PROPERTIES AND PRICING

OF FINANCIAL ASSETS
Chapter 10
Properties of Financial Assets
Financial assets have certain properties that
determine or influence their attractiveness to
investors and issuers. Financial assets have
following eleven properties:
● Moneyness ● Convertibility
● Divisibility and ● Currency
Denomination ● Liquidity
● Reversibility ● Return Predictability
● Cash Flow ● Complexity
● Term to Maturity ● Tax Status
Properties of Financial Assets
● Moneyness
The financial assets, which are used as a
medium of exchange or in settlement of
transaction, are called money. Money consists
of all currency and all forms of deposits that
permit check issuing.
Other assets, which are not money, but can be
transformed into money with little cost delay,
or risk, are called near money. These are
savings deposits and securities issued by the
government.
Properties of Financial Assets
● Divisibility and Denomination
Divisibility relates to the minimum size in
which a financial asset can be liquidated and
exchanged for money. A deposit is theoretically
infinitely divisible. But some financial assets
have varying degree of divisibility depending on
their denomination (class, category or group).
Denomination is the monetary value of the
amount that each unit of the asset will pay at
maturity. Many bonds in USA come in $ 1000
denominations.
Properties of Financial Assets
● Reversibility:
It ensures investing in a financial asset and then
getting out of it and back into cash again.
A financial asset such as a deposit at a bank is
highly reversibly, because usually there is no charge
and limit for adding to or withdrawing from it.
For other financial asset transaction cost may be
unavoidable. For financial assets, the bid-ask spread
is the difference between the price at which a dealer
is willing to buy an asset and the price at which he is
ready to sell it.
Properties of Financial Assets
● Cash Flow
The return that is realised by holding a
financial asset is called cash flow, which
pays the issuer of the financial asset to its
owners. The return depends on the
expected sale price of a stock. In
calculating the expected return, non-cash
payments like dividends and option to
purchase additional stock are to consider.
Properties of Financial Assets
● Cash Flow
In the world of non-negligible inflation, it is important
to distinguish between nominal expected return and
real expected return.
For example, if the nominal expected return for a
one-year investment of $ 1000 is 6%. Then at the end
of the year, the investor is expected to receive $ 1060
(1000 + 1000 x .06). Let us consider that at the end of
the year the inflation is 4%. Then the real expected
return, i.e. the purchasing power of $1060 is only
$1019.23 (1060 ÷ 1.04).
Properties of Financial Assets
● Term to Maturity
This is the duration after which a financial asset
in scheduled to make its final payment.
The asset for which the holder of the asset can
ask for payment at any time is called demand
asset, as for example, the deposits.
In UK, there is a bond that promise to pay a
fixed amount per year, but the principal is never
paid.
Properties of Financial Assets
● Term to Maturity
It should be noted that even a financial asset with
a stated maturity period may be terminated before
the stated maturity, because of bankruptcy and/or
reorganisation of the issuer. This is denoted as call
provision.
Some time the investor may have the privilege of
asking for early payment, which is called put
option.
Properties of Financial Assets
● Term to Maturity
The maturity for some assets may be extended at
the description of the issuer. For example, French
government issues a six years obligation, which
allows the investor at the end of third year to
change it in a new six-year asset.
Properties of Financial Assets
● Convertibility
Convertibility is a provision of a financial
asset, which allows the owner to convert it into
another financial asset.
● Currency
Currency is the type of nominal monetary unit
in which an asset is denominated and its
payments are made. Most financial assets are
denominated in one currency, such US Dollars
or Yen.
Properties of Financial Assets
● Currency
Responding to the wishes of the investors to
reduce currency risk, some issuers issue dual
currency financial asset. As for example, some
Eurobonds pay interest in one currency but the
principal in a second currency. In most cases
US Dollars and Yen are commonly paired.
Properties of Financial Assets
● Liquidity
For many financial assets liquidity is determined
by contractual arrangement. Ordinary deposits, for
example, are perfectly liquid because the banks
have the obligation to convert them at par on
demand.
A private pension fund on the other hand may be
regarded as totally illiquid, because these could be
cashed only at retirement.
Again, liquidity may not depend only on the
financial asset but also on the quantity one wishes
to sell.
Properties of Financial Assets
● Return Predictability
Return predictability is a basic property of
financial assets. The risk of a financial asset is
related with the uncertainty of its return.
The value of financial asset depends on the
cash flow expected and the interest added to
this cash flow. The uncertainty about future
cash flow and interest rate makes financial asset
risky.
Properties of Financial Assets
● Return Predictability
The cash flow from US securities is regarded
as riskless.
If inflation is absent the determinants of real
and nominal uncertainty and risk coincide. In
presence of highly unpredictable inflation,
however, real return may be drastically harder
to predict than nominal returns.
Properties of Financial Assets
● Complexity
Combination of two or more financial assets
together make the property complex. To assess the
true value of such an asset, it may be broken into its
component parts and price each separately.
A good example of complex asset is the callable
bond, a bond, which is entitled to pay before the
maturity. A complex asset may be viewed as a
package of cash flow, options for which belong to
either the issuer or the holder of the asset.
Properties of Financial Assets
● Tax Status
Tax status of a financial asset indicates the
exposure of gains or payments from asset to
taxation by government units.
Government regulation for taxing the income
from ownership or sale financial assets varies
widely. Tax differs from year to year from country
to country. Moreover tax rate may differ from
financial asset to financial asset depending on the
type of issuer, duration of the maturity, nature of
the owner, etc. For example, the pension fund is
tax-free
Principles of Pricing Financial
Assets
● The correct price of an asset equals:

● where: P = the price of the financial asset

CFt = the cash flow in year t (t=1,2,…,N)
N = maturity of the financial asset
r = appropriate discount rate
● The appropriate discount rate is equal to:

r = RR + IP + DP + MP + LP + EP

where:
Appropriate Discount Rate
RR = the real rate of interest, which is the reward for the
investment in the asset.
IP = the inflation premium, which is the portion of the rate of
return rewarded for the change in inflation rate.
DP = the default risk premium, which is reward for taking risk of
default of the asset.
MP = the maturity premium, which is the compensation for long
term investment in the asset.
LP = the liquidity premium, which is the reward for investment in
an asset that may not be readily converted in cash at market value.
EP = the exchange-rate risk premium, which is the reward for
investment in asset that is not denominated in the investor’s home
currency.
Example
Let us construct a simple example the pricing of a financial
asset.
Suppose a bond has a maturity of four year and pays annual
interest of $ 50 plus principal of $ 1000. The periodic coupon
rate is $50. The duration of the asset is 4 year, i.e. N = 4.
Further, we assume that: RR = 2.5%, IP = 3.0%, DP = 2.0%,
MP = 0.5%, LP = 1% and EP = 0.0% (that means, the cash flow
is denominated in home currency, in our example in US
Dollars). Then, r = 2.5% + 3.0% + 2.0% + 0.5% + 1.0% + 0.0%
= 9.0%.
Example
The price of this bond is:
Price and Asset Properties
● The price of a financial asset is inversely related to its
discount rate.
» As the discount rate rises, the price falls.
» As the discount rate falls, the price rises.

Example: Let us consider again the above example for the

pricing of a financial asset with different appropriate
discount rate. Suppose the bond has again the maturity of
four year and pays annual interest of $ 50 plus principal of $
1000. The periodic coupon rate is $50. The duration of the
asset is 4 year, i.e. N = 4. And the appropriate discount rate,
r = 4%, 5%, 6%, 7%, 8%, 9%, 10%, 11%, 12%, and 13%.
Price and Asset Properties
Cash flow Appropriate discount Rate Price ($)
4 1036.30
5 1000.00
6 965.35
7 932.26
8 900.64
9 870.41
10 841.51
11 813.85
12 787.39
13 762.04
Relation of Asset Price with Asset
Properties
● Reversibility Effect
Let us suppose that ensuring reversibility of a financial
asset, brokers have been commissioned. If a
commission of $ N (N is the amount of commission in
US Dollar) is imposed by brokers to buy or sell the
bond, the Price of the bond:
Relation of Asset Price with Asset Properties

