Financial Assets: Study Guide (Macroeconomics 4.1)

What a financial asset is

Unit 4 moves from goods and services to the financial sector: money, banks and interest rates. It starts with a simple question. If you have some wealth, in what form should you keep it?

A financial asset is a claim on something of value, usually a promise of future payments. It is not a physical thing like a car or a machine. You can keep your wealth in three main classes of financial asset in this course:

• Money. The most liquid forms of money are cash (notes and coins) and demand deposits. A demand deposit is money in a checking (current) account that you can withdraw or spend at any time, for example with a debit card.
• Bonds. A bond is an interest-bearing asset. When you buy a bond, you lend money to the issuer (a government or a firm). The issuer promises to pay interest and to repay a fixed amount, the face value, on a set date, the maturity date.
• Stocks (shares). A stock is equity: a share of ownership in a company. Stockholders may receive part of the profits (dividends) and gain or lose as the market value of the company changes. Nothing is promised.

The three attributes: liquidity, rate of return and risk

Economists compare financial assets using three attributes.

• Liquidity is how easily and quickly an asset can be used to buy things, or turned into money, without losing value. Cash is perfectly liquid: it already is money. A demand deposit is almost as liquid. To use a bond or a stock, you must first sell it, which takes time, and the price you get may be lower than you hoped.
• Rate of return is the gain from holding the asset over a period, as a percentage of what it cost. For a bond, the main part is the interest. For a stock, it is dividends plus any rise (or minus any fall) in its price.
• Risk is the chance that the actual return will be different from what you expected, including the chance of losing part of what you put in.

Asset	Liquidity	Rate of return	Risk
Cash	highest: it is already money	zero	very low (but loses purchasing power if prices rise)
Demand deposits	very high: spend directly from the account	zero or very low interest	low
Bonds	lower: must be sold first, and the price can change	interest, fixed when the bond is issued	moderate: the price can fall, and the issuer could fail to pay
Stocks	lower: must be sold first, and the price can change a lot	dividends plus price changes; on average higher, but not promised	higher: the price can fall sharply

Two patterns run through the table.

1. Liquidity versus return. The most liquid assets pay the least. You give up interest in exchange for being able to spend at once.
2. Return versus risk. Assets that offer a higher expected return usually carry more risk. People will only hold a risky asset if they expect to be paid for the risk.

No asset is best on all three attributes. The right choice depends on what the money is for. Money you need for next week’s shopping should be liquid. Money you are saving for twenty years can earn more in less liquid, riskier assets.

Why the opportunity cost of holding money is interest

Money is the most liquid asset, but cash earns nothing, and demand deposits earn little or nothing. Every valda you hold as money could instead be in a bond earning interest.

The opportunity cost of holding money is the interest you could have earned by holding other financial assets, such as bonds.

This links back to opportunity cost in Topic 1.2: the cost of a choice is the value of the best alternative given up. Here, the cost of keeping wealth liquid is the interest forgone. So when interest rates rise, holding money becomes more costly, and people try to hold less of it. You will use this idea in Topic 4.5 to explain why the demand for money slopes downward.

Bond prices and interest rates

A bond’s interest payments are fixed when it is issued. But bonds can be bought and sold after that, in the bond market, at whatever price buyers will pay. A bond that already exists and is being resold is a previously issued bond.

Suppose market interest rates rise after a bond is issued. New bonds now pay more interest than the old one. Why would anyone pay the full price for the old bond, with its lower fixed interest, when a new bond pays more? Nobody would. To sell the old bond, its owner must cut the price until the buyer earns the same rate of return as on a new bond.

The reverse is also true. If market interest rates fall, the old bond’s fixed interest now looks generous. Buyers compete for it, and its price rises until its return falls to the new, lower market rate.

The price of a previously issued bond and the interest rate on it are inversely related. “The interest rate on a bond” here means the rate of return a buyer earns at the current price (its yield). When bond prices fall, that rate rises, and when bond prices rise, it falls. The two statements describe the same event.

Our fictional economy: Valdoria

Valdoria is the fictional country used across the Marlbridge macroeconomics pages. Its currency is the valda (VD). All prices, rates and people below are fictional.

Worked example 1: the price of a previously issued bond

A year ago, the Valdorian government issued a two-year bond. It now has one year left to maturity. In one year it will pay its owner VD 1,060: the face value of VD 1,000 plus VD 60 of interest. That was a 6% return when the bond was issued, because the market interest rate on similar bonds was 6%.

Question. Kemal owns the bond and wants to sell it today. New one-year government bonds pay the market interest rate. (a) What will buyers pay for Kemal’s bond if the market rate is still 6%? (b) What if the market rate has risen to 8%? (c) What if it has fallen to 5%? (d) Explain the pattern, and say whether Kemal gains or loses compared with a price of VD 1,000.

