Chapter- Two

FINANCAIL ASSETS, FINANCIAL TRANSACTION

AND FINANCAIL INTRMEFDIATION
Financial asset can be defined as an investment asset
whose value is derived from a contractual claim of
what they represent.
These are liquid assets as the economic resources or
ownership can be converted into something of value
such as cash. These are also referred to as financial
instruments or securities.

They are widely used to finance real estate and

ownership of tangible assets.

These are basically legal claims and these legal

contracts are subject to future cash at a predefined
maturity value and predetermined time frame.
Financial instruments are comprised of evidences
(= claims on the issuers) of:
 
 Debt (= claims on ultimate borrowers).
 Deposits (= claims on banks).
 Shares / equity (= claims on companies).
 Participation interests (PIs) (= claims on
investment vehicles).
 Derivatives.
Financial Instrument Types
We cover these instruments and issues related to
them under the following sections:
 
 Financial instrument types.
 Share instruments.
 Debt instruments.
 Deposit instruments.
 Instruments of investment vehicles.
 Derivative instruments
Financial instruments are borrowing instruments
held by lenders (ultimate and financial). How does
one categorize financial instruments? Some
tantalizing questions in this regard:
 
 Are there two categories: primary securities
(issued by ultimate borrowers) and indirect
securities (issued by financial intermediaries)?
 Are there two categories: debt and shares /
equity, because they are fundamentally
different?
 Are there two categories: marketable and non-
marketable?
 Are shares / equities borrowing instruments or
are they evidences of ownership of companies?
 Do preference shares represent ownership of
companies or are they just long-term loans?
 If equity finance in the form of ordinary
(common) shares is regarded as permanent
capital, are perpetual bonds not the same in
nature?
 Are deposit instruments debt instruments?
 Are the liabilities of the investment vehicles
debt instruments?
 What do the QFIs issue to fund themselves?
  
CENTRAL
BANK Surplus funds

ULTIMAT
E
ULITMATE
BORRO
LENDERS
WERS Interb
Securities (surplus
ank
(def icit economic
debt
economic units)
BANKS
units) Interbank
HOUSEH  
debt  
HOUSEH
OLD INVESTMEN
BANKS OLD
SECTO T VEHICLES
Securitie
s SECTO
R
R
Securitie CIs
s
CISs
AIs
CORPO QFIs: CORPO
RATE DFIs, RATE
SECTO SPVs, Securities SECTO
R Financ R
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GOVERN MENT
etc
MENT SECTOR
SECTOR Securit
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FOREI GN
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SECT Securiti
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OR
OR
These questions are posed to indicate that there is no
definitive answer as to how financial instruments should
be categorized. However, in our opinion the most logical
and technically correct categorization is:
 
 Evidences of shares / equity (because the majority of
shares represent ownership of companies and they pay
dividends).
 Evidences of debt (because the majority of debt is non-
perpetual and they pay interest).
 Evidences of deposits (because they are the liabilities of
specialist companies and carry a different risk profile).
 Evidences of investments in investment vehicles
(because they are fundamentally different to the rest of
the financial instruments).
In addition there are derivative instruments, which,
although they do not represent lending and borrowing,
cannot be called anything but financial instruments.
We discuss each of these in some detail. However,
before we do so, we present a further discussion on
whether shares / equities can be regarded as financial
instruments

Economic sticklers would maintain that shares /

equities are not financial instruments. This is based on
the premise that shares represent part-ownership of a
company and that they are not redeemable. They
would also maintain that finance means debt, not
shares / equity.
Share Instruments
There are two broad types of shares:
 
Ordinary (also called common) shares (also called
stocks). These shares impart to the holder the right to vote
on issues that affect the company. However, the
shareholder does not have a right to the profits until the
board of directors declares a dividend.

Preference (also called preferred) shares. These shares

impart to the holder the prior right over ordinary
shareholders to the distribution of dividends and capital in
the event of the company winding up.
There are a number of types of preference
shares:
 
 The “normal” or “common” preference share
(= redeemable and pays a fixed dividend).
 Non-cumulative preference share.
 Participating preference share.
 Convertible preference share.
 Hybrids of the above.
Shares stand behind debt in the line-up for
payment in the event of the liquidation of the
company, and ordinary shares stand behind
preference shares. This means that ordinary shares
have a residual value, or residual claim, status.

