Chapter 11- properties and pricing of financial assets

Properties of Financial Assets

  • 11 properties of financial assets are:
  1. moneyness
  2. divisibility and denomination
  3. reversibility
  4. cash flow
  5. term to maturity
  6. convertibility
  7. currency
  8. liquidity
  9. return predictability
    1. complexity

tax status

  • What is Moneyness?

    • Money is currency and all forms of deposits that allow check writing.
    • %%Near Money%%- Assets that are close to money can be transformed into money at little cost, delay, or risk.
    • ==Examples==: Time and savings deposits and security issued. Also known as the “Treasury bill”
    • Moneyness is a desirable property for investors

  • What are divisibility and denomination?

    • %%divisibility%%- minimum size in which a financial asset can be liquidated and exchanged for money.
    • The smaller the size= more financial assert is divisible.
    • Deposits are infinity divisible but other financial assets depend on the degree of divisibility from the denomination, in which the dollar is valued by the amount that each unit of the asset will pay maturity
    • ==Example: Bonds== come in 1,000 denomination / commercial paper in 25,000 units / certain deposit in 100,000 or more.
    • Divisibility is wanted for investors but not borrowers.

  • What is Reversibility?

    • %%reversibility-%% the cost of investing in a financial asset and then backing out of it and then into cash again
    • AKA: Turnaround cost or round trip cost
    • ==Example==: Deposit in the bank there is no charge for adding to or withdrawing from it.
    • Financial assets traded in organized markets or with market makers: most relevant component= %%Bid-ask spread.%%
    • added to commissions and time and cost of delivering the asset
    • The greater the variability the greater probability of the market maker incurring a loss in excess of a stated bound between the time of buying and the reselling of the financial asset.
    • ==Example:== treasury bills have a very stable price, but a speculative stock will exhibit much larger short-run variations.
    • The thickness of market: determining factor of a bid-spread charged by a market-maker.
    • %%Thin Market:%% few trades on a regular or continuous basis.

  • Term to Maturity

    • %%term to maturity:%% length of the period until the date at which the instrument is scheduled to make its final payment or the owner is entitled to demand liquidation.
    • Creditors can ask for repayment at any time = checking accounts, savings accounts are called %%demand instruments.%%
    • %%Call provision:%% the debtor to repay in advance, usually at some penalty and only after a number of years from the time of issuance.
    • ==Example:== perpetual bonds have a call provision to call for bonds five years after being made.
    • %%Put option:%% an investor may be privileged to ask for early repayment.
    • example: the French government issues a six-year obligation renouvelable du Tresor, which allows the investor to switch to a new six-year debt after the end of the third year.

  • Convertibility

    • Conversion occurs within one class of asset, as when a bond is converted into another.
    • ==Example:== a corporation convertible bond is a bond that the bondholder can change into equity shares.

  • Liquidity

    • How many sellers stand to lose if they wish to sell immediately as opposed to engaging in a costly and time-consuming search
    • ==Example==: quite an illiquid financial asset is the stock of a small corporation or the bond issued by a small school district.
    • The market for that is really thin, so it’s harder to find someone suitable for this bond, thus resulting in a discount price.

  • Return Predictability

    • %%return predictability%%: basic property of financial assets, that is a major determinant of their value.
    • Volatility will be a consequence of the uncertainty about future interest rates and future cash flows.

  • Complexity

    • Some of those prices are the value of the complete asset.
    • %%Callable bond:%% issuer is entitled to repay the debt prior to the issue’s scheduled maturity date.
      • In effect buy a bond and sell it to the issuer an option that allows the issuer to redeem that bond at a set price to the issue’s scheduled maturity.
    • %%Putable bond%% has payments that can be made in a different currency at the option of the bondholder, and a bond that can be sold back to the issuer at a fixed price.

  • Principles of pricing financial asset

    • price of an asset equals the PV of all cash flows that the owner of the asset expects to receive during its life.

  • Discount rate

    • the return that the market or the consensus of investors requires on the asset.
    • r=RR+IP+DP+MP+LP+EP
    • RR= real rate of interest - a reward for not consuming and for lending to other users
    • IP= inflation premium- compensation for the expected decline in the purchasing power of the money lent to borrowers.
    • DP= default risk premium the reward for taking on the risk of default or risk of loss of principle for other assets.
    • MP= maturity premium- investing in an asset that may not be converted to cash at a fair market value
    • EP= exchange rate risk premium, investing in an asset that is not denominated in the investor’s home currency
    • %%Required yield%%= follows from the fact that the price of a financial asset is equal to the present value of its cash flow.
    • %%Zero coupons bond%%= investor purchases the bond at a price below its principal and gets the principal at the maturity date.
    • zero coupons will have greater price sensitivity than a bond with a coupon rate selling at the same required yield and same maturity.
    • %%Modified duration%%- cash flow does not change when the interest rate change
    • %%Effective duration%%-cash flow changes when interest rates change