Properties and Pricing of

Financial Assets
Fintech and Financial Markets
Agenda
• Moneyness
• Divisibility & Denomination
• Reversibility
• Liquidity
• Cash Flows
• Term to Maturity
• Convertibility
• Currency
• Return Predictability
• Complexity
• Tax Status
• Pricing Financial Assets
Moneyness
• How close is the asset to cash (demand deposit)
• Depends on several factors
• Price Risk: Can the asset lose a lot relative to purchase cost?
• Saleability: Can the asset be sold quickly?
• Impact: How much will the price change when it is sold
• Short term government securities [T Bills] are close to cash
• In crisis times this may not be true
• Fixed Deposits are close to cash
• Liquid Funds and Ultra-short funds are close to cash
Divisibility, Denomination & Minimums
• Smallest size that one can purchase or sell asset in exchange for
money
• Demand deposits can theoretically be 1 paise
• Time deposits are usually in Rs 500 increments
• Mutual fund units can be bought for a minimum of Rs 500, but for
any amount above that.
• Bonds usually in Rs 1000 denomination
• Equities: 1 share
Reversibility
• Round trip cost
• Buying an asset and selling it out into cash again
• Key costs
• Transaction costs
• Broker
• Demat
• Clearing
• Bid-Ask
• Impact cost
• Thick /Thin Markets
Cash Flows

• Expected Cash Flows

• Interest
• Principal 100
• Sale proceeds
• 3Year Bond
• Rs 100 paid 5 5 5 5 5 5
• 10% interest (semi-
annual)
• Held to maturity 6m 12m 18m 24m 30m 36m
• Every 6 mo: Rs
10%*100/2 = Rs 5
• On Maturity: Rs 100
100
Cash Flows: Intermediate Sale
?

• Same Bond
• This time we intend
5 5
to sell after 15
months
• We do not know 6m 12m 15m
what the sale price
will be when we sell.
Cash flow is
uncertain. 100
Term to Maturity
• The time from now when final payment associated with the asset is
made
• 1 day
• Perpetual
• Unknown
• Bonds and other assets
• Call: Issuer can retire bonds
• Put: Investor can force issuer to retire the bond
• In bonds the prices at which the put/call can take place are usually pre-
decided
• In other assets these may not be known upfront
Convertibility
• Can be converted to another asset
• Convertible Bonds
• Convertible Preference Shares
• For convertible bonds
• Conversion Price: Effective price per share at conversion
• Conversion Premium = Conversion Price – current stock price
• Conversion Value = Value of Instrument when converted to shares
= number of shares receivable upon conversion * current price per share
 Currency
USD 1.27
• Currency of cash flows
• Can be single or multi-currency
• Key risk: risk of currency value
fluctuation 5 5 5 5 5
• Eg. Bond bought in Rs, interest
paid in Rs. Principal repaid in
USD at then rate 6m 12m 18m 24m 30m 36m
• Why such a bond?
• Who bears currency risk?
• Issuer: ?
• Investor: ? 100
• Both?

We will see that the forward rate of Rs/USD can be fixed today using a forward contract. This removes currency risk
Liquidity
• Very complex topic
• How ”easy” it is to buy and sell the asset
• “Easy” depends….
• Quantity: 100 shares versus 10000
• How quickly the deal can be done
• Impact cost: How much is lost on trying to sell
• Transaction costs
• Bid-ask
• Demat
• Broker
• Also depends on order rate at exchange
 Liquid Versus Illiquid Security

• In OTC Market one may have to pay several percent to broker for some illiquid products
• Sometimes processing a purchase/sale may imply significant registrar costs.eg Hedge
Fund units
• For unlisted shares in small companies, legal costs are enormous
Cash Flow Predictability
• Cash flows can be uncertain
• Bonds sold before maturity
• Govt Securities – are they riskless?
• Shares
• Dividends
• Sale price
• Options
• Uncertainty due to
• Timing
• Amount
• Possibility of non-payment even if Time and Amount are fixed
Complexity
• Some assets are a combination of simpler assets
• Callable/Puttable bonds
• Futures with embedded options
• Quantos
• Convertible Bonds
• Structured products
• Max of/Min of
• Range Structures
Tax Status
• Instruments can be tax free
• E.g. Tax free bonds
• Govt, Municipal bonds
• For some instruments dividends are taxable, buybacks are not (or rate is
different)
• However the tax status of the investor matters
• E.g. Tax Free bonds are tax free in India, but a US Citizen tax resident in India will still
have to pay tax
• Every investor has to consider his tax status and hence tax rate
• Issuer domicile jurisdiction
• Market domicile jurisdiction
• Investor domicile jurisdiction
• Post tax return = pre-tax return(1-Tax Rate)
Principles of Pricing Financial Assets
• Asset Price = Present value (PV) of future cash flows
• The process of finding a present value involves a discount rate
• Discount rate = real rate + inflation premium + default risk premium +
maturity premium + liquidity premium + exchange rate risk premium
• This accounts for using a discount rate that is consistent with the risk
of the cash flow
• High risk cash flows: high discount factor
• Low risk cash flows: low discount factor
 100
Example 1 Govt Bond:

!""
Price (PV) = (!.!") = 90.91
• Investor can buy A
government bond which 12m
pays a single cash flow of ?
Rs 100 at maturity in 1Y If an investor deposits Rs 100 with the govt, in 1 year she will definitely
get back ( as the cash flow is riskfree) Rs 100 of principal + Rs 10 of
• Govt also accepts 1 Year interest = Rs 110
deposit at a interest rate
Hence Rs 100 now is equivalent to Rs 110 in future
of 10%
If the bond is less than Rs 90.91 , everybody will buy the bond because it
• What is the fair price of has a greater return than the deposit. Its price will rise
the bond?
If the bond is greater than Rs 90.91, investors will sell the bond to invest
in the deposit.

Equilibrium price will be Rs 90.91

 100
Example 2 Govt Bond:

!""
Price (PV) = (!.!") = 90.91
• Investor can buy
• A government bond which 12m
pays a single cash flow of ?
Rs 100 at maturity in 1Y
• A bond issued by a startup Startup Bond:
company which also pays a !""
100
single cash flow of Rs 100 Price (PV) =
(!.!")
= 90.91
at maturity in 1Y
!""
• Govt also accepts 1 Year Price (PV) = = 86.95
(!.!&)
deposit at a rate of 10%
!""
Price (PV) = (!.'&) = 80.00 12m

Which of these prices would you prefer to pay for a startup bond? Why?
Another way?
• We adjusted discount rate in the previous example
• Can we not adjust the cash flow by using an expected cash flow and the
same discount rate as a risk free asset?
• Indeed we can
• In the previous case, we could have used an expected cash flow of Rs 88,
discount rate 10% to get the same price of Rs 80.00
• Why a lower cash flow?
• The cash flow is risky and one may not get back Rs 100.
• This method is called risk neutral pricing
• Used in some cases e.g. Option Pricing