Assets, Contracts, and Markets: An Introduction | CFA Level I Equity Investments

Commonly Traded Assets

In this lesson, we’ll explore various classes of investment assets and contracts and learn how financial markets can be classified. Some of the most commonly traded assets include:

• Securities: debt instruments, equities, and shares in pooled investment vehicles
• Currencies: monies issued by national monetary authorities
• Commodities: precious metals, energy products, industrial metals, and agricultural products
• Real assets: real estate and other physical assets of value, like airplanes or machinery

Securities: Fixed-Income and Equity

Securities can be classified as fixed-income or equity securities.

Fixed-Income Securities:

Fixed-income securities, also known as bonds, are debt instruments that pay periodic interest and return principal at maturity. They can be issued by governments, corporations, or other entities. The main types of fixed-income securities are:

1. Government bonds: Issued by national governments to finance public projects or manage debt levels. They are generally considered lower risk investments.
2. Corporate bonds: Issued by companies to raise capital for business activities. They typically offer higher yields than government bonds but carry higher risk.

Equity Securities:

Equity securities, or stocks, represent ownership interests in a company. Investors who buy stocks become shareholders, with rights to vote on company matters and receive dividends. There are two main types of equity securities:

1. Common stock: Represents ownership and voting rights in a company. Common shareholders receive dividends if declared and have a claim on the company’s assets in case of liquidation, after all debts and preferred stock claims are settled.
2. Preferred stock: Grants ownership without voting rights but offers priority in dividend payments and claims on assets during liquidation. Preferred stock can be seen as a hybrid between common stock and bonds.

Warrants

Warrants are similar to options in that they give the holder the right to buy a firm’s common stock at the stated exercise price prior to the warrant’s expiration. Warrants are considered equity because they are issued by the company and can potentially become equity if the holder exercises the right to purchase.

Pooled Investment Vehicles

Individual securities can be combined into pooled investment vehicles, structures that combine the funds of many investors to build up a portfolio of investments. Such pooled investment vehicles can be mutual funds, exchange-traded funds, asset-backed securities, or hedge funds. The investor’s ownership interests can be referred to as shares, units, depository receipts, or limited partnership interests.

Mutual Funds: Open-Ended and Closed-Ended

Mutual funds can be open-ended or closed-ended. Open-ended funds issue new shares when an investor buys in, and redeem existing shares when an investor sells, usually on a daily basis. The price at which a fund redeems and sells the shares is based on the net asset value of the fund’s portfolio expressed on a per-share basis. Investors generally buy and sell open-ended mutual funds by trading with the mutual fund manager.

In contrast, closed-ended funds issue shares in primary market offerings. Once issued, investors cannot sell their shares of the fund back to the fund by demanding redemption. Instead, they must sell their shares to other investors in the secondary market. The secondary market prices may differ from their net asset values, usually at a discount.

Exchange-Traded Funds (ETFs)

Exchange-traded funds also trade like closed-end funds, in which the investors trade their shares in the secondary market. Unlike closed-end mutual funds, their market price is actually quite close to the net asset value of the portfolio. This is because ETFs have special provisions allowing some authorised participants to convert their shares into individual portfolio securities when the price is significantly below NAV or exchange portfolio shares for ETF shares when the price is significantly above NAV. Such activities help to keep the market price of the ETF close to the NAV per share of the portfolio.

Asset-Backed Securities

Asset-backed securities are securities whose values and income payments are derived from a pool of assets, such as mortgages, credit card debt, or car loans. The interest and principal repayments on these loans are passed through to investors, with different classes of claims and levels of risk, based on the seniority of the security held by the investor.

Hedge Funds

Hedge funds are organised as limited partnerships, with the investors as the limited partners and the fund manager as the general partner. The limited partners are qualified investors who are wealthy enough and well informed enough to tolerate and accept substantial losses, should they occur. Hedge fund managers typically charge a management fee based on the amount of assets under management, as well as an incentive fee based on their investment results. They try to add value by utilising various strategies, and leverage is often used to amplify the gains.

Currencies and Foreign Exchange Markets

Now, an asset that we are very familiar with: currencies are monies issued by national monetary authorities. Approximately 175 currencies are currently in use throughout the world. Some of these currencies are regarded as reserve currencies, which are currencies that national central banks and other monetary authorities hold in significant quantities for international trade and as a foreign reserve. The primary reserve currencies are the US dollar and the euro. Secondary reserve currencies include the British pound, the Japanese yen, and the Swiss franc.

