Level 1 CFA® Exam:
Main Types of Assets
In this lesson, we're going to have a closer look at the four main types of assets, namely, securities, currencies, contracts, and commodities.
Fixed Income Securities
One type of security is a fixed income security. Unlike in the case of stocks, in case of fixed income securities we have a specified schedule for the repayment of the principal and interest. Note that there are two types of payment schedules. The first one is when interest is fixed as a percentage of the borrowed principal amount, whereas the other one is when interest depends on a variable factor, such as LIBOR, inflation rate and so on. In the second case, actual interest will vary from period to period.
Fixed-income instruments include:
- bonds (issued by state governments, local authorities, or businesses),
- treasury bills (issued by governments),
- commercial paper (issued by companies), and
- certificates of deposit (issued by banks).
A special type of bonds are convertible bonds. Unsurprisingly, they can be converted into other assets, usually stocks. The conversion is carried out on pre-determined conditions.
Treasury bills, commercial paper, and certificates of deposit usually mature within less than a year.
Fixed-income instruments with short maturities, that is shorter than a year, are usually called notes, whereas instruments maturing within more than a year are referred to as bonds.
Additionally fixed-income instruments maturing within more than a year can be classified into short-term, intermediate-term, and long-term instruments, but there are no clear-cut boundaries between them.
Equities are instruments representing ownership rights in companies, so holding them involves a number of privileges associated with a company. Ownership rights of a common shareholder depend on the number of shares he or she holds.
If the company's management decides to distribute the company's profits, shareholders are paid dividends. The value of dividends depends on the amount per share stated in a particular currency. This value multiplied by the number of shares held by a shareholder is the amount of his dividend.
Additionally, in the event of the company's liquidation, shareholders have a right to share in the assets that are left after debtors, employees and other entities or institutions are paid up.
Another right enjoyed by shareholders is to elect representatives in the board of directors.
In addition to common shares, a company can issue preferred shares. Preferred shareholders enjoy additional rights as compared to common shareholders. For example, they can be entitled to higher dividends or additional dividends, or to a greater share in the company's assets in the event of liquidation. The privileges associated with preferred shares are most commonly stated as a multiple of the rights associated with a common share. Preferred shares, given their qualities, are sometimes considered to be fixed-income instruments.
We should also mention here instruments called warrants. A warrant is a type of instrument closely associated with shares. It is an instrument that gives its holder a right to buy the issuer's stock at a specified price (the so-called exercise price) on specific conditions. A warrant has a fixed expiration date, after which the rights attached to it expire as well.
Pooled Investment Vehicles
Pooled investment vehicles are institutions whose business consists in the accumulation and investment of funds deposited by investors. Pooled investment vehicles include:
- mutual funds,
- depositories, or
- hedge funds.
A currency is a monetary medium of exchange that can only be issued by national monetary authorities. At present, there are about 175 currencies in circulation. Some currencies are considered to be reserve currencies because they are commonly accepted for the purposes of international transactions. To ensure safety, reserve currencies are kept by the central banks of many countries in large quantities.
The primary reserve currencies are:
- the U.S. dollar and
- the euro.
The secondary reserve currencies are:
- the British pound,
- the Japanese yen, and
- the Swiss franc.
Currency trades take place in the foreign exchange market. Trades between large institutions are usually agreed in negotiations and settled within two business days, whereas retail currency trade takes place mostly in local branches of banks.
Contracts are agreements under which a certain transaction is to happen at a future time. Contracts include very different instruments, including futures contracts, forward contracts, swap contracts, option contracts, and insurance contracts. The value of a contract depends on the price of a specific financial instrument called the underlying asset. If the price of the underlying asset goes up, profits are made by the party who holds the long position in the contract, that is the party that is going to buy the underlying asset in the future. The seller of the underlying asset makes a profit if its price goes down.
A contract can be either:
- settled physically, which means that the underlying asset is actually delivered, or
- settled in cash, where only cash changes hands.
Cash settlement is actually the most common form of settlement.
A forward contract, just like a futures contract, consists in the delivery of certain goods in the future from one party to another. A forward contract is concluded to hedge against the risk of adverse changes in the price of the goods. Unlike futures contracts, forward contracts are not traded on exchanges and are not standardized, which means that the parties to the transaction can individually agree on its terms. Let's have a look at an example of how a forward contract works.
One of the most complex contracts are options.
There are two parties to an option contract: the writer, that is the seller of an option and the purchaser who we call the holder. An option is an instrument that gives its holder either a right to buy or a right to sell the underlying asset, depending on the type of an option.
Call Option vs Put Option
So, you need to know the crucial distinction between two types of options:
- call options and
- put options.
The option that gives its holder a right to buy an underlying asset is called a call option. On the other hand, a put option gives its holder a right to sell an underlying asset.
Note that when we talk about call and put options, we talk about the right of the holder, and not her obligation, to buy or sell the underlying asset in the future. However, the writer of the option will have an obligation to sell or buy the underlying asset from the option holder if she demands it. The price that we need to pay to become option holders is called the option premium. That's the price of the right to buy or sell the underlying.
Commodities is a very broad category that includes such assets as precious metals, energy products, industrial metals, or agricultural products.
There are two types of commodity markets:
- spot commodity market, and
- forward commodity market.
In a spot commodity market, commodities are delivered immediately. Futures and forward commodity markets are for future delivery.
Who mostly trades in commodity markets? It's the producers and processors of commodities trading as part of their ordinary business operations. Running a business in their branches gives them access to precious information on the market, which is why they can be called information-motivated investors. Commodity markets also attract investment managers who use commodities to hedge against risk. Still, as they can't physically store commodities, they more commonly trade in futures markets, which are much more liquid.
Real assets include things such as real estate, aircraft, or machines, that is assets that until recently were only useful resources for operating a business. For some time now, they have been included in investment portfolios. This is the case because they offer high rates of return, but also because they allow for risk diversification.
Real assets are often quite complicated to value, so they may not necessarily be the best instrument to include in a portfolio. What is more, investment managers often have to additionally employ experts in the field, which increases the costs of investing in real assets.
- There are four major asset classes: securities, contracts, currencies, and commodities. We also distinguish real assets.
- Securities include debt instruments, equities, and shares in pooled investment vehicles.
- Contracts include forward, futures, swap, and option contracts.
- Unlike in the case of stocks, in case of fixed income securities we have a specified schedule for the repayment of the principal and interest.
- Equities are instruments representing ownership rights in companies.
- Preferred shareholders enjoy additional rights as compared to common shareholders.
- Pooled investment vehicles are institutions whose business consists in the accumulation and investment of funds deposited by investors.
- A currency is a monetary medium of exchange that can only be issued by national monetary authorities.
- The value of a contract depends on the price of a specific financial instrument called the underlying asset.
- A forward contract involves the counterparty risk that is the risk that the other party will fail to perform as agreed.
- Unlike a forward contract, a futures contract is a standardized instrument, and it is guaranteed by a clearing house.
- A swap contract is about the exchange of periodic payments between two parties.
- An option is an instrument that gives its holder either a right to buy or a right to sell the underlying asset, depending on the type of an option (call option vs put option).
- There are two types of commodity markets: spot commodity market, and forward commodity market.
- Real assets are included in investment portfolios because they may offer high rates of return, but also because they allow for risk diversification.