FINANCIAL ASSETS

Reversibility, also called round-trip cost, refers to the cost of investing in a financial asset and then getting out of it and back into cash again. For financial assets traded in organized markets or with “market makers,” the most relevant component of round-trip cost is the so- called bid-ask spread, to which might be added commissions and the time and cost, if any, of delivering the asset. The bid-ask spread consists of the difference between the price at which a market maker is willing to sell a financial asset (i.e., the price it is asking) and the price at which a market maker is willing to buy the financial asset (i.e., the price it is bid- ding). The spread charged by a market maker varies sharply from one financial asset to another, reflecting primarily the amount of risk the market maker assumes by “making” a market. This market-making risk can be related to two main forces.
One is the variability of the price as measured, say, by some measure of dispersion of the relative price over time. The greater the variability, the greater the probability of the market maker incurring a loss in excess of a stated bound between the time of buying and reselling the financial asset. The variability of prices differs widely across financial assets. The second determining factor of the bid-ask spread charged by a market maker is what is commonly referred to as the thickness of the market, which is essentially the prevailing rate at which buying and selling orders reach the market maker (i.e., the frequency of transactions). A “thin market” sees few trades on a regular or continuing basis. Clearly, the greater the frequency of orders coming into the market for the financial asset (referred to as the “order flow”), the shorter the time that the financial asset must be held in the market maker’s inventory, and hence the smaller the probability of an unfavorable price movement while held. Thickness also varies from market to market. A low round-trip cost is clearly a desirable property of a financial asset, and as a result thickness itself is a valuable property. This attribute explains the potential advantage of large over smaller markets (economies of scale), and a market’s endeavor to standardize the instruments offered to the public.
The term to maturity, or simply maturity, is the length of the interval until the date when the instrument is scheduled to make its final payment, or the owner is entitled to demand liquidation. Maturity is an important characteristic of financial assets such as debt instruments. Equities set no maturity and are thus a form of perpetual instrument. Liquidity serves an important and widely used function, although no uniformly accepted definition of liquidity is presently available. A useful way to think of liquidity and illiquidity, proposed by James Tobin, is in terms of how much sellers stand to lose if they wish to sell immediately against engaging in a costly and time consuming search.2 Liquidity may depend not only on the financial asset but also on the quantity one wishes to sell (or buy). Even though a small quantity may be quite liquid, a large lot may run into illiquidity problems. Note that liquidity again closely relates to whether a market is thick or thin. Thinness always increases the round-trip cost, even of a liquid financial asset. But beyond some point it becomes an obstacle to the formation of a market, and directly affects the illiquidity of the financial asset.
An important property of some financial assets is their convertibility 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 other situations, the conversion spans classes. For example, with a corporate convertible bond the bondholder can change it into equity shares. Most financial assets are denominated in one currency, such as U.S. dollars or yen or euros, and investors must choose them with that feature in mind. Some issuers have issued dual-currency securities with certain cash flows paid in one currency and other cash flows in another currency.
The return that an investor will realize by holding a financial asset depends on the cash flow expected to be received, which includes dividend payments on stock and interest payments on debt instruments, as well as the repayment of principal for a debt instrument and the expected sale price of a stock. Therefore, the predictability of the expected return depends on the predictability of the cash flow. Return predictability, a basic property of financial assets, provides the major determinant of their value. Assuming investors are risk averse, as we will see in later chapters, the riskiness of an asset can be equated with the uncertainty or unpredictability of its return.
An important feature of any financial asset is its tax status. Govern- mental codes for taxing the income from the ownership or sale of financial assets vary widely if not wildly. Tax rates differ from year to year, country to country, and even among municipalities or provinces within a country. Moreover, tax rates may differ from financial asset to financial asset, depending on the type of issuer, the length of time the asset is held, the nature of the owner, and so on.