Financial Asset

A financial asset is a claim on the future income or assets of another party, represented by a contract or a security. Financial assets include bank deposits, bonds, shares, loans, and derivatives. They are distinguished from real assets, which are physical and productive.

Types

Financial assets may be classified in several ways. By the type of claim, they may be debt, which entitles the holder to fixed payments, or equity, which entitles the holder to a residual claim. By maturity, they may be short-term or long-term.

By the nature of the issuer, they may be issued by governments, by firms, or by households. Government securities are typically the lowest-risk assets in a market, and they serve as benchmarks for the pricing of other assets.

By the degree of liquidity, they may be more or less easily converted into cash. Liquid assets can be sold quickly with little effect on their price, while illiquid assets cannot.

Valuation

The value of a financial asset is the present value of the cash flows that it is expected to generate, discounted at a rate that reflects the time value of money and the risk of the cash flows.

The cash flows may be contractual, as for a bond, or contingent, as for a share or a derivative. The discount rate reflects the risk-free rate and a premium for the risk of the asset. The valuation therefore depends on expectations about the cash flows and on the required rate of return.

Risk

Financial assets are exposed to several types of risk. Credit risk is the risk that the issuer will fail to meet its obligations. Market risk is the risk that the price of the asset will move adversely. Liquidity risk is the risk that the asset cannot be sold quickly at a fair price. Interest rate risk is the risk that changes in interest rates will affect the value of the asset.

The risks of an asset are related to its characteristics. A long-term bond is more exposed to interest rate risk than a short-term bond. A share is more exposed to market risk than a government bond. The assessment and the pricing of risk are central to the functioning of financial markets.

Role in the Economy

Financial assets channel funds from savers to borrowers and thereby support investment and growth. They allow savers to hold claims that match their preferences for liquidity and for risk, and they allow borrowers to raise funds for investment.

Financial assets also provide the basis for the payment system and for the management of risk. They are used as collateral, as stores of value, and as instruments of speculation. Their creation and their trading are central to the functioning of the financial system.

The Pricing of Assets

The pricing of financial assets is based on the present value of expected cash flows and on the required rate of return. The required return reflects the risk-free rate and a premium for the risk of the asset.

Several models are used to determine the required return. The capital asset pricing model relates the required return to the beta of the asset, which measures its sensitivity to market movements. The arbitrage pricing theory relates the required return to several factors. The models differ in their assumptions and in their empirical performance.

The pricing of assets also depends on the characteristics of the market. In a well-functioning market, prices reflect the information available to participants. When information is incomplete or when markets are segmented, prices may deviate from fundamentals.

Market Efficiency

The efficient market hypothesis holds that asset prices reflect all available information, so that it is impossible to earn excess returns consistently. The hypothesis implies that price changes are unpredictable and that active management cannot outperform the market after costs.

The hypothesis is supported by evidence on the difficulty of outperforming the market and on the rapid response of prices to news. It is challenged by evidence on anomalies, including the tendency of value stocks to outperform growth stocks and of prices to react slowly to some types of information.

The debate about market efficiency continues, and it is relevant to the design of policy. If markets are efficient, regulation should focus on disclosure and on the prevention of manipulation. If markets are inefficient, there may be a role for policy to correct mispricing and to reduce the risk of bubbles.

Financial Assets and Financial Stability

Financial assets are central to financial stability, since their pricing and their trading affect the balance sheets of institutions and the flow of credit. Changes in asset prices can amplify shocks, through their effect on collateral values and on the willingness of institutions to lend.

The creation of financial assets through credit is central to the build-up of leverage and to the emergence of crises. The analysis of financial stability therefore focuses on the growth of credit and on the valuation of assets, and on the interaction between them.

The regulation of financial assets and of the institutions that hold them is designed to contain these risks. The framework includes capital requirements, liquidity requirements, and disclosure requirements, and it is complemented by macroprudential instruments that address systemic risk.

Summary

Financial assets are claims on future income, and their pricing and their role in the financial system are central to the analysis of finance. The analysis of pricing, of market efficiency, and of financial stability informs the understanding of the role of finance in the economy.

See also

• Financial Economics
• Capital Market
• Banking