Financial Assets

Financial Assets

Broadly an asset is any possession that has value in an exchange. Assets can be classified as tangible or intangible. A tangible asset is one whose value depends on particular physical properties for example building, land or machinery etc. Intangible assets by contrast represents legal claims to some future benefits. Their value bears no relation to the form, physical or otherwise, in which these claims are recorded.

Financial assets are intangible assets. For financial assets, the typical benefit or value is a claim to future cash. The entity that has agreed to make future cash payments is called the issuer of the financial asset and the owner of the financial asset is referred to as the investor.

For example; in the case of the car loan, the terms of the loan establish that the borrower must make specified payments to the commercial bank over time, the payments includes repayment of the amount borrowed  plus interest. The cash flow is made up of the specified payments  that the borrower must make.

Similarly in case of a Treasury bonds the government (issuer) agrees to pay the holder or the investor the bond interest payments every 6 months until the bond matures, then at the maturity date repay the amount borrowed.

Financial assets and tangible assets are linked. Ownership of tangible assets is financed by the issuance of some type of financial assets; either debt instruments or equity instruments.

Debt and Equity Instruments

The claim that the holder of a financial asset has may be either a fixed amount or a varying or residual amount. In the former case the financial asset is referred to as debt instrument. The car loan , treasury bonds are examples of debt instruments requiring fixed payments.

An equity instrument (also called a residual claim) obligates the issuer of the financial asset to pay the holder an amount based on earnings. Common stock is an example of an equity instrument. A partnership share in a business is another example.

Some securities fall into both categories. Preferred stock, for example is an equity instrument that the entitles the investor to receive a fixed amount, this payment is contingent(chance) however and due only after payments to debt instrument holders are made.

There are various types of risk involved with the trading of these assets. The first risk is the risk attached to the potential  purchasing power of the expected cash flow. This is called purchasing power risk, or inflation risk. The second is the risk that the issuer or borrower will default on the obligation. This is called credit risk, or default risk. Finally for financial assets whose cash flow in not determined in own currency, there is the risk that the exchange rate will change adversely, resulting in loss of own currency. This risk is referred to as foreign exchange risk.

Role of Financial Assets

Financial assets have two principal economic functions. The first is to transfer funds from those who have surplus funds to invest to those who need funds to invest in tangible assets. The second economic function is to transfer funds in such a way as to redistribute the unavoidable risk associated with the cash flow generated by tangible assets among those seeking and those providing the funds.

These two functions can be illustrated with the help of three examples :

  1. “A” has obtained a license to manufacture wristwatches. He estimates that he will need $1 million to purchase plant and equipment to manufacture the watches. Unfortunately, he has only $200,000 to invest, and that is his life savings, which he does not want to invest, even though he has confidence that there will be a receptive market for watches.
  2. “B” has recently inherited $730,000. She plans to spend $30,000 on some jewellery, furniture etc…and invest the balance $700,000.
  3. “C” an up-and-coming attorney with a big company has received a bonus check that after taxes has netted him $250,000. He plans to spend $50,000 on a BMW and invest the balance , $200,000.

Suppose that, quite by accident , “A”, “B” and “C” meet at a social function. Sometime during their conversation, they discuss their financial plans, by the end of the evening they agree to deal. “A” agrees to invest $100,000 of his savings in the business and sells 50 % interest to “B” for $700,000. “C” agrees to lend “A” $200,000 for four years at an interest rate of 18% per year. “A” will be responsible for operating the business without the assistance of “B” or “C”. “A” now has his $1 million to manufacture watches.

Two financial claims came out of this meeting. The first is an equity instrument issued by “A”and purchased by “B” for $700,000. The other is the debt instrument issues by “A” and purchased by “C”  for $200,000. Thus two financial assets allowed funds to be transferred from “B” and “C”, who had surplus fund to invest, to “A” who needed funds to invest n intangible assets in order to manufacture the watches. This transfer of funds is the first economic function of the financial assets.

The fact that “A” is not willing to invest his life savings of $200,000 means that he wanted to transfer part of that risk. He does so by selling “B” a financial asset that gives her a financial claim equal to one half the cash flow from the business. He further secures an additional amount of capital from “C” , who is not willing to share in the risk of the business, in the form of an obligation requiring payment of a fixed cash flow, regardless of the outcome of the venture. The shifting of the risk is the second economic function of financial assets.

Role of Financial Markets

A financial market is a market where financial assets are exchanged or traded. Although the existence of the financial market is not a necessary condition for the creation and exchange of a financial asset, in most economies financial assets are created and subsequently traded in some type of financial market. The market in which the financial assets trades for immediate delivery is called the spot market or cash market.

Financial market provides three additional economic functions along with the functions described as the functions of the asset market:

First , the interactions of buyers and sellers in a financial market determine the price of the traded asset. Or equivalently, they determine the financial return on a financial asset. As the inducement for firms to acquire funds on the required return that investors demand, it is the feature of financial markets that signals how the funds in the economy should be allocated among financial assets. This is called the price discovery process.

Second, financial markets provide a mechanism for an investor to sell a financial asset. Because of this feature, it is said that a financial market offers liquidity, an attractive feature when circumstances either force or motivate an investor to sell. If there were not liquidity, the owner would be forced to hold a debt instrument until it matures and an equity instrument until the company is either voluntarily or involuntarily liquidated.

The third economic function of a financial market is that it reduces the cost of transacting. There are two cost associated with transacting : search cost and information cost. Search cost represents explicit cost, such as money spent to advertise one’s intension to sell or purchase a financial asset , and implicit costs, such as the value of time spent in locating a counterparty. The presence of such form of organised financial market reduces cost. Information cost are associated with assessing the investment merits of a financial asset, i.e. the amount and the likelihood of the cashflow expected to be generated . In an efficient market, prices reflect the aggregate information collected by all market participants.

Classification of the Financial Markets

We can classify the financial market on the basis of various factors:

  1. Classification by Nature of its claim :
    1. Debt Market
    2. Equity market
  2. Classification by Maturity of claim:
    1. Money Market
    2. Capital Market
  3. Classification by Seasoning of claim:
    1. Primary Market
    2. Secondary Market
  4. Classification by Immediate Delivery or Future Delivery:
    1. Cash or Spot Market
    2. Derivative Market
  5. Classification by Organisational structure:
    1. Auction Market
    2. Over-the-counter Market
    3. Intermediated Market
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