CHAPTER 1 INTRODUCTION Dr. Shirley E. Maranan

Learning Objectives After reading this chapter you will understand: What a financial asset is. The distinction between a debt instrument and an equity instrument. The general principles for determining the price of a financial asset. Ten properties of financial assets. The principal economic functions of financial asset.

Learning Objectives The different ways to classify a financial market. What is meant by a derivative instrument. The reasons for the globalization of financial markets. The classification of global financial markets. What is meant by an asset class What a financial market is and principal economic functions it performs.

In a market economy, the allocation of economic resources is driven by the outcome of many private decisions. Prices are the signals that direct economic resources to their best use. The types of markets in an economy can be divided into (1) the market for products (manufactured goods and services), or the product market; and (2) the market for the factors of production (labor and capital), or the factor market.

Financial Assets Asset – any possession that has value in an exchange. – Tangible - depends on particular physical properties or reproducible assets. Example: Building, land, machinery – Intangible – represents legal claims to some future benefit. Their value bears no relation to the form, physical or otherwise, in which the claims are recorded (future cash). Example: Financial assets, financial instruments or securities.

In financial assets there is an: -Issuer of the financial asset -The entity that agrees to make future cash payments. -Investor -The owner of the financial asset

Examples of financial asset: A bond issued by the US Department of Treasury A bond issued by General Electric Corporation A bond issued by the state of California A bond issued by the government of the Philippines An automobile loan A home mortgage loan Common stock issued by Microsoft Corporation

Debt vs. Equity Claims The claims of the holder of a financial asset may be either a fixed dollar amount or a varying, or residual, amount. In the former case, the financial assets is referred to as a debt instrument since it requires fixed dollar payments to borrow the funds (bonds). An equity claim (residual claim) obligates the issuer of the financial asset to pay the holder an amount based on earnings. If any, after holder of debt instrument have been paid. Example: common stock

The Value of a Financial Asset Valuation is the process of determining the fair value or price of a financial asset. The fundamental principle of a financial asset if the present value of the cash flow expected. This principle applies regardless of the financial asset. Consequently, it applies equally to common stock, a bond, a loan or real estate. The principle is simple: Just determine the cash flow and the calculate the PV.

Process For Valuing a Financial Asset Estimate the cash flow (cash flow = interest, principal repayment, dividends, expected sale price of an asset Determine the appropriate interest rate for discounting the cash flow * Minimum interest rate * Plus premium required for perceived risk Value of financial asset = PV of expected cash flow

Types of Risks in Financial Asset Credit risk (default risk) – The risk that the issuer or borrower will default on the obligation. Purchasing power (inflation risk) – The risk attached to the potential purchasing power of the cash flow expected. Foreign exchange risk – Financial assets whose cash flow is not denominated in US dollar and entail a risk that the exchange rate will change adversely resulting in fewer US dollars.

Principal Economic Functions of Financial Assets Transfer funds from those parties who have surplus funds to invest to those who need funds to invest in tangle assets. Transfer funds in such a way as to redistribute the unavoidable risk associated with the cash flow generated by the tangible assets among those seeking and those providing the funds.

However, the claims held by the final wealth holder generally differ from the liabilities issued by the final demanders of funds because of the activity of entities operating in financial markets, called the financial intermediaries.

Properties of Financial Assets 1.Moneyness -Some financial assets acts as a medium or in settlement of transaction and these are money (currency and all forms of deposits). -Near money are other financial assets, although not money, closely approximate money in that they can be transformed into money at little cost delay or risk (time and savings deposit, security) 2.Divisibility and Denomination -It relates to the minimum size at which a financial asset can be liquidated and exchange for money. The smaller the size, the more financial asset is divisible.

3.Reversibility (Round-trip cost) -It refers to the cost of investing in financial asset and then getting out of it and back into cash again. -Example: bid-ask spread, adding-withdrawing cash 4.Term to Maturity -The length of the interval until the date when the instrument is scheduled to make its final payment or the owner is entitled to demand liquidation. -Instrument for which the creditor can ask for repayment at any time are called demand instruments. -Financial assets with a stated maturity may terminate before its stated maturity. An early termination may occur due to bankruptcy or reorganization, provisions entitling the debtor to repay in advance or the investor may have the privilege of asking for early repayment.

5.Liquidity -According to Prof. James Tobin, liquidity is in terms of how much sellers stand to lose if they wish to sell immediately against engaging in a costly and time-consuming search. -Example of liquid assets: bank deposits -Example of illiquid assets: Stocks, bonds, pensions 6.Convertibility -Financial assets can be change or transformed into other financial assets. -The timing, costs and conditions for conversion are clearly spelled out in the legal description of the convertible security at the time of issuance.

