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CHAPTER 1
Introduction
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Learning Objectives
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 assets
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3. Learning Objectives (continued)
What a financial market is and the principal economic functions it performs
The different ways to classify financial markets
What is meant by a derivative instrument
The reasons for the globalization of financial markets
What is meant by an asset class
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Financial Assets
Asset
any possession that has value in an exchange
Tangible asset
The value depends on particular physical properties (e.g. buildings, land, or machinery)
Intangible assets
Represent legal claims to some future benefit
Examples include financial assets, financial instruments, or securities
Investor
The owner of the financial asset
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Financial Assets
Financial assets include
A bond issued by the U.S. Department of the Treasury
A bond issued by General Electric Corporation
A bond issued by the state of California
A bond issued by the government of France
An automobile loan
A hone mortgage loan
Common stock issued by Microsoft Corporation
Common stock issued by Honda Motor Company
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Financial Assets
Debt versus Equity Claims
Debt instrument
the claims of the holder of a financial asset is a fixed dollar amount
Equity claim (residual claim)
obligates the issuer of the financial asset to pay the holder an amount based on earnings, if any, after holders of debt instruments have been paid
Fixed income instruments
both debt and preferred stock that pays a fixed dollar amount
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Financial Assets
The Value of a Financial Asset
Valuation
The process of determining the fair value or price of a financial asset
Fundamental principle of valuation
The value of any financial asset is the present value of the cash flow expected
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Financial Assets
The Value of a Financial Asset
Estimating the cash flow
Cash flow – the cash that is expected to be received each period from investing in a particular financial asset
the type of financial asset and the characteristics of the issuer determine the degree of certainty
U.S. government never defaults on debt instruments
Other debt instrument are not known with certainty
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Financial Assets
The Value of a Financial Asset
Estimating the cash flow
Three reasons why cash flow of debt instruments is not known:
The issuer might default
Provisions included in most debt instruments grant the issuer and/or the investor the right to change how the borrowed funds are repaid
The interest rate the issuer pays can change over the time the borrowed funds are outstanding
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Financial Assets
The Value of a Financial Asset
The appropriate interest rate for discounting the cash flow is determined by addressing:
What is the minimum interest rate the investor should require?
The interest rate available in the financial market on a default-free cash flow
How much more than the minimum interest rate should the investor require?
Should reflect the risks associated with realizing the cash flow expected
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11. Figure 1-1 Summary of the Process for Valuing a Financial Asset
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Financial Assets
The Value of a Financial Asset
Various types of risk include:
Credit risk (Default risk)
the risk that the issuer or borrower will default on the obligation
Purchasing power risk (Inflation risk)
the risk attached to the potential purchasing power of the cash flow expected
Foreign exchange risk
the risk that the exchange rate will change adversely
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Financial Assets
The Role of Financial Assets
Two principal economic functions:
Financial assets transfer funds from those parties who have surplus funds to invest to those who need funds to invest in tangible assets
Financial assets 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
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Financial Assets
The Role of Financial Assets
Financial intermediaries
Entities who seek to transform the final liabilities into different financial assets preferred by the public
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Financial Assets
Properties of Financial Assets
Moneyness
Divisibility and denomination
Reversibility
Term to maturity
liquidity
Convertibility
Currency
Cash flow and return predictability
Complexity
Tax status
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Financial Assets
Properties of Financial Assets
Moneyness
Money – financial assets which act as a medium of exchange or in settlement of transactions
Near money – financial assets, although not money, closely approximate money in that they can be transformed into money at little cost, delay, or risk
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Financial Assets
Properties of Financial Assets
Divisibility and denomination
Divisibility –the minimum size at which a financial asset can be liquidated and exchanged for money
The smaller the size, the more the financial asset is divisible
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Financial Assets
Properties of Financial Assets
Reversibility
Reversibility (round-trip cost) – the cost of investing in a financial asset and then getting out of it and back into cash again
Bid-ask spread –the difference between the price at which a market maker is willing to sell a financial asset and the price at which a market maker is willing to buy the financial asset
The variability of the price as measured by some measure of dispersion of the relative price over time
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Financial Assets
Properties of Financial Assets
Bid-ask spread can be related to two main forces:
The variability of the price as measured by some measure of dispersion of the relative price over time
Thickness of the market – the prevailing rate at which buying and selling orders reach the market maker
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Financial Assets
Properties of Financial Assets
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
Demand instruments – instruments for which the creditor can ask for repayment at any time
e.g. checking accounts and many savings accounts
Even a financial asset with a stated maturity may terminate before its stated maturity.
