Major Types of Assets

45.c: Major Types of Assets

Securities: Debt instruments, equities and share in pooled investment vehicles are generally referred to as Securities. Debt instruments promise to pay a certain amount to the investor on pre-determined schedule while equities represent an ownership stake in companies after all other claims including those of lenders have been paid back.

Types of debt instruments:

• Bonds represent debt issued for the long term while notes are the intermediate term. Bills are issued by governments while the certificates of deposits are issued by banks.
• Short-term debt issued by firms is referred to as Commercial paper
• Convertible debt can be exchanged for a fixed number of shares by the lender
• In Repurchase agreements, borrower sells a high-value asset while agreeing to buy it at a higher price at a later date

Types of equity instruments:

• Common stocks represent the residual claim on a firm's cash flow once senior claims (lenders, preferred stockholders) have been paid
• Preferred Shareholders have a right to fixed payments over the life of security and sit between lenders and common stockholders in term of claim seniority
• Warrants give the security holder right to buy the stocks (usually common stock) at a fixed price prior to warrant expiry

Pooled investment vehicles include mutual funds, trusts, hedge funds etc. which issue shares representing shared ownership in the assets these vehicles hold. Mutual Funds (MFs) pool money from multiple investors and invest it in a portfolio of securities. They can be open ended or close ended. Open-ended MFs issue new shares and redeem existing shares on demand while close-ended MFs issue shares in the primary markets while their redemption happens in secondary markets. Investors in close-ended schemes can’t sell back shares to MFs. NAV or net asset value of an MF is the difference between a fund’s assets and its liabilities and is the price at which they are traded (though close-ended MFs can trade at discount or premium to NAV).

ETFs (exchange traded funds) and ETNs (exchange traded notes) are open-ended MFs that investors can buy/sell among themselves in secondary markets. Prices of ETFs closely follow fund's NAV due to the presence of Authorized Participants (APs) who can trade directly with the fund as well. If the price of an ETF falls below its NAV, APs will buy from the secondary market and sell it to the fund at NAV and vice versa. Some ETFs allow only in kind deposits or redemptions. Buyers have to pay for such funds in the form of securities (and not cash) while sellers will also receive securities on redemption. Such funds are also called depositories and their securities are also known as depository notes.

Asset-backed securities derive their value from a pool of assets (for e.g. house loans, car loans credit card loans etc) and pay their investors through earnings on these assets.

Hedge funds are investment pool of a group of wealthy investors (limited partners) who appoint fund manager (general partner) to manage the fund’s investments. Hedge fund managers receive fees on the basis of the size of the fund as well as performance fees depending on the fund’s performance. Hedge funds can also use leverage to take on more risk and potentially higher profits.

Currencies like USD, GBP, JPY are issued by respective country’s central banks. Reserve currencies are currencies help by major central banks in significant quantities. USD is the most prominent reserve currency in the world today followed by Euro. Currencies are traded on exchanges and currency trade involves very high volumes generally.

Contracts: In a contract, traders agree to certain actions in a future date and derive their value from an underlying asset (shares, commodities, index etc). Contract settlement can either be in cash or physical form.

Contracts for difference (CFDs) are derivative contracts that allow people to speculate on price changes for an underlying asset. The underlying asset could be a common stock or an index. Dealers sell CFDs to their client and the clients sell the CFDs back to the dealers. The difference in the price of the underlying asset will be the profit/loss for the investor. All contracts for difference are cash settled regardless of the underlying asset on which they are based.

Forward Contracts: It is an agreement to buy an asset in future at a price agreed to today. For e.g. an agreement to buy 100kg cotton, 90 days from now at USD 1/kg. These contracts are not traded on exchanges.

Futures Contract: It is a standardized version of the forward contract with the clearinghouse guaranteeing performance by both the parties involved. Clearinghouse acts as a buyer for sellers and as a seller for buyers. It charges all the participants an amount called the initial margin when they enter a contract. Margin accounts are settled on a daily basis by the clearinghouse. Traders who have suffered a loss on that day will have their losses deducted from the margin money while those in profits will have their margins increased. Traders whose margins dip below the minimum maintenance margin must redeploy cash otherwise the trader’s broker will trade to square off the position. Variation margins are also maintained to limit liabilities associated with future contracts.

Swap Contracts: These involve two parties exchanging payments for cash flows dependent on future asset prices or interest rates. For example, in an interest rate swap, fixed interest payments are swapped for variable interest payments. A commodity swap, on the other hand, is driven by price uncertainty of any commodity in future. In a currency swap, parties exchange payments in one currency for another to hedge their respective foreign exchange risks. In an equity swap, parties exchange fixed payments for return on a stock or stock index.

Option contracts: They give the investor option to buy or sell an asset at a fixed price (called the strike price) on or before a specified date (maturity date) in the future. European options can be exercised only when they mature while American options can be exercised earlier as well. A call option gives the investor the right to buy while a put option gives her the sell option. The investor will look to buy the call option if the strike price is below the market price, while put option will be profitable is the strike price is above the market price. The price paid to buy an option is called premium.

Insurance Contracts promise to pay holder in case of an unexpected event like death, injury, accident etc.

Credit default spread (CDS) is a type of insurance that promises payment in case of default by companies issuing bonds. It helps in managing the credit risk.

Commodities like precious metal (gold, silver), metals, oil, agriculture goods etc. trade in forward, future and spot markets. These contracts are used by industries, farmers etc to hedge their risk against volatile commodity prices while analysts also seek to find profit opportunities through information gathering and analysis.

Real assets include real estate, equipment, machinery etc. While traditionally held by end users like industry, farmers they are increasingly finding favor with institutional investors because of return potential, tax benefits and diversification from traditional assets. They are heterogeneous, illiquid, and there are substantial costs involved in managing these assets. These problems tend to cause real assets to be misvalued in the market and information-motivated traders may occasionally identify significantly undervalued assets.

MLP (Master Limited Partnership) and REIT (Real Estate Investment Trust) are entities that securitize real assets and give investors indirect exposure to real assets. These entities charge management fees and pass on the remaining profits to the investors. These investment vehicles tend to be more liquid than the asset itself.

Check your concepts:

(45.8) Which of the following is most likely to trade closer to its NAV?

(a) Exchange-traded fund
(b) Open-ended mutual fund
(c) Closed-ended mutual fund

(45.9) Which of the following statements is most accurate?

(a) Variation margin is greater than the difference between initial margin and maintenance margin
(b) Variation margin is equal to the difference between initial margin and maintenance margin
(c) Variation margin is lesser than the difference between initial margin and maintenance margin

(45.10) Which of the following is least likely to be a characteristic of real assets?

(a) Homogeneous
(b) Illiquid
(c) High cost of management

Solutions:

(45.8) Correct Answer is B: The open-ended mutual funds trade closest to their NAV. The close-ended mutual funds generally trade at discount to NAV due to their relative illiquidity. However, they occasionally trade at a premium as well if the performance of the fund is too good. The ETFs also generally trade closer to NAV.

(45.9) Correct Answer is A: Variation margin is needed when the amount in the margin account falls below the maintenance margin and then the margin account is replenished back to the initial margin. So, the variation margin is greater than the difference between the initial margin and maintenance margin.

(45.10) Correct Answer is A: Real assets are heterogeneous, illiquid and incur substantial costs to manage them.

Exam Alert: ETFs are very important for the exam point of view. The candidate should be really comfortable with the differences between open-ended mutual funds, close-ended mutual funds, and ETFs.