FINANCIAL MARKETS

AND INSTITUTIONS
CHAPTER-2:FINANCIAL MARKETS AND FINANCIAL TRANSACTIONS
 FINANCIAL ASSETS:

An asset is any resource that is expected to provide future benefits, and thus possesses
economic value.
**Assets are divided into two categories:
 tangible assets with physical properties
and
 intangible assets.
 FINANCIAL ASSETS

Tangible Assets:
 Value is based on physical properties
 Examples include building, land, machinery

Intangible Assets:
 Claim to future income
 Examples include various types of financial assets
 Types of Financial Assets:
 Cash
FINANCIAL ASSETS
 Mutual funds
 Certificates of deposits
 Commercial paper
 Government bond
Financial assets, often called financial instruments, are  Corporate notes & bonds
intangible assets, which are expected to provide future
benefits in the form of a claim to future cash. Some  Municipal bond
financial instruments are called securities and generally  Foreign bond
include stocks and bonds.
 Common stock
 Preferred stock, etc.
 ISSUER VS. INVESTORS

Any transaction related to financial instrument includes at least two parties:

1. the party that has agreed to make future cash payments and is called the issuer;

2. the party that owns the financial instrument, and therefore the right to receive the
payments made by the issuer, is called the investor.
 KEY DIFFERENCES BETWEEN DEBT AND
EQUITY CAPITAL

The key differences between debt and equity capital are discussed under following
headings:

a. Voice in Management
b. Claims on Income and Assets
c. Maturity
d. Tax Treatment
 A. VOICE IN MANAGEMENT
• Unlike creditors (lenders), holders of
equity capital (common and preferred
stockholders) are owners of the firm.
Holders of common stock have voting
rights that permit them to select the
firm’s directors and to vote on special
issues.
• In contrast, debt holders and preferred
stockholders may receive voting
privileges only when the firm has
violated its stated contractual obligations
to them.
 B. CLAIMS ON INCOME AND ASSETS

• Holders of equity have claims on both • Debt holders’ claims will be satisfied
income and assets that are secondary to first that is interest and in maturity
the claims of creditors. Principal amount.
 C. MATURITY

• Equity capital is a permanent form of • Debt Capital has a specific maturity date
financing for the firm. It does not with fixed interest rate.
“mature” so repayment is not required.
 D. TAX TREATMENT

• Interest payments to debt holders are • dividend payments to a firm’s common

treated as tax-deductible expenses by the and preferred stockholders are not tax
issuing firm deductible.
 VALUE OF FINANCIAL ASSETS (1)

Valuation is the process of determining the fair value of a financial

asset. The process is also referred to as “valuing” or “pricing” a
financial asset. The fundamental principle of valuation is that the
value of any financial asset is the present value of the expected
cash flows. This principle applies regardless of the financial asset.
Thus, the valuation of a financial asset involves the following two
steps:

1. Estimate the expected cash flows

2. Calculate the present value

 VALUE OF FINANCIAL ASSETS (2)

1. Estimate the expected cash flows:

Cash Flow (CF) is the increase or decrease in the amount of money a business, institution, or individual has. In
finance, the term is used to describe the amount of cash (currency) that is generated or consumed in a given time
period from investing in a particular financial Asset.
**Type of financial asset:
Debt Instrument
Equity Instrument
 VALUE OF FINANCIAL ASSETS (3)

2. Calculate the present value:

After estimating the cash flow, the next step is to determine the appropriate interest rate. This interest rate
will be used to calculate the present value for discounted value.
Minimum interest rate
Plus, Premium required for perceived risk
***Various Types of risk:
•Credit Risk
•Inflation risk
•Foreign-Exchange risk
 FINANCIAL ASSETS VS. TANGIBLE ASSETS (1)
• Financial assets are intangible, These assets
represent value that can be converted into
cash.
• Financial assets lose value due to changes
in market yields and other market price
fluctuations.
• while financial assets can be revalued.
• Financial assets are redeemed when they
mature.
• Tangible assets, on the other hand, are
physical assets. These assets represent value
that can be converted into cash.
• Tangible/physical assets lose value due to
depreciation, wear and tear.
• Physical/tangible assets can be depreciated
over their useful life
• Physical tangible assets are disposed off when
they served for their useful economic life,
 FINANCIAL ASSETS VS. TANGIBLE ASSETS (2)
• Financial assets are recognized at fair value
(present value of future cash flow).
• Financial assets may yield cash flows of
return during the time that they are held and
a final receipt on the asset’s face value.
• Financial assets do not require additional
costs to keep them functional,
• Physical/tangible assets are recognized at cost.
• Physical/ tangible assets, may receive such
cash flows in terms of rent or may contribute
to increased earnings through the use in the
production or increase in market value at the
point of sale.
• Physical/ tangible assets may need to be
repaired, maintained and upgraded from
time to time.
 ROLE OF FINANCIAL ASSETS

• Financial assets provide the following key economic functions.

