INTRODUCTION TO FINANCIAL INSTITUTIONSLecturer: Mahwish Khokhar

Frank J. FabozziFranco Modigliani

Frank J. JonesMicheal G. Ferri

Financial Assets An asset is any possession that has value in an

exchange.

Assets can be classified into two categories:

1. Tangible: whose value depend on particular physical property

2. Intangible: Legal claim for some future benefits. Their values bear no relations to the form physical or otherwise, in which these claims are recorded.

Debt vs. Equity Instruments

Debt Instrument: the claim that a holder of a financial asset has may be either a fixed amount, or varying, or residual amount.

FOR EXAMPLE: Car loan, US treasury Bond, GM Corporation Bonds etc.

Cont’d..

Equity Instrument: (also called residual claim) obliges the issuer of Financial Asset to pay the holder an amount based on earnings, if any, after holder of debt instrument is paid.

FOR EXAMPLE: Common Stock, Partnership Share and Preferred Stock.

The Price of FA and Risk

Price of a FA is equal to the present value of expected cash flow even if the cash flow is not known with certainty.

Types of Risks:1. Purchasing Power Risk or Inflation Risk

2. Credit Risk of Default Risk

3. Exchange Rate Risk

Financial Assets vs. Tangible Assets

FA and TA share a common characteristic, both are suppose to bring benefit or their owner. Both bring future cash flows (CFs) to the owner.

FA and TA are linked. FA or debt instrument or equity instrument are all used to buy tangible assets for the owner.

The Role of Financial Assets

FA has two principle economic functions:1. Transfer funds from those who have surplus

funds to invest in TA.2. Transfer funds in such a way as to

redistribute the unavoidable risk associated with Cash Flows generated by the tangible assets among those seeking and providing the funds.

Financial Markets

FM is a market where FA are exchanged (i.e. traded). Although the existence of financial markets is not necessary to trade securities in most economies.

The market in which financial assets are traded for immediate delivery is called SPOT or CASH MARKET.

Cont’d.. Role of Financial Markets

Primarily there is interaction of buyers and sellers to determine the price of the traded asset. (Demand and Supply)

Or, equivalently determine the required rate of return on the FA. This process is called the price discovery method.

Cont’d..

Secondly, financial markets provide a mechanism for an investor to sell a FA. Because of this feature, it is said that FM offers liquidity, an attractive feature when circumstances force investor to sell. If there is no liquidity the investors will be forced to hold the debt instrument until it matures and an equity instrument until a company is voluntarily or involuntarily liquidated.

Cont’d..

Third function of the financial market is that it reduces the transaction costs.

There are two costs associated with the transacting:1. Search Costs: it represent the explicit costs, such as

the money spent to advertise one’s intentions to sell or purchase a financial asset.

2. Information Costs: it represent implicit costs associated with the time spent to find the counterparty.

Cont’d.. Classification of the Financial Markets

There are many ways to classify the Financial Markets. One way is by the type of financial claim, such as debt markets and equity markets. Another is by maturity of the claim.

For Example: There is a FM for short term debt instruments, called the money market and one for longer maturity FAs called the capital markets.

Difference Between Capital Market and Money Market

A financial market is a market that brings buyers and sellers together to trade in financial assets such as stocks, bonds, commodities, derivatives and currencies. The purpose of a financial market is to set prices for global trade, raise capital and transfer liquidity and risk. Although there are many components to a financial market, two of the most commonly used are money markets and capital markets. 

Money markets are used for a short-term basis, usually for assets up to one year. Conversely,capital markets are used for long-term assets, which are any asset with maturity greater than one year. Capital markets include the equity (stock) market and debt (bond) market. Together the money and capital markets comprise a large portion of the financial market and are often used together to manage liquidity and risks for companies, governments and individuals.

Cont’d..

Money Market Instruments consists of Money market securities consist of negotiable certificates of deposit (CDs), bankers acceptances, U.S. Treasury bills, commercial paper, municipal notes, federal funds and repurchase agreements (repos).

Both the stock and bond markets are parts of the capital markets. For example, when a company conducts an IPO, it is tapping the investing public for capital and is therefore using the capital markets. This is also true when a country's government issues Treasury bonds in the bond market to fund its spending initiatives.

Cont’d..

FM’s can be categorized as those dealing with the financial claims that are newly issued, called the primary market.

And those for exchanging financial claims that are previously issued, called the secondary markets or the market for secondary instruments.

Bullish and Bearish Market

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Assignment # 1

Explain the difference between tangible and intangible assets and how they are related?

A US investor who purchases the bonds issued by the US. Government made the following statement: “By buying this debt instrument I am not exposed to default risk or purchasing power risk.” Explain why you agree or disagree with this statement?

What is the basic principle in determining the price of a financial asset?