This was originally posted in the Wind Trader's Stormspire on 28th "November 2010. Moving it into the public forums for greater benefit and just an interesting/insightful read. - Sinshroud.

Inflation exists in wow. That is, the value of gold changes over time and it generally decreases in value. This (short) post is an attempt to quantify inflation and to use it to explain how a concept called Net Present Value (NPV) works in finance.

NPV is a core financial descision-making tool. If you do an NPV calculation, and it's positive, you should (with a lot of caveats I'll explain later) make the trade. This is a tool that is directly transferable outside of warcraft - most financial decisions that you make will benefit from a back of the envelope NPV calculation.

Here is a really simple example of an NPV calculation:

Suppose I see a Hyacynth McCaw sitting on the AH for 9000g. Now, ignoring all transaction fees (AH cut, relisting, etc.) I "know" that it's worth 15,000g on my server. Should I buy it and relist it?

All NPV does is make the decision making process a little more obvious. It does this by looking at the cash flows for the lifetime of the trade. Thus:

Day 0: -9000g

Day that it sells: +15,000g

Expected Value (EV): +6000g

So far, so good - it looks like this trade will net us 6000g. Still, that "Day that it sells" is very vague. Let's try to quantify that a bit more. Let's say we know it will sell in exactly 30 days, and we know this with 100% certainty.

It's still +6000g, but how much is that REALLY worth, given that we are going to tie up our cash for 30 days? To calculate this, we need to have a value for inflation.

To get this value, I looked at the priceof a commonly traded item that started out very high when it was first available and slowly dropped to almost nothing: primordial saronite.

See the smooth descent from 600g to 100g in 3 months? That's a drop of around 83% in 3 months, or about 27.7% a month. I'm going to use this number as a first stab at an inflation figure.

Just a reminder of what this means: we would be equally happy with 100g now, or 127.7g in 30 days. An investment that cost us 100g today and paid off 110g in 30 days would not be good for us. This may not be right, but we are at least in the right ballpark - with more analysis (a "basket of goods") we could do better.

Back to the deal:

NPV = -9,000 + (1 - 0.277)*15,000 = 9000 - 10845 = +1,845g

It's positive, so the deal is still a good one, but it's not nearly as good as it looks when you see that +6000g figure. Now, let's add some risk.

I'm going to assume for a moment that I know the market for Hyacinth McCaws on my server. On average, on any given day, there is a 5% chance that my pet will sell. What does this mean in real life?

Remember that the 5% chance is independent - if I went 100 days without selling the pet, it's still just a 5% chance of it selling the next day. therefore:

Chance of sale on day:

1: 5%

2: 9.75%

3: 14.27%

...

30: 78.6%

Let's say that after a month, if it doesn't sell, I'm going to sell it for half price (7500g) to get a guaranteed sale that day. Let's also say that even if it sells on day 1, I am not going to use the money until day 30 (this is to simplify, for right now).

(0.786*15,000) + ((1-0.786)*7500) = 11790 + 1605 = 13,395g

Pretty good!

But now we need to take into account inflation:

NPV = -9000 + (1-0.277)*13395 = 684.585g

It's still positive, so it looks like it's going to be a good deal, but now we really have a solid idea of how good a deal it is. If the 9000g represents most of our assets, we now have the ability to decide if this is the best use of our money, or if there is another, higher NPV, deal that we would be better spending our money on.

Perhaps the 9000g could be spent on something that will sell for 11,000g but it's guaranteed in a week:

NPV = -9000 + (1-((0.277/30)*7))*11000 = -9000 + 0.9354*11000 = +1289.4

The second deal, despite giving us less cash, has a higher NPV and we should take that deal instead.

So, what was the point of all this?

The point was to explain how to make good descisions in the face of risk and inflation. There is a lot more to take into account, and I fudged the numbers a bit (I should have had 30 different calculations for the McCaw, not just 1) but hopefully you can at least understand where I am coming from.

If anyone is interested, I'd be happy to share some spreadsheets where you can input the deal you are considering, the chance of it selling in a given day, the "salvage value" and your own best guess at an inflation number. I'd also be interested in modifying the inflation number to dynamically update based on data on a basket of goods from the undermine journal for your particular server, but perhaps that is for another day.