Finance Fundamentals

Level 0: Foundations | Module 0.1 | Time: 2 hours

🎯 Learning Objectives

By the end of this module, you will:

• Understand what financial assets are and how they differ
• Grasp fundamental market mechanics (supply/demand, pricing)
• Learn the relationship between risk and return
• Master time value of money concepts
• Calculate compound interest and growth

Prerequisites: None. Complete beginner friendly.

What is an Asset?

An asset is anything of value that can be owned, traded, or converted to cash. In finance, we focus on financial assets - ownership claims or debt instruments that can generate returns.

Major Asset Classes

1. Stocks (Equities)

What: Ownership shares in a company

How They Work:

• You buy stock → you own a piece of the company
• Company profits → stock price may rise
• Company struggles → stock price may fall

Returns Come From:

• Capital Appreciation: Stock price increases
• Dividends: Company shares profits with shareholders

Example:

You buy 10 shares of Tesla at $200/share = $2,000 investment
Tesla stock rises to $250/share = Your shares worth $2,500
Your gain: $500 (25% return)

Risk Level: Medium to High Typical Annual Return: 7-10% historically (but volatile)

2. Bonds (Fixed Income)

What: Loans you make to governments or corporations

How They Work:

• You buy a bond → you become the lender
• Issuer pays you interest (coupon) regularly
• At maturity, you get your principal back

Returns Come From:

• Interest Payments: Regular coupon payments
• Price Appreciation: Bond prices can increase

Example:

You buy a $10,000 bond with 5% annual coupon, 10-year maturity
You receive: $500/year for 10 years = $5,000 in interest
At year 10: You get your $10,000 principal back
Total return: $5,000 (50% over 10 years)

Risk Level: Low to Medium Typical Annual Return: 3-6% historically

3. Cryptocurrency

What: Digital assets using blockchain technology

How They Work:

• Decentralized (no central authority)
• Limited supply (e.g., 21M Bitcoin max)
• Value based on supply/demand, adoption, technology

Returns Come From:

• Price Appreciation: Value increases as demand grows
• Staking Rewards: Some cryptos pay for network participation

Example:

You buy 1 Bitcoin at $30,000
Bitcoin rises to $45,000
Your gain: $15,000 (50% return)

But it could also fall 50% just as easily!

Risk Level: Very High Typical Annual Return: Highly variable (-50% to +200%)

4. Commodities

What: Physical goods like gold, oil, wheat

Risk Level: Medium to High

5. Real Estate

What: Physical property (residential, commercial, land)

Risk Level: Medium

Asset Class Comparison

How Markets Work

Markets exist to match buyers and sellers. Price is determined by supply and demand.

Supply and Demand Fundamentals

Law of Demand: When price ↓, quantity demanded ↑ (more buyers) Law of Supply: When price ↑, quantity supplied ↑ (more sellers)

Equilibrium Price: Where supply meets demand

Example: Bitcoin Market

Scenario: Positive news about Bitcoin adoption

Before News:
- Price: $30,000
- Buyers: 1,000 wanting to buy
- Sellers: 1,000 wanting to sell
- Market balanced

After Positive News:
- More buyers enter (demand increases)
- Price rises to $32,000
- Some sellers take profit
- New equilibrium at $32,000

Why?
- More demand + same supply = higher price
- This is how markets "price in" information

Market Participants

1. Retail Investors (Individual traders like you)

• Smaller position sizes
• Longer time horizons typically
• Emotional trading risks

2. Institutional Investors (Banks, hedge funds, pensions)

• Large position sizes
• Professional management
• Move markets with their trades

3. Market Makers (Provide liquidity)

• Always willing to buy or sell
• Profit from bid-ask spread
• Reduce volatility

4. Speculators (Bet on price direction)

• Short-term trading
• Add liquidity but can increase volatility

Risk vs Return

Golden Rule of Finance: Higher potential returns come with higher risk.

