In contrast to such real assets are financial assets, such as stocks and bonds. Such securities are no more than sheets of paper or, more likely, computer entries and do not contribute directly to the productive capacity of the economy. Instead, these assets are the means by which individuals in well-developed economies hold their claims on real assets. Financial assets are claims to the income generated by real assets (or claims on income from the government).
If we cannot own our own auto plant (a real asset), we can still buy shares in General Motors or Toyota (financial assets) and, thereby, share in the income derived from the production of automobiles.
While real assets generate net income to the economy, financial assets simply define the allocation of income or wealth among investors. Individuals can choose between consuming their wealth today or investing for the future. If they choose to invest, they may place their wealth in financial assets by purchasing various securities. When investors buy these securities from companies, the firms use the money so raised to pay for real assets, such as plant, equipment, technology, or inventory. So investors’ returns on securities ultimately come from the income produced by the real assets that were financed by the issuance of those securities.
The distinction between real and financial assets is apparent when we compare the balance sheet of U.S. households, with the composition of national wealth in the United States, Household wealth includes financial assets such as bank accounts, corporate stock, or bonds. However, these securities, which are financial assets of households, are liabilities of the issuers of the securities. For example, a bond that you treat as an asset because it gives you a claim on interest income and repayment of principal from General Motors is a liability of General Motors, which is obligated to make these payments to you.
Your asset is GM’s liability. Therefore, when we aggregate over all balance sheets, these claims cancel out, leaving only real assets as the net wealth of the economy. National wealth consists of structures, equipment, inventories of goods, and land.
We will focus almost exclusively on financial assets. But you shouldn’t lose sight of the fact that the successes or failures of the financial assets we choose to purchase ultimately depend on the performance of the underlying real assets.
A TAXONOMY OF FINANCIAL ASSETS
It is common to distinguish among three broad types of financial assets: fixed income, equity, and derivatives. Fixed-income securities promise either a fixed stream of income or a stream of income that is determined according to a specified formula. For example, a corporate bond typically would promise that the bondholder will receive a fixed amount of interest each year.
Other so-called floating-rate bonds promise payments that depend on current interest rates. For example, a bond may pay an interest rate that is fixed at two percentage points above the rate paid on U.S. Treasury bills. Unless the borrower is declared bankrupt, the payments on these securities are either fixed or determined by formula. For this reason, the investment performance of fixed-income securities typically is least closely tied to the financial condition of the issuer.
Nevertheless, fixed-income securities come in a tremendous variety of maturities and payment provisions. At one extreme, the money market refers to fixed-income securities that are short term, highly marketable, and generally of very low risk. Examples of money market securities are U.S. Treasury bills or bank certificates of deposit (CDs). In contrast, the fixedincome capital market includes long-term securities such as Treasury bonds, as well as bonds issued by federal agencies, state and local municipalities, and corporations. These bonds range from very safe in terms of default risk (for example, Treasury securities) to relatively risky (for
example, high yield or “junk” bonds). They also are designed with extremely diverse provisions regarding payments provided to the investor and protection against the bankruptcy of the issuer.
Unlike fixed-income securities, common stock, or equity, in a firm represents an ownership share in the corporation. Equity holders are not promised any particular payment. They receive any dividends the firm may pay and have prorated ownership in the real assets of the firm. If the firm is successful, the value of equity will increase; if not, it will decrease. The performance of equity investments, therefore, is tied directly to the success of the firm and its real assets. For this reason, equity investments tend to be riskier than investments in fixed-income securities.
Finally, derivative securities such as options and futures contracts provide payoffs that are determined by the prices of other assets such as bond or stock prices. For example, a call option on a share of Intel stock might turn out to be worthless if Intel’s share price remains below a threshold or “exercise” price such as $30 a share, but it can be quite valuable if the stock price rises above that level.1 Derivative securities are so named because their values derive from the prices of other assets. For example, the value of the call option will depend on the price of Intel stock. Other important derivative securities are futures and swap contracts.
Derivatives have become an integral part of the investment environment. One use of derivatives, perhaps the primary use, is to hedge risks or transfer them to other parties. This is done successfully every day, and the use of these securities for risk management is so commonplace that the multitrillion-dollar market in derivative assets is routinely taken for granted.
Derivatives also can be used to take highly speculative positions, however. Every so often, one of these positions blows up, resulting in well-publicized losses of hundreds of millions of dollars. While these losses attract considerable attention, they are in fact the exception to the more common use of such securities as risk management tools. Derivatives will continue to play an important role in portfolio construction and the financial system.
In addition to these financial assets, individuals might invest directly in some real assets. For example, real estate or commodities such as precious metals or agricultural products are real assets that might form part of an investment portfolio.
Read More: Real Assets Versus Financial Assets
