Chapter 1: Financial Assets and Financial Markets

What are the 4 most common ways to classify financial markets?

1) by the type of financial claim 2) by maturity of the claims 3) by whether or not the claims are newly issued 4) by organizational structure

How do you classify assets?

1) common stocks 2) bonds 3) cash equivalents 4) real estate

what are the steps of valuing an asset?

1) estimating cash flows 2) determine interest rates

what is cash flow?

the cash that is expected to be received each period from investing in a particular financial asset -note: the denomination (Euro vs. Yen for example) of the cash flow doesn't matter as long as you work in one set of units

what is an issuer?

the entity making future cash payments

How do you determine the value of a financial asset?

the fundamental principle of valuation is that the price of a financial asset is the present value of the expected cash flow

what are the factors contributing to the integration of financial markets?

- the deregulation or liberalization of markets and the activities of market participants in key financial centers of the world - technological advances for monitoring world markets, executing orders, and analyzing financial opportunities - increased institutionalization, i.e. the shift away from the dominance by retail investors to dominance by institutional investors of financial markets - none of the above factors are mutually exclusive

What is the price discovery process?

-deals with the interactions of buyers and sellers in a financial market determine the price of the traded asset or the first economic function of financial markets -it is the inducement for firms to acquire funds depends on the required returns that investors demand, and this feature of financial markets signals how the funds in the economy should be allocated among financial assets

How are financial assets and tangible assets linked?

-ownership of tangible assets is usually financed by the issuance of some type of financial asset--either debt or equity -cash flows from the tangible asset will service the obligation of the debt and comprise any residual for the equity

What are some examples of hybrid financial assets?

-preferred stock pays a fixed amount, but only after creditors are paid -convertible bonds pay a fixed amount, but can be converted to common stock

what does liquidity do for an investor to sell a financial asset in a financial market?

-this is an attractive characteristic when circumstances either force or motivate an investor to sell -without liquidity, an owner must hold a debt instruments until it matures and equity instruments until the company either voluntarily or involuntarily liquidates

what are the 2 questions needed to determine the appropriate interest rate?

-what is the minimum interest rate the investor should require? -how much more than the minimum interest rate should the investor require?

what is the traditional cutoff between short term and long term financial assets?

1 year

Why are generic fixed income instruments risky?

1) the issuer might default; 2) provisions included in most debt instruments grant the issuer or investor ability to change how the borrowed funds are rapid; 3) the interest rate the issuer pays can change over time

What 2 principal economic functions do financial assets serve?

1) they transfer funds from those who have surplus funds to invest to those who need funds to invest in tangible assets 2) in theory, they transfer funds in such a way as to redistribute the unavoidable risk associated with the cash flow generated by tangible assets

what are the 3 economic functions that financial markets provide additional to those provided by financial assets?

1)the interactions of buyers and sellers in a financial market determine the price of the traded asset 2) financial markets provide a mechanism for an investor to sell a financial asset, i.e. this feature offers liquidity 3) reduce the search and information costs of transaction

what is market capitalization?

a corporation's market capitalization is equal to the total market value of its common stock outstanding

what is an equity market or stock market?

a financial market in which equity instruments are traded

what is a debt market?

a financial market in which the debt instruments are traded

what are some examples of financial assets?

a security (equity of debt) or financial instrument (derivative)

what are derivative instruments key to?

allowing investors to more effectively implement certain investment decisions to achieve their financial goals and allowing issuers to effectively raise more funds on satisfactory terms

What is an asset?

an asset is any possession that has value in any exchange

what is a intangible asset?

an asset that represents legal claims to a future benefit, e.g. patents, trademarks, copyrights, goodwill, and brand recognition

What is a tangible asset?

an asset that takes physical form, e.g. machinery, buildings, and land (fixed assets) or inventory (current assets).

how can organizational structures be classified?

auction markets, over-the-counter markets, and intermediate markets

why is common stock also risky?

because the timing and amount of dividends can vary

why in valuation, is estimating cash flows typically the "easier" step?

because you can usually work with physical probabilities of events for estimating expected cash flows

what do both financial assets and tangible assets expect to generate?

