CFA INSTITUTE
INVESTMENT FOUNDATIONS
3RD Edition
COURSE OF STUDY
© 2018 CFA Institute. All rights reserved.
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ISBN 978-1-946442-74-1 (print volume 1)
ISBN 978-1-946442-75-8 (print volume 2)
ISBN 978-1-946442-73-4 (ebk)
February 2019
TABLE OF CONTENTS
Title Page
Copyright Page
Table of Contents
How to Use
Welcome!
How to Use Your Study Materials
Learning Outcomes
Command Words
Customise Your Study Program
Acronyms
We Want Your Feedback
Acknowledgments
Module 1. Industry Overview
Chapter 1. The Investment Industry: A Top-Down View
Learning Outcomes
1. Introduction
2. The Financial Services Industry
3. Financial Institutions
3.1. Banks
3.2. Insurance Companies
4. How Economies Benefit from the Existence of the
Investment Industry
4.1. Economic Systems
4.2. How the Investment Industry Fosters
Economic Growth
5. How Investors Benefit from the Existence of the
Investment Industry
5.1. How the Investment Industry Serves Investors
5.2. Need for Trust, Laws, and Regulations
6. Investment Industry Participants
6.1. How Companies and Governments Raise
Capital
6.2. How the Investment Industry Helps Savers
Invest Their Money
7. Key Forces Driving the Investment Industry
Summary
Chapter Review Questions
Answers
Module 2. Ethics and Regulation
Chapter 2. Ethics and Investment Professionalism
Learning Outcomes
1. Introduction
2. Why Ethical Behaviour Is Important
3. Obligations of Employees in the Investment Industry
3.1. Obligations to Clients
3.2. Obligations to Employers
3.3. Obligations to Co-Workers
3.4. Identifying Your Obligations
4. Ethical Standards
4.1. Codes of Ethics and Professional Standards
4.1.1. How the Code of Ethics Guides
Investment Professionals
4.1.2. How the Code of Ethics May Guide All
Employees in the Investment Industry
5. Benefits of Ethical Conduct and Consequences of
Unethical Conduct
5.1. Benefits of Ethical Conduct
5.2. Consequences of Unethical Conduct
5.2.1. Consequences for Industry and
Economy
5.2.2. Consequences for Clients
5.2.3. Consequences for Employers
5.2.4. Consequences for Individuals
6. Framework for Ethical Decision Making
Summary
Chapter Review Questions
Answers
Chapter 3. Regulation
Learning Outcomes
1. Introduction
2. Objectives of Regulation
3. Consequences of Regulatory Failure
4. A Typical Regulatory Process
4.1. Classification of Regulatory Regimes
5. Types of Financial Market Regulation
5.1. Gatekeeping Rules
Personnel.
Financial products.
5.2. Operational Rules
Net capital.
Handling of customer assets.
5.3. Disclosure Rules
Corporate issuers.
Market transparency.
Disclosure triggers.
5.4. Sales Practice Rules
Advertising.
Fees.
Information barriers.
Suitability standards.
Restrictions on self-dealing.
5.5. Trading Rules
Market standards.
Market manipulation.
Insider trading.
Front running.
Brokerage practices.
