CHAPTER 1
INTRODUCTION
FINANCIAL ASSETS
An asset is any possession that has value in an exchange. It can be tangible or intangible, the latter being a
financial asset. Specifically, a financial asset is a claim to a future benefit. For example, in the case of an
automobile loan the borrower issues a note to the lender, who now holds a claim to future cash flows.
Debt versus Equity Instruments
A debt instrument is a contractual claim, paying fixed dollar amounts. An equity instrument (or residual claim)
obligates the issuer to pay the holder an amount based on earnings after holders of debt instruments are paid.
Some securities combine both debt and equity features, such as preferred stock or convertible debt.
Price of a Financial Asset and Risk
The price (or value) of any financial asset is equal to the present value of expected cash flows. The return on an
asset is the amount paid to the investor relative to the price paid by him. Related to return is the degree of risk,
namely the certainty of expected cash flows. The degree of risk ranges from very low -- as in the case of payments
on U.S. Treasury securities -- to very high in the cases of some equities and low-rated bonds. Uncertainty or risk
takes several forms: (1) purchasing power risk (or inflation risk); (2) credit or default risk; (3) foreign
exchange risk.
Financial Assets versus Tangible Assets
,Both types of assets are expected to generate cash flows to their owners. They are also linked in the sense that
tangible assets are financed by the issuance of some type of financial claim, e.g. mortgages finance commercial
buildings. The use of the offices generates income that helps pay off the loan.
Role of Financial Assets
The principal economic functions of financial assets are: (1) to transfer funds from persons who have surplus funds
to those who need funds to invest in tangible assets (e.g. mortgage funds lending to homebuyers); (2) 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 (seekers of funds ask others to share the risks in their
undertakings).
,FINANCIAL MARKETS
Financial markets where financial assets are exchanged. Delivery of the actual asset may occur immediately ( spot
or cash market) or in the future (future or forward market).
Role of Financial Markets
Financial markets provide the following functions.
1. Price discovery process. Price is determined by supply and demand, the interaction of buyers and sellers. The
returns provide signals for funds allocations among investments;
2. Liquidity. Well-developed markets provide an opportunity to convert a financial asset into cash at close to real
value of the asset;
3. Reduced transactions costs. In the price discovery process, searching for counter parties and information
costs (assessing merits of an investment or the likelihood of expected cash flows) are costly. An informationally
efficient market exists when prices reflect all information known by market participants.
Classification of Financial Markets
There are various ways to classify financial markets.
Maturity of claim. Money market for financial instruments a year or less to maturity. Capital market for securities
longer than a year.
Seasoning of claim. Primary market is for new or first issue market. Secondary market involves sales of previously
marketed claims.
, Time of delivery. While prices are set immediately, the actual delivery of the financial asset may be now (spot or
cash market) or later (futures or forward market).
Organizational structure. Auction market involving brokers acting for clients in organized exchanges, over-the-
counter markets (OTC) wherein trades are made through dealers who buy for and sell from their own inventory.
In intermediated markets, financial institutions sell their own securities issues to customers and invest the
proceeds.
Market Participants
Participants run the full range, from households, non-financial business firms, financial institutions, and public
regulators.
INTRODUCTION
FINANCIAL ASSETS
An asset is any possession that has value in an exchange. It can be tangible or intangible, the latter being a
financial asset. Specifically, a financial asset is a claim to a future benefit. For example, in the case of an
automobile loan the borrower issues a note to the lender, who now holds a claim to future cash flows.
Debt versus Equity Instruments
A debt instrument is a contractual claim, paying fixed dollar amounts. An equity instrument (or residual claim)
obligates the issuer to pay the holder an amount based on earnings after holders of debt instruments are paid.
Some securities combine both debt and equity features, such as preferred stock or convertible debt.
Price of a Financial Asset and Risk
The price (or value) of any financial asset is equal to the present value of expected cash flows. The return on an
asset is the amount paid to the investor relative to the price paid by him. Related to return is the degree of risk,
namely the certainty of expected cash flows. The degree of risk ranges from very low -- as in the case of payments
on U.S. Treasury securities -- to very high in the cases of some equities and low-rated bonds. Uncertainty or risk
takes several forms: (1) purchasing power risk (or inflation risk); (2) credit or default risk; (3) foreign
exchange risk.
Financial Assets versus Tangible Assets
,Both types of assets are expected to generate cash flows to their owners. They are also linked in the sense that
tangible assets are financed by the issuance of some type of financial claim, e.g. mortgages finance commercial
buildings. The use of the offices generates income that helps pay off the loan.
Role of Financial Assets
The principal economic functions of financial assets are: (1) to transfer funds from persons who have surplus funds
to those who need funds to invest in tangible assets (e.g. mortgage funds lending to homebuyers); (2) 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 (seekers of funds ask others to share the risks in their
undertakings).
,FINANCIAL MARKETS
Financial markets where financial assets are exchanged. Delivery of the actual asset may occur immediately ( spot
or cash market) or in the future (future or forward market).
Role of Financial Markets
Financial markets provide the following functions.
1. Price discovery process. Price is determined by supply and demand, the interaction of buyers and sellers. The
returns provide signals for funds allocations among investments;
2. Liquidity. Well-developed markets provide an opportunity to convert a financial asset into cash at close to real
value of the asset;
3. Reduced transactions costs. In the price discovery process, searching for counter parties and information
costs (assessing merits of an investment or the likelihood of expected cash flows) are costly. An informationally
efficient market exists when prices reflect all information known by market participants.
Classification of Financial Markets
There are various ways to classify financial markets.
Maturity of claim. Money market for financial instruments a year or less to maturity. Capital market for securities
longer than a year.
Seasoning of claim. Primary market is for new or first issue market. Secondary market involves sales of previously
marketed claims.
, Time of delivery. While prices are set immediately, the actual delivery of the financial asset may be now (spot or
cash market) or later (futures or forward market).
Organizational structure. Auction market involving brokers acting for clients in organized exchanges, over-the-
counter markets (OTC) wherein trades are made through dealers who buy for and sell from their own inventory.
In intermediated markets, financial institutions sell their own securities issues to customers and invest the
proceeds.
Market Participants
Participants run the full range, from households, non-financial business firms, financial institutions, and public
regulators.
