FINANCIAL SYSTEMS-FINANCIAL INSTRUMENTS
A financial instrument is defined as, a claim against the income or wealth of a business firm, house hold or unit of government, normally represented by a certificate, receipt or other legal document, and which is usually created by the lending of money. Financial Assets are by therefore nature intangible assets e.g
i. Treasury Bills
ii. Bonds
iii. Shares
Role of financial assets
1. Transfer funds from surplus units to deficit units to invest in intangible assets.
2. Transfer funds in such a way as to redistribute the unavoidable risk associated with the cash flow generated by tangible assets among those seeking and those providing the funds.
Properties of financial assets
These properties influence the attractiveness to investors:
i. MONEYNESS : Some financial assets are used as a medium of exchange- these assets are called money. Other assets are near money/quasi-money for example Treasury bills. Therefore moneyness is a desirable property for investors.
ii. DIVISIBILITY & DENOMINATION : Divisibility relates to the minimum size at which a financial asset can be liquidated and exchanged for money. The smaller the size the more the financial asset is divisible.
iii. REVERSIBILITY : Also known as round-trip cost refers to the cost of investing in a financial asset and then getting out of it and back into cash again e.g Bank deposit. A low round-trip cost is clearly a desirable property of a financial asset, and as a result thickness is a valuable property. Thickness of the market is essentially the prevailing rate at which buying and selling orders reach the market maker. A thin market is one which has few trades on a regular and continuing basis.
iv. TERM TO MATURITY : The term to maturity is the length of interval until the date when the instrument is scheduled to make its final payment or the owner is entitled to demand liquidation. However, it should be recognized that even a financial asset with a stated maturity, may terminate before its stated maturity.
This may occur for several reasons including bankruptcy or because of provisions entitling the debtor to repay in advance or the investor may have the privilege of asking for early repayment.
v. LIQUIDITY: Liquidity is determined by contractual arrangements. Deposits at a bank are perfectly liquid because the bank has a contractual obligation to convert them at par on demand. However, financial contracts representing a
claim on private pension fund may be regarded as totally illiquid because these can be cashed only on retirement. Liquidity may depend not only on the financial asset but also on the quantity one wishes to sell or buy. A small quantity may be quite liquid while one may run into illiquidity problems with large lots.
vi. CONVERTIBILITY : Some financial assets are convertible into other financial assets. In some cases, the conversion takes place within one class of financial assets, as when a bond is converted into another bond. In some cases the conversion spans classes e.g a Corporate convertible bond may be changed into equity. Normally the timing, costs and conditions are clearly spelled out in the legal descriptions of the convertible security at the time it is issued.
