2-Financial Markets Page 26 Wednesday, February 4, 2004 1:15 PM
26 The Mathematics of Financial Modeling and Investment ManagementSome financial assets are contracts that either obligate the investor
to buy or sell another financial asset or grant the investor the choice to
buy or sell another financial asset. Such contracts derive their value
from the price of the financial asset that may be bought or sold. These
contracts are called derivative instruments and the markets in which
they trade are referred to as derivative markets. The array of derivative
instruments includes options contracts, futures contracts, forward con-
tracts, swap agreements, and cap and floor agreements.
Although the existence of a financial market is not a necessary con-
dition for the creation and exchange of a financial asset, in most econo-
mies financial assets are created and subsequently traded in some type of
organized financial market structure. A financial market can be classi-
fied by its organizational structure. These organizational structures can
be classified as auction markets and over-the-counter markets. We
describe each type later in this chapter.Economic Functions of Financial Markets
The two primary economic functions of financial assets were already dis-
cussed. Financial markets provide three additional economic functions.
First, the interactions of buyers and sellers in a financial market
determine the price of the traded asset; or, equivalently, the required
return on a financial asset is determined. The inducement for firms to
acquire funds depends on the required return that investors demand, and
this feature of financial markets signals how the funds in the economy
should be allocated among financial assets. It is called the price discovery
process. Whether these signals are correct is an issue that we discuss
when we examine the question of the efficiency of financial markets.
Second, financial markets provide a mechanism for an investor to
sell a financial asset. This feature offers liquidity in financial markets, an
attractive characteristic when circumstances either force or motivate an
investor to sell. In the absence of liquidity, the owner must hold a debt
instrument until it matures and an equity instrument until the company
either voluntarily or involuntarily liquidates. Although all financial
markets provide some form of liquidity, the degree of liquidity is one of
the factors that differentiates various markets.
The third economic function of a financial market reduces the
search and information costs of transacting. Search costs represent
explicit costs, such as the money spent to advertise the desire to sell or
purchase a financial asset, and implicit costs, such as the value of time
spent in locating a counterparty. The presence of some form of orga-
nized financial market reduces search costs. Information costs are
incurred in assessing the investment merits of a financial asset, that is,