1  Financial assets and markets

1.1 Financial assets

An asset is any resource owned by a person or business. Assets can be tangible, such as buildings and equipment, or intangible, such as goodwill, copyrights or patents. Tangible assets are anything that can be touched. Intangible assets lack that physical substance.

It is often hard to value an intangible asset. What is the value of the name “McDonalds”? What is the value of the copyright for my contribution on drums in a sound recording?

Financial assets are assets that get their value from a contractual right or claim of ownership. Financial assets include:

• Cash
• Bank deposits
• Stocks: A share of ownership in a company, entitling the owner to a share of the company’s profits
• Bonds: A financial asset by which the bond issuer owes the bond holder a debt for which they are obliged to pay interest, the principal at a later date, or both
• Derivatives: A derivative is a contract that derives it performance from the performance of an underlying entity. Examples of derivatives include futures, which are an agreement to buy something at a predetermined price at a specified time in the future, or options, which give the option holder the right (but not obligation) to buy or sell an asset a specified price before or on a specified date.

Financial assets sit somewhere between tangible and intangible assets. In economics and law, financial assets are usually classed as intangible assets as they lack physical form. However, under accounting standards they are often classed as tangible assets as they are easily valued and should be included in company accounts. Their precise treatment varies across countries and legal systems.

1.2 Financial markets

A financial market is a market in which people trade financial securities (a trade-able financial asset). Securities include stocks, bonds, derivatives and commodities such as metals and agricultural outputs.

The type of financial market that you hear most about in the media are exchanges, which are organisations that facilitate the trade in financial securities.

In Australia, our best known exchange is the ASX. The ASX provides a facility where traders can buy and sell securities, such as stocks and derivatives. Buyers and sellers are matched, with prices on most of their markets publicly available in near real-time.

The beauty of public exchanges is that they provide a rich and detailed history of prices of stocks and other securities that we can examine. Heavily traded stocks might trade many times every minute, providing a highly detailed trajectory of their prices over time.

1.3 Valuing a financial asset

The value of a financial asset traded on a financial market has one easily accessible measure of its value: its price.

This does, however, raise the question of why a purchaser would want to pay that price for an asset. They must value the asset at the price or higher, or they would not purchase.

The value of a financial asset will ultimately be realised in the flow of payments that asset entitles the owner to in the future. For example, ownership of a stock will yield a stream of dividends to the owner until such time as they sell or the company is wound up.

As a result, one simple model of the value of a security is that the value equals the rationally expected present value of future payments. This is often called the “fundamental value” of a security.

Calculating this fundamental value requires a “discount rate”, which reflects the stock’s risk. Payments in the future are discounted by this discount rate. A challenge with any model is that you need to know what the appropriate discount for risk is, but this is not something we know.