything that they want to be I mean we're seeing in in Europe and in Japan and some of those countries that the interest rate is becoming negative Okay, so they're setting the interest rate as negative and that's absolutely mind-boggling because it means that It's almost like saying to someone would you rather have say Nine rent. Oh, sorry. Would you rather have 11 ran today or 10 ran tomorrow? You know that that's almost that's almost one where we'd expect say a hundred percent of people to choose 11 ran today rather than 10 ran tomorrow But a negative interest rate kind of puts that situation on the table, which you'd think okay Nobody would then lend at a at a negative interest rate But and this is where we're gonna get later on also into finance is you have this thing called regulation and Regulation sets a bunch of rules for investing and you have to invest if you're a big organization like a pension scheme a certain Proportion say around 60% of your assets Into government bonds and government bonds might have a negative interest rate Which means you're investing and you're taking a loss up front So you're lending money to them. There's a chance that they may not pay it back There's a chance that the the currency might devalue and you're still on top of all of that getting hit With a negative interest rate. It's almost like taxing someone for having money. It's like almost like you're a capital a Capital tax and there's no way that you can not invest in this because of the regulations So this is where finance starts setting up these rules and all the regulators set up these things with really great intentions but they can have terrible consequences and And so yeah, this comes back to this whole interest rate. I mean the interest rate It's a really weird concept and I find it really strange that it is point number one on the syllabus is Explain what is meant by the risk-free rate? And I think I mean the notes have kind of just got one page on this You know, they do mention the printing more and the currency risk But I think what they just want you to understand for the exam is that it's a rate at which money can be borrowed or lent When the repayments is certain, you know, there's no risk There's no risk of default and all those type of stuff but it's really unfortunate because Like I've just shown is that it is very hypothetical and this risk-free rate of return does not exist and What's also a little bit scary is well Interest rates are kind of I guess I guess you could say this they're they're made up Okay, interest rates are made up. They're look they're made up with they're not just, you know Thumbs up the central bank does put a little bit of thought behind it They do think about how it's gonna affect inflation and you know What it can do for price stability in the economy and all that type of stuff, you know They want it growth to be controlled and all that type of stuff So they definitely there's a lot of thought that is put into what the interest rate should be but at the end of the day It's it's made up. It's not a a natural rate. Okay, it's not It's not natural in the sense that say the the speed of light or the force of mortality This you know where we can actually see it observe in nature, you know people dying at a certain rates type of thing like that You know mortality rates so mortality rates are are natural, but interest rates I mean the way I'm thinking now are kind of like they're made up But look, I'm still very much just starting out studying for the subject my opinion my change Like I said, I haven't prepared for this video. This is me just talking out loud Let me know what your thoughts are in the comment section below about this risk-free rate of return I definitely know that there's a lot more to be thought about around here And it's something I'm gonna touch on when I study some of the later courses, but there we go Thanks so much for watching. I'm just recording all of this on my tablet using a screen