Asset Classes Definition
Asset Classes are defined as financial instruments that have similar characteristics and similar behavior in the markets. For instance, equities, which cover all the different kinds of stocks together, form an asset class. Asset class categorization is important for investors and their issuers to understand the laws and regulations guiding these groups. An asset class, say bonds, is subject to a different set of SEC laws as compared to equities.
Below is the list of most common types of Asset Classes.
- Equity
- Fixed Income Securities
- Cash and Cash Equivalents
- Real Estate
- Derivatives
List of Top 5 Types of Asset Classes
Let us discuss each type of asset classes in detail –
#1 – Equity
First in the list of the asset classes is Equities. Equity is a share of ownership in a company that guarantees the proceeds from liquidation or sale of the company once all debts are paid.
A company wants to raise $10mn from the public. It will issue equity shares to the buyers who will provide the capital in lieu of ownership (proportional) in the company. In the event of liquidation or sale, the shareholders will be eligible for the money left after all assets are liquidated/sold and the debtors paid off.
It is the fraction of this equity (owners’ equity) that are sold over time by the owners of the company to raise additional money. However, what amount each shareholder gets is based on his ownership in this equity capital.
Equity Example
To understand this type of asset classes is reproduced below:
What is the paid-up capital of a company XYZ who has issued 500,000 shares each carrying a par value of $10?
Solution:
Step 1: Paid-up capital = Issue price times the number of shares issued
Step 2: Paid-up capital = $10 * 500,000
Step3: Paid-up capital = $5 Million
A company issues equity for the following reasons:
- Access to huge capital from the public.
- No obligated to pay regular income.
- Not bound by dividend payments.
- Equity becomes the only option of financing when it faces credit risk issues.
However, issuing equity has certain disadvantages also. The involvement of numerous shareholders causes a conflict of interest. More the shareholders less the control of the original owners in terms of both ownership fraction and decision-making. One of the biggest setbacks for equity issuer is its cost (compared to debt).
#2 – Fixed Income Securities
These are securities that guarantee a fixed regular income to investors besides the repayment of principal at the end of maturity. For example, a 3-year corporate bond that pays an 8% coupon rate will make fixed coupon payments of $80 for each of the 3 years apart from the face value of the bill that is returned to the investor upon maturity.
A coupon rate can have monthly to annual payments. A US treasury bill is also an example of fixed income security. However, it does not pay fixed coupon payments; it is considered a very safe investment.
Fixed Income Securities Example
How a simple bond works can be shown from the following asset classes example.
Suppose an investor purchases a 5-year $1000 face value corporate bond from a company that promises a 5% coupon rate annually. The payment schedule is as follows:
Solution:
You can refer the below given excel template for a detailed calculation of asset classes.
Financing by bonds is beneficial for a company because –
- Cheaper source than equity financing.
- The privilege of tax shield on interest.
- Companies can make provisions for payment schedules which in case of equity, is rather unpredictable.
However fixed income securities are more susceptible to credit risk.
#3 – Cash and Cash Equivalents
Under this type of asset class, Cash is one of the most important elements in a business. Cash can be used for short-term investments and lending whereas it can also be borrowed on short-term for operational expenses.
Cash equivalents, on similar lines, are short-term promised funds and are highly liquid. Cash equivalents usually have low-interest rates because of their short-term nature. For example, a commercial paper is issued by a corporate body as a means of lending short term funds.
#4 – Real Estate
This category of assets implies its name from its physical attribute. These are real and tangible assets as opposed to other asset classes. Real estate is an investment source for a company or an individual investor because it gives them protection against inflation and while assuring them of high capital gains. On the contrary, real estate investments are subject to depreciation, which is an expense in the company’s books of accounting.
#5 – Derivatives
Under this type of asset class, A derivative is a contract that derives its value from an underlying which can be an asset. Suppose a farmer is uncertain about the prices of wheat after three months. He can hedge the risk by entering into an agreement with a grain buyer to eliminate the risk of price uncertainty. Derivatives are traded by taking either a long position or a short position.
The price of a contract that is fixed at the time of agreement is called strike price. The contract sets out the expiration date beyond which the right (obligation for forwards/futures) to buy/sell the asset expires.
What is the Broader Picture?
From the perspective of a company that has expansion plans in the foreseeable future, the management of these asset classes becomes an important subject. To put simply, a company’s capital structure may be a function of the various asset classes it establishes. The financing needs of a firm are well addressed by stocks and bonds, whereas the short term expenses are borne out by cash and cash equivalents. The concept of capital asset pricing model (CAPM) is significant when asset classes like common stock, preferred stock, and debts are raised.
To a general investor as well, the knowledge of various asset classes is important. Different asset classes offer different profiles for rate and return. Over a specific study period, the US small-cap stocks have given a much greater return than the US government bonds.
Diversification of risk vis-à-vis the optimization of expected return can be addressed by a sound understanding of different asset classes. Thus, asset classes can prove to be very helpful in investment strategies for the individual investor and financing needs of corporates.
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