Saturday, 11 May 2013

A Background to Financial Assets

Financial markets essentially revolve around the buying and selling of assets, intangible assets to be precise. An intangible asset is an asset that's physical properties are irrelevant to its value - it tends to just be a piece of paper.  The relevant part is the future claim to some income or benefit that the asset legally entitles the owner to. The owner of the asset would be referred to as the investor, whereas the person/institution that is agreeing to pay out in the future is known as the issuer. Examples of these intangible, also known as financial, assets would be common stock, bonds, loans or mortgages to name but a few. These differ from tangible assets. The value of a tangible asset is derived directly from its physical properties. Examples of these would be a house or a car.

The return the investor receives on these financial assets depends on what sort of asset they've purchased. It could be an equity instrument or a debt instrument. If the investor has purchased an equity instrument then the issuer will be paying an amount out depending on the earnings of the asset. So, for example, an equity instrument could be a partnership share in a business. The issuer would then pay the investor an amount depending on the profits earned by the business. In contrast to this, a debt instrument involves fixed payments to the investor. These would be loans or bonds, when a fixed interest rate is paid out. One exception to the rule would be a convertible bond - these allow the investor to switch between debt and equity if certain conditions are met.

Financial assets play two key roles in the economy. They are a method of transferring funds to those who need them to purchase tangible assets from those who have excess funds. They also act as a method of redistributing the risk that comes with the cash flow generated by tangible assets among those seeking and those providing the funds.  

The price of an asset is the most important factor - this is essentially what determines whether people will buy and/or sell. The basic principle to follow is that the price of the asset is equal to the current value of its expected cash flow. The certainty of that cash flow is what causes variations in the price of the asset. The assets are all subject to risk, and it's this risk that can cause price fluctuations, allowing investors to potentially profit. The three main risks that financial assets are subject to are the following:
  • Purchasing Power Risk - This is to do with the rate of inflation. The rate of inflation will affect the real value of the financial asset and thus cause the price to fluctuate.
  • Credit/Default risk - This is the risk that the issuer will default on their obligation. Or, in Lehman's terms, the risk that the person agreeing to pay up cannot pay up, causing the investor to lose money.
  • Foreign Exchange Risk - The risk associated with the value of the currency changing and potentially being worth less.

There is a relationship between tangible and financial assets. Financial assets tend to be used to finance tangible assets. So a debt instrument may be issued to generate funds to buy some delivery vehicles, for example.

There's a simple introduction to financial assets.  An intangible asset that legally obliges the issuer to pay the investor an agreed amount in the future. The play a pivotal role in the economy - moving funds around from those with an excess to those that need them. The price is determined by how much the asset is expected to bring in at a future date, this value is subject to fluctuations caused by different types of risk. Hope that all makes sense 

1 comment:

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