Financial Asset Classes

Hi,

In this blog, I am trying to explain various types of financial assets with more focus on derivatives and its variants.

Financial assets are broadly classified into equity, debt securities, and derivatives.                               

Equities or common stocks represent ownership share in the corporation.

§  Common stock holders have residual claim on the assets and income of the corporation (when the corporation is liquidated they have a last claim), and their liability is limited (creditors cannot lay claim to personal assets of the stock holder). 

§  Equity shareholders are entitled to vote and receive dividends (if declared). Returns to shareholders are tied to corporation performance.  

§  An investor can purchase share of foreign company, not directly, but through Depository Receipts. American Depository Receipts (ADRs) are certificates traded in U.S. markets representing ownership in shares of a foreign company.

Debt or fixed income securities promise to pay fixed stream of income (e.g., In a 8% 5 year bond, par value $1,000; the investor gets $80 as interest each year) or a stream of income determined by a specified formula (e.g., In a 5 year LIBOR +2% bond, par value $1,000; the investor gets interest at the prevailing LIBOR rate + 2%).

§  London Interbank Offered Rate (LIBOR) is short term interest rate at which large banks in London are willing to lend money among themselves, and it also acts as reference rate in European money market.

§  Money market securities consists of very short term, highly marketable, low risk securities (e.g., Treasury bills, Certificate of Deposits, Commercial papers, Repos and Reverses etc.)

§  Long term securities include Treasury bonds, bonds issued by federal agencies, state and local municipalities (these will be discussed separately).

A derivative security derives its value from another security’s characteristics or value. The other security is termed as underlying asset.

Derivatives have variants such as forwards, futures, options, and swaps etc.

A spot contact is an agreement to buy/sell an asset today. In contrast, a forward contract is an agreement to buy/sell an asset at an agreed (exercise) price and quantity to be delivered on or before the future agreed date (expiration date).

§  Forwards are private contracts traded in over-the-counter markets and are usually between two financial institutions or between financial institution and one of its clients. They are highly customized and usually not regulated.

Future contract, unlike forward contract, is a more formalized, legally binding agreement and are traded on registered exchanges.

§  They are highly standardized regarding quality, quantity, delivery time and location for each specified commodity.

§  Clearing house acts as counterparty to all future contracts (i.e., if one of the party to the contract fails to fulfill his/her obligation clearing house fulfills the contract either by buying/selling).

§  Futures contracts are marked to market on a daily basis (i.e., profit/loss are booked on a daily basis). The investor is required to maintain sufficient funds in margin account.

§  A long position in a futures contract is held by the trader who commits to purchase the asset on the delivery date. A trader holds short position if he/she commits to deliver the asset on delivery date.

A call option contract gives the option holder the right, but not the obligation, to buy an asset at the exercise price from the option seller within the specified time period.  

A put option contract gives the option holder the right, but not the obligation to sell an asset at the exercise price from the option buyer within the specified time period.

§  The value of an option depends upon strike (exercise) price, current stock price, time to expiration (maturity), dividends etc. To exercise or not to exercise the option depends on all these factors.

§  The buyer of option contract (both call and put) has to pay option premium. The owner of the option contract is called buyer or holder of long position, and the seller is called writer or holder of short position.

§  An American option contract can be exercised at any time between the issue date and expiration date, but a European option contract can be exercised only on the expiration date.

§  There are various trading strategies involving options (e.g., covered calls, protective puts, butterfly spreads, bull and bear spreads etc.)

A swap is an over-the-counter agreement between two entities to exchange cash flows in the future. For example, a corporation agrees to pay cash flows equal to interest at a predetermined fixed rate on a notional principal for a predetermined period. In return, it receives interest at a floating rate on the same notional principal for the same period of time. This type of swap is known as interest rate swap.

§  Currency swap involves exchange of principal and interest payments in one currency for principal and interest payments in another currency. Currency swaps are used to transform liabilities into assets.