Asset Classes Definition
Assets are classified into different classes based on their types, purpose or the basis of return or markets into various classes like fixed assets, equity (equity investments, equity-linked saving schemes), real estate, commodities (gold, silver, bronze), cash and cash equivalents, derivatives (equity, bonds, debt, etc.), and alternative investments like hedge funds, bitcoins, etc.
It can also be 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, form an asset class. Asset class categorization is essential 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.
List of Top 5 Types of Asset Classes
- Equity
- Fixed Income Securities
- Cash and Cash Equivalents
- Real Estate
- Derivatives
Let us discuss each type of asset classes in detail –
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#1 – Equity
First, in the list of 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 sharesIssue Equity SharesShares Issued refers to the number of shares distributed by a company to its shareholders, who range from the general public and insiders to institutional investors. They are recorded as owner's equity on the Company's balance sheet.read more to the buyers who will provide the capital in lieu of ownership (proportional) in the company. In the event of liquidationLiquidationLiquidation is the process of winding up a business or a segment of the business by selling off its assets. The amount realized by this is used to pay off the creditors and all other liabilities of the business in a specific order.read more or sale, the shareholders will be eligible for the money left after all assets are liquidated/sold, and the debtors paid off.
Accounting EquationAccounting EquationAccounting Equation is the primary accounting principle stating that a business's total assets are equivalent to the sum of its liabilities & owner’s capital. This is also known as the Balance Sheet Equation & it forms the basis of the double-entry accounting system. read more,
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 capitalPaid-up CapitalPaid in Capital is the capital amount that a Company receives from investors in exchange for the stock sold in the primary market, including common or preferred stock. This considers the sale of stock that an issuer directly sells to the investor & not the sale of stock on the secondary market between investors. read more 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 paymentsDividend PaymentsDividend is that portion of profit which is distributed to the shareholders of the company as the reward for their investment in the company and its distribution amount is decided by the board of the company and thereafter approved by the shareholders of the company.read more.
- 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 the 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 three 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 billTreasury BillTreasury Bills or a T-Bill controls temporary liquidity fluctuations. The Central Bank is responsible for issuing the same on behalf of the government. It is given at its redemption price and a discounted rate and is repaid when it reaches maturity.read more is also an example of a 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 rateCoupon RateThe coupon rate is the ROI (rate of interest) paid on the bond's face value by the bond's issuers. It determines the repayment amount made by GIS (guaranteed income security). Coupon Rate = Annualized Interest Payment / Par Value of Bond * 100%read more annually. The payment schedule is as follows:
Solution:
You can refer to 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 financingEquity FinancingEquity financing is the process of the sale of an ownership interest to various investors to raise funds for business objectives. The money raised from the market does not have to be repaid, unlike debt financing which has a definite repayment schedule.read more.
- The privilege of tax shield on interest.
- Companies can make provisions for payment schedules, which in the 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 equivalentsCash EquivalentsCash equivalents are highly liquid investments with a maturity period of three months or less that are available with no restrictions to be used for immediate need or use. These are short-term investments that are easy to sell in the public market..read more, 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 positionShort PositionA short position is a practice where the investors sell stocks that they don't own at the time of selling; the investors do so by borrowing the shares from some other investors to promise that the former will return the stocks to the latter on a later date.read more.
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The price of a contract that is fixed at the time of agreement is called the strike priceStrike PriceExercise price or strike price refers to the price at which the underlying stock is purchased or sold by the persons trading in the options of calls & puts available in the derivative trading. Thus, the exercise price is a term used in the derivative market.read more. 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. 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)Capital Asset Pricing Model (CAPM)The Capital Asset Pricing Model (CAPM) defines the expected return from a portfolio of various securities with varying degrees of risk. It also considers the volatility of a particular security in relation to the market.read more 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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