TOC
1. Definition
A financial claim is a claim to the ownership of a series of future cash flow. A financial claim is also called a financial asset, security, or instrument.
A financial liability: the obligation to pay the future cash flows
In a closed economy: total financial assets = total financial liabilities
2. Characteristics of financial claims
2.1 Risk and expected return
Risk refers to the uncertainties of the future cash flows that determine the value of a financial claim; Risk is measured by variance
Expected return is a weighted average of all possible returns; the weights are the possibilities of each possible return
2.2 Real value certainty
Nominal value is the stated value. While Real value is the nominal value adjusted for inflation ⇒ the value of a financial claim expressed in the base-year money
Measure inflation: use CPI ⇒ Inflation rate = (CPI-CPI)/CPI
Relation between the real value and the nominal value:
- Nominal return (r), Real return (R), inflation rate (i) have the equation:
- , approximately: r=R+i
- inflation and real value:
- i > r ⇒ R < 0 ⇒ real value decrease
- i = r ⇒ R = 0 ⇒ real value not change
- i < r ⇒ R > 0 ⇒ real value increase
Real value certainty: measures the extent to which the real value of a financial claim is affected by inflation. High real value certainty means that asset is less affected by inflation, i.e. less sensitive. Some asset examples:
- Cash: lowest real value certainty
- Debt: low real value certainty
- Shares: high real value certainty
- Property: very high real value certainty
2.3 Liquidity
Liquidity measures how easily and quickly a piece of financial asset can be converted into cash without loss (Cash itself is liquidity)
Liquidity and return: liquid assets usually offer lower returns than illiquid assets while Investors like liquid assets
Rule of thumb: Assets having an open market is normally more liquid than those that do not; Assets that can be dealt at a short notice is usually more liquid than those that cannot
Measurement of liquidity: 1. Basic and direct measure is based on the intra-day data including bid-ask spread; 2. Derived or indirect measures based on daily data (less costly to compute) including Trading volume; turnover, Amihud illiquidity measure (price impact per dollar of trading volume), etc.
2.4 Term to maturity
Term to maturity is the time remaining before a financial claim expires. The range of term to maturity is . For debt, it’s normally from 1 day to 30 years while for shares, it’s usually indefinite.
2.5 Currency denomination
All financial claims are denominated in a certain currency, like GBP, USD etc. It is not subject to the jurisdiction and regulation of its country of origin.
3. Debt and equity
Equity is the claim to company’s ownership including Common equity, Preferred shares, Control rights (including voting rights) and cash flow rights, etc.
The cash flows of equity includes Dividend, Selling price Residual liquidation value, etc.
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