Financial Assets (AQA A Level Economics)

• Debt is a liability; it represents what firms owe
  • Individuals or businesses that lend money to a firm are called creditors
  • E.g. Banks loans, corporate bonds, and mortgages
• Equity represents all physical and financial assets owned by firm
  • Firms can raise finance by issuing shares or corporate bonds
• Firms can use both debt and equity as a source of finance for their operations
   

The Difference Between Debt and Equity as a Source of Finance

Characteristic	Debt	Equity
Ownership rights	There are no ownership rights for creditors	It involves selling shares in a company where shareholders have ownership rights
Risk and return	Money must be repaid to creditors with interest	Shareholders are entitled to a share of the company's profits in the form of dividends
Voting rights	There are no voting rights for creditors	Shareholders often have voting rights in company decisions

Key terminology in the bond market

• Market interest rates (also known as yields) are the cost of borrowing money or the return on savings
• Bond prices are the amount investors are willing to pay for government bonds
  • Governments and big companies issue bonds to raise funds for various purposes, like covering a government's budget deficit or allowing a company to invest in new equipment

Nominal Value, Coupon and Maturity of Bonds

Nominal Value	Coupon	Maturity
Investors buy bonds at face value, also known as the nominal value, becoming bondholders	A coupon is the guaranteed fixed annual interest payment to the investor  The interest rate is fixed on the duration of the bond	Maturity is the date of expiration of the bond  It is usually more than one year, as a result, this investment is illiquid  At maturity, investors receive the full nominal value of the bond
E.g the nominal value is £1,000	E.g  An investor receives 5% of the nominal value of a bond each year	E.g Maturity date is 5 years

Interest rates, bond prices and secondary markets

• Before a bond reaches maturity, it can be resold in secondary markets
• Investors can buy or sell them at prices different from the nominal value 
  • E.g. Market price is £1,100 compared to nominal value of £1,000
• Market prices for bonds vary in the secondary market due to market forces
  
  • If the interest on bonds is high relative to other returns on investment, demand for bonds increases
    • The lower the demand for bonds, the lower the market price

Diagram: The Relationship Between Interest Rates and Bond Prices

When interest rates rise, bond prices fall - and vice versa

• Market forces cause interest rates to vary 
• If government issues a bond this year with 5% interest, they may have to issue bonds with 7% interest next year due to market forces
• The interest rate on each bond is fixed
   
• 5% bonds now have a less attractive return on investment in the secondary market 
• E.g, They have a 2% lower return compared to new bonds issued 
• Existing bonds will be less attractive to investors 
• As a result, demand falls for existing bonds, causing price of bonds to fall
  
  

• The opposite will also be true. If the government issues new bonds at a lower interest rate, then the demand for existing bonds will increase 
• If government issued a bond last year at 5%, they may have to issue bonds at 3% this year
• Existing bonds will be more attractive to investors than the new bonds 
• As a result, demand for existing bonds rises, causing the price to rise
• The new bond price may fall relatively quickly in the secondary market
  
  

• Therefore, long-run rate of interest and yields have an inverse relationship with government bonds prices
• As interest rates rise, bond prices fall 
• As interest rates fall, bond prices rise