Method. A buyer will pay the amount that, invested at the market rate for one year, would grow to VD 1,060. So price = 1,060 ÷ (1 + market rate), with the rate written as a decimal.

(a) Market rate 6%: price = 1,060 ÷ 1.06 = VD 1,000.00.

(b) Market rate 8%: price = 1,060 ÷ 1.08 = VD 981.48. Check: a buyer who pays VD 981.48 and receives VD 1,060 earns (1,060 − 981.48) ÷ 981.48 × 100 = 8.00%, the same as on a new bond.

(c) Market rate 5%: price = 1,060 ÷ 1.05 = VD 1,009.52. Check: (1,060 − 1,009.52) ÷ 1,009.52 × 100 = 5.00%.

(d) The bond’s payment is fixed at VD 1,060. When the market rate rises, buyers will only pay less for it, so the price falls. When the market rate falls, they will pay more, so the price rises. If rates rise to 8%, Kemal suffers a capital loss of 1,000 − 981.48 = VD 18.52. If rates fall to 5%, he makes a capital gain of 1,009.52 − 1,000 = VD 9.52.

Interpretation. A bond is not risk-free even if the government always pays. Its owner can lose if interest rates rise before the bond is sold. That is part of the “risk” attribute of bonds.

Worked example 2: the opportunity cost of holding money

Sana runs a small shop in Valdoria. On average over the year she keeps VD 8,000 as money: cash in the till and a demand deposit that pays no interest. She could instead put some of it into one-year government bonds.

Question. (a) The interest rate on bonds is 4%. What is Sana’s yearly opportunity cost of holding VD 8,000 as money? (b) The bond rate rises to 7%. What is the opportunity cost now? (c) Sana reacts by holding only VD 5,000 as money and buying bonds with the rest. What is her opportunity cost of holding money now? Why does she not move all VD 8,000 into bonds? (d) Compare the three assets she could use for this wealth.

(a) Interest forgone = 8,000 × 0.04 = VD 320 a year.

(b) Interest forgone = 8,000 × 0.07 = VD 560 a year. The same amount of money now costs her VD 240 more to hold, because the interest she gives up is higher.

(c) Interest forgone = 5,000 × 0.07 = VD 350 a year. She does not move everything into bonds because she needs liquidity: she must pay suppliers and give change every day. Bonds would have to be sold first, which takes time and might mean selling at a loss if rates rise further (Worked example 1). She balances the interest she earns against the convenience and safety of money.

(d)

Choice for her VD 8,000	Liquidity	Return	Risk
Cash and demand deposit	can pay suppliers at once	0%	very low
One-year government bonds	must be sold to spend	about 7%	price falls if rates rise
Shares in a Valdorian company	must be sold to spend	uncertain; could be higher	price can fall sharply

Check. If her deposit had paid 0.5% interest, the opportunity cost in (a) would be the extra interest she gives up: 8,000 × (0.04 − 0.005) = VD 280. The principle is the same: the cost of holding money is the interest forgone on the alternative.

Interpretation. As interest rates rise, people and firms economise on money and hold more bonds. As rates fall, holding money costs less, so they hold more of it.

Common misconceptions

• “Money is the best asset because it is safest.” Money is the most liquid, but it pays little or nothing. Its cost is the interest given up.
• “The opportunity cost of holding money is inflation.” In this course the opportunity cost is the interest forgone on other assets such as bonds. Inflation reduces the purchasing power of money, but that is a separate idea (Topic 2.5).
• “When interest rates rise, bond prices rise too.” For previously issued bonds, the relationship is inverse: higher market rates mean lower prices.
• “A bond’s interest payment changes when market rates change.” The payment on an existing bond is fixed when it is issued. It is the price that adjusts, and so the rate of return a new buyer earns.
• “A stock is a loan to the company.” A stock is ownership (equity). A bond is the loan.
• “Liquidity means how profitable an asset is.” Liquidity is how quickly and easily an asset can be spent or turned into money without losing value. It has nothing to do with profit.
• “Higher return with no extra risk.” In general, assets that offer a higher expected return carry more risk.
• “Government bonds have no risk at all.” Even if the government always pays, a bondholder who sells before maturity can lose when interest rates rise.

Where this leads

Next, Topic 4.2, Nominal v. Real Interest Rates, asks what an interest rate is really worth once you allow for inflation. Topic 4.3 defines money and its functions, and Topic 4.5 uses the opportunity cost of holding money to build the money market. If you are coming from fiscal policy, the automatic stabilizers study guide closes Unit 3.

Now try the practice questions, then use the revision notes and the checklist to consolidate.