It should be apparent that holders of debt

instruments are creditors of the issuing companies.
They are not owners of the issuing companies, but
they have a superior claim on the issuing
companies’ profits and assets in relation to the
shareholders.
Example of Ordinary Share Certificate
Example of Preference Share Certificate
 Debt instruments
As a result of the processes of borrowing, lending and
financial intermediation, there is a wide range of debt
instruments in the financial systems of the world. A debt
instrument can be defined as a claim against a person or
company or institution (such as a government entity) for
the payment of a future sum of money (the nominal /
face / redemption value) and/or a periodic payment of
money. In many instances there is no periodic payment
of money (as in the case of treasury bills), while in
others there is (as in the case of most long-dated bonds,
interest on which is payable six-monthly in arrears).
Similarly, there may be no promise of a sum of money
in the future but a periodic payment only, as in the case
of an undated bond (perpetual bond).
The debt market is made up of:
The short-term debt market (STDM)
Long-term debt market (LTDM)
 
The most common money market instrument requires the
issuer to pay a single amount at maturity, while the most
common bond instrument requires the issuer to pay periodic
interest and to redeem the claim on the maturity (due) date.
 
One of the most important characteristics of financial claims
is that of reversibility or marketability. This refers to the
ease with which the holders of securities can recover their
investments, and can be achieved in one of two ways, i.e. by
recourse to the issuer or by recourse to a secondary market
(in which the holder can sell the claim).
The financial system and the debt (and share) and
securities issued by the ultimate lenders and QFIs. For
the moment we exclude the banking / deposit part of the
money market.
 The household sector (as a borrower) is not able to issue
marketable securities, for obvious reasons. They may
issue IOUs to friends or family, but generally the debt
they incur is loans from banks in various forms such as:
 
 Overdrafts.
 Mortgages.
 Fixed term loans.
 Leasing contracts.
 Instalment credit contracts.
The financial debt instrument (claim / asset) held by
the bank is a contract, a mortgage bond, a negative
balance on a bank statement, or some other evidence
of debt.
NMD in these forms make up a large proportion of
banks’ balance sheets. As we have seen, NMD may
be split into
short-term debt (= money market debt; e.g. overdrafts
belong here), or
long-term debt (= long-term debt market; e.g.
mortgage advances and leasing contracts fit here).
 
The corporate sector issues NMD in the main
because most companies are not large enough to be
able to issue marketable debt (MD) (no investor will
buy this debt). It is only the large listed companies
that are able to issue MD (if the debt is highly rated
by a rating agency). The NMD issued by companies
is essentially the same as for the household sector,
and the NMD of these two sectors makes up the vast
majority of banks’ balance sheets. The MD issued by
the corporate sector is relatively small.
The MD issued by the corporate sector is:
 Corporate bonds: These are longer-term (i.e. longer
than a year and usually 3–15 years) fixed- interest
and variable-rate securities.
Commercial paper (CP): These are undertakings to
pay a certain sum of money on a particular date in the
future. They are not endorsed by banks, and are
short-term in currency (i.e. in term to maturity).
Bankers’ acceptances (BAs): BAs are bills of
exchange drawn on and accepted (guaranteed) by a
bank. They usually are drawn for periods of 91 days
and 182 days. Countries have different conventions in
this respect.
Securitization bonds: (as the SPVs are usually
companies, the paper can be termed corporate bonds).
An example is mortgage-backed securities (MBS).

Collateralized debt obligations: (CDOs, also called

collateralized loan obligations – CLOs).

