Chapter 1 Introduction Learning Objectives What a Financial Asset is The distinction between Debt & an Equity instrument The general purpose for determining the price of an Asset Properties of Financial Assets Principle Economic Functions of Financial Assets What a Financial Market is & its principle Economic Functions Different ways to classify Financial Markets What is meant by Derivative Instruments Globalization of financial Markets
An 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
In 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
The Value of a Financial Asset Valuation is the process of determining the fair value or price of Financial Asset The fundamental Principle of valuation is that the value of any financial Asset is the Present Value of the cash flow expected The 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 Effect The appropriate interest rate for discounting the cash flows
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 discounting Minimum interest rate on U.S Treasury Securities Plus Premium required for perceived risk Value of Financial Asset = Present Value of Expected Cash flows
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
Properties of Financial Assets Moneyness Divisibility Reversibility Term to maturity Liquidity Convertibility Currency Cash flow & return predictability Complexity Tax status
Properties of Financial Assets Moneyness Some financial Assets are used as medium of exchange or in settlement of transactions Divisibility Relates to the minimum size at which at which a financial Asset can be liquidated and exchanged for money Reversibility (round-trip cost) Depends on Price volatility & liquidity Term to maturity The term to maturity is the length of the interval until the date when the instrument is scheduled to make its final payment. Liquidity Liquidity depends not only on the financial asset but also on the quantity one wishes to buy & sell.
Properties of Financial Assets Convertibility An important property of some financial Assets is that they are convertible into other financial Assets Currency Most financial Assets are denominated in one currency but there are dual-currency securities as well. Cash flow & return predictability The 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 Status Governmental codes for taxing the income form the ownership or sale of financial Assets vary widely.
A financial Market is a market where Financial Assets are exchanged.
Role of Financial Markets Price Discovery Process Liquidity Reduction of search & information costs
Role of Financial Markets Price Discovery Process Interaction of buyers & sellers in a financial Market determines the price of the traded asset Liquidity Financial Markets provide a mechanism for an investor to sell financial Asset Reduction of search & information costs Search 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
Classification of Financial Markets Type of Claim Maturity of Claim New or Seasoned Issue
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)
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.
Globalization of Financial Markets Globalization means the integration of Financial Markets throughout the world into an international Financial Market.