Understanding Risk

Risk = Uncertainty about future returns = Possibility of losing money

Types of Risk:

1. Market Risk (Systematic Risk)

• Entire market falls (2008 crisis, 2020 COVID)
• Can’t be diversified away
• Affects all assets

2. Specific Risk (Unsystematic Risk)

• Company-specific problems (Tesla recall, FTX collapse)
• Can be reduced through diversification
• Affects specific assets

3. Volatility Risk

• How much prices swing up and down
• High volatility = high risk (but also opportunity)

4. Liquidity Risk

• Difficulty selling an asset quickly
• Illiquid assets may force you to sell at bad prices

Risk-Return Trade-off

Visual Risk Pyramid (Lowest Risk to Highest):

                  /\
                 /  \  Crypto, Leveraged Products
                /----\
               /      \  Stocks, Emerging Markets
              /--------\
             /          \ Bonds, Real Estate
            /------------\
           / Cash, T-Bills \  ← Lowest Risk, Lowest Return
          /----------------\

Higher up = Higher Risk + Higher Potential Return

Example: Comparing Investments

Investment A: US Treasury Bond

• Expected Return: 4% annually
• Risk: Very low (government backed)
• Volatility: Minimal

Investment B: Tech Stock (NVIDIA)

• Expected Return: 15% annually (variable)
• Risk: Medium-High
• Volatility: ±30% in a year is normal

Investment C: Small-Cap Crypto

• Expected Return: Could be 100% or -80%
• Risk: Extremely high
• Volatility: ±50% in a week is possible

Which to choose?

• Depends on your risk tolerance
• Your time horizon
• Your financial goals

Time Value of Money

Core Principle: Money today is worth more than the same amount in the future.

Why?

1. Inflation: Prices rise, purchasing power falls
2. Opportunity Cost: Money today can be invested to grow
3. Uncertainty: Future is uncertain

Present Value vs Future Value

Present Value (PV): What future money is worth today Future Value (FV): What today’s money will be worth in the future

Formula:

FV = PV × (1 + r)^n

Where:
- FV = Future Value
- PV = Present Value (today's amount)
- r = interest rate (as decimal)
- n = number of periods

Example: Future Value Calculation

Question: You invest $10,000 today at 7% annual return. What’s it worth in 10 years?

Given:
- PV = $10,000
- r = 0.07 (7%)
- n = 10 years

Calculation:
FV = $10,000 × (1.07)^10
FV = $10,000 × 1.9672
FV = $19,672

Result: Your $10,000 grows to $19,672 in 10 years

Example: Present Value Calculation

Question: What’s the present value of receiving $20,000 in 10 years, assuming 7% discount rate?

Rearrange formula:
PV = FV / (1 + r)^n

PV = $20,000 / (1.07)^10
PV = $20,000 / 1.9672
PV = $10,167

Result: Receiving $20,000 in 10 years is worth $10,167 today

Why this matters:

• Lets you compare investments with different time horizons
• Foundation for all option pricing
• Critical for structured products valuation

Compound Interest

The Eighth Wonder of the World - Albert Einstein

Simple Interest vs Compound Interest

Simple Interest: Earn interest only on principal

$10,000 at 5% simple interest for 3 years:
Year 1: $10,000 + $500 = $10,500
Year 2: $10,500 + $500 = $11,000
Year 3: $11,000 + $500 = $11,500

Total Interest: $1,500

Compound Interest: Earn interest on interest

$10,000 at 5% compound interest for 3 years:
Year 1: $10,000 × 1.05 = $10,500
Year 2: $10,500 × 1.05 = $11,025 (earned interest on the $500)
Year 3: $11,025 × 1.05 = $11,576

Total Interest: $1,576 (vs $1,500 simple)

Difference: $76 (seems small, but grows exponentially over time!)

The Power of Time

Same Investment, Different Time Horizons

$10,000 invested at 8% annually:

After 5 years:  $14,693
After 10 years: $21,589
After 20 years: $46,610
After 30 years: $100,627
After 40 years: $217,245

The last 10 years more than doubled the entire 30-year gain!
This is exponential growth.

Compound Frequency Matters

Interest can compound:

• Annually (once per year)
• Quarterly (4 times per year)
• Monthly (12 times per year)
• Daily (365 times per year)
• Continuously (infinite - theoretical)

Formula for Different Compounding:

FV = PV × (1 + r/m)^(n×m)

Where:
- m = compounding frequency per year

Example: $10,000 at 8% for 10 years

Annual Compounding:      $21,589
Quarterly Compounding:   $21,911
Monthly Compounding:     $22,080
Daily Compounding:       $22,253
Continuous Compounding:  $22,255

Key Insight: More frequent compounding = higher returns, but the difference diminishes with higher frequency.

