Principal attributes of financial assets

Financial assets are items that hold value and can be used to store wealth or facilitate transactions. People and businesses hold various financial assets to meet different needs, such as making payments or earning returns. These assets differ based on three main attributes: liquidity, rate of return, and risk. Understanding these attributes helps explain why individuals choose certain assets over others.

Key attributes defined

• Liquidity - The ease with which an asset can be converted into cash without losing value. Highly liquid assets can be quickly turned into cash for spending.
• Rate of return - The earnings or interest gained from holding the asset over time, often expressed as a percentage.
• Risk - The chance that the asset's value could decrease or that the expected return might not be realized.

These attributes are interconnected. For example, assets with high liquidity often have lower rates of return because they are safer and easier to access, while higher-risk assets might offer greater returns to compensate for the uncertainty.

Types of financial assets including money

Money is a key financial asset that enables people to compare the value of goods and services. It serves as a medium of exchange, a unit of account, and a store of value. Beyond money, other financial assets provide alternatives for saving or investing, each with varying levels of liquidity, return, and risk. Interest rates represent the price of borrowing or saving money, influencing choices among these assets.

Most liquid forms of money

The most liquid financial assets are forms of money that can be used immediately for transactions:

• Cash - Physical currency like bills and coins, which has the highest liquidity but typically offers no rate of return and low risk.
• Demand deposits - Funds in checking accounts that can be withdrawn on demand, also highly liquid with minimal return and low risk.

These forms prioritize ease of use over earning potential.

Other financial assets

• People can hold assets other than the most liquid forms of money to potentially earn higher returns, though often at the cost of lower liquidity or higher risk.
• Bonds - Interest-bearing assets issued by governments or companies to borrow money. Bondholders receive regular interest payments and the principal back at maturity. They offer moderate liquidity, a fixed rate of return, and relatively low risk compared to stocks.
• Stocks - Equity shares representing ownership in a company. They provide potential returns through dividends and capital gains but come with lower liquidity and higher risk due to market fluctuations.

Choosing between these depends on balancing the attributes: money for immediate needs, bonds for steady income, and stocks for growth potential.

Comparing attributes across financial assets

This table illustrates how assets with higher potential returns generally involve more risk and less liquidity. As a result, investors might diversify to manage these trade-offs.

The relationship between bond prices and interest rates

Bonds are a common way to save or invest, but their value changes with market conditions. The price of previously issued bonds has a specific relationship with interest rates, which affects their attractiveness to investors. This inverse relationship arises because bonds compete with new bonds offering current interest rates.

How bond prices and interest rates interact

The price of previously issued bonds and interest rates on bonds are inversely related. This means when interest rates rise, the price of existing bonds falls, and when interest rates fall, existing bond prices rise.

This occurs because:

• If new bonds offer higher interest rates, older bonds with lower rates become less appealing, so their market price drops to attract buyers.
• Conversely, if new bonds have lower rates, older bonds with higher rates increase in value, as they provide better returns.

For example, a bond issued at a 5% interest rate will see its price decrease if market rates rise to 6%, making it necessary to sell at a discount to match the higher yield.

Opportunity cost of holding money

Holding money provides liquidity but comes at a cost, especially when other assets could generate earnings. The opportunity cost of holding money is the interest that could have been earned from holding other financial assets such as bonds.

This cost increases when interest rates are high, as the forgone returns from alternatives become more significant. As a result, people might shift from holding cash to bonds or stocks to minimize this opportunity cost and maximize wealth.