Let us consider that the amount of commission

N = $35, then:

● Taxation Impact
Let us consider that a government agency imposes a tax
of $T (amount of Tax of amount T is imposed on US
Treasure Bill) on each transaction, i.e. to buy or sell the
bond. Let the tax deduction is T, so:
Relation of Asset Price with Asset Properties
Taxation Impact

If T = $ 20, then:
Relation of Asset Price with Asset Properties
● Default Risk
Let us assume that right before the marketing of the bond, a
news spreads that the bond is less risky.
And as effect the default risk falls from 2% to 1%.
So the appropriate discount rate falls from 9% to 8%.
As effect the price of the financial asset (bond) increases from $
870.41 to $900.64 ( see table).
Relation of Asset Price with Asset Properties
● Liquidity Effect
Let us assume the case that the liquidity of the bond in the
example declines. As an effect of this change, the investors now
willing to buy this asset wish to have an increased liquidity
premium.
Let us assume that the liquidity premium increases on this
ground from 1% to 3%. So in our case the appropriate discount
rate increases from 9% to 11%. As effect, the prise of the asset
falls from $870.41 to $813.85 (see table).
Relation of Asset Price with Asset Properties
● Currency Exchange Effect
Suppose that the bond, mentioned in the example, is issued by a
German Firm in Deutsche Mark. The Firm expects investment
from US investors, but the US investors have the risk of
unfavourable exchange rate development. If they are offered a
exchange rate risk premium of 3%, then the appropriate discount
rate is 12% (9% + 3% = 12%). So the price of the asset falls
$870.41 to $787.39 (see table).
Price Volatility of Financial
Assets
Price volatility of financial assets shows
how the characteristics of a financial asset and the
level of interest rates affect the price responsiveness
of a financial assets to a change in required yield
(rate of return).

This represents a measure that can be used to gauge

the appropriate price sensitivity of a financial asset
to changes in the required yield.
Price Volatility of Financial
Assets
● Maturity
The longer the maturity of a financial asset, the
greater its price sensitivity to a change in the
required yield.
A bond’s price sensitivity to a change in the
discount rate is positively related to the bond’s
maturity.
If the required rate were to change, the price
sensitivity of the bond with the longer maturity
would be greater than that of the bond with the
shorter maturity.
Price Volatility of Financial
Assets
● Coupon Rate
The lower the coupon rate, the greater the price
sensitivity to a change in the required yield.
A zero-coupon bond will have greater price
sensitivity than a bond with a coupon rate selling at
the same required rate and with the same maturity.
Price Volatility of Financial
Assets
● Coupon Rate: Value ($) of different bonds of 15
years’ maturity

r = 9% r = 10% Decline by
CR = 5% 677.57 619.70 57.88 (or 8.5%)
CR = 10% 1080.61 1000 80.61 (or 7.5%)
Price Volatility of Financial
Assets
● Level of Interest Rates
The lower the initial yield level, the greater the
price sensitivity.
For a given maturity, the amount price change and
the percentage price change is higher for the lower
initial discount rates than at the higher initial
discount rates.
The lower the level of yields, the greater the affect a
change in interest rates will have on the price of a
financial asset.
Price Volatility of Financial
Assets
● Level of Interest Rates: Value ($) of different
bonds of 15 years’ maturity & 5% coupon rate

r = 5% r = 6% Decline by

1000 902.88 97.20 (or 9.72%)

r = 13% r = 14% Decline by
483.01 447.20 35.81 (or 7.41 %)
Duration
● A measure of the approximate price
sensitivity of a financial asset to interest rate
changes.

● It is the approximate change in the price of an

asset for a 100 basis point change in interest
rates.

● For a given bond, the longer the duration, the

greater its price sensitivity.