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Lecture 1

Financial Theory and Corporate Policy (Brunel University London)

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EC1030 LECTURE 1

An Introduction to Financial Assets and Markets

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A market is any arena in which buyers and sellers meet to exchange items of value.
(a) The market for manufactured goods and services is called the product market.
(b) The market for factors of production such as labour and capital is called the
factor market.
The financial market is one particular part of the product market - the market for
financial assets.

A. FINANCIAL ASSETS

(1) WHAT IS A FINANCIAL ASSET?

An asset is any possession that has a value in exchange.

(a) A tangible asset is one whose value depends on its particular physical properties
e.g. land & buildings
(b) An intangible asset represents a legal claim to some future benefit.
Financial assets (securities or instruments) are intangible assets - their benefit being
a claim to future cash.

The entity that has agreed to make future cash payments is called the issuer
(borrower) of the asset; the owner of the asset is referred to as the investor (or
lender).

Examples of financial assets:

(a) Commercial bank loans e.g. Barclays makes a loan to Mr.X to purchase a car 
the borrower must make specified payments to the bank over time - these include
repayment of the amount borrowed and interest.

(b) Government bonds e.g. A bond issued by the U.K. government  the gov
(issuer/borrower) agrees to pay the holder (investor/lender) the bond interest
payments every period + the original amount borrowed on the maturity date.

(c) Corporate bonds e.g. A bond issued by Vodafone.

Similar to (b) but this time the issuer is a company.

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(d) Equities e.g. An ordinary share issued by Vodafone  the investor (shareholder)
is entitled to receive the dividends distributed by the company.

(2) DEBT vs EQUITY CLAIMS

The claim that the owner of a financial asset has may be either a fixed amount or a
varying amount.

If fixed  the financial asset is a debt instrument e.g. car loan, gov bond, and
corporate bond.
If variable  the financial asset is an equity instrument e.g. the ordinary share.

(3) THE PRICE OF A FINANCIAL ASSET AND ITS RISK

(a) The price of a financial asset

A basic economic concept is that

‘the price of a financial asset is equal to the present value of its expected cash flow,
even if the cash flow is not known with certainty.’

Expected cash flow  the stream of cash payments the holder expects to receive in
the future.
Present value  the worth of a future stream of income expressed in today’s value.

e.g. U.K. Gov Bond. Pays £50 every 6 months for 30 years and £1000 on maturity.
Both the £50 every 6 months and the £1000 after 30 years can be regarded as cash
flows.
Obviously, £1000 in 30 years’ time is not the same as £1000 today.
To work out the price of this financial asset we need to somehow work out the
present (today’s) value of these expected cash flows - done by discounting future
values to their present values.

(b) The expected rate of return of a financial asset.

Pt+1  Pt
E(rate of return) = 100%
Pt
If the price of a financial asset is currently £100 and its only cash flow is expected to
be £105 one year from now, then
105 - 100 5
E(rate of return) =   5%
100 100

(c) The risk of a financial asset.

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Risk- the possibility of suffering some form of loss or damage.

Both holders and issuers of financial assets are exposed to various types of risk:

(a) Default (credit) risk:

In the case of the Barclays car loan, the ability of the borrower to repay presents
some uncertainty about the future cash flow  issuer is exposed to default risk.
(b) Inflation (purchasing power) risk  the risk of the purchasing power of the
future cash flow decreasing because of inflation.
(c) Foreign exchange risk  the risk of adverse movements in the exchange rate.

(4) The role of financial assets:

(a) They act as intermediaries for the transfer of funds from surplus to deficit units.

(b) They facilitate the transfer of risk from those wanting to avoid it to those willing
to bear it.

B. FINANCIAL MARKETS

(1) WHAT IS A FINANCIAL MARKET?

A financial market is a market where financial assets are exchanged (traded).

(2) WHAT ROLE DO FINANCIAL MARKETS PLAY IN THE ECONOMY?

(a) Aid the price discovery process

Firms demand funds in order to invest in tangible assets by selling financial assets.
Individuals supply (invest) any excess funds they have by buying financial assets.
Both demand and supply depends on the price of financial assets.
This price is determined in financial markets by the interactions of buyers and
sellers and it acts as a signal as to how scarce resources should be efficiently
allocated amongst financial assets.

