There are peculiar characteristics that are inherent in
financial assets that are normally used partly to determine their pricing in the financial markets. These characteristics are identified and discussed below.
1
Moneyness
The moneyness of the financial assets implies that they are easily convertible to cash within a defined time and determinable value. The cost of transactions involved in securing funds from them before the maturity date can be likened to agency cost besides the cost of discounting some of them, which reduces their face value. Therefore, these financial instruments are regarded as near money because of the ease with which they can be traded for cash. Examples are Treasury bills, Treasury certificates, Trade bills, Commercial papers, and Certificate of Deposits, among others.
2
Divisibility & Denomination
The financial assets are usually made out in denominations depending on the face value that the corporate organizations and institutions that are using them to raise funds from the financial markets. The divisibility of such near money refers to the minimum monetary value in which a financial asst can be liquidated or exchanged for money by the holder.
Divisibility for financial assets is imperative so as to enable both suppliers and borrowers to understand the magnitude of funds involved in each of them; the borrowers have certain amount to source and the suppliers will like to know the amount that is required of him to part with for the transaction. It is also necessary so that a limit cab set for the minimum amount of subscription for each instrument and the overall amount of subscription that may accrue to a particular investor. For instance, many bonds can denominated like N1,000 denomination while that of certificate of deposits are denominated form N500,000.
3
Reversibility
The financial assets are highly reversible in the sense that they are like deposits in accounts of customers with the banks. This implies that the cost of investing in the financial assets and getting them back into cash is negligible. Hence reversibility of financial assets is often regarded as turnaround cost or roundtrip cost.
The most relevant part of the roundtrip cost as associated with financial assets constitutes what is known as the ‘bid-ask spread’ in which commissions cost of delivery an asset is entrenched. In the well-organized financial market there are market makers who take responsibility of assuming risk in associated with the financial assets while making the market or carrying inventory of financial assets.
Therefore, the spread being charged by the market makers varies in line with financial assets that are traded. Some financial assets carry less risk than others; for instance, marketable securities that can easily be converted into liquid cash with little or no hassles because they are more liquid than other financial assets. The risk involved in marketable securities or mortgage loan stock cannot be comparable with risk inherent in bond issue of a fledgling company.
The risk involved in market making is related to market forces that are twofold such as: Variability of the price; and Thickness of the market.
a)
Variability of Price of financial asset
This is determined by some measure of dispersion in the price. It implies that the greater the variability in price, the greater the probability that the market maker may loose in the bargain. For instance, a speculative stock such as shares will be fraught with much larger short-run variations. On the other hand, Treasury bills, which government securities (or gilt-edged securities) exhibit stable price with less short-run variation.
b)
Thickness of the Market for financial asset
The thickness of the market implies the frequency of transactions on a given financial asset. A thin market reflects a financial asset that has few trades on a regular or continuous basis, hence the greater the order flows on it the shorter the time that the asset will be held in the inventory of market makers. Therefore, such financial asset will exhibit smaller probability of an unfavourable price movement while it is in the inventory of market makers. A thick market is associated with market where frequent transaction on financial assets is being exhibited and this varies from market to market. Hence a particular market for a financial asset such as shares may be thick while in another such financial asset may be thin. For instance, the shares of blue-chip firms will exhibit thickness in transactions while the shares of small companies may exhibit thinness in transactions in a given market situation.
4
Cash
Flow This refers to the return that an investor will derive from holding a financial asset, which invariably depends on all the cash distributions that the asset will pay holders. This is expressed in terms of the dividend on shares or coupon yield payments that are associated with bonds.
The return on investment in a financial asset is also affected by the repayment of the principal amount for a debt instrument and any expected price variation of the stock. In calculation of expected returns on a financial asset, factors that should be considered include non-cash payments in form of stock dividend yield and options to purchase additional stock or the distribution of other securities that must be factored in the consideration. The issue of inflation implies that there is difference between normal effective return and real effective return on financial assets. Therefore, the net real return on financial assets is the amount of cash returns that are accruable after adjusting the nominal returns against inflation.
5
Maturity Period
In financial parlance, the maturity period refers to the length of time within which the corporate entity or institution that employs a financial instrument to raise funds will use the funds before its payment back to the holders of such instrument. For instance, a bond can be held by a corporate entity for a period of thirty (30) years while that of government can extend to a period of ninety-nine (99) years before their repayment to the holders.
There are some financial instruments being traded in the financial markets that may not reach the stated maturity dates before they are terminated by the corporate entities that use them to raise funds. There are reasons that may be responsible for such situation which include the following:
Bankruptcy:- a situation in which the company is being unable to meet its external financial obligations and therefore, declared bankrupt;
Reorganization:- a situation in which the company is restructuring its ownership structure and operations; and
Call Provision:- the financial instrument being associated with call provision.
The case of call provision implies that the company as the debtor or user of the funds takes responsibility of setting aside sinking funds with which to redeem the instruments eventually.
The sinking fund is normally made as one of the contractual obligations that are established in the agreement or indenture regulating the usage of the funds from the financial instrument.
