Basic financial knowledge

What does it mean to have a general financial culture to guide us when it comes to making small and big financial decisions throughout our lives? A method to measure adult financial literacy, which has been adopted at international level, investigates three things: knowledge of basic economic concepts, smart financial behaviour (for example, the habit of covering current expenditure without falling into debt) and that of making long-term financial decisions (for example, the decision to save).

The data collected by the Bank of Italy highlight how Italians have a very low level of financial knowledge by comparison with the OECD average, and that the indicator of financial behaviour is at worrying levels (Italians do not regularly engage in financial planning and are little inclined to purchase financial instruments).

Test your knowledge. In this section you can try your hand at a simplified version of the test used in international surveys to discover what your financial literacy level is. Take the test!

Imagine you receive a gift of €1,000 that you can only spend one year from now and that the annual inflation rate is 1 per cent. In one year's time, with that same sum, you will be able to buy exactly the same things that you could buy today.

Correct answer: FALSE. Prices can change at any time in market economies: some rise, others fall. When there is a general increase in prices, this is called inflation.

Over time inflation reduces the amount of goods and services that a person can buy with a given unit of currency (for example, €1). In other words, inflation erodes the purchasing power of money. The primary task of the European System of Central Banks (ESCB), of which the Bank of Italy is a member, is to ensure price stability, which is defined as a year-on-year inflation rate of below, but close to, 2 per cent.

Imagine that you lend €25 to your friend and that the very next day he repays you exactly €25. Your friend has paid you interest of 1 per cent on the amount borrowed.

Correct answer: FALSE. The interest rate is the price of money and is the basis for calculating the cost incurred by the person who uses a sum of money for a certain period of time. In this case, the amount repaid was the same as that borrowed so no interest was paid.

The law sets a limit (ceiling rates) above which the interest rate is considered usurious and therefore illegal. The ceiling rates are not set by the Bank of Italy, but rather are calculated automatically according to a formula established by law and based on the average market rates obtained on a quarterly basis by the Bank of Italy and published by the Ministry of Economy and Finance.

You should always check whether the person offering you a loan is an authorized financial operator.

Imagine that you deposit €100 in a bank for one year and that the bank agrees to pay interest on the amounts deposited at an annual rate of 2 per cent. At the end of the first year, if you have not withdrawn the €100 or deposited other sums, there would be €102 in the account.

Correct answer: TRUE. Let's do the maths. On 1 January 2018 you deposited €100 (principal), on which €2 of interest has accrued by the end of the year.

Date	Principal	Rate	Months	Interest	Balance
1 January 2018	€100
31 December 2018	€100	2%	12	€2	€102

On 31 December 2018 the available balance is €102: €100 of starting principal + €2 of interest.

Imagine that you have €100 in a deposit account and that the bank agrees to pay a guaranteed interest rate of 2 per cent on the amounts deposited. If you have not made any other deposits or withdrawals on the account, the balance after 5 years is €110.

Correct answer: FALSE. The balance is higher as a result of compound interest. At the end of the first year, the interest is added to the principal; the following year interest is calculated on this combined amount, and so on. At the end of the first year, the €100 deposited will have generated €2 of interest, therefore the principal upon which interest accrues in the second year amounts to €102. At the end of the second year the interest is calculated on a balance of €2.04; the €0.04 is the interest generated on the €2 of interest added to the starting principal at the end of the first year. This compounding of interest repeats itself each year thereafter, as shown in the table below. Therefore, after 5 years you will have a little more than €110 in your account!

Date	Principal	Rate	Months	Interest	Balance at year-end
1 January 2019	€102	2%	12	€2,04	€104,04
1 January 2020	€104,04	2%	12	€2,0808	€106,1208
1 January 2021	€106,1208	2%	12	€2,1224	€108,2432
1 January 2022	€108,2432	2%	12	€2,1649	€110,4081

According to the results of the Bank of Italy's survey on the financial literacy of Italian adults (IACOFI), less than half of the adult population is able to calculate simple interest, and not even one fourth knows how to calculate compound interest correctly.

You have to know how to calculate a percentage in order to be able to understand the yield on or the cost of even the most common and simple banking products. Whether the capitalized interest is simple or compound, you still need to calculate percentages.

You need to know three things to calculate interest (I): the principal (P), which is the amount on which the interest is calculated; the interest rate (r); and the period of time (t). The formula used to calculate simple interest is I=(Pxtxr)/100. Be careful: the rate must be expressed in a manner that is consistent with the time period (annual rate for time measured in years; semi-annual rate for time measured in semi-annual increments, etc.).

An investment with a high return is probably very risky.

Correct answer: TRUE. High returns require the assumption of high risks by investors. When considering an investment you should collect as much information as possible to understand how much the effective return is likely to differ from the expected return and the probability that the value of the investment will fall. You should also try to understand under what conditions and within what time frame the investment can be liquidated (that is, be exchanged for cash). Be careful: you should also take projected inflation into account when considering the return on an investment.

When you invest your money in financial assets you run a series of risks. Here is a brief description of the main risks.

Credit risk, connected with the failure to pay interest and/or to repay the principal invested, in whole or in part.
Market risk, where the value of the investment may fall due to changes in prices or the general performance of the financial market.
Liquidity risk, when it is costly or difficult to sell the financial asset or when a lot of time is needed to find a buyer.

High inflation means that the cost of living is rising rapidly.

Correct answer: TRUE. When we consider our situation in the future, and especially if we are looking at least 5 years down the road, we should take into account the effects of inflation. The value of €1 today is certainly greater than €1 in 5 years' time when inflation is present. When signing a contract for financial services or products we should try to understand how much of the amount we are paying is dependent on general price trends.

For example, in the long run we should take into account whether making a fixed-rate mortgage payment is sustainable based on our take-home pay; in fact, over time, a fixed-rate instalment payment as a percentage of our income tends to become smaller the more the inflation rate rises.

Likewise, yields on financial products are normally expressed in nominal terms, i.e. they do not take into account increases in the cost of living. We should therefore look at the real (actual) yield, after inflation.

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