Types of Financial Assets

Once a firms begins to expand, it needs to find sources of capital to finance its business plans.  Stocks and bonds are two prevalent kinds of financial assets that businesses can utilize to fund its operations.  In the field of finance, three broad types of financial assets exist- debt, equity, and derivatives. 
 

Debt securities promise your initial investment back plus interest payments along the way.  Sometimes, this stream of income is fixed, meaning the debt holder will receive a predetermined amount of interest each year (or month).  Other so-called floating-rate bonds promise payments that depend on current interest rates.  For instance, a bond might pay an interest rate that is fixed at 3 percentage points above the rate paid on U.S. treasury bills.  Debt securities are sold in two broad markets- the money market and the capital market.  Securities in the money market are short-term, highly liquid, and generally low-risk.  Bonds in the capital market range from very safe to relatively risky, and have terms greater than one year.  Common examples of capital market securities include U.S. Treasury bills, state and municipal bonds, and corporate bonds.
 

On the other hand, equity represents a share of ownership in the corporation.  Equity holders are not guaranteed any payments, but they can receive income if the stock price appreciates or the company declares a dividend.  The stock price will increase if the firm is successful and other investors have confidence that the firm will continue to perform well.  This is why equity tends to be more risky that debt--the value of the equity is dependent upon the success of the firm and its real assets. 
 

Finally, derivatives are securities providing payoffs that depend on the values of other assets such as bond or stock prices.  The derivative itself is simply a contract between two or more parties.  Its value is determined by the fluctuations in the underlying asset.  For example, a Brazilian investor purchasing shares of German company off the German stock exchange would be exposed to exchange-rate risk while holding that stock.  To hedge (guard) against this risk, the investor could purchase currency futures at specified exchange rate for the future stock sale.  The primary purpose of derivatives is to guard against risk or transfer it to another party.
 

While debt and equity are fairly straightforward, derivatives are not only difficult to understand, but frowned upon by the world’s best investor- Warren Buffett.  He does an excellent job of explaining what they are.
 

“Charlie and I are of one mind in how we feel about derivatives and the trading activities that go with them: We view them as time bombs, both for the parties that deal with them and the economic system...Essentially, these instruments (derivatives) call for money to change hands at some future date, with the amount to be determined by one or more reference items, such as interest rates, stock prices, or currency values.  If, for example, you are either long or short on an S&P 500 futures contract, you are a party to a very simple derivatives transaction- with your gain or loss derived from the movements in the index.  Derivatives contracts are of varying duration and their value is often tied to several variables.”