ECO349H5 Chap.1 Financial Assets and the Financial System
Financial Assets and the Financial System
Claims across time
Financial assets divide future goods and monetary payoffs between parties. A useful first question is whether the exchange ends today or creates a claim that remains open. A spot purchase transfers the good and payment together. A bond, loan or share instead records a present transfer and a rule for later cash flow.
Draw both dates before calculating: identify who supplies funds, who receives them, and which side records an asset or a liability.
Read the contract before pricing it
Debt and equity allocate project outcomes differently. Debt specifies promised repayment and therefore has a flat contractual region once the promise can be met, although default can make realized repayment lower.
Equity is a residual claim, so its payoff rises with value after senior promises have been satisfied. A payoff schedule describes the contract. Price asks what that schedule is worth today given probabilities, time and alternatives. Mixing those objects is the most common source of a false break-even calculation.
Balance-sheet language keeps the two perspectives consistent.
The saver acquires a financial asset; the issuer obtains financing and records the matching claim against itself. One party’s asset is normally another party’s liability or ownership claim, but the underlying productive asset can create aggregate value. Financial intermediation changes who holds the claim, the information collected and the liquidity offered.
It does not create resources merely by relabelling entries.
Separate expected payoff from realized payoff
A state-contingent claim has several possible realized outcomes. Expected payoff is a probability-weighted average across them, not the amount received in any particular state.
Expected return also divides the expected net payoff by the current price, so the same future schedule supports different returns at different purchase prices. When probabilities are supplied, show the state table first. When probabilities are absent, do not quietly assume equal likelihood.
Timing matters even when a payoff is certain.
A dollar later is not automatically equivalent to a dollar now because current funds have an opportunity cost. Liquidity adds another margin: two claims with the same promised maturity payoff can differ in value if one is difficult to sell beforehand. Credit risk adds a separate margin because the promised amount may not be delivered.
A strong comparison names which dimension changes while holding the others fixed.
Use payoff diagrams as arguments
Label the horizontal variable, the claimant’s net payoff and the point where the line changes slope. For an equity purchase, subtract the acquisition price from the ownership share of project value. The horizontal intercept is the break-even project value, not necessarily the most likely outcome.
For debt, mark face value and any default region. Then explain every segment in words so the diagram continues to communicate if an arithmetic label is removed.
For an exam response, begin with the parties and dates, write the contractual payoff, and only then introduce probability or discounting. Finish by interpreting the sign and unit of the answer.
If the calculation produces a project value, do not call it a return; if it produces a percentage, state the investment base. This order makes later chapters on bonds, risk pricing and banking extensions of the same claims framework rather than unrelated formula sets.
What this chapter covers
- 01
Financial claims
- 02
Balance sheets
- 03
Debt and equity
- 04
Payoff schedules
- 05
Savers and borrowers
Worked example · free
Break even on an equity claim
- 2Write the shareholder's net payoff after subtracting the purchase price.
- 2Set net payoff to zero and isolate total project value.
Key terms
- Financial Claim
- A Financial Claim is an enforceable or expected right to a future payoff.
- Inside Equity
- Inside Equity is the owner residual that balances assets against outside liabilities.
Financial Assets and the Financial System FAQ
How is a financial asset different from a real asset?
A financial asset is a claim on future resources delivered by another party, while a real asset can provide services directly. Some contracts reference real assets, but the payoff promise and the underlying object still perform different economic roles.
Why must both balance sheets be shown?
The buyer exchanges cash for a claim while the issuer receives cash and creates an obligation or ownership interest. Showing both sides prevents a transfer from being mistaken for new aggregate wealth and makes counterparty exposure visible.
Is expected payoff the same as value?
No. Value also depends on timing, risk preferences, state covariance, enforceability and liquidity. Expected payoff is one input, and the later pricing chapters supply the discounting and risk adjustment needed to move from receipts to price.
Exam move
Draw the transaction at initiation and settlement, then sketch net payoff by project value. Explain each kink in words.
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