2-Financial Markets Page 72 Wednesday, February 4, 2004 1:15 PM
72 The Mathematics of Financial Modeling and Investment Management■ The two principal economic functions of financial assets are to (1)
transfer funds from those parties who have surplus funds to invest to
those who need funds to invest in tangible assets; and (2) transfer funds
in such a way as to redistribute the unavoidable risk associated with
the cash flow generated by tangible assets among those seeking and
those providing the funds.
■ Financial assets possess the following properties that determine or
influence their attractiveness to different classes of investors: (1) mon-
eyness; (2) divisibility and denomination; (3) reversibility; (4) term to
maturity; (5) liquidity; (6) convertibility; (7) currency; (8) cash flow
and return predictability; and (9) tax status.
■ There are five ways to classify financial markets: (1) nature of the
claim; (2) maturity of the claims; (3) new versus seasoned claims; (4)
cash versus derivative instruments; and (5) organizational structure of
the market.
■ Financial markets provide the following economic functions: (1) They
signal how the funds in the economy should be allocated among finan-
cial assets (i.e., price discovery); (2) they provide a mechanism for an
investor to sell a financial asset (i.e., provide liquidity); and (3) they
reduce search and information costs of transacting.
■ Pricing efficiency refers to a market where prices at all times fully
reflect all available information that is relevant to the valuation of
securities.
■ Financial intermediaries obtain funds by issuing financial claims
against themselves to market participants, then investing those funds.
■ Asset managers manage funds to meet specified investment objectives—
either based on a market benchmark or based on liabilities.
■ Common stocks, also called equity securities, represent an ownership
interest in a corporation; holders of this types of security are entitled to
the earnings of the corporation when those earnings are distributed in
the form of dividends.
■ A bond is a financial obligation of an entity that promises to pay a
specified sum of money at specified future dates; a bond may include a
provision that grants the issuer or the investor an option to alter the
effective maturity.
■ A futures contract and forward contract are agreements that require a
party to the agreement either to buy or sell the underlying at a desig-
nated future date at a predetermined price.
■ Futures contracts are standardized agreements as to the delivery date
and quality of the deliverable, and are traded on organized exchanges;
a forward contract differs in that it is usually nonstandardized, there is
no clearinghouse (and therefore counterparty risk), and secondary
markets are often nonexistent or extremely thin.