Financial Assets and Their Key Attributes

Financial Assets

  • Definition: Financial assets are claims that entitle the holder to future income from the issuer.
Key Attributes of Financial Assets
  • Liquidity:
    • Description: How quickly an asset can be converted into cash without losing value.
    • Types:
    • Highly liquid: Money (currency, checking accounts).
    • Less liquid: Savings accounts, certificates of deposit (CDs).
  • Rate of Return:
    • Definition: The income generated by an asset and its ability to protect against inflation.
  • Risk:
    • Description: The likelihood of an asset losing value.
Classes of Financial Assets
  • Money:
    • Highly liquid, very low risk, generates no income (M1 measure of money).
    • Includes cash, checking accounts, traveler’s checks.
  • Bonds:
    • Represents an obligation to pay a sum in the future.
    • Fairly liquid and risk varies (government vs. corporate bonds).
    • Generates income through interest payments.
  • Stocks:
    • Represents ownership in a company.
    • Generates income via dividends but carries more risk than depository accounts.
  • Mutual Funds:
    • Value derived from a portfolio of financial assets (stocks/bonds).
    • Generates income through dividends or interest payments.

Objectives of Financial Assets

  • Liquidity Preference:
    • If money is needed soon, prefer liquid assets (currency, checking).
    • If not, prefer assets with better interest income (bonds, CDs).
  • Opportunity Cost:
    • Holding liquid assets implies foregone interest on other investments (like bonds).
    • Conversely, holding less liquid assets incurs opportunity cost related to liquidity.
Saving and Borrowing Dynamics
  • Saving:
    • Funds are made available for borrowing in financial markets.
    • Savers can be private, public, or foreign.
  • Borrowing:
    • Borrowers may include consumers, businesses, or governments, and can be domestic or foreign.
Financial System Tasks
  • Transfer Funds: Between savers (lenders) and borrowers.
  • Reduce Transaction Costs: Lower the costs of making deals.
  • Manage Financial Risk: Address uncertainty related to financial outcomes.
  • Provide Liquid Assets: Ensure availability of assets that can convert to cash quickly.

Interest Rates

  • Nominal vs. Real Interest Rate:
    • Nominal Interest Rate = Real Interest Rate + Expected Rate of Inflation.
    • Example: If real interest is 2% and inflation is 6%, nominal is 8%.
    • Unforeseen inflation can erode the expected real return.
Calculating Interest Rates
  • Formula: To calculate the nominal and real interest rate accredited to the loan or investment.
    • Real Interest = Nominal Interest - Inflation Rate.

Financial Market Models

  • Direct Finance: Involves going directly to the markets (money markets & capital markets).
  • Indirect Finance: Involves intermediaries or financial institutions (banks).

Conclusion

  • Understanding financial assets, their attributes, and the financial system's operations is crucial for effective financial management and decision-making in both saving and investing contexts.

  • Takeaway: Investors must balance the trade-off between liquidity and returns when choosing assets. Awareness of interest rates' dynamics is vital for optimizing lending and borrowing outcomes.