6
Convertibility
This characteristic implies that a financial asset or instrument can be converted into another class of asset which will still be held by the corporate entity has original used to raise funds for its operations. The conversion can take a form of bond being converted to bond, preference shares being converted to equity shares, and a company bond being converted into equity shares of the company.
The opportunity for convertibility of financial instruments into another financial assets has to be entrenched in the covenant which has been written to guide the contractual agreement on the instrument or to regulate the behaviour of the company using the funds from the instruments. Nevertheless, such a provision can be negotiated in the course of the usage of the funds by a company especially when the holders discover that the company is manipulating its operational and financial records to shortchange them.
7
Currency
Financial assets are normally denominated in currencies of the various countries around the world. This implies financial assets of the Nigerian financial system are denominated in Naira such as Federal Government Loan Stock, Treasury Bills, Treasury Certificate, Shares and Corporate and State Government Bonds. Those financial assets in Japan are denominated in Yen, those in the United States of America are in Dollars, those in United Kingdom are in Pounds Sterling while those in China are in Yuan, etc.
You have also learned from the initial section of this study unit that financial assets as products of transactions in the financial markets can be denominated in various currencies particularly the local currencies of various economies around the world. Nevertheless, there are those financial instruments that are traded across international boundaries in some countries especially in highly developed capital markets in US, UK, Japan, France, and South Africa, just to mention but a few. Such financial assets are usually denominated mainly in American dollars and any other international money that is acceptable around the world.
Furthermore, it is important for investors to know the currency in which certain financial assets are denominated when buy them. For instance, the recent ECO Bank shares were denominated in US dollars when they were offered to the public for subscription. These shares were floated across international boundaries many countries in Africa. Therefore, the use of an international currency such as the US dollars made it easier for the bank to handle the transactions in the stock seamlessly. Nevertheless, subscribers were made to pay the equivalent of their total amount of subscription in their local currencies. The dividends for these shares are also being paid in US dollars.
Dual currency securities may be issued in some instances. For instance, the EURO Bonds are issued in dual currencies for ease of transactions by multiple subscriptions by various investors around the world. Therefore, it is the policy on EURO Bonds to pay interest in one currency while the principal repayment is effected in another currency.
8
Liquidity
You have learned from above that one of the main characteristics of financial assets is the moneyness of such instruments which implies that they are easily convertible to cash within a defined time and determinable value. The cost of transactions involved in securing funds from them before the maturity date can be likened to agency cost besides the cost of discounting some of them, which reduces their face value. Hence, these financial instruments are regarded as near money because they are highly liquid in terms of the ease with which they can be traded for cash. Good examples of highly liquid financial instruments include Treasury bills, Treasury certificates, Certificate of Deposits, Bills of Exchange, and shares of blue chip companies, e.g., Shares of Cadbury, First Bank, Guaranty Trust Bank, etc.
However, there are some financial instruments that cannot be easily converted to cash whenever the holders need money. Therefore, they are illiquid because the holders may have to retain them till they are matured; alternatively they can only trade them for very insignificant value in capital markets where there are jobbers that may be willing to carry them in their stock of securities. Presently there are no jobbers operating in the Nigerian Stock Exchange, and hence the stock brokers in the Exchange are usually not willing to trade in financial instruments of weak corporate entities.
9
Predictable Returns
The return on financial assets must be predictable for the purpose of their being patronized by investors. For instance, the investors should be able to know the percentage of interest that are attached to certain debt instruments before they will be prepared to stake their funds on them. This is because performance of a company cannot be taken for granted due to the mere fact that top management and the boards of directors are known to be manipulating the accounting records of their companies these days. This is more reason why investors are always very skeptical in patronizing financial instruments of some corporate entities due to their antecedents in manipulating their accounting records. The cases of Cadbury in Nigeria and Enron in the US are classical testimonies to the unwholesome accounting practices in the operations of companies around the world.
However, the returns on bonds, development loan stocks, and preference shares are determinable so that the investors are aware about the expected returns on their investment. There other government securities such as Treasury bills and Treasury certificates which are traded in money market that command fixed returns. The apex bank has the responsibility in their issuance and also their repayment as well as the payment of their returns to the subscribers. Therefore, State government bonds, Federal Government development loan stocks, Treasury bills and Treasury certificates are regarded as gilt-edged securities because their returns as well as principal amount of investment in these securities must be paid as at when due for settlement.
The issue of unpredictability of future returns on some securities such as equity shares results from volatility in earnings by the companies in their operations. However, the unpredictability to future returns can be measured on how it relates to the level of volatility of a given financial asset. The returns on equity shares like dividends are the residual payments from the earnings of corporations. Nevertheless, the attraction in these shares is the possibility of capital appreciation in their value but subject to the performance of their corporations and capital market operational forces.
10
Tax Status of Returns
The returns on various financial assets are subject to tax status because they are taxable earnings. The tax authorities are interested in collection of taxes on earnings from financial assets as securities which are regarded as incomes for investors. However, the tax status on financial assets varies from one economy to another.
The rate of such taxes on financial assets is also subject to variation from time to time depending on the interest of the government which must be adhered to by the tax authorities. The tax status on financial assets also differs from one type of security to another depending on the nature of the issuing companies or institutions such as Federal, State, or local government.
