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Financial
Assets

Understand stocks, bonds, and other financial instruments that drive modern economies and connect savers to borrowers.

AP Macroeconomics

What Are Financial Assets?

A financial asset is a claim on future income or value. Unlike physical (real) assets such as land or machinery, financial assets are intangible: their value comes from a contractual right to receive cash flows, ownership stakes, or other economic benefits.

Three Major Categories

Stocks
Ownership shares in a corporation. Returns come from dividends and capital gains.
Bonds
Loans to a government or corporation. The issuer pays periodic interest and returns the principal at maturity.
Bank Deposits
Money held in savings or checking accounts. FDIC-insured, low risk, low return.

Why They Matter for the Economy

Financial assets channel funds from savers to investors. When households buy bonds or stocks, the money flows to firms and governments that use it for capital investment, fueling economic growth.

Savers (Households) Funds Financial Markets (Stocks, Bonds) Funds Borrowers (Firms, Gov't) Returns Returns

Bonds: The Basics

A bond is an IOU. The issuer borrows money and promises to pay the bondholder a fixed coupon rate (interest) and return the face value (par value) at maturity.

1
Face Value (Par): The amount repaid at maturity, typically \( \$1{,}000 \).
2
Coupon Rate: The annual interest rate paid on the face value.
3
Maturity Date: When the principal is repaid to the bondholder.
4
Market Price: What the bond trades for today, which can differ from face value.

Bond Prices and Interest Rates

Interest Rate Bond Price Price Price up Price down Low High

This is because a bond's fixed coupon becomes less attractive when newer bonds offer higher rates, so its market price drops to compensate.

Stocks: Ownership Claims

A stock (equity share) represents partial ownership in a corporation. Stockholders earn returns through dividends (share of profits) and capital gains (selling at a higher price).

Dividends
Periodic cash payments from the firm's earnings to shareholders.
Capital Gains
Profit earned when the stock is sold at a price higher than the purchase price.

Stocks vs. Bonds

Feature Stocks Bonds
Type of claim Ownership (equity) Debt (loan)
Returns Dividends + capital gains Fixed interest (coupon)
Risk level Higher Lower
Maturity No maturity Fixed maturity date
Priority in bankruptcy Paid last Paid before stockholders

The Risk-Return Tradeoff

In financial markets, higher potential returns come with higher risk. Investors must decide how much risk they are willing to accept.

Risk Expected Return Savings Bonds Stocks Low High

Understanding Liquidity

Liquidity measures how quickly and easily an asset can be converted into cash without losing value. Cash itself is the most liquid asset.

1
Most liquid: Cash and checking deposits: immediately available.
2
Moderately liquid: Stocks and government bonds: sold on markets within seconds, but prices may fluctuate.
3
Less liquid: Real estate and long-term CDs: selling takes days or weeks and may involve penalties.

Key Formulas to Know

Real Interest Rate
$$ r = i - \pi $$ where \( r \) = real rate, \( i \) = nominal rate, \( \pi \) = inflation rate
Bond Yield
$$ \text{Yield} = \frac{\text{Coupon Payment}}{\text{Market Price}} $$ Yield rises when bond price falls.

How to Analyze a Financial Asset

1
Identify the type: Is it equity (stock), debt (bond), or a deposit?
2
Assess risk level: Government bonds < corporate bonds < stocks.
3
Check liquidity: How easily can it be sold without losing value?
4
Calculate real return: Use \( r = i - \pi \) to find the inflation-adjusted gain.
5
Consider the inverse rule: Rising interest rates lower existing bond prices.

Example 1: Real Return

A government bond pays a nominal interest rate of 6%. The current inflation rate is 2%. What is the real interest rate?

Example 2: Bond Yield Calculation

A bond has a face value of \( \$1{,}000 \) and pays an annual coupon of \( \$50 \). It currently trades at \( \$800 \). What is its yield?

Example 3: Interest Rate Change

The Federal Reserve raises the federal funds rate. What happens to the price of existing bonds in the secondary market?

1
Rates rise: Newly issued bonds offer higher coupon rates.
2
Existing bonds become less attractive: Their fixed coupons are below the new market rate.
3
Bond prices fall: Sellers must lower prices so their bonds' yield matches the new higher rate.

Common Mistakes

✕ Confusing stocks and bonds
Stocks are ownership; bonds are debt. Bondholders are creditors, not owners.
✕ Forgetting the inverse rule
When interest rates rise, bond prices fall: not stay the same, not rise.
✕ Ignoring inflation
A 5% nominal return means little if inflation is 4%. Always calculate the real rate.

Question 1 of 5

If the nominal interest rate on a bond is 7% and the inflation rate is 3%, what is the real interest rate?

Question 2 of 5

When market interest rates increase, what happens to the price of existing bonds?

Question 3 of 5

Which of the following is the most liquid financial asset?

Question 4 of 5

A bond with a face value of \( \$1{,}000 \) and a coupon payment of \( \$60 \) is trading at \( \$1{,}200 \). What is the bond's current yield?

Question 5 of 5

A stockholder earns a return through which two methods?