Financial Assets

Concept of Financial Assets

While human capital is an extremely important part of economic growth, capital used to generate more capital has been of ever-growing importance for economies worldwide. An economic system that provides efficient channels that move an individual's savings to investment will have a higher possibility of generating more economic growth.

These funds are provided to startups and businesses through individual savings, promoting further development and creating more value in society. A business that takes a loan and then pays back the loan with an interest payment provides a return for the lender and provides income for other people employed in the business or own shares in the business.

Where does this process take place, and what channels in the economy enable the movement of funds from borrowers to savers?

Financial markets are markets where individuals can invest their savings and generate returns. Savings are invested in a financial asset, enabling individuals to create more wealth.

Financial Assets Definition

We will look at a simple definition of financial assets to get a clear understanding of what it is.

There are also physical assets, which involves investing in tangible objects. On the other hand, financial assets are not investments into a real tangible product but rather in financial products created by financial institutions.

A loan is one of the most common examples of a financial asset. As it is a financial asset, a loan is also a liability. How? Well, when you go to the bank and take a loan, you owe money to the bank, which you will have to pay back together with interest on top. This serves as an asset for the bank, but it is a liability for you as you will have to end up paying the loan sooner or later. In addition to loans, other types of financial assets include stock, bonds, and bank deposits. As the financial asset is a claim on another party's future income, it will always be an asset for one side and a liability for the other.

The interest that could be earned from holding financial assets represents the opportunity cost of holding cash. The higher the return, the more expensive it becomes to hold cash.

Financial Asset Types

There are four main types of financial assets that you should know: loans, bonds, loan-backed securities, and stocks.

Loans

We are all familiar with loans. Loans involve two main parties, the lender and the borrower, and are an agreement between the two parties. It consists of allowing the use of funds by the borrower for a certain period of time in exchange for an additional amount of money paid on top of the loan. The majority of individuals come across loans when they take out a mortgage to help them fund their house purchases. Companies may also take out bank loans to expand their inventories or business operations further.

The main advantage of the loan is that it is customized to meet the specific demands a borrower might have. Before a small company gets loan approval, it must fulfill the particular requirement and explain to the lender its business strategy and why they are likely to succeed and can pay the loan back. The same goes for individuals looking to buy a property or a car. This then allows the lender to make a tailored loan according to the needs and demands of the borrower. They agree on the return date and the interest being paid on the loan. This is extremely important for reducing default risk, which is the risk of the borrower not being able to pay back the loan.

Some disadvantages come with loans. Whether it's to an individual or an enterprise, extending credit to someone or something involves a significant amount of transaction costs, such as negotiating loan terms, investigating the borrower's credit history and ability to repay, etc.

Large companies that need huge funds, such as multinational corporates or governments, typically opt for a more streamlined strategy. They sell (or issue) bonds to reduce their borrowing costs.

Bonds

A bond is basically a loan from an investor to a borrower. Bonds are not precisely like commercial bank loans, as they usually involve huge sums. Additionally, large companies and governments decide to take loans from investors instead of taking loans from a bank.

It is an agreement that the borrower makes with the investors to get the funds from them and have them paid back at a future date, together with an extra amount of money for having used their money. This way, bonds serve as a financial asset for the investor and a liability for the company or government that issues the bond.

Key components of the bond include the maturity date, the interest paid on the bond, and the price. The interest on a bond is paid by the issuer monthly or yearly, depending on the type of bond and the maturity date, which is the date when all the funds plus the interest are paid to the investor.

One important thing to note here is that bonds are one of the most liquid financial assets after cash and bank deposits. Being more liquid means that they are easy to sell. That is especially true for government bonds, as investors know that the government will pay back the loan; hence there is demand for it. The bond market, where investors buy and sell different bonds is enormous and way more extensive than the stock market. On the other hand, loans are far more difficult for resale because, unlike bonds, they are not standardized: they vary in size, quality, terms, etc.

Another important aspect of bonds is that the price of previously issued bonds is inversely related to the interest rate on bonds. That means that as the interest rate goes up, the bond price will decline. As the interest rate goes up, bonds that yield higher interest will be more in demand, and the demand for those previously issued bonds with lower interest will drop, which translates into a price decline of the previously issued bond.

Bond investors can receive all the information about the bond issuer before making the transaction. That enables investors to make the best and most informed decision possible. For that reason, you have bond rating agencies, which are independent companies that rate and monitor each bond issuer. The rating of the bond issuer shows the risk that they have in defaulting, the risk of the bond issuer not being able to pay back the bond. Usually, the lower the rating an agency gives, the higher the chance for the bond issuer to default.

Loan-backed securities

As the name suggests, this type of financial asset consists of pools of loans made by banks. To better understand it, imagine there are three people: Lucy, John, and Jim, taking a loan from the Bank of America. The loan agreement is such that each of them will pay the loan back after 5, 6, and 9 years. Bank of America makes a profit on each of these loans, but it might be the case that they could reduce the administration cost of having these loans on their balance sheet and instead give them to someone else to collect the interest payments. Bank of America collects these loans into a pool and makes security out of them, then sells shares of the pooled loans to investors, who would own a part of these loans.

Loan-back securities have grown to be a common practice in financial markets. Mortgage-backed securities, which are made of thousands of mortgage loans, are one of the most common examples. These types of financial assets are also risky, and they are considered the leading cause of the 2008 financial crisis.

Stocks

A stock is a share in the ownership of a company. When you buy stocks, you own parts of the business. Stock is another one of the most liquid forms of money after cash and demand deposits.

To be able to buy stocks, a company should be publicly traded. Large and multinational companies are usually publicly traded, and you can buy shares in these companies via the stock market exchange. However, small companies are often privately held, and shares of these companies are not sold to the public.

The benefit of stocks is that they allow higher returns than other financial assets; however, they are riskier. Shareholders enjoy seeing their stock go up as the market goes up in value. Imagine having bought shares in Tesla years ago; you could have been rich by now – depending on the amount you have invested, of course.

Financial Assets Examples

Bonds, stocks, loans and even cash are all examples of financial assets. Below you can find more examples of each of the finacial asset type:

• Bonds: a US treasury bond is a type of financial asset issued by the US government to investors. It has a maturity date of 20 years or 30 years.

• Stocks: Apple (NASDAQ: AAPL)

• Loans: a loan taken by your local bank

• Cash: even though it is used less, it remains a common financial asset owned by everyone.