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Financial Assets
Properties of Financial Assets
Liquidity
Serves an important and widely used function, although no uniformly accepted definition is presently available
Liquidity closely related to whether a market is thick or thin. Thinness always increases the round-trip cost, even of a liquid financial asset
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Financial Assets
Properties of Financial Assets
Convertibility
The timing, costs, and conditions for conversion are clearly spelled out in the legal descriptions of the convertible security at the time of issuance
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Financial Assets
Properties of Financial Assets
Cash flow and return predictability
The predictability of the expected return depends on the predictability of the cash flow
Nominal expected return – the dollars expected to be received but does not adjust those dollars to take into consideration changes in their purchasing power
Real expected return – the nominal expected return after adjustment for the loss of purchasing power of the financial asset as a result of inflation
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Financial Assets
Properties of Financial Assets
Complexity
Combination of two or more simpler assets
To find the true value one must “decompose” or “strip” the asset into its component parts and price each component separately
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Financial Assets
Properties of Financial Assets
Tax Status
Tax rates differ from:
Year to year
Country to country
Among municipal units within a country
Financial asset to financial asset
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Financial Markets
Financial market
Where financial assets are exchanged
In most economies financial assets are created and subsequently traded in some type of organized financial market structure (i.e., exchange traded or “over-the-counter (OTC)”
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Financial Markets
The Role of Financial Markets
3 additional economic functions:
Price discovery process - the interactions of buyers and sellers in a financial market determine the price of the traded asset
Provide a mechanism for an investor to sell a financial asset
Reduces the search and information costs of transacting
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Financial Markets
The Role of Financial Markets
Search costs
Represent explicit costs
Information costs
Incurred in assessing the investment merits of a financial assets
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Financial Markets
Classification of Financial Markets
Types of financial claims
Debt market
Equity market
Stock market
Fixed income market
Common stock market
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30. Figure 1-2 Classification of Financial Markets by Type of Claim
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Financial Markets
Classification of Financial Markets
Maturity of the claims
Money market - a financial market for short-term financial assets (<= 1 year)
Capital market - the financial market for longer maturity financial assets (> 1 year)
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32. Figure 1-3 Classification of Financial Markets by Maturity of Claim
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Financial Markets
Classification of Financial Markets
Whether the financial claims are newly issued
Primary market - the market for newly issued financial assets
Secondary market - the market, where after a certain period of time, the financial asset is bought and sold among investors
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Financial Markets
Globalization of Financial Markets
The integration of financial markets throughout the world into an international financial market
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Financial Markets
Globalization of Financial Markets
Factors contributing to the integration of financial markets
Deregulation or liberalization of markets and the activities of market participants in key financial centers of the world
Technological advances for monitoring world markets, executing orders, and analyzing financial opportunities
Increased institutionalization of financial markets
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Financial Markets
Globalization of Financial Markets
Institutionalization of financial markets
The shifting of the financial markets in the U.S. and other major industrialized countries from dominance by retail investors to institutional investors
Emerging markets
Participation in the financial markets of developing economies
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37. Figure 1-4 Classification of Global Financial Markets
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Derivative Markets
Derivative instruments
Some contracts give the contract holder either the obligation or the choice to buy or sell a financial asset
Such contracts derive their value from the price of the underlying financial asset
Options contracts
Futures contracts
Forward contracts swap agreements
Cap and floor agreements
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Asset Classes
Four major asset classes:
Common stocks
Bonds
Cash equivalents
Real estate
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Asset Classes
Asset classes expanded by separating foreign securities and U.S. securities:
U.S. common stocks
Non-U.S. (or foreign) common stocks
U.S. bonds
Non-U.S. (or foreign) bonds
Cash equivalents
Real estate
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Asset Classes
U.S. common stocks classified as asset classes:
Large capitalization stocks
Mid capitalization stocks
Small capitalization stocks
Growth stocks
Value stocks
*market capitalization = total market value of its common stock outstanding
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Asset Classes
U.S. bonds classified as asset classes:
U.S. government bonds
Investment-grade corporate bonds
High-yield corporate bonds
U.S. municipal bonds
Mortgage-backed securities
Asset-backed securities
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Asset Classes
Non-U.S. stocks and bonds classified as asset classes:
Developed market foreign stocks
Developed market foreign bonds
Emerging market foreign stocks
Emerging market foreign bonds
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Asset Classes
Characteristics of emerging markets:
Have economies that are in transition but have started implementing political, economic, and financial markets reforms in order to participate in global capital market
May expose investors to significant price volatility attributable to political risk and the unstable value of their currency
Have a short period over which their financial markets have operated
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