Real Assets Vs Financial Assets
Assets are classified as real assets and financial assets based on their nature. Real assets are mostly tangible and they possess productive capacity. They are used to produce goods and services. Examples of real assets are property, plant and equipment, human capital, etc. Financial assets represent claims on income and other assets and define the allocation of income or wealth. Examples of financial assets are shares of stocks, bonds, Treasury securities, etc. Financial assets have the following characteristics.
Financial assets do not exist physically. They represent the ownership right through a piece of paper known as a certificate of ownership. For example, if you deposit money in a fixed deposit account of a bank, you receive a certificate of deposit. If you purchase shares issued by a company you receive a certificate of shares from the company. Similarly, if you buy a life insurance policy from an insurance company, the insurance company will issue a policy certificate to you. In all these cases, your ownership right is stated in a piece of paper and financial assets do not have a physical character.
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Generally, financial assets are considered more liquid than physical assets. It means they can be easily converted into cash. Real assets generally do not pose this character. They may take a relatively longer time to sell and convert into cash. In other words, it takes longer time to sell land than to sell shares of stock. The reason is that the markets for financial assets (the capital market and money market) are more developed than the markets for real assets.
Financial assets do not have their own productive capacity. They generate income from the investment in real assets. For example, if you purchase shares issued by a company, the investment in shares does not generate income directly. The funds you invest in shares are used by the company to buy real assets such as land, buildings, machinery, inventory, etc., which generate income.
Financial assets are easily moveable. They can be easily carried from one place to another place because their existence is simply represented by a certificate of ownership. Further, the ownership also can be easily transferred by selling the certificate of ownership.
ASSET AND LIABILITY:
The creation of financial instruments (shares, bonds, certificate of deposit, etc.) requires two parties. One party issues/ sells it and another party buys it. For example, you can buy shares only when a company issues it. You can buy a certificate of deposit only when a bank issues it. The shares and the certificates of deposit are assets for you, but they represent liabilities for the issuing company and the bank. Similarly, if you purchase a life insurance policy, it represents an asset for you but a liability for the insurance company. Thus, financial instruments are assets for one party and financial liabilities for another party.
In this text, we study investing in financial assets, therefore, our focus will be on financial assets. Financial assets, also known as securities are classified into three types – debt, equity, and derivatives.
Debt securities promise fixed returns over a period of time to the investors. Therefore, they are also known as fixed-income securities. Debt securities are further divided into money market and capital market fixed-income securities Money market securities are of a short-term nature and, hence mature within one year. Treasury bills, certificates of deposits, banker’s acceptance, commercial paper, etc. are examples of money market debt securities. Capital market debt securities have a maturity longer than one year. Bonds issued by the government and corporations are examples of capital market debt securities. Debt securities are useful for investors who are willing to accept fixed returns for low risk. We discuss in detail about different types of debt securities.
Equity securities represent an ownership interest in a corporation. The investor becomes the owner of the corporation and possesses the residual right on assets and income but does not have the mandatory right to claim dividends. Being the shareholder, the investor is not promised with fixed return; but has the right to all income that remains after paying to debt holders. The return to the shareholders is tied to the success of the corporation. Shareholders get higher returns on the better performance of the corporation. But, they get no return in case the corporation incurs a loss. Thus, equity securities are riskier than the fixed-income securities to the investors.
Derivative securities are those securities whose value depends on the value of other assets (known as underlying assets). By investing in derivative securities, the investor has the right to buy or sell an underlying asset on which the derivative is written. Options, warrants, and futures are examples of derivative securities. The call option gives you the right to buy stocks at a predetermined price and the put option gives you the right to sell stocks at a predetermined price. Futures are contracts between two parties that obligate (i) the seller of the contract to deliver an asset, and (ii) the buyer of the contract to take the delivery of an asset at some specific date, at a price agreed on the date of the contract. The derivative market is yet to develop in Nepal. Only commodity derivatives are traded in a few exchanges but the market for call and put options does not exist in Nepal.
Derivative securities possess high risk because they have uncertain returns or unstable market value, but they have high expected value as well. These securities are primarily used to hedge the risk. Therefore, they have become an integral part of the investment environment.