 The first is to transfer of funds from those entities, who have surplus funds to invest to those who
need funds to invest in tangible assets ;
 The second function is transferring funds in such a way as to redistribute the unavoidable risk
associated with each cash flow generated by tangible assets among those seeking and those
providing the funds.
PROPERTIES OF FINANCIAL ASSETS (1)

1. Moneyness
2. Divisibility and denomination
3. Reversibility
4. Term to maturity
5. Liquidity
PROPERTIES OF FINANCIAL ASSETS (2)

6. Convertibility

7. Currency

8. Cash flow and return predictability

9. Complexity
10. Tax Status
 PROPERTIES OF FINANCIAL ASSETS (3)

1. Moneyness:
Some financial assets are used as a medium of exchange or in settlement of transactions. These
assets are called money. In some countries they consist of currency and all forms of deposits that
permit check writing
Other financial assets are called near money, although these are not money, are very close to
money in that they can be transformed into money at little cost, delay or risk, include time and saving
deposits, T- bill etc.
 PROPERTIES OF FINANCIAL ASSETS (4)

2. Divisibility and denomination:

A denomination is a classification for the stated or face value of financial instruments such as
currency notes, coins, as well as bonds and other fixed-income investments.
Incase of financial assets divisibility and denomination refers to the minimum amount or size in
which assets can be traded.
For example, US bonds are generally sold in $ 1,000 denominations and deposits are
infinitely divisible.
 PROPERTIES OF FINANCIAL ASSETS (5)

3. Reversibility:
This refers to the cost of investing in a financial asset then getting out of it into cash again. It is
commonly referred to as the turnaround cost or round-trip cost. This cost comes in the form of
commissions for market makers, bid-ask spread and the time and cost of delivery of the asset if any.
The bid-ask spread is mainly determined by the thickness or thinness (frequency of the transactions)
of the market. A low turn around cost is clearly desirable property of a financial asset.
 PROPERTIES OF FINANCIAL ASSETS (6)

4. Term to maturity:
The term to maturity often referred as maturity is the length of the interval until the date when the
instrument is scheduled to make its final payment, or the owner is entitled to demand liquidation.
 PROPERTIES OF FINANCIAL ASSETS (7)

5. Liquidity:

Financial liquidity refers to how easily assets can be converted into cash.

In other words, liquidity describes the degree to which an asset can be quickly bought or sold in the
market at a price reflecting its intrinsic value. Cash is universally considered the most liquid asset
because it can most quickly and easily be converted into other assets. Assets like stocks and bonds are
very liquid since they can be converted to cash within days. However, large assets such as property,
plant, and equipment are not as easily converted to cash. For example, checking account is liquid, but if
you owned land and needed to sell it, it may take weeks or months to liquidate it, making it less liquid.
 PROPERTIES OF FINANCIAL ASSETS (8)

6. Convertibility:

Convertibility implies that a financial asset or instrument can be converted into another class of asset
which will still be held by the corporate entity has original used to raise funds for its operations. The
conversion can take a form of bond being converted to bond, preference shares being converted to
equity shares, and a company bond being converted into equity shares of the company.
 PROPERTIES OF FINANCIAL ASSETS (9)

7. Currency:

Financial assets are normally denominated in currencies of the various countries around the world.
This implies financial assets in Japan are denominated in Yen, those in the United States of America
are in Dollars, those in United Kingdom are in Pounds Sterling while those in China are in Yuan, and
in BD in taka, etc.
 PROPERTIES OF FINANCIAL ASSETS (10)

8. Cash flow and return predictability:

The return that an investor will realize by holding a financial asset depends on the cash flow that is
expected to received. This includes dividend payments on stock and interest payments on debt
instruments, as well as the repayment of principal for a debt instrument and the expected sale price of
a stock.

Therefore, the predictability of the expected return depends on the predictability of cash flow and
there are clear differences between ‘nominal expected return’ & ‘real expected return’.
 PROPERTIES OF FINANCIAL ASSETS (11)

9. Complexity:

Some financial assets are complex in the sense that are actually combinations of two or more simpler
assets. To find the true value of such an asset, one must decompose it into its component parts and
price of each component separately.
 PROPERTIES OF FINANCIAL ASSETS (12)

10. Tax Status:

The returns on various financial assets are subject to tax status because they are taxable earnings. The
tax authorities are interested in collection of taxes on earnings from financial assets as securities
which are regarded as incomes for investors. However, the tax status on financial assets varies from

- year to year

- country to country

- among municipal units within a country

- financial asset to financial asset.

 ROLE OF FINANCIAL MARKETS

• First: the interactions of buyers and sellers in a financial market determine the price of the
traded asset, or, equivalently, the required return on a financial asset is determined.

• Second: financial markets provide a mechanism for an investor to sell a financial asset.

• Third: economic function of a financial market is that it reduces the search and
information costs of transacting.
 FINANCIAL TRANSACTIONS (1)

Financial systems change constantly in response to shifting demands from public, the
development of new technology and changes in laws & regulations.
Over time, the ways of carrying out financial transactions have evolved in complexity.
In particular, the transfer of funds from savers to borrower can be accomplished in at least three
different ways, which are as follows:
1) Direct Finance
2) Semi - direct Finance
3) Indirect Finance
(1) DIRECT FINANCE
(3) SEMI-DIRECT FINANCE
(3) INDIRECT FINANCE