2-Financial Markets Page 23 Wednesday, February 4, 2004 1:15 PM
Overview of Financial Markets, Financial Assets, and Market Participants 23Some financial assets act as a medium of exchange or in settlement
of transactions. These assets are called money. Other financial assets,
although not money, closely approximate money in that they can be
transformed into money at little cost, delay, or risk. Moneyness clearly
offers a desirable property for investors. Divisibility and denomination
divisibility relates to the minimum size at which a financial asset can be
liquidated and exchanged for money. The smaller the size, the more the
financial asset is divisible.
Reversibility, also called round-trip cost, refers to the cost of invest-
ing in a financial asset and then getting out of it and back into cash
again. For financial assets traded in organized markets or with “market
makers,” the most relevant component of round-trip cost is the so-
called bid-ask spread, to which might be added commissions and the
time and cost, if any, of delivering the asset. The bid-ask spread consists
of the difference between the price at which a market maker is willing to
sell a financial asset (i.e., the price it is asking) and the price at which a
market maker is willing to buy the financial asset (i.e., the price it is bid-
ding). The spread charged by a market maker varies sharply from one
financial asset to another, reflecting primarily the amount of risk the
market maker assumes by “making” a market. This market-making risk
can be related to two main forces.
One is the variability of the price as measured, say, by some measure
of dispersion of the relative price over time. The greater the variability,
the greater the probability of the market maker incurring a loss in excess
of a stated bound between the time of buying and reselling the financial
asset. The variability of prices differs widely across financial assets. The
second determining factor of the bid-ask spread charged by a market
maker is what is commonly referred to as the thickness of the market,
which is essentially the prevailing rate at which buying and selling orders
reach the market maker (i.e., the frequency of transactions). A “thin
market” sees few trades on a regular or continuing basis. Clearly, the
greater the frequency of orders coming into the market for the financial
asset (referred to as the “order flow”), the shorter the time that the finan-
cial asset must be held in the market maker’s inventory, and hence the
smaller the probability of an unfavorable price movement while held.
Thickness also varies from market to market. A low round-trip cost is
clearly a desirable property of a financial asset, and as a result thickness
itself is a valuable property. This attribute explains the potential advan-
tage of large over smaller markets (economies of scale), and a market’s
endeavor to standardize the instruments offered to the public.
The term to maturity, or simply maturity, is the length of the inter-
val until the date when the instrument is scheduled to make its final pay-
ment, or the owner is entitled to demand liquidation. Maturity is an