2-Financial Markets Page 24 Wednesday, February 4, 2004 1:15 PM
24 The Mathematics of Financial Modeling and Investment Managementimportant characteristic of financial assets such as debt instruments.
Equities set no maturity and are thus a form of perpetual instrument.
Liquidity serves an important and widely used function, although no
uniformly accepted definition of liquidity is presently available. A useful
way to think of liquidity and illiquidity, proposed by James Tobin, is in
terms of how much sellers stand to lose if they wish to sell immediately
against engaging in a costly and time consuming search.^2 Liquidity may
depend not only on the financial asset but also on the quantity one
wishes to sell (or buy). Even though a small quantity may be quite liq-
uid, a large lot may run into illiquidity problems. Note that liquidity
again closely relates to whether a market is thick or thin. Thinness
always increases the round-trip cost, even of a liquid financial asset. But
beyond some point it becomes an obstacle to the formation of a market,
and directly affects the illiquidity of the financial asset.
An important property of some financial assets is their convertibility
into other financial assets. In some cases, the conversion takes place
within one class of financial assets, as when a bond is converted into
another bond. In other situations, the conversion spans classes. For
example, with a corporate convertible bond the bondholder can change
it into equity shares. Most financial assets are denominated in one cur-
rency, such as U.S. dollars or yen or euros, and investors must choose
them with that feature in mind. Some issuers have issued dual-currency
securities with certain cash flows paid in one currency and other cash
flows in another currency.
The return that an investor will realize by holding a financial asset
depends on the cash flow expected to be received, which includes divi-
dend payments on stock and interest payments on debt instruments, as
well as the repayment of principal for a debt instrument and the
expected sale price of a stock. Therefore, the predictability of the
expected return depends on the predictability of the cash flow. Return
predictability, a basic property of financial assets, provides the major
determinant of their value. Assuming investors are risk averse, as we
will see in later chapters, the riskiness of an asset can be equated with
the uncertainty or unpredictability of its return.
An important feature of any financial asset is its tax status. Govern-
mental codes for taxing the income from the ownership or sale of finan-
cial assets vary widely if not wildly. Tax rates differ from year to year,
country to country, and even among municipalities or provinces within
a country. Moreover, tax rates may differ from financial asset to finan-
cial asset, depending on the type of issuer, the length of time the asset is
held, the nature of the owner, and so on.(^2) Tobin, “Properties of Assets.”