(b) Provide liquidity

Liquidity  the ease with which financial assets can be bought and sold.
If financial markets were illiquid  when investors wanted to sell their financial
assets they would not be able to do so.
 An investor holding a debt instrument would be forced to hold onto it until it
matured.

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(c) Reduce the cost of transacting by minimising

(i) Search costs

(a) Explicit search costs e.g. money spent on advertising ones intention to buy or sell
a financial asset.
(b) Implicit search costs e.g. time spent in finding a counterpart.
FM’s reduce these costs.

(ii) Information costs: costs involved in acquiring the information necessary to

assess whether or not to invest in a financial asset.
In an efficient financial market there is no need to acquire this information since it is
already discounted in prices i.e. prices should reflect all relevant information in
efficient financial markets.

(3) CLASSIFICATION OF FINANCIAL MARKETS

(a) Classification by nature of claim: Debt & Equity markets.

The classification depends on whether the claim is fixed, as in debt markets, or
variable, as in equity markets.

(b) Classification by maturity of claim: Money & Capital markets

(i) The money markets deal with short-term debt instruments such as short-term
gov bonds (T-Bills) or short-term agreements between banks (Certificates of
Deposit).
(ii) The capital markets are usually for longer maturity financial assets e.g. Long-
term gov bonds (Gilts), long-term corporate bonds, equities etc...

(c) Classification by seasoning of claim: Primary & Secondary markets.

Financial markets can also be classified by those dealing with financial claims that
are:
(i) newly issued. Fin claims that are newly issued are issued on the Primary market.
(ii) Financial claims that were previously issued and are now being traded are
traded on the Secondary market.

(d) Classification by immediate or future delivery: Cash (Spot) markets vs

Derivative markets.
(i) The Spot market is the market where the financial asset trades for immediate
delivery e.g. buying a share.
(ii) The Derivative market is where the financial asset in question trades for future
delivery e.g. Futures and Options markets. The financial asset is not physically
exchanged now but at some future date.

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(4) WHO ARE THE MAIN MARKET PARTICIPANTS?

(a) Households e.g. when buying or selling shares, borrowing from commercial
banks etc..
(b) Companies e.g. raising finance for investments, insuring themselves against
certain types of risk etc...
(c) Governments e.g. raising finance for public spending.
(d) Supranational organisations e.g. World Bank provides capital for member
countries at preferential rates.
(e) Regulators

(5) WHY DO FINANCIAL MARKETS NEED TO BE REGULATED?

5 standard reasons are given:
(a) To prevent the issuers of securities from defrauding investors by concealing
relevant information  disclosure rules must be specified.
(b) To promote competition and fairness in the trading of financial assets. i.e. avoid
the problems of monopoly.
(c) To promote the stability of financial institutions i.e. avoid banking collapses.
(d) To restrict the activities of foreign concerns.
(e) To control the level of economic activity i.e. to avoid destabilising effects on the
economy.

C. FINANCIAL INSTITUTIONS AND INTERMEDIARIES

(1) WHAT IS A FINANCIAL - AS OPPOSED TO A NON-FINANCIAL

INSTITUTION?

One of the main participants in financial markets are companies (enterprises). We

can distinguish between:
(a) A non-financial enterprise either manufactures products or provides non-
financial services.
(b)Financial enterprises (also known as Financial Institutions e.g. Commercial
banks, Investment Houses, Insurance companies, Securities Firms etc..)
provide the following financial services:

(2) WHAT TYPES OF SERVICES DO THEY PROVIDE?

(a) Exchange (buy and sell) financial assets on behalf of their customers i.e. provide
a brokerage service.
(b) Exchange financial assets for their own accounts.
(c) Assist in the creation of financial assets for their customers and then sell those
financial assets to other market participants i.e. provide an underwriting service.
(d) Provide investment advice to other market participants.
(e) Manage the portfolios of other market participants.

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(f) Transform financial assets acquired through the market into more widely
preferable types of assets - which become their own liability.
This last service is provided by Financial Intermediaries.

(3) THE ROLE OF FINANCIAL INTERMEDIARIES

Financial intermediaries obtain funds by issuing claims against themselves to

market participants and then they invest those funds for themselves e.g.

Thus, the commercial bank has transformed the deposit into a desirable financial
asset - the loan - which is more preferred.

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