Download financial market

CHAPTER 1
INTRODUCTION
Dr. Shirley E. Maranan
Learning Objectives
After reading this chapter you will understand:
• What a financial asset is.
• The distinction between a debt instrument and
an equity instrument.
• The general principles for determining the price
of a financial asset.
• Ten properties of financial assets.
• The principal economic functions of financial
asset.
Learning Objectives
• The different ways to classify a financial market.
• What is meant by a derivative instrument.
• The reasons for the globalization of financial
markets.
• The classification of global financial markets.
• What is meant by an asset class
• What a financial market is and principal economic
functions it performs.
In a market economy, the allocation of
economic resources is driven by the outcome of
many private decisions. Prices are the signals
that direct economic resources to their best use.
The types of markets in an economy can be
divided into (1) the market for products
(manufactured goods and services), or the
product market; and (2) the market for the
factors of production (labor and capital), or the
factor market.
Financial Assets
• Asset – any possession that has value in an
exchange.
– Tangible
- depends on particular physical
properties or reproducible assets.
Example: Building, land, machinery
– Intangible – represents legal claims to some future
benefit. Their value bears no relation to the form,
physical or otherwise, in which the claims are
recorded (future cash).
Example: Financial assets, financial instruments or
securities.
In financial assets there is an:
- Issuer of the financial asset
- The entity that agrees to make future cash
payments.
- Investor
- The owner of the financial asset
Examples of financial asset:
•
•
•
•
A bond issued by the US Department of Treasury
A bond issued by General Electric Corporation
A bond issued by the state of California
A bond issued by the government of the
Philippines
• An automobile loan
• A home mortgage loan
• Common stock issued by Microsoft Corporation
Debt vs. Equity Claims
The claims of the holder of a financial asset may be
either a fixed dollar amount or a varying, or
residual, amount. In the former case, the financial
assets is referred to as a debt instrument since it
requires fixed dollar payments to borrow the
funds (bonds).
An equity claim (residual claim) obligates the issuer
of the financial asset to pay the holder an amount
based on earnings. If any, after holder of debt
instrument have been paid. Example: common
stock
The Value of a Financial Asset
• Valuation is the process of determining the
fair value or price of a financial asset.
• The fundamental principle of a financial asset
if the present value of the cash flow expected.
This principle applies regardless of the
financial asset. Consequently, it applies
equally to common stock , a bond, a loan or
real estate.
• The principle is simple: Just determine the
cash flow and the calculate the PV.
Process For Valuing a Financial Asset
Estimate the cash flow
(cash flow = interest, principal repayment, dividends,
expected sale price of an asset
Determine the appropriate interest rate for
discounting the cash flow
* Minimum interest rate
* Plus premium required for perceived risk
Value of financial asset =
PV of expected cash flow
Types of Risks in Financial Asset
• Credit risk (default risk)
– The risk that the issuer or borrower will default on
the obligation.
• Purchasing power (inflation risk)
– The risk attached to the potential purchasing
power of the cash flow expected .
• Foreign exchange risk
– Financial assets whose cash flow is not
denominated in US dollar and entail a risk that the
exchange rate will change adversely resulting in
fewer US dollars.
Principal Economic Functions of
Financial Assets
• Transfer funds from those parties who have
surplus funds to invest to those who need
funds to invest in tangle assets.
• Transfer funds in such a way as to redistribute
the unavoidable risk associated with the cash
flow generated by the tangible assets among
those seeking and those providing the funds.
However, the claims held by the final wealth
holder generally differ from the liabilities issued
by the final demanders of funds because of the
activity of entities operating in financial markets,
called the financial intermediaries.
Properties of Financial Assets
1. Moneyness
-
-
Some financial assets acts as a medium or in
settlement of transaction and these are money
(currency and all forms of deposits).
Near money are other financial assets, although not
money, closely approximate money in that they can
be transformed into money at little cost delay or risk
(time and savings deposit, security)
2. Divisibility and Denomination
-
It relates to the minimum size at which a financial
asset can be liquidated and exchange for money. The
smaller the size, the more financial asset is divisible.
3. Reversibility (Round-trip cost)
-
It refers to the cost of investing in financial asset and
then getting out of it and back into cash again.
Example: bid-ask spread , adding-withdrawing cash
4. Term to Maturity
-
-
The length of the interval until the date when the
instrument is scheduled to make its final payment or
the owner is entitled to demand liquidation.
Instrument for which the creditor can ask for
repayment at any time are called demand
instruments.
Financial assets with a stated maturity may
terminate before its stated maturity. An early
termination may occur due to bankruptcy or
reorganization, provisions entitling the debtor to
repay in advance or the investor may have the
privilege of asking for early repayment.
5. Liquidity
-
-
According to Prof. James Tobin, liquidity is in
terms of how much sellers stand to lose if they
wish to sell immediately against engaging in a
costly and time-consuming search.
Example of liquid assets: bank deposits
Example of illiquid assets: Stocks, bonds,
pensions
6. Convertibility
-
Financial assets can be change or transformed
into other financial assets.
The timing, costs and conditions for conversion
are clearly spelled out in the legal description of
the convertible security at the time of issuance.
7. Currency
-
Most financial assets are demominated in one
currency, such as US dollar, yen, or euro and investor
must choose them with that feature in mind.