5.6. Proxy Voting Rules
5.7. Anti-Money-Laundering Rules
5.8. Business Continuity Planning Rules
6. Company Policies and Procedures
6.1. Supervision within Companies
6.2. Compensation Plans
6.3. Procedures for Handling Violations
7. Consequences of Compliance Failure
Summary
Chapter Review Questions
Answers
Module 3. Inputs and Tools
Chapter 4. Microeconomics
Learning Outcomes
1. Introduction
2. Demand and Supply
2.1. Demand
2.1.1. The Law of Demand
2.1.2. The Demand Curve
2.1.3. Effect of Income on Demand
2.1.4. Effect of the Expected Future Price of a
Product on Demand
2.1.5. Effect of Changes in General Tastes
and Preferences on Demand
2.1.6. Effect of Prices of Other Products on
Demand
2.1.6.1. Substitute Products
2.1.6.2. Complementary Products
2.1.6.3. Unrelated Products
2.2. Supply
2.3. Market Equilibrium
3. Elasticities of Demand
3.1. Price Elasticity of Demand
3.1.1. Own Price Elasticity of Demand
3.1.2. Cross-Price Elasticity of Demand
3.1.3. Interpreting Price Elasticities of Demand
3.2. Income Elasticity of Demand
4. Profit and Costs of Production
4.1. Accounting Profit vs. Economic Profit
4.2. Fixed Costs vs. Variable Costs
4.3. Effect of Fixed Costs on Profitability
5. Pricing
6. Market Environment
6.1. Perfect Competition
6.2. Pure Monopoly
6.3. Monopolistic Competition
6.4. Oligopoly
Summary
Chapter Review Questions
Answers
Chapter 5. Macroeconomics
Learning Outcomes
1. Introduction
2. Gross Domestic Product and the Business Cycle
2.1. Economic Growth
2.2. The Business (or Economic) Cycle
Expansion.
Peak.
Contraction.
Trough and recovery.
2.3. Causes of Business Cycles
2.4. Global Nature of Business Cycles
2.5. Economic Indicators
3. Inflation
3.1. Measuring Inflation
Consumer price index.
Producer price index.
Inflation rates and price indices.
Implicit GDP deflator.
3.2. The Effects of Inflation on Consumers,
Businesses, and Investments
Consumers.
Businesses.
Investments.
3.3. Other Changes in the Level of Prices
Deflation.
Stagflation.
Hyperinflation.
4. Monetary and Fiscal Policies
4.1. Monetary Policy
4.1.1. Open Market Operations
4.1.2. Central Bank Lending Rates
4.1.3. Reserve Requirements
4.1.4. Limitations of Monetary Policy
4.2. Fiscal Policy
4.2.1. Role and Tools of Fiscal Policy
4.2.2. Limitations of Fiscal Policy
Time lags.
Unexpected responses.
Unintended consequences.
4.3. Fiscal or Monetary Policy
Summary
Chapter Review Questions
Answers
Chapter 6. Economics of International Trade
Learning Outcomes
1. Introduction
2. Imports and Exports
2.1. The Need for Imports and Exports
2.2. Trends in Imports and Exports
3. Comparative Advantages among Countries
4. Balance of Payments
4.1. Current Account
4.1.1. Components of the Current Account
4.1.2. Importance of the Current Account
4.2. Capital and Financial Account
4.3. Relationship between the Current Account and
the Capital and Financial Account
4.4. Why Does a Country Run a Current Account
Deficit and How Does It Affect Its Currency?
5. Foreign Exchange Rate Systems
6. Currency Values
6.1. Major Factors That Affect the Value of a
Currency
6.1.1. Balance of Payments
6.1.2. Level of Inflation
6.1.3. Level of Interest Rates
6.1.4. Level of Government Debt
6.1.5. Political and Economic Environment
6.2. Relative Strength of Currencies
7. Foreign Exchange Market
7.1. Foreign Exchange Rate Quotes
7.2. Spot and Forward Markets
Summary
Chapter Review Questions
Answers
Chapter 7. Financial Statements
Learning Outcomes
1. Introduction
2. Roles of Standard Setters, Auditors, and Regulators
in Financial Reporting
3. Financial Statements
3.1. The Balance Sheet
3.2. The Income Statement
3.3. Profit and Net Cash Flow
3.4. The Cash Flow Statement
3.5. Links between Financial Statements
4. Financial Statement Analysis
4.1. How Liquid Is the Company?
4.2. Is the Company Generating Enough Profit
from Its Assets?
4.3. How Is the Company Financing Its Assets?
4.4. Is the Company Providing Sufficient Return for
Its Shareholders?
4.5. Summary of Ratios
4.6. Market Valuations
Summary
Chapter Review Questions
Answers
Chapter 8. Quantitative Concepts
Learning Outcomes
1. Introduction
2. Time Value of Money
2.1. Interest
2.1.1. Simple Interest
2.1.2. Compound Interest
2.1.3. Comparing Simple Interest and
Compound Interest
2.1.4. