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Describe financial assets and state what the term means.

FRM® Part I · Financial Markets and Products · Pricing Financial Forwards and Futures · FRM1.FM.10.a

The idea

A financial asset is a claim on future cash flows or a stake in an entity, such as a share, a bond, a currency deposit or a stock index. Its value comes from the payments it entitles the holder to, not from physical use. This matters for forwards and futures because financial assets can be priced by arbitrage. So can investment assets such as gold, which many investors hold purely for investment. An investor can buy or short the asset and take the opposite forward position, so the forward price is pinned to the spot price, the financing rate and any known income. Consumption commodities such as oil or copper differ. Storage costs and a convenience yield for physical holders mean arbitrage gives only bounds. A financial asset has no storage cost and no convenience yield. The usual mistake is to believe the forward price depends on the expected future spot price. It depends on the cost of replicating the position today.

A practice question

From the question bank, with the reason each wrong option is wrong.

Which of the following is best described as a financial asset?

  1. A tonne of crude oil held in storage ready for refiningWhy not: Treats a physical consumption commodity as a financial claim; oil has no contractual cash flows and is held for use.
  2. A bar of gold kept in a vaultWhy not: Gold is a physical investment asset; confuses an asset held for investment with a claim on future cash flows.
  3. A leased office building owned outright by a firmWhy not: A real (physical) asset: its value comes from its use, not from a claim on financial cash flows.
  4. A share of common stock, which is a claim on a firm's earnings and dividends - correct

A financial asset is a claim on future cash flows or on an entity, such as a stock, bond, currency or index. Oil and buildings are physical assets, and gold is a physical investment asset rather than a claim.

A harder one

A risk manager is listing the underlyings of the forward contracts on her book: a 10-year government bond, an equity index, a euro-dollar currency pair and crude oil. How many of these are financial assets?

  1. OneWhy not: Counts only the bond; omits the index and the currency, which are also claims or financial quantities.
  2. TwoWhy not: Excludes the currency (or the index) wrongly; a currency deposit and an index of equities both represent financial claims.
  3. Three - correct
  4. FourWhy not: Counts crude oil as a financial asset; oil is a physical consumption commodity with storage costs and a convenience yield.

The bond, the equity index and the currency are financial; crude oil is a consumption commodity, so three of the four.

The hardest tier

A stock paying no dividends and a barrel of oil both trade at a spot price of USD 100, the one-year risk-free rate is 5% continuously compounded, and the one-year forward price quoted for each is USD 102, below USD 105.13. Which statement is correct?

  1. Arbitrage exists in the stock because it can be sold short and the proceeds lent, but not necessarily in oil, whose holders may value physical possession - correct
  2. Arbitrage exists in both, because each forward is below the cost-of-carry priceWhy not: Applies the stock logic to oil; holders of oil for consumption will not sell it to lend the proceeds, so the lower forward price is sustainable.
  3. Arbitrage exists in neither, because forward prices can differ from spot grown at the risk-free rateWhy not: Ignores that for a financial asset the short-sale and lending replication forces the equality.
  4. Arbitrage exists in oil but not the stock, because oil has storage costs that raise its cost of carryWhy not: Reverses the logic; storage costs raise the cost of carry, and a forward below the cost-of-carry price is arbitrage-free for oil when a convenience yield exists.

For a financial asset the reverse cash-and-carry is feasible: short the stock, lend at 5%, buy forward. For a consumption asset holders get a convenience yield and will not sell, so F below S e^(rT) can persist.

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