I.  Financial Assets

• An asset is anything with value in a marketplace
• tangible assets are physical property
• examples:  car, building, land
• intangible assets are legal claims on something of value
• A financial asset is an intangible assets, a claim to future cash flows
• the issuer pays the cash flows, the investor receives the cash flows
• example:  the city of NY issues bonds to rebuild infrastructure around the WTC
• NYC is the issuer,  those who buy the bonds are investors
• financial assets are also known as financial instruments or securties
• financial assets are used to finance tangible assets
• Debt vs. equity
• when cash flows are fixed dollar amounts the financial asset is a debt instrument
• examples:  bonds, loans
• when cash flows are variable and residual to other claims the financial assets is an equity instrument
• example:  common stock, where the stock owner is entitled to a share of earnings AFTER debt holders are paid.
• Price & risk
• The price of a financial asset is equal to the present value of its expected cash flows
• seems easy enough, except we must decide how to calculate
• appropriate present value?  what discount rate?
• expected cash flows?  are they certain or risky?  how risky?
• Risk is the degree of uncertainty about the timing and amounts of cash flow.  It comes in many forms
• inflation risk:   cash flows will buy less in the future than they do today
• credit/default risk:   issuer may not be able to make promised payments or may pay late
• foreign-exchange risk:  cash flow values NOT in U.S. dollars will be affected by the exchange rate
• Role of financial assets
• transfers funds from those with surplus funds (savers) to those who need them (borrowers)
• redistribute risk to those willing to bear that risk
• financial intermediaries are essential to these functions

• Why have financial markets?
• buyers and sellers come together and determine price (value) of financial assets
• price is a signal about value and changes in value, and how funds should be allocated
• easier to buy and sell -- liquidity
• this makes financial assets more popular, and funds more available
• liquidity varies across different markets
• reduces transactions costs
• reduces search time for buyer and seller
• reduces need to independently gather information--it is reflected in the price of an asset
• financial markets yield information, liquidity, and cost efficiency
• Classification of financial markets
• type of assets:   debt vs. equity market
• maturity of assets
• money market:  short-term debt securities
• capital market:  long-term debt or equity securities
• delivery of assets
• cash/spot market:  asset exchange immediately after trade (2 days)
• derivative market:  asset exchange occurs on future date after trade (months)
• age of asset
• primary market:  exchange of newly issued securities
• secondary market:  exchange of previously issued securities
• structure of market
• exchange:   buyers and sellers meet in physical location to trade
• over-the-counter (OTC) market:  buyers and sellers linked through dealers and geographically dispersed
• Globalization of financial markets
• what does it mean?
• financial markets in many countries are so closely linked they merge into one international financial market
• globalization has increased dramatically in the past 20 years
• why has it happened?
• Because it can.   Advances in telecommunications and computer technology make speedy international trades feasible
• Deregulation has opened up more markets around the world
• Financial markets are increasingly dominated by large institutional traders that are willingly to invest across borders
• Globalization has the advantage of offering more funding sources to borrowers and lower costs.

• what are derivatives?
• contracts give holder right or obligation to buy/sell a financial assets in the future
• value of contract is based on value of the underlying financial assets to be bought/sold
•  derivative asset
• examples:  futures contracts, options contracts, interest rate swaps
• how are derivatives used?
• derivatives are an effective, cheap way of managing risk
• risk from fluctuating interest rates
• risk from fluctuating stock prices
• risk from fluctuating exchange rates
• derivative contracts used to offset risks faced in primary business