Practical Applications

Application 1: Comparing Investments

Scenario: You have $50,000 to invest. Compare two options:

Option A: Corporate bond paying 6% annually for 5 years

FV = $50,000 × (1.06)^5 = $66,911
Gain: $16,911

Option B: Stock expected to return 10% annually for 5 years

FV = $50,000 × (1.10)^5 = $80,526
Gain: $30,526

BUT: Stock is riskier! Are you comfortable with potential -20% years?

Application 2: Inflation Impact

Scenario: You keep $10,000 in cash for 10 years. Inflation averages 3%.

Purchasing power in 10 years:
PV = $10,000 / (1.03)^10 = $7,441

You lost $2,559 in purchasing power by holding cash!

Lesson: Inflation is a hidden tax. Money must grow to maintain value.

Application 3: The Rule of 72

Quick Mental Math: How long to double your money?

Years to Double ≈ 72 / Interest Rate

Examples:
- 6% return: 72/6 = 12 years to double
- 8% return: 72/8 = 9 years to double
- 10% return: 72/10 = 7.2 years to double

Try it:

• Bitcoin claims 100% average annual return: 72/100 = 0.72 years (less than a year to double!)
• But is that sustainable? No.

Key Takeaways

1. Assets have different risk/return profiles

• Match assets to your goals and risk tolerance
• Diversification reduces risk

2. Markets price in information through supply/demand

• Prices reflect collective wisdom (and sometimes collective panic)
• No one can consistently predict short-term moves

3. Risk and return are inseparable

• Higher returns require accepting higher risk
• Understand your true risk tolerance

4. Time value of money is fundamental

• Money today > money tomorrow
• Foundation for all derivatives pricing

5. Compound interest is powerful

• Start early, let time work for you
• Reinvest returns to maximize growth

Practice Exercises

Exercise 1: Future Value

Question: You invest $25,000 at 9% annually. What’s it worth in 15 years?

FV = $25,000 × (1.09)^15
FV = $25,000 × 3.642
FV = $91,052

Answer: $91,052

Exercise 2: Comparing Returns

Question: Which is better?

• A: $100,000 in 20 years
• B: $40,000 today

Assume 6% discount rate.

Calculate PV of Option A:
PV = $100,000 / (1.06)^20
PV = $100,000 / 3.207
PV = $31,180

Option A present value: $31,180
Option B present value: $40,000

Answer: Option B is better ($40,000 > $31,180)

Exercise 3: Compound Growth

Question: How much must you invest today at 7% to have $1,000,000 in 30 years?

Rearrange: PV = FV / (1 + r)^n

PV = $1,000,000 / (1.07)^30
PV = $1,000,000 / 7.612
PV = $131,367

Answer: Invest $131,367 today to reach $1M in 30 years

Interactive Calculator

Use the Time Value Calculator to explore these concepts with different values.

Common Mistakes

Mistake 1: Ignoring Inflation

• Nominal returns look good, but real returns (after inflation) matter
• Always adjust for inflation in long-term planning

Mistake 2: Chasing High Returns Without Understanding Risk

• 20% returns sound great until you experience a -50% year
• Know the downside, not just the upside

Mistake 3: Focusing on Absolute $ Instead of % Returns

• $1,000 gain on $5,000 investment (20%) is better than
• $1,000 gain on $50,000 investment (2%)

Mistake 4: Not Starting Early

• A 25-year-old investing $5,000/year beats
• A 35-year-old investing $10,000/year
• Because of those extra 10 years of compounding

Mistake 5: Holding Cash Long-Term

• Inflation erodes purchasing power
• Cash is for short-term needs and emergencies only

Next Steps

You’ve mastered the fundamentals! You now understand:

• ✅ What assets are and how they differ
• ✅ Basic market mechanics
• ✅ Risk/return relationships
• ✅ Time value of money
• ✅ Compound interest power

Continue to: Introduction to Derivatives →

This next module builds on time value and risk concepts to introduce options and derivatives.

Additional Resources

Books:

• “The Intelligent Investor” by Benjamin Graham
• “A Random Walk Down Wall Street” by Burton Malkiel

Online:

• Khan Academy - Finance & Capital Markets
• Investopedia - Finance Basics

Practice:

• Use the FORGE Structure Tool to explore real asset prices
• Try the interactive calculators in the Tools section

Next Module: Introduction to Derivatives →