FINANCIAL ASSET

Financial assets, also referred to as financial instruments or securities, are intangible assets. They are often used to finance the ownership of tangible assets as equipments and real estate. In general, financial assets serve two main economic functions: the first is to transfer funds from those who have surplus funds to invest to those who need a source of financing tangible assets. The second is to redistribute the risk associated to the investment in tangible assets between different counterparties according to their preferences and risk aversion. Financial assets represent legal claims to future cash expected often at a defined maturity. The counterparties involved in the agreement are the institution or entity that will pay the future cash (issuer) and the investors. Some examples of financial assets are: stocks, bonds, bank deposits, loans. All these instruments can be classified in different categories according to the features of the cash flow associated with them. They can be classified as debt instruments or equity instruments. Debt instruments as bonds or loans require a fixed amount payment; equity instruments have an uncertain cash flow, based on the issuer’s earnings. Equity instruments are also referred to as residual claims because the issuer can satisfy these claims only after holders of debt instruments have been paid. There are also fixed income instruments that can be paid only after claims on debt instruments have been satisfied. This is the case of preferred stocks and convertible bonds. In general, all financial assets present some typical properties. Financial assets can be used as a medium of exchange or can be converted into money at little cost or risk. This attractive property for investors is called moneyless. Divisibility and Denomination refers to the minimum amount or size in which assets can be traded. For instance, US bonds are generally sold in $ 1,000 denominations, commercial paper in $25,000 units and deposits are infinitely divisible. Another property of financial assets is reversibility, also referred to as turnaround cost or round-trip cost. It indicates the cost of buying an asset and then re-selling it. The Cash Flow is the return associated to the investment on financial assets corresponded in different forms according to the type of financial asset as dividends and options of stocks or coupon payments on bonds. Term to maturity is the length of the period until the final repayment date or the date at which the owner can demand the asset liquidation. In different cases the financial assets may terminate before the stated maturity (in presence of call provisions, bankruptcy of the issuer...) or can be also increased or extended on demand of both counterparties. Convertibility relates to the possibility to convert the financial assets into another type of asset. This is the case of convertible bonds and preferred stocks. Currency refers to the currency in which the asset’s cash flow is denominated. There are some assets denominated in one currency that allow to earn cash flow in a different currency (dual currency securities), created to reduce the exchange rate risk. For example, some types of Eurobonds can pay interest in one currency and principal in a second currency. Another property that characterizes financial assets is the Liquidity. The degree of liquidity of an instrument can be determined either in the financial market or it can be determined by means of contractual obligations. An example of agreement that can determine the degree of liquidity of an instrument is the claim of a private pension fund. In this case, the asset is clearly considered illiquid in that the claim can be satisfied not before the retirement date. Another basic property is the Risk/Return predictability, for which the riskiness associated to an asset depends on the uncertainty about future interest rates and future cash flow (nominal expected returns). In case the future cash flow is known in advance, as contractually determined, the uncertainty may regard only the solvency of the debtor. A financial asset can be also regarded as a combination of two or more simpler financial instruments whose value is the sum of the price of its component parts. For instance, the price of a callable bond corresponds to the price of a similar non-callable bond less the value of the option that allows the issuer to redeem the bond early. This property is called Complexity. Finally, the last property is the so-called Tax status which depends on the governmental regulations applying to the asset. The tax treatment generally varies according to the issuer and owner nature, the asset maturity, the country’s or different territorial unit's legislation, and so on.
These properties are important to determine the pricing of the financial asset. Basically, the true or correct price of a financial instrument is equal to the present value of its expected cash flow. However, there are several theories on the pricing of financial assets directly related to the notion of expected returns.

Bibliography
Fabozzi F., Modigliani F., Jones F. (2010), Foundation of Financial Markets and Institutions, Pearson International Edition.

Editor: Bianca GIANNINI 
© 2010 ASSONEBB