Asset Classes

Introduction

What is an investment?

  • A commitment of resources with the expectation of a future payoff.
  • Financial investments: stocks, bonds, options, futures.
  • Other investments: education, physical fitness, relationships.

Decisions faces by investors:

  • Risk-return trade-off.
  • Efficient pricing of financial assets.

Real vs. Financial Assets

Real assets are goods (generally tangible) that are used to produce other goods or services: buildings, machines, land, knowledge.

  • Productivity of economy determined by real assets.

Financial assets are claims to income generated by real assets.

  • Firms use the money raised through financial assets to invest in plants, equipment, labor, etc.
  • Holder of financial asset receives a portion of the resulting returns from real assets.

While real assets determine wealth, financial assets determine distribution of wealth.

Equity Assets

Equity (stock) is an ownership claim in a particular firm.

  • Equity holder owns a prorated share of the real assets of a firm and is entitled to a portion of the profits that is not reinvested (dividends).
  • The return to an equity asset is not guaranteed: it is tied to the financial well-being of the firm.

Equity Example

Consider The Coca-Cola Company.

  • On 14 Jan 2014, there were 4.42 billion shares of KO outstanding.
  • On 28 Nov 2013, KO decided to pay $1.24 billion in dividends to shareholders.
  • This amounted to $0.28 paid to each share.
  • If the company were liquidated, each share would entitle the holder to 1/4,420,000,000 of all KO assets.

Equity Prices

There are several ways to think about the price of an equity share.

  • Add the values of all firm assets and divide by the number of shares outstanding.
  • Alternatively, it is the present value of all future payments (dividends).
\[P = \sum_{t=1}^{\infty} \frac{D_t}{(1+r)^t}\]
  • \(D_t\) represents the dividend payment at future date \(t\), and \(r\) is the competitive interest rate that you could otherwise earn on your money.

Present Value

Recall that present value is a way to value future payments in current terms.

  • Money paid to you in the future should be less than money paid now.
  • Why?

Present Value

Suppose you can earn 10% interest on every dollar you save tonight.

  • Then if you save $0.9091 tonight, it will be worth $0.9091 \(\times\) 1.1 = $1 tomorrow.
  • If I offer you either $0.92 today or $1 tomorrow, which would you pick?
  • If I offer you either $0.90 today or $1 tomorrow, which would you pick?

Fixed Income Assets

Fixed income securities are assets with payments determined by a formula (e.g. bonds).

  • U.S. Treasury bills/bonds, commercial paper, CDs.
  • Although fixed income payments are determined mathematically there is still risk (interest rate risk, default risk).
  • Longer maturity fixed income assets tend to be more risky.
  • Fixed income is typically less risky than equity because the payments are guaranteed.

Fixed Income Assets

  • Fixed income assets are typically a way for firms or governments to borrow money.
  • It is possible to hold both equity and debt (fixed income) assets for the same firm.

Fixed Income Prices

Fixed income assets typically promise a stream of payments at future dates.

  • Coupon payments at regular intervals.
  • A final principal payment (face value) at the end.
  • The price of a fixed income asset is the present value of these payments.
\[P = \sum_{t=1}^T \frac{C_t}{(1+r)^t} + \frac{F}{(1+r)^T}.\]

Derivatives

Derivatives are assets whose payoffs are determined by another (underlying) asset.

  • Options are assets which allow the holder the option to buy or sell an asset at a pre-specified price at a future date.
  • Futures are contracts to buy and sell assets (real or financial) for a pre-specified price at a future date.
  • These assets are called derivatives because their value derives from the value of the underlying asset.
  • Derivatives are commonly used for hedging (insurance) but are sometimes used for speculation, too.