It will be evident that corporate bonds, securitization

(SPV) bonds (CDOs, etc) are part of the bond market,
whereas CP and BAs are part of the money market
The government sector differs from country to
country, but there are at least two levels:
Central government and local governments. Some
countries have provincial governments. Central
governments usually fund part of their budget deficits
by the issue of MD (because this form of funding is
cheaper):
 
Government bonds, which range from a few years to
up to 30 years, and make up the major part of bond
market.
Treasury bills (TBs), which range from 91 days to
273 days (in most countries).
Example of Central Government Bond
Example of Treasury Bill
 Bonds
This type of financial assets is usually debt instrument
sold by companies or government in order to raise
fund for short-term projects.
 A bond is a legal document that states money the
investor has lent the borrower and the amount when it
needs to be paid back (plus interest) and the bond’s
maturity date.
Some of the popular types of bonds are:
Fixed rate bonds which have coupons
remaining constant throughout the life of the
bond.
Floating Rate Notes are those having the
coupon linked to the reference rate of interest
such as the LIBOR. Since these are volatile in
nature, they are classified as Floating. Fo r e.g.
the interest rate maybe defined as LIBOR +
0.25% and does get re-calculated on a periodical
basis.
Corporate Bonds is a debt security issued
by various Corporations and sold to various
investors. The backing for such bonds depends
on the payment ability of the company which
in turn is linked to future possible earnings of
the company from its operations. These are the
aspects looked in by the credit rating agencies
before giving in their confirmation.
Government Bonds is a bond issued by the
National Government promising to make
regular payments and repay the face value on
maturity. The terms on which the government
can market depends on the creditworthiness in
the market.
Zero Coupon Bonds does not pay periodical
interest. They are usually issued at a discount to
the par value making it attractive. This difference
is then rolled up on maturity and the full principal
amount is paid on maturity. Such bonds can also
be issued by financial institutions through
stripping off the coupons from the principal
amount.
High Yield Bonds are those which are rated
below investment grade by the credit rating
authorities. Since these are lower grade, they are
expected to offer larger yield and making them
attractive. These are also termed as Junk Bonds.
Convertible Bonds allows the holder to
exchange a bond against a number of equity
shares. These are considered as hybrid
securities since they combine features of
equity as well as debt.

Inflation-indexed bonds are those in which

the principal and the interest amount is linked
to the inflation prevailing in the economy.
Subordinated bonds have a lower priority
than other bonds of the issuer at the time of
liquidation. The risk is higher compared to
Senior bonds and once the creditors and senior
bondholders are paid, the subordinated
bondholders are prioritized.

Comparatively, they have a lower credit rating

and some of the examples are bonds issued by
banks, asset backed securities etc.
 Deposit instruments
Below Figure illustrates the instruments of the
former illustration (debt and shares) as well as the
issuers of deposit securities, i.e. the central bank and
the private sector banks. It also indicates the three
interbank markets, which we cover in the text on
money creation).
 
The central bank in most countries is the sole issuer
of notes and coins. It may seem strange to call these
deposit securities, but they are: the public and banks
that hold these have made a deposit with the central
bank.
MD = marketable debt;
NMD = non-marketable debt;
CP = commercial paper;
BAs= bankers’ acceptances;
CDs = certificates of deposit (= deposits );
NCDs = negotiable certificates of deposit;
NNCDs = non-negotiable certificates of deposit;
foreign sector issues foreign shares and foreign MD
(foreign CP & foreign bonds);
PI = participation interest (units)
 
Figure 5: financial instruments / securities
  
CENTRAL
BANK • C
D
s
=
BORROW N LENDERS
ERS
C (surplus
(deficit economic
Interb D CDs
economic units)
ank s
units)
debt &
BANKS N
CDs =
HOUSE Interban NCDN  
HOUSE
Debt = NMD k debt s& C
 
HOLD HOLD
Share INVESTME
SECTO s BANKS NNCD CDs SECTO
NT
R Shares
Deb
t Ds s R
VEHICLES
Debt = MD (CP,
CORPO BAs, bonds) & CIs ORPOR
C

RATE NMD QFIs: ATE

DFIs, CISs
SECTO AIs SECTO
R Debt = MD (bills, SPVs, R
bonds) Debt = MD (CP,
Finance
  Co’s, etc bonds) & NMD GOVERN
Shares MENT
Debt = MD (CP,
bonds)
GOVERN Share SECTOR
MENT s
Debt
SECTOR
 
FORE
FOREIGN Share
s IGN
SECTOR Debt
SECT
OR
 Instruments of investment vehicles
A reminder of the investment vehicles:
  Contractual intermediaries:
 Insurers.
 Retirement funds.
 Collective investment schemes:
 Securities unit trusts (SUTs).
 Property unit trusts (PUTs).
 Exchange traded funds (ETFs).