8. Cash flow and return predictability
-
The predictability of expected return depends on the
predictability of the cash flow.
Return predictability, a basic property of financial
assets, provides the major determinant of their
value.
In a world of nonnegligible inflation, it is important
to determine the following:
-
Nominal expected return – dollars expected to be received
with considering the changes in purchasing power.
Real expected return – nominal expected return after
adjustment for the loss of purchasing power.
9. Complexity
-
Property of financial assets wherein they can
combine two or more simpler assets.
To find the true value of such an asset, one must
“decompose” in into its components parts and price
each component separately.
10.Tax status
-
Governmental codes for taxing the income from the
ownership or sale financial assets vary widely if not
wildly.
Tax rate differs from year to year, country to country,
and even among municipal units within a country.
Tax rates also differs depending on the type of issuer,
the length of time the asset is held, the nature of
owner , and alike.
Financial Markets
Financial assets are exchanged (traded) in a
financial market.
Although the existence of a financial market is
not a necessary condition for the creation and
exchange of a financial asset, in most economies
financial assets are created and subsequently
traded in some type of organized financial
market structure.
The Role of Financial Markets
• Price discovery process
– The inducement for firms to acquire funds
depends on the required return that investor
demands , and this feature of financial markets
signal how the funds of the economy should be
allocated among financial assets.
• Liquidation in financial markets
• Reduction of search and information cost
– Search cost
• Represents explicit costs, such as the money spent to
advertise the desire to sell or purchase a financial asset,
and implicit cost such as the value of the time spent in
locating a counterparty.
– Information cost
• Incurred in assessing the investment merits of a
financial asset, that is, the amount and the likelihood of
the cash flow expected to be generated.
Classification of Financial Market
• By type of claim
• By maturity of claim
• By whether the financial claim are newly
issued
• By organizational structure
Classification of Financial Markets by
Type of Claim
Fixed dollar amount claim
Debt instrument
Preferred stock
Fixed income market
Debt market
Residual or equity claim
Common stock
Equity (stock) market
Common stock market
Classification of Financial Markets by
Maturity of Claim
Debt instrument
Maturity 1 year
or less
Money markets
Common stock and preferred stock
Maturity greater
than 1 year
Capital markets
Classification of Financial Market by
Whether the Financial Claim are Newly
Issued
• When an issuer sells a new financial asset to
the public, it is said to “issue” the financial
asset. The market for newly issued financial
asset is called the primary market.
• After a certain period of time, the financial
asset is bought and sold among investors. The
market where this activity takes place is
referred to as the secondary market.
Classification of Financial Market by
Organizational Structure
• Auction market
• Over-the-counter market
• Intermediate market
Globalization of Financial Markets
• Globalization means the integration of financial
markets throughout the world into an
international financial market.
• The factors contributing to the integration of
financial markets are:
– Deregulation or liberalization of markets and the
activities of market participants in key financial
centers in the world.
– Technological advances for monitoring world markets,
executing
orders,
and
analyzing
financial
opportunities.
– Increased institutionalization of financial markets.
• Institutionalization of financial market
– Unlike retail investors, institutional investors
shows greater willingness to transfer funds across
national borders to improve the risk/reward
opportunities of a portfolio that includes financial
assets of foreign issuers.
– Moreover, investors have nor limited their
participation in foreign markets to those of
developed economies. Participation in the
financial markets of developing economies is
referred to as emerging markets which continues
to increase.
Classification of Global Financial
Markets
Internal market
(also called national market)
Domestic markets
External market
(also called international
market, offshore market or
Euromarket)
Foreign markets
Derivatives Market
• The contracts that derive their value from the
price of the underlying financial assets. The
array of derivative instruments includes:
– Option contracts
– Future contracts
– Forward contracts
– Swap agreements
– Cap and floor agreements
The key role of derivative instruments in
global financial markets was expressed in a May
1994 report published by US General Accounting
Office (GAO) titled Financial Derivatives: Actions
Needed to Protect the Financial System:
Derivatives serves as an important function of
the global financial marketplace, providing endusers with opportunities to better manage
financial risks associated with their business
transactions. The rapid growth and increasing
complexity of derivatives reflects both the demand
from end users for better way to manage their
financial risks and the innovative capacity of the
financial services industry to respond to market
demands.
Major Asset Classes
•
•
•
•
Common stock
Bond
Cash equivalents
Real estate
Types of US securities
•
•
•
•
•
•
US common stocks
Non-US common stocks
US bonds
Non-US bonds
Cash equivalents
Real estate
Types of US common stocks
•
•
•
•
•
Large capitalization stocks
Mid capitalization stocks
Small capitalization stocks
Growth stocks
Value stocks
Types of US bonds
•
•
•
•
•
•
US government bonds
Investment-grade corporate bonds
High-yield corporate bonds
US municipal bonds
Mortgage-backed securities
Asset-backed securities
Types of non-US stocks and bonds
•
•
•
•
Developed market foreign stocks
Developed market foreign bond
Emerging market foreign stocks
Emerging market foreign bonds
• With the exception of real estate , all the asset
classes are referred to as traditional asset
classes.
• Real estate and all other assets that are not in
included in the abovementioned classification
are referred to as non-traditional asset
classes or alternative asset classes. They
include commodities, private equities, hedge
funds and currencies.
End…