The Mathematics of Financial Modelingand Investment Management

2-Financial Markets Page 34 Wednesday, February 4, 2004 1:15 PM

34 The Mathematics of Financial Modeling and Investment Management

investor, and the competitive forces of investors with similar motiva-

tions for trading.

The cost of not transacting represents an opportunity cost. Oppor-

tunity costs may arise when a desired trade fails to be executed. This

component of costs represents the difference in performance between an

investor’s desired investment and the same investor’s actual investment

after adjusting for execution costs, commissions, and fees. Opportunity

costs have been characterized as the hidden cost of trading, and it has

been suggested that the shortfall in performance of many actively man-

aged portfolios is the consequence of failing to execute all desired

trades.^14 Measurement of opportunity costs is subject to the same prob-

lems as measurement of execution costs. The true measure of opportu-

nity cost depends on knowing what the performance of a security would

have been if all desired trades had been executed at the desired time

across an investment horizon. As these are the desired trades that the

investor could not execute, the benchmark is inherently unobservable

OVERVIEW OF MARKET PARTICIPANTS

With an understanding of what financial assets are and the role of finan-

cial assets and financial markets, we can now identify who the players are

in the financial markets. By this we mean the entities that issue financial

assets and the entities that invest in financial assets. We will focus on one

particular group of market players, called financial intermediaries, because

of the key economic functions that they perform in financial markets. In

addition to reviewing their economic function, we will set forth the basic

asset/liability problem faced by managers of financial intermediaries.

There are entities that issue financial assets, both debt instruments

and equity instruments. There are investors who purchase these finan-

cial assets. This does not mean that these two groups are mutually

exclusive—it is common for an entity to both issue a financial asset and

at the same time invest in a different financial asset.

A simple classification of these entities is as follows: (1) central gov-

ernments; (2) agencies of central governments; (3) municipal govern-

ments; (4) supranationals; (5) nonfinancial businesses; (6) financial

enterprises; and (7) households. Central governments borrow funds for

a wide variety of reasons. Many central governments establish agencies

to raise funds to perform specific functions. Most countries have munic-

ipalities or provinces that raise funds in the capital market. A suprana-

tional institution is an organization that is formed by two or more

central governments through international treaties. Businesses are classi-