 Alternative investments:
 Hedge funds (HFs).
 Private equity funds (PEFs).
Derivative Instruments
In addition to the debt, deposit, share and PI
securities, there are a number of other related
financial instruments that are called derivatives.

The name arises from the fact that these

instruments are derived from debt and share
instruments, which mean that they cannot exist
on their own, and they derive their value from
the underlying debt and share instruments.
.
Derivative Instruments
  Forwards / futures on swaps

FORWARDS
SWAPS

FUTURES
OPTIONS

Options Options on
on swaps =
futures swaptions
It must be added that there are also other
derivative instruments that are derived not from
debt instruments but from commodities (soft, such
as grain, and hard, such as metals). In addition
there are derivatives that are not derived from
debt, shares or from commodities, such as weather
derivatives; they are also financial instruments.
 
The wide array of derivatives can be quite
confusing: futures, swaps, options, swaptions,
forward rate agreements, forwards, caps and
floors, repos, weather derivatives, credit
derivatives, etc. Sorting them out in a logical sense
is a challenge.
Our attempt is presented in Figure above
Derivatives are found in all markets.
 
Essentially, forwards and futures are contracts to
buy or sell an asset (commodity, financial
instrument or index) on a specified date in the
future at a price determined upfront. An option is
the same, except that the buy or sell is optional and
the date is on the contract expiry date or before.
Swaps are contracts to exchange cash flows on
specified dates in the future, based on a notional
amount.
Direct vs. Indirect Financing
Direct Financing
You engage in direct financing when you
borrow money from a friend and give him or
her your IOU or when you purchase stocks or
bonds directly from the corporate issuing
them. These direct financial arrangements take
place through financial markets, markets in
which lenders (investors) lend their savings
directly to borrowers. Brokers, dealers and
investment bankers play important roles in
direct financing.
Dealers carry an inventory of securities from
which they stand ready either to buy or sell
particular securities at stated prices. The
inventory of securities held by a dealer is
called a position. Taking a position is an
essential part of a dealer's operation. The
dealers who make a market of a security
quote a price at which they are willing to buy
(the bid price) and a price at which they are
willing to sale (the ask price).
They make profits on the spreads between
the bid and ask prices. Brokers provide a
pure search service in that they act merely as
matchmakers, bringing lenders and
borrowers together. Brokers differ from
dealers in that brokers do not take positions.
Either a buyer or a seller of securities may
contact a broker. Their profits are derived by
charging a commission fee for their services.
Indirect Financing
Financial intermediaries purchase direct
claims with one set of characteristics (e.g.
term to maturity, denomination) from
borrowers and transform them into direct
claims with a different set of characteristics,
which they sell to the lenders. The
transformation process is called
intermediation. Notice that in the financial
intermediation market the lender's claim is
against the financial intermediaries rather than
the borrower.
In producing financial commodities,
intermediaries perform the following asset
transformation services:
(1) Denomination Divisibility;
(2) Maturity Flexibility;
(3) Diversification;
(4) Liquidity.
 
Types of Financial Intermediaries
Financial intermediaries can be grouped in the
following way
(1) Depository Institutions: commercial banks,
savings and loan associations, savings banks, and
credit unions. They derive the bulk of their
loanable funds from deposit accounts sold to the
public.

(2) Contractual Savings Institutions: insurance

companies and pension funds. They attract funds
by offering financial contracts to protect the saver
against risk.
(3) Investment Intermediaries: finance companies,
mutual funds, venture capitalist, and money market
mutual funds (MMMFs). They sell shares to the
public and invest the proceeds in stocks, bonds, and
other securities.
In Taiwan, the central bank and depository
institutions are called monetary institutions,
because they issue monetary indirect securities
(deposit contracts etc.), while contractual
savings institutions and investment
intermediaries issue non-monetary indirect
securities (shares and insurance policies) to
finance their investments.