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Capital Markets. Introduction. Chapter 1 Lecture 1. 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
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Introduction Chapter 1 Lecture 1
Chapter 1IntroductionLearning 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
Financial Assets • 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
Debt Vs Equity Claims • 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.
Financial Markets • 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)
Derivative Instruments • 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.
