Q&A with CMMB Securities

 Q. What is meant by capital appreciation?

Tony, Cantaro

A: There are two types of income, which can be earned on a financial investment. Firstly, interest income refers to that earned on a fixed income type of investment and would be a function of the rate on the investment and the time over which it is held. For example, the income earned on a fixed deposit held at a fixed rate of return for a fixed time period is referred to as interest. However, there are other types of income, which can be earned on an investment. Capital appreciation is one of them and refers to the increase in the value of the capital invested in the financial instrument. For example, if one purchases 100 shares at $6 per share and over a month the price of the share increases to $7 per share, capital appreciation over that month is measured as the increase in value, which in this case is $1,000 ($7000-$6000). Similarly if the price of the share fell to $5 the decrease in the value of the investment is $1,000 ($6000-$5000) and is referred to as capital depreciation, the opposite of capital appreciation.

The key difference between interest as opposed to capital appreciation is that interest is a function of the time held, whereas capital appreciation can occur irrespective of the time held and is impacted by a number of factors. For example, the level of capital appreciation on a share would be related to the level of interest rates, growth rate of the company, it’s level of profitability and the cost of capital in the economy. Fixed income instruments are not impacted by these external variables and hence the returns are quite conservative. However, in equity type instruments where there is room for capital appreciation (or its downside - depreciation) the returns are much higher as the risk arising from the impact of many variables is also much higher.

Q. I’m getting mixed messages from commercial banks. On the one hand they are almost begging people to come in and borrow money and on the other hand bank charges keep inching up. What’s going on?

Beverly, Valsayn

A: Banks serve an extremely important purpose in the economy. They mobilise capital by bringing together parties which have excess funds with other parties who have borrowing needs. They are in essence intermediaries and so are serving different needs on both sides of the market. Banks first have to source funds by engineering investment vehicles and advertising the rates thereon. They therefore must target individuals and corporations who may have excess funds to invest by offering a good risk-adjusted rate of return, flexibility and safety. On the other hand they also have to invest those funds, which they are paying for from depositors, in order to generate income. They would therefore want to loan these funds out to individuals and corporations who have borrowing needs.

Currently, the banks have an excess level of funds due to the high level of liquidity in the financial system. As with any commodity, once the level of supply increases, suppliers become aggressive in trying to push their own inventory. Similarly banks, which are suppliers of money, are all trying to loan out as much of their funds as possible in order to increase their income. Remember, once the banks are paying depositors for money and have no way to invest this money they are making a negative carry on the funds which they have taken in. This explains why the banks may be so aggressive to lend funds in the market, hence the increased incidence of loan sales and specials. On the other hand, if liquidity in the financial system had been tight, the banks would be looking for money rather than trying to increase loans. They would have therefore been targeting depositors rather than borrowers. It all depends on the level of liquidity in the financial system. So there is no contradiction here. As regards the level of bank charges, these are determined by market forces. If the level of competition in a market is increased, prices would naturally fall. This is a question for the regulators.

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E-mail : cmmbsecurities@mycmmb.com