both are expected to generate future cash flows for their owners

what is another way to classify financial markets?

by the maturity of the claims

what is a 3rd way to classify financial markets?

by whether the financial claims are newly issued or not

what is an example of equity claims (or residual claims)?

common stock

what is the sector of the stock market that does not include preferred stock?

common stock market

what is called a fixed income instrument?

debt and preferred stock

what is classified under the fixed income market?

debt instruments and preferred stock can be classified as part of this

What do risk-free assets have?

have certain cash flows, while risky assets don't

what is the foreign market?

in the foreign market of a country, securities of issuers not domiciled in the country are sold and traded

what are financial assets?

intangible assets representing claims to future cash flows

how do you classify global financial markets?

internal or external

what is a standard way of defining asset classes?

is in terms of the investment attributes that the members of the asset class have in common -or defining an asset class is based simply on the asset classification scheme used by asset manager

what is the domestic market?

is the one in which issuers domiciled in the country issue securities and those securities are subsequently traded

what is the 3rd economic function of a financial market?

is to reduce the search and information costs of transaction

what is a derivative instrument?

it derives its value from the value of an underlying asset -as with any financial asset, derivative instruments can be used for speculative purposes as well as for accomplishing a specific financial or investment objective

what is an external market or international market or offshore market or the Euromarket (even though this market is not limited to Europe it began there)?

it includes securities with the following distinguishing features: at issuance they are offered simultaneously to investors in a number of countries and they are issued outside the jurisdiction of any single country

what is a money market?

it is a financial market for short-term financial assets

what is a financial market?

it is a market in which financial assets are exchanged -the existence of a financial market is not a necessary condition for the creation and exchange of a financial asset! -however, in most economies financial assets are created and subsequently exchanged in financial markets

what is an internal market or national market?

it is the financial market of a given country, it can be decomposed into the two parts: domestic market and foreign market

what is the minimum interest rate, or discount rate?

it is the risk-free rate, for example, the rate U.S. Treasury securities in the United States, German govt. bonds in Europe, or the interbank lending rate for a region, with the London interbank offered rate (LIBOR) being the most "global" risk-free rate used

What should the premium over the interest rate on a U.S. Treasury security or other benchmark the investor should require reflect?

it should reflect the risks associated with realizing the cash flow expected. The greater the perceived risk, the larger the premium required.

what are examples of debt instruments?

loans & bonds issued by the U.S. Department of Treasury, Apple Inc., and the state of California

what can claims be traded for in a financial market?

may be traded for a fixed dollar amount (debt instruments) or for a residual amount (equity instruments)

what is included in the array of derivative instruments?

options contracts, futures contacts, forward contracts, swap agreements, and cap and floor agreements

what can preferred stock be classified as?

preferred stock represents an equity claim that entitles the investor to receive a fixed dollar amount and so this asset could be classified as part of either market

What is reflected in the prices of an informationally efficient market or an efficient market?

prices reflect the aggregate information collected by all market participants

what are some examples of cash flow?

principal repayment, dividends, interest rate

what are the 2 kinds of assets?

risk-free and risky -example: U.S. govt. issued debt and just about everything else, respectively

what does globalization mean?

the integration of financial markets throughout the world into an international financial market -because of the globalization of financial markets, entities (investors) in any country seeking to raise funds (purchase assets) need not be limited to their domestic financial markets

what is a capital market?

the market for longer-maturity financial assets

what is the primary market?

the market for newly issued assets

what is the secondary market?

the market where the financial asset is bought and sold (i.e. exchanged or traded) among investors after a certain period of time

what is an investor?

the owner of the financial asset

what are information costs?

they are 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

what do equity claims (residual claims) do?

they obligate issuer of the financial asset to pay the holder an amount based on earnings less payments to holders of debt

what do debt instruments do?

they pay a fixed dollar amount

what are search costs?

they represent explicit costs, such as the money spent to advertise the desire to sell or purchase a financial asset, and implicit costs, such as the value of the time spent in locating a counterparty.

Some financial assets can be hybrids. What does this mean?

when a financial asset is a hybrid, it is made up of debt and equity

what is said to "issue" the financial asset?

when an issuer sells a new financial asset to the public