7.Currency -Most financial assets are demominated in one currency, such as US dollar, yen, or euro and investor must choose them with that feature in mind. 8.Cash flow and return predictability -The predictability of expected return depends on the predictability of the cash flow. -Return predictability, a basic property of financial assets, provides the major determinant of their value. -In a world of nonnegligible inflation, it is important to determine the following: -Nominal expected return – dollars expected to be received with considering the changes in purchasing power. -Real expected return – nominal expected return after adjustment for the loss of purchasing power.

9.Complexity -Property of financial assets wherein they can combine two or more simpler assets. -To find the true value of such an asset, one must “decompose” in into its components parts and price each component separately. 10.Tax status -Governmental codes for taxing the income from the ownership or sale financial assets vary widely if not wildly. -Tax rate differs from year to year, country to country, and even among municipal units within a country. -Tax rates also differs depending on the type of issuer, the length of time the asset is held, the nature of owner, and alike.

Financial Markets Financial assets are exchanged (traded) in a financial market. Although the existence of a 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 organized financial market structure.

The Role of Financial Markets Price discovery process – The inducement for firms to acquire funds depends on the required return that investor demands, and this feature of financial markets signal how the funds of the economy should be allocated among financial assets. Liquidation in financial markets Reduction of search and information cost

– Search cost Represents explicit costs, such as the money spent to advertise the desire to sell or purchase a financial asset, and implicit cost such as the value of the time spent in locating a counterparty. – Information cost Incurred in assessing the investment merits of a financial asset, that is, the amount and the likelihood of the cash flow expected to be generated.

Classification of Financial Market By type of claim By maturity of claim By whether the financial claim are newly issued By organizational structure

Classification of Financial Markets by Type of Claim Fixed dollar amount claimResidual or equity claim Debt instrumentPreferred stockCommon stock Fixed income marketEquity (stock) market Debt marketCommon stock market

Classification of Financial Markets by Maturity of Claim Debt instrumentCommon stock and preferred stock Maturity 1 year or less Maturity greater than 1 year Money marketsCapital markets

Classification of Financial Market by Whether the Financial Claim are Newly Issued When an issuer sells a new financial asset to the public, it is said to “issue” the financial asset. The market for newly issued financial asset is called the primary market. After a certain period of time, the financial asset is bought and sold among investors. The market where this activity takes place is referred to as the secondary market.

Classification of Financial Market by Organizational Structure Auction market Over-the-counter market Intermediate market

Globalization of Financial Markets Globalization means the integration of financial markets throughout the world into an international financial market. The factors contributing to the integration of financial markets are: – Deregulation or liberalization of markets and the activities of market participants in key financial centers in the world. – Technological advances for monitoring world markets, executing orders, and analyzing financial opportunities. – Increased institutionalization of financial markets.

Institutionalization of financial market – Unlike retail investors, institutional investors shows greater willingness to transfer funds across national borders to improve the risk/reward opportunities of a portfolio that includes financial assets of foreign issuers. – Moreover, investors have nor limited their participation in foreign markets to those of developed economies. Participation in the financial markets of developing economies is referred to as emerging markets which continues to increase.

Classification of Global Financial Markets Internal market (also called national market) External market (also called international market, offshore market or Euromarket) Domestic marketsForeign markets

Derivatives Market The contracts that derive their value from the price of the underlying financial assets. The array of derivative instruments includes: – Option contracts – Future contracts – Forward contracts – Swap agreements – Cap and floor agreements

The key role of derivative instruments in global financial markets was expressed in a May 1994 report published by US General Accounting Office (GAO) titled Financial Derivatives: Actions Needed to Protect the Financial System: Derivatives serves as an important function of the global financial marketplace, providing end- users with opportunities to better manage financial risks associated with their business transactions. The rapid growth and increasing complexity of derivatives reflects both the demand from end users for better way to manage their financial risks and the innovative capacity of the financial services industry to respond to market demands.

Major Asset Classes Common stock Bond Cash equivalents Real estate

Types of US securities US common stocks Non-US common stocks US bonds Non-US bonds Cash equivalents Real estate Types of US common stocks Large capitalization stocks Mid capitalization stocks Small capitalization stocks Growth stocks Value stocks

Types of US bonds US government bonds Investment-grade corporate bonds High-yield corporate bonds US municipal bonds Mortgage-backed securities Asset-backed securities Types of non-US stocks and bonds Developed market foreign stocks Developed market foreign bond Emerging market foreign stocks Emerging market foreign bonds

With the exception of real estate, all the asset classes are referred to as traditional asset classes. Real estate and all other assets that are not in included in the abovementioned classification are referred to as non-traditional asset classes or alternative asset classes. They include commodities, private equities, hedge funds and currencies.

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