Real assets create wealth. Financial assets represent claims to parts or all of that wealth. Financial assets determine how the ownership of real assets is distributed among investors.
Financial assets can be categorized as fixed income, equity, or derivative instruments. Top-down portfolio construction techniques start with the asset allocation decision—the allocation of funds across broad asset classes—and then progress to more specific security-selection decisions.
Competition in financial markets leads to a risk-return trade-off, in which securities that offer higher expected rates of return also impose greater risks on investors. The presence of risk, however, implies that actual returns can differ considerably from expected returns at the beginning of the investment period. Competition among security analysts also results in financial markets that are nearly informationally efficient, meaning that prices reflect all available information concerning the value of the security. Passive investment strategies may make sense in nearly efficient markets.
Financial intermediaries pool investor funds and invest them. Their services are in demand because small investors cannot efficiently gather information, diversify, and monitor portfolios. The financial intermediary sells its own securities to the small investors. The intermediary invests the funds thus raised, uses the proceeds to pay back the small investors, and profits from the difference (the spread).
Investment banking brings efficiency to corporate fund raising. Investment bankers develop expertise in pricing new issues and in marketing them to investors.
Recent trends in financial markets include globalization, securitization, financial engineering of assets, and growth of information and computer networks.