Currencies trade in foreign exchange markets. In spot currency transactions, one currency is immediately exchanged for another. The rate of exchange is called the spot exchange rate.

Now, the exchange of currencies does not need to be transacted immediately. Two parties can agree on a fixed rate to exchange at on a date in the future. This can be arranged by means of a contract, which we will skip ahead to for now to explain financial contracts.

Financial Contracts and Derivatives

Derivatives are financial contracts whose value is derived from an underlying asset, index, or rate. They enable parties to manage risks, speculate on price movements, or gain exposure to specific assets. The main types of derivatives are:

1. Forwards: Customized contracts traded over-the-counter (OTC) to buy or sell an asset at a specified future date and price.
2. Futures: Standardized contracts traded on exchanges, similar to forwards, but with greater liquidity and ease of trading.
3. Swaps: Contracts where two parties agree to exchange cash flows or assets, such as interest rate swaps, currency swaps, and equity swaps.
4. Options: Contracts that give the holder the right, but not the obligation, to buy (call option) or sell (put option) an asset at a predetermined price on or before a specified future date.
5. Insurance contracts: Agreements where the insured pays a premium to hedge against the risk of an unfavorable event, such as life, liability, or automobile insurance. Credit default swaps are a type of insurance contract used to hedge against bond default risk.

Commodities and Real Assets

Commodities:

Commodities encompass a wide range of products, including energy products, industrial metals, precious metals, agricultural products, and carbon credits. There are two primary types of commodity markets:

1. Spot commodity markets: Trades commodities for immediate delivery. Primarily used by producers and processors of commodity products who can handle immediate deliveries.
2. Forward and futures markets: Trades commodities for future delivery. Used by producers, consumers, and traders looking to hedge against price changes or speculate on future price movements.

Traders and investment managers may engage in commodity trading to speculate on future price changes or use commodities as hedges against risks in their portfolios. They typically prefer trading in futures markets due to the higher liquidity provided by central exchanges compared to spot and forward markets.

Real Assets:

Real assets include tangible investments such as real estate, equipment, and infrastructure. Traditionally held by firms for operational purposes, real assets are increasingly held by institutional investors, who can invest directly or indirectly through investment vehicles.

1. Direct investments: Provide direct income, tax advantages, and diversification benefits but often entail substantial management costs, require significant due diligence, and are illiquid due to large investment sizes and limited investor pools.
2. Indirect investments: Can be made through vehicles like real estate investment trusts (REITs), master limited partnerships (MLPs), or stocks of firms with substantial real asset ownership. Investors own interests in these vehicles, which hold the assets directly, offering more liquidity than direct ownership of the assets.

Classification of Markets

All these assets trade in markets, which can be classified in a number of ways.

In summary, understanding the classification of markets is essential for investors, traders, and financial professionals. The classifications of markets can be organized as follows:

1. Delivery time:
   • Spot markets: Trade instruments for immediate delivery
   • Forward or futures markets: Trade contracts for future delivery
   • Options markets: Trade contracts that deliver in the future, but only if holders exercise them
2. Source:
   • Primary market: Issuers sell new securities to investors; funds flow to the issuer
   • Secondary market: Subsequent sales of securities; funds flow between traders
3. Maturity:
   • Money markets: Markets for debt securities with maturities of one year or less (e.g., repurchase agreements, negotiable certificates of deposit, government bills, and commercial paper)
   • Capital markets: Markets for longer-term debt securities and equity securities with no specific maturity date
4. Investment type:
   • Traditional investment markets: Include publicly traded debts and equities, and shares in pooled investment vehicles that hold publicly traded debts and/or equities (e.g., equity index ETFs)
   • Alternative investment markets: Include hedge funds, private equities, commodities, real estate, and infrastructure investments; often hard to trade, hard to value, and may require substantial investor due diligence

Familiarity with these market classifications enables better decision-making and risk management when participating in various financial markets and investing in different asset classes.

In summary, understanding different types of financial contracts, investment assets, and market classifications is essential for investors, traders, and financial professionals. Familiarity with these concepts enables better decision-making and risk management when participating in various financial markets and investing in different asset classes.