2-Financial Markets Page 28 Wednesday, February 4, 2004 1:15 PM
28 The Mathematics of Financial Modeling and Investment ManagementPerfect Market
In order to explain the characteristics of secondary markets, we will first
describe a “perfect market” for a financial asset. Then we can show how
common occurrences in real markets keep them from being theoretically
perfect.
In general, a perfect market results when the number of buyers and
sellers is sufficiently large, and all participants are small enough relative
to the market so that no individual market agent can influence the com-
modity’s price. Consequently, all buyers and sellers are price takers, and
the market price is determined where there is equality of supply and
demand. This condition is more likely to be satisfied if the commodity
traded is fairly homogeneous (for example, corn or wheat).
There is more to a perfect market than market agents being price
takers. It is also required that there are no transaction costs or impedi-
ments that interfere with the supply and demand of the commodity.
Economists refer to these various costs and impediments as “frictions.”
The costs associated with frictions generally result in buyers paying
more than in the absence of frictions, and/or sellers receiving less.
In the case of financial markets, frictions would include:■ Commissions charged by brokers.
■ Bid-ask spreads charged by dealers.
■ Order handling and clearance charges.
■ Taxes (notably on capital gains) and government-imposed transfer fees.
■ Costs of acquiring information about the financial asset.
■ Trading restrictions, such as exchange-imposed restrictions on the size
of a position in the financial asset that a buyer or seller may take.
■ Restrictions on market makers.
■ Halts to trading that may be imposed by regulators where the financial
asset is traded.Role of Brokers and Dealers in Real Markets
Common occurrences in real markets keep them from being theoreti-
cally perfect. Because of these occurrences, brokers and dealers are nec-
essary to the smooth functioning of a secondary market.
One way in which a real market might not meet all the exacting
standards of a theoretically perfect market is that many investors may
not be present at all times in the marketplace. Further, a typical investor
may not be skilled in the art of the deal or completely informed about
every facet of trading in the asset. Clearly, most investors in even
smoothly functioning markets need professional assistance. Investors
need someone to receive and keep track of their orders for buying or