3 Chapter 1 Introduction Learning Objectives What a Financial Asset isThe distinction between Debt & an Equity instrumentThe general purpose for determining the price of an AssetProperties of Financial AssetsPrinciple Economic Functions of Financial AssetsWhat a Financial Market is & its principle Economic FunctionsDifferent ways to classify Financial MarketsWhat is meant by Derivative InstrumentsGlobalization of financial Markets
5 Financial AssetsAn Asset is any possession that has value in exchange.Assets can be classified as tangibles or intangibles.Tangible Assets is one whose value depends on particular physical properties.Intangible Asset represents legal claim to some future benefit.For Financial Instruments, the typical Future benefit is a claim to future cash.Issuer Vs Investor
7 Debt Vs Equity ClaimsIn case of Debt instruments, the claim that the holder has is a fixed dollar amount.An 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.Hybrid Financial Assets
8 The Value of a Financial Asset Valuation is the process of determining the fair value or price of Financial AssetThe fundamental Principle of valuation is that the value of any financial Asset is the Present Value of the cash flow expectedThe type of financial Asset, weather debt instrument or an equity instrument, and the characteristics of the issuer determines the degree of certainty of cash flows expected.Inflation EffectThe appropriate interest rate for discounting the cash flows
9 Summary of the process for valuing a financial Asset Estimate The Cash flow(Cash flow = interest, principle, dividends, expected sale price of stock)Determine the appropriate interest rate for discountingMinimum interest rate on U.S Treasury SecuritiesPlus Premium required for perceived riskValue of Financial Asset = Present Value of Expected Cash flows
10 The role of Financial Assets The first is to transfer funds from those who have surplus funds to those who need funds to invest in tangible Assets.The second function is transferring funds in such a way as to redistribute the unavoidable risk associated with the cash flow generated by tangible Assets among those seeking & those providing for funds
11 Properties of Financial Assets MoneynessDivisibilityReversibilityTerm to maturityLiquidityConvertibilityCurrencyCash flow & return predictabilityComplexityTax status
12 Properties of Financial Assets MoneynessSome financial Assets are used as medium of exchange or in settlement of transactionsDivisibilityRelates to the minimum size at which at which a financial Asset can be liquidated and exchanged for moneyReversibility(round-trip cost) Depends on Price volatility & liquidityTerm to maturityThe term to maturity is the length of the interval until the date when the instrument is scheduled to make its final payment.LiquidityLiquidity depends not only on the financial asset but also on the quantity one wishes to buy & sell.
13 Properties of Financial Assets ConvertibilityAn important property of some financial Assets is that they are convertible into other financial AssetsCurrencyMost financial Assets are denominated in one currency but there are dual-currency securities as well.Cash flow & return predictabilityThe return that an investor will realize by holding a financial asset depends on a cash flow that is expected to be received.Complexity(Convertible Bonds, callable Bonds, Putable Bonds)Tax StatusGovernmental codes for taxing the income form the ownership or sale of financial Assets vary widely.
15 Financial MarketsA financial Market is a market where Financial Assets are exchanged.
16 Role of Financial Markets Price Discovery ProcessLiquidityReduction of search & information costs
17 Role of Financial Markets Price Discovery ProcessInteraction of buyers & sellers in a financial Market determines the price of the traded assetLiquidityFinancial Markets provide a mechanism for an investor to sell financial AssetReduction of search & information costsSearch Costs include explicit (advertisement costs) & implicit costs (opportunity costs).Information Costs are those entailed with assesing the amount & the likelihood of the cash flow expected to be generated
18 Classification of Financial Markets Type of ClaimMaturity of ClaimNew or Seasoned Issue
19 Classification of Financial Markets Type of Claim(Debt market, Stock Market)Maturity of Claim(Money Market, Capital Market)New or Seasoned Issue(Primary Market, Secondary Market)
21 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. Consequently, these contracts are called Derivative Instruments.The array of Derivative Instruments include Options Contracts, Future Contracts & Forward Contracts.
22 Globalization of Financial Markets Globalization means the integration of Financial Markets throughout the world into an international Financial Market.