2-Financial Markets Page 36 Wednesday, February 4, 2004 1:15 PM
36 The Mathematics of Financial Modeling and Investment Managementtransforming financial assets that are less desirable for a large part of
the public into other financial assets—their own liabilities—which are
preferred more by the public. This transformation involves at least one
of four economic functions: (1) providing maturity intermediation; (2)
risk reduction via diversification; (3) reducing the costs of contracting
and information processing; and (4) providing a payments mechanism.
Maturity intermediation involves a financial intermediary issuing lia-
bilities against itself that have a maturity different from the assets it
acquires with the fund raised. An example is a commercial bank that
issues short-term liabilities (i.e., deposits) and invests in assets with a
longer maturity than those liabilities. Maturity intermediation has two
implications for financial markets. First, investors have more choices con-
cerning maturity for their investments; borrowers have more choices for
the length of their debt obligations. Second, because investors are reluctant
to commit funds for a long period of time, they will require that long-term
borrowers pay a higher interest rate than on short-term borrowing. In con-
trast, a financial intermediary will be willing to make longer-term loans,
and at a lower cost to the borrower than an individual investor would, by
counting on successive deposits providing the funds until maturity
(although at some risk as discussed below). Thus, the second implication is
that the cost of longer-term borrowing is likely to be reduced.
To illustrate the economic function of risk reduction via diversifica-
tion, consider an investor who invests in a mutual fund. Suppose that
the mutual fund invests the funds received in the stock of a large num-
ber of companies. By doing so, the mutual fund has diversified and
reduced its risk. Investors who have a small sum to invest would find it
difficult to achieve the same degree of diversification because they
would not have sufficient funds to buy shares of a large number of com-
panies. Yet by investing in the investment company for the same sum of
money, investors can accomplish this diversification, thereby reducing
risk. This economic function of financial intermediaries—transforming
more risky assets into less risky ones—is called diversification. While
individual investors can do it on their own, they may not be able to do it
as cost effectively as a financial intermediary, depending on the amount
of funds they have to invest. Attaining cost-effective diversification in
order to reduce risk by purchasing the financial assets of a financial
intermediary is an important economic benefit for financial markets.
Investors purchasing financial assets should develop skills necessary
to understand how to evaluate an investment. Once those skills are
developed, investors should apply them to the analysis of specific finan-
cial assets that are candidates for purchase (or subsequent sale). Inves-
tors who want to make a loan to a consumer or business will need to
write the loan contract (or hire an attorney to do so). While there are