CHAPTER 1
INTRODUCTION
This chapter discusses the basic characteristics and functions of financial assets and markets.
FINANCIAL ASSETS
An asset is any possession that has value in an exchange. A tangible asset is an asset that takes
physical form, such as a building or machinery. An intangible asset represents legal claims to some
future benefit. A financial asset is a security or financial instrument, and it is an intangible asset
representing a claim to future cash flow.
An issuer is an entity that agrees to make future cash payments. An investor is a person who owns a
financial asset.
Debt Versus Equity Claims
A debt instrument is a financial asset that pays a fixed dollar amount. An equity claim is a claim on
the residual cashflow. Common stock is an example of an equity claim. Some financial instruments are
hybrids. For example, preferred stock pays a fixed amount, but only after creditors are paid, and a
convertible bond pays a fixed amount, but may be convertible into common stock.
The Value of a Financial Asset
The price of any financial asset is the present value of the expected cash flow. Cash flow is the cash
expected to be received from each period from investing in a particular financial asset (e.g., dividends,
principal repayment, interest). The cash can be in any form of currency (e.g., U.S. dollars, European
euros, Japanese yen).
,Estimating the Cash Flow
Some cash flows of debt instruments are said to be certain and risk free (e.g., U.S. government issued
debt). Others are uncertain and carry risk. Debt instruments have three risks: (1) issuer default, (2)
contractual rights to change how the principal and interest are repaid, (3) interest rate fluctuation
during the time the debt is outstanding.
As for equity, the amount and timing of dividends are uncertain, and the value of the common stock
fluctuates with the market.
With both equity and debt instruments, the nominal dollar amount of the cash flow does not adjust for
any changes in the real purchasing power of the cash flow. Because of inflation, the purchasing power
may change even as the nominal amount is fixed.
The Appropriate Interest Rate for Discounting the Cash Flow
Once the cash flow is estimated, the investor must answer two questions to value the instrument: (1)
what is the minimum interest rate? (2) what premium above this minimum is needed?
The minimum interest rate, or discount rate, is the risk free rate, e.g., U.S. Treasury securities, other
default free sovereign debt, or the London interbank offered rate (LIBOR). The premium above this
minimum rate is determined by the riskiness of the cash flow. The more risky the cash flow, the more
the investor seeks a premium.
Thus far, there are three forms of risk discussed: credit (default) risk is the risk of not getting paid by
the issuer; inflation (purchasing power) risk is the risk that the purchasing power of the cash flow
will decline with inflation; foreign exchange risk is the risk that cash flow paid in a foreign currency
will decline in value as it is converted to domestic currency.
Financial Assets Versus Tangible Assets
,Both financial and tangible assets are expected to generate future cash flows for its owner. They are
linked. Ownership of a tangible asset is financed by the issuance of a financial asset. The cash flow for a
financial asset is generated by a tangible asset.
The Role of Financial Assets
Financial assets serve two principal economic functions: (1) to transfer funds from those who have
surplus funds to those who need funds to invest in tangible assets, (2) to transfer funds in such a way
as to redistribute the unavoidable risk associated with cash flows generated by tangible assets.
Properties of Financial Assets
Financial assets possess, in varying degrees, certain properties that determine or influence their
attractiveness to different classes of investors and issuers. There are ten properties of financial assets.
Moneyness
Money is a financial asset that acts a medium of exchange or in settlement of transactions. Near
money is a financial asset that closely approximates money. Moneyness is the property of
exchangeability between financial assets and money. Moneyness is desirable for investors.
Divisibility and Denomination
This property is related to the minimum size in which a financial asset can be liquidated and
exchanged for money. Divisibility may depend on the denomination. The smaller the size, the more the
financial asset is divisible. Divisibility is desirable for investors.
Reversibility
, This refers to the cost of investing in a financial asset and then getting out of it and back into cash again
(round-trip cost). For financial assets that are traded in organized markets and with market makers,
the most relevant component of this cost is the bid-ask spread. This constitutes the spread between
the price at which the market-maker is willing to buy the financial asset (bid price) and the price at
which the market-maker is willing to sell (ask price). The bid-ask spread is determined by two factors:
(1) variability of price as determined by the dispersion of relative price over time, (2) the thickness of
the market, essentially the prevailing rate at which buying and selling orders reach the market maker
(i.e., the frequency of transactions).
Term to Maturity
This is the length of the interval until the date at which the instrument is scheduled to make its final
payment, or the time until the owner is entitled to demand liquidation. Demand instruments are
instruments where the creditor can demand repayment at any time. Maturities vary and some
instruments can be repaid earlier than maturity due to contractual provisions or arrangements, and
bankruptcy and reorganization.
Liquidity
Although there is at present no uniformly accepted definition of liquidity, a useful way to think of
liquidity and illiquidity is in terms of how much the seller stands to lose if he wishes to sell
immediately rather than allowing some time to pass and instead engaging in a costly and time-
consuming search for an immediate buyer. Some financial assets are illiquid, e.g., stock in small
companies. One must search for a buyer. Other assets may be very liquid in small amounts, but illiquid
in big amounts.. Liquidity is closely related to the thickness of the market.
Convertibility
This refers to the notion that some financial assets can be converted into other assets, e.g., a
convertible bond or a share of convertible preferred stock can be converted into common stock.
Currency
INTRODUCTION
This chapter discusses the basic characteristics and functions of financial assets and markets.
FINANCIAL ASSETS
An asset is any possession that has value in an exchange. A tangible asset is an asset that takes
physical form, such as a building or machinery. An intangible asset represents legal claims to some
future benefit. A financial asset is a security or financial instrument, and it is an intangible asset
representing a claim to future cash flow.
An issuer is an entity that agrees to make future cash payments. An investor is a person who owns a
financial asset.
Debt Versus Equity Claims
A debt instrument is a financial asset that pays a fixed dollar amount. An equity claim is a claim on
the residual cashflow. Common stock is an example of an equity claim. Some financial instruments are
hybrids. For example, preferred stock pays a fixed amount, but only after creditors are paid, and a
convertible bond pays a fixed amount, but may be convertible into common stock.
The Value of a Financial Asset
The price of any financial asset is the present value of the expected cash flow. Cash flow is the cash
expected to be received from each period from investing in a particular financial asset (e.g., dividends,
principal repayment, interest). The cash can be in any form of currency (e.g., U.S. dollars, European
euros, Japanese yen).
,Estimating the Cash Flow
Some cash flows of debt instruments are said to be certain and risk free (e.g., U.S. government issued
debt). Others are uncertain and carry risk. Debt instruments have three risks: (1) issuer default, (2)
contractual rights to change how the principal and interest are repaid, (3) interest rate fluctuation
during the time the debt is outstanding.
As for equity, the amount and timing of dividends are uncertain, and the value of the common stock
fluctuates with the market.
With both equity and debt instruments, the nominal dollar amount of the cash flow does not adjust for
any changes in the real purchasing power of the cash flow. Because of inflation, the purchasing power
may change even as the nominal amount is fixed.
The Appropriate Interest Rate for Discounting the Cash Flow
Once the cash flow is estimated, the investor must answer two questions to value the instrument: (1)
what is the minimum interest rate? (2) what premium above this minimum is needed?
The minimum interest rate, or discount rate, is the risk free rate, e.g., U.S. Treasury securities, other
default free sovereign debt, or the London interbank offered rate (LIBOR). The premium above this
minimum rate is determined by the riskiness of the cash flow. The more risky the cash flow, the more
the investor seeks a premium.
Thus far, there are three forms of risk discussed: credit (default) risk is the risk of not getting paid by
the issuer; inflation (purchasing power) risk is the risk that the purchasing power of the cash flow
will decline with inflation; foreign exchange risk is the risk that cash flow paid in a foreign currency
will decline in value as it is converted to domestic currency.
Financial Assets Versus Tangible Assets
,Both financial and tangible assets are expected to generate future cash flows for its owner. They are
linked. Ownership of a tangible asset is financed by the issuance of a financial asset. The cash flow for a
financial asset is generated by a tangible asset.
The Role of Financial Assets
Financial assets serve two principal economic functions: (1) to transfer funds from those who have
surplus funds to those who need funds to invest in tangible assets, (2) to transfer funds in such a way
as to redistribute the unavoidable risk associated with cash flows generated by tangible assets.
Properties of Financial Assets
Financial assets possess, in varying degrees, certain properties that determine or influence their
attractiveness to different classes of investors and issuers. There are ten properties of financial assets.
Moneyness
Money is a financial asset that acts a medium of exchange or in settlement of transactions. Near
money is a financial asset that closely approximates money. Moneyness is the property of
exchangeability between financial assets and money. Moneyness is desirable for investors.
Divisibility and Denomination
This property is related to the minimum size in which a financial asset can be liquidated and
exchanged for money. Divisibility may depend on the denomination. The smaller the size, the more the
financial asset is divisible. Divisibility is desirable for investors.
Reversibility
, This refers to the cost of investing in a financial asset and then getting out of it and back into cash again
(round-trip cost). For financial assets that are traded in organized markets and with market makers,
the most relevant component of this cost is the bid-ask spread. This constitutes the spread between
the price at which the market-maker is willing to buy the financial asset (bid price) and the price at
which the market-maker is willing to sell (ask price). The bid-ask spread is determined by two factors:
(1) variability of price as determined by the dispersion of relative price over time, (2) the thickness of
the market, essentially the prevailing rate at which buying and selling orders reach the market maker
(i.e., the frequency of transactions).
Term to Maturity
This is the length of the interval until the date at which the instrument is scheduled to make its final
payment, or the time until the owner is entitled to demand liquidation. Demand instruments are
instruments where the creditor can demand repayment at any time. Maturities vary and some
instruments can be repaid earlier than maturity due to contractual provisions or arrangements, and
bankruptcy and reorganization.
Liquidity
Although there is at present no uniformly accepted definition of liquidity, a useful way to think of
liquidity and illiquidity is in terms of how much the seller stands to lose if he wishes to sell
immediately rather than allowing some time to pass and instead engaging in a costly and time-
consuming search for an immediate buyer. Some financial assets are illiquid, e.g., stock in small
companies. One must search for a buyer. Other assets may be very liquid in small amounts, but illiquid
in big amounts.. Liquidity is closely related to the thickness of the market.
Convertibility
This refers to the notion that some financial assets can be converted into other assets, e.g., a
convertible bond or a share of convertible preferred stock can be converted into common stock.
Currency
