The Mathematics of Financial Modelingand Investment Management

2-Financial Markets Page 35 Wednesday, February 4, 2004 1:15 PM

Overview of Financial Markets, Financial Assets, and Market Participants 35

fied into nonfinancial and financial businesses. These entities borrow

funds in the debt market and raise funds in the equity market. Nonfinan-

cial businesses are divided into three categories: corporations, farms,

and nonfarm/noncorporate businesses. The first category includes cor-

porations that manufacture products (e.g., cars, steel, computers) and/or

provide nonfinancial services (e.g., transportation, utilities, computer

programming). In the last category are businesses that produce the same

products or provide the same services but are not incorporated.

Financial businesses, more popularly referred to as financial institu-

tions, provide services related to one or more of the following:

1. Transforming financial assets acquired through the market and consti-
   tuting them into a different and more preferable type of asset—which
   becomes their liability. This is the function performed by financial
   intermediaries, the most important type of financial institution.


2. Exchanging financial assets on behalf of customers.


3. Exchanging financial assets for their own account.


4. Assisting in the creation of financial assets for their customers and then
   selling those financial assets to other market participants.


5. Providing investment advice to other market participants.


6. Managing the portfolios of other market participants.

Financial intermediaries include: depository institutions that

acquire the bulk of their funds by offering their liabilities to the public

mostly in the form of deposits; insurance companies (life and property

and casualty companies); pension funds; and finance companies. Later

in this chapter we will discuss these entities. The second and third ser-

vices in the list above are the broker and dealer functions. The fourth

service is referred to as securities underwriting. Typically, a financial

institution that provides an underwriting service also provides a broker-

age and/or dealer service.

Some nonfinancial businesses have subsidiaries that provide finan-

cial services. For example, many large manufacturing firms have subsid-

iaries that provide financing for the parent company’s customer. These

financial institutions are called captive finance companies.

Role of Financial Intermediaries

Financial intermediaries obtain funds by issuing financial claims against

themselves to market participants and then investing those funds. The

investments made by financial intermediaries—their assets—can be in

loans and/or securities. These investments are referred to as direct

investments. As just noted, financial intermediaries play the basic role of