2-Financial Markets Page 37 Wednesday, February 4, 2004 1:15 PM
Overview of Financial Markets, Financial Assets, and Market Participants 37some people who enjoy devoting leisure time to this task, most of us
find that leisure time is in short supply, so to sacrifice it, we have to be
compensated. The form of compensation could be a higher return
obtained from an investment. In addition to the opportunity cost of the
time to process the information about the financial asset and its issuer,
there is the cost of acquiring that information. All these costs are called
information processing costs. The costs of writing loan contracts are
referred to as contracting costs. Another dimension to contracting costs
is the cost of enforcing the terms of the loan agreement. There are econ-
omies of scale in contracting and processing information about financial
assets, because of the amount of funds managed by financial intermedi-
aries. The lower costs accrue to the benefit of the investor who pur-
chases a financial claim of the financial intermediary and to the issuers
of financial assets, who benefit from a lower borrowing cost.
While the previous three economic functions may not have been
immediately obvious, this last function should be. Most transactions
made today are not done with cash. Instead, payments are made using
checks, credit cards, debit cards, and electronic transfers of funds. These
methods for making payments are provided by certain financial interme-
diaries. The ability to make payments without the use of cash is critical
for the functioning of a financial market. In short, depository institu-
tions transform assets that cannot be used to make payments into other
assets that offer that property.Institutional Investors
Managers of the funds of financial entities manage those funds to meet
specified investment objectives. For many institutional investors (insur-
ance companies, pension funds, investment companies, depository institu-
tions, and endowments and foundations), those objectives are dictated by
the nature of their liabilities. It is within the context of the asset/liability
problem faced by managers of institutional funds that investment vehicles
and investment strategies make any sense. Therefore, in this section we
provide an overview of the investment objectives of institutional investors
and the constraints imposed on managers of the funds of these entities.Nature of Liabilities
The nature of an institutional investor’s liabilities will dictate the gen-
eral investment strategy to pursue. Depository institutions, for example,
seek to generate income by the spread between the return that they earn
on their assets and the cost of their funds. Life insurance companies are
in the spread business. Pension funds are not in the spread business, in
that they themselves do not raise funds in the market. Certain types of