Fundamentals of Financial Instruments. Sunil K. Parameswaran
would have to be expressed in terms of every other good or service. The availability of money leads to a tremendous reduction in the amount of price-related information that is required to be processed.
Take the case of a 100-good economy. In the absence of money, we would require 100C2 or 4,950 prices.2 However, if a currency were to be available, we would require only 100 prices, a saving of almost 98% in terms of the required amount of information. Think of the saving for a modern economy, which has billions of goods.
MONEY AS A MEDIUM OF EXCHANGE
Money is usually the only financial asset that every business, household, and government department will accept as payment in return for goods and services.
Why is it that everyone is willing to readily accept money as compensation? It is primarily because they can always use it whenever needed to acquire any goods and services that they may desire. Thus, due to the existence of money, it is possible to clearly separate, in time, the act of sale of goods and services from any subsequent acquisition of goods and services. In the absence of money, we would have to exchange goods and services for other goods and services, a phenomenon which is termed as barter or countertrade.
MONEY AS A STORE OF VALUE
Money also serves as a store of value, or as a reserve of future purchasing power. However, just because an item is a store of value, it need not necessarily mean that it is a good store of value. In the case of money, inflation (the erosion of its purchasing power) is a virtually constant feature.
For instance, take the case of a good that costs $2 per unit. Thus, if an investor has $10 with him, he can acquire five units. However, if he were to keep the money with him for a year, he may find that the price in the following year is $2.50 per unit and hence he can acquire only four units. This is a manifestation of inflation, which may be considered to be a silent killer of wealth.
MONEY IS PERFECTLY LIQUID
What is a liquid asset? An asset is defined to be liquid if it can be quickly converted into cash with little or no loss of value. Why is liquidity important? In the absence of liquidity, market participants will be unable to transact quickly at prices that are close to the true or fair value of the asset. Buyers and sellers will need to expend considerable time and effort to identify each other, and very often will have to induce a transaction by offering a large premium or discount. If a market is highly liquid at a point in time, it means that plenty of buyers and sellers are available. In an illiquid or thin market, a large purchase or sale transaction is likely to have a major impact on prices. A large purchase transaction will send prices shooting up, whereas a large sale transaction will depress prices substantially. Liquid markets therefore have a lot of depth, as characterized by relatively minimal impact on prices. Liquid assets are characterized by three attributes:
Price stability
Ready marketability
Reversibility
In these respects, money is obviously the most liquid of all assets because it need not be converted into another form to exploit its purchasing power.
However, liquid assets come with an attached price tag. The more liquid the asset in which an investment is made, the lower the interest rate or rate of return from it. Thus, there is a cost attached to liquidity in the form of the interest forgone due to the inability to invest in an asset paying a higher rate of return. Such interest that is forgone is lost forever, and consequently cash is the most perishable of all economic assets.
Consider a financial surplus of $100,000 that is available with an individual. The most liquid way to keep it would be in the form of cash, but there will be a nil return. If the person were to park the surplus funds in a savings account, he would have to sacrifice by way of liquidity, but would get a return. If he were to move the funds to a time deposit, he would lose even more liquidity, but would earn a greater return as compared to a savings account.
EQUITY SHARES
Equity shares or shares of common stock of a company are financial claims issued by the firm, which confer ownership rights on the investors who are known as shareholders. All shareholders are part owners of the company that has issued the shares, and their stake in the firm is equal to the fraction of the total share capital of the firm to which they have subscribed. In general, all companies will have equity shareholders, for common stock represents the fundamental ownership interest in a corporation. Thus, a company must have at least one shareholder. Shareholders will periodically receive cash payments from the firm called dividends. In addition, they are exposed to profits and losses when they seek to dispose of their shares at a subsequent point in time. These profits/losses are referred to as capital gains and losses.
Equity shares represent a claim on the residual profits after all the creditors of the company have been paid. That is, a shareholder cannot demand a dividend as a matter of right. The creditors of a firm, including those who have extended loans to it, obviously enjoy priority from the standpoint of payments, and are therefore ranked higher in the pecking order.
Equity shares have no maturity date. Thus, they continue to be in existence as long as the firm itself continues to be in existence. Shareholders have voting rights and have a say in the election of the board of directors. If the firm were to declare bankruptcy, then the shareholders would be entitled to the residual value of the assets after the claims of all the other creditors have been settled. Thus, once again, the creditors enjoy primacy as compared to the shareholders.
The major difference between the shareholders of a company, as opposed to a sole proprietor or the partners in a partnership, is that they have limited liability. That is, no matter how serious the financial difficulties facing a company may be, neither it nor its creditors can make financial demands on the common shareholders. Thus, the maximum loss that a shareholder may sustain is limited to his investment in the business. Hence, the lowest possible share price is zero.
DEBT SECURITIES
A debt instrument is a financial claim issued by a borrower to a lender of funds. Unlike equity shareholders, investors in debt securities are not conferred with ownership rights. These securities are merely IOUs (an acronym for “I Owe You”), which represent a promise to pay interest on the principal amount either at periodic intervals or at maturity, and to repay the principal itself at a prespecified maturity date.
Most debt instruments have a finite lifespan, that is, a stated maturity date, and hence differ from equity shares in this respect. Also, the interest payments that are promised to the lenders at the outset represent contractual obligations on the part of the borrower. This means that the borrower is required to meet these obligations irrespective of the performance of the firm in a given financial year. Quite obviously, it is also the case that in the event of an exceptional performance, the borrowing entity does not have to pay any more to the debt holders than what was promised at the outset. It is for this reason that debt securities are referred to as fixed income securities. The interest claims of debt holders have to be settled before any residual profits can be distributed by way of dividends to the shareholders. Also, in the event of bankruptcy or liquidation, the proceeds from the sale of assets of the firm must be used first to settle all outstanding interest and principal. Only the residual amount, if any, can be distributed among the shareholders.
While debt is important for a commercial corporation in both the public and private sectors of an economy, it is absolutely indispensable for central or federal, state, and local (municipalities) governments when they wish to finance their developmental activities. Although such entities can raise resources by way of taxes, and in the case of the federal government by printing money, they obviously cannot issue equity shares. For instance, a US citizen cannot become a part owner of the state of Illinois.
Debt