Chapter-Four
Financial Instruments
4.1 Introduction
4.2 Real Vs Financial assets
4.3 Types of Financial Instruments
4.4 Characteristics of Financial Assets
Introduction
• The third component of financial system is
financial instruments.
• Financial claims such as financial assets dealt
in a financial market are referred to as
financial instruments.
• Example, Government bonds, corporate
bonds, common stock, Preferred stocks,
commercial papers, etc.
Real Vs Financial assets
• Assets are things that people own.
• Generally assets can be classified in to two
broad classes as Real and Financial assets
• The distinction between these terms is easy
when viewed from an accounting point view.
• A real asset does not have a corresponding
liability associated with it while Financial
assets have a corresponding liability.
Real Vs Financial assets
• A financial asset carries a corresponding liability somewhere. If an
investor buys shares of stock, they are an asset to the investor
but show up on the right side of the issuer corporation’s
balance sheet.
• A financial asset, therefore, is on the left-hand side of the
owner’s balance sheet and the right-hand side of the
issuer’s balance sheet.
• Real assets of a business can be building, land, machinery,
real estate, inventory, and so on.
• Financial assets may take forms like deposits, loans,
securities, and so on.
Types of Financial Instruments
• Classification of Financial instruments is
entirely dependent on the type of the market
where these securities are being traded.
• If the financial instrument is being traded in
the money market, the instrument is said to
be money market debt instrument.
Types of Financial Instruments
1. Money market financial instrument: are instrument
used to raise short term source of finance.
Example: treasury bills, commercial papers,
negotiable instruments, promissory notes, certificates
of deposits.
2. Capital market instruments: long term
Example: corporate bonds, Treasury bonds, Notes,
Municipality bonds, Common stocks, Preferred
stocks .
3. Derivative instruments
Examples: forwards, futures and options
Characteristics of Financial Assets
1. Money-ness
• Some financial assets are used as a medium of
exchange or in settlement of transactions. These
assets are called money.
• Those financial assets which can be transformed in to
money at little cost, delay or risk can also be
considered as money.
• For example, money and cash deposited in a checking
account can be used as a medium of exchange.
Characteristics of Financial Assets
2. Divisibility and denomination
• Divisibility relates to the minimum size at which a financial asset
can be liquidated and exchanged for money. Or,
• Minimum amount to sell or purchase an asset or the extent to
which fractional amounts of an asset can be sold and bought.
• For example, physical assets such as car, building etc are often
indivisible.
• A financial asset such as a deposit at a bank is infinitely divisible
but other financial assets have varying degrees of divisibility
depending on their denomination.
• 200 shares of common stock with par value of Br.100 is
equivalent to 400 shares of common stock with Par value of Birr
50
Characteristics of Financial Assets
3. Reversibility
• It refers to the cost of investing in a financial asset and then
getting out of it and back in to cash again. That is, cost of
investing in asset, then selling it for cash. Consequently, it refers
to round-trip cost.
• Example, a financial asset such as a deposit at a bank is
obviously highly reversible because usually there is no charge for
depositing to or withdrawing from it. Thus, deposits -- cost
close to zero.
• For financial assets traded in organized markets or with “market
maker”, the most relevant component of round-trip cost is the
so-called bid-ask spread, to which might be added commissions
and the time and costs, if any, of delivering the assets.
Characteristics of Financial Assets
• The spread charged by a market maker varies
sharply from one financial assets to another,
reflecting primarily the amount of risk the market
maker is assuming by “making” a market.
• This market making risk can be related to two
main forces.
A. The variability of the price of financial assets.
B. The thickness of the market (the number of
buyers and sellers).
Characteristics of Financial Assets
4. Cash flows and return predictability
• Return predictability is a basic property of
financial assets, in that it is a major
determinant of their value.
• Assuming that investors are risk averse, the
riskiness of an asset can be equated with the
uncertainty or unpredictability of its return.
Characteristics of Financial Assets
5. Term of Maturity
• It is the length of time interval until the date when the
instrument is scheduled to make its final payment, or
the owner is entitled to demand liquidation.
• Maturity may be uncertain for some financial
instruments or assets, example common stock and non-
redeemable preferred stock
• The maturity period may be certain for some financial
assets like Treasury bill, bonds, commercial paper etc.
Characteristics of Financial Assets
6. Convertibility and Transferability
• It refers to the ability of the financial assets to be converted
into another financial assets within the same class or different
class.
• More over securities can be transferred from one party to the
other with out affecting the legal status of the original issues
• Example:
I. When a bond is converted in to anther bond.
II. A corporate convertible bond is a bond that the bond
holder can change in to equity.
Characteristics of Financial Assets
7. Liquidity and Marketability
• How easily are the assets converted to cash?
• It refers to the speed with which the asset can be sold.
• How easy is the asset to buy/sell?
• How cheap is it the asset to buy/sell?
• Liquidity may depend not only on the financial assets but also on
the quantity one wishes to sell or buy. While a small quantity may
be quite liquid, a large lot may be run into illiquidity problem.
• Note that liquidity is again closely related to whether a market is
thick or thin. Thinnest always has the effect of increasing the
round trip cost, even of a liquid financial asset.
End of chapter Four
Thank you
