Risk and financial assets:

Two defining characteristics of financial markets are the time dimension enters explicitly into the picture, and there is a varying degree of risk present. In the market for many financial assets, risk is pervasive. This unit concentrates on the analysis of uncertainty and risk. Of course, the time dimension is occasionally brought in, but that is only central in a few theories. The next unit will leave out uncertainty and risk from the picture, and discuss the time dimension, the time value of money and the determination of interest rates. This unit is primarily about risky assets.

To set the ball rolling, in this section, we look at the concept of an asset and find out how it differs from an ordinary good; this gives us an idea of the concept of investing in an asset.

Investment, in general terms, can be defined as sacrifice of current money or resources for benefits in the future. Very simply stated,  investment  is deferred consumption. Investment is done in assets. What are assets?  Assets are claims to resources. These can be real or financial. Real assets are assets that are physical in nature, like real estate while financial assets are claims. Physical assets are also called  tangible assets while  intangible assets are legal claims to some future benefits. The entity that has agreed to make future cash payments is known as the issuer of the financial asset, while the owner of the financial asset is called the investor.

The claim that the holder of a financial asset has may be either a fixed amount or a varying (or residual) amount. In the first case, the financial asset is called a debt instrument, while in the latter case it is called an equity claim. Some financial assets display characteristics of both types. Those among these that pay a fixed amount are called fixed-income instruments.  Debt instruments,  equity claims, and instruments whose prices are derived from that of some other underlying assets (these are called derivatives, are together called securities. The main roles of  financial assets are: first,  to transfer funds from those who have surplus funds to those who require funds to invest in tangible assets, and secondly, to redistribute and spread the risk associated with the cash  flow generated by tangible assets among those seeking and those providing the funds. Of course, these functions are carried out through financial intermediaries and financial markets.

In the subsequent sections, the unit discusses the risk and returns associated with assets; some important theories of asset  pricing; the concept of efficient financial markets; and finally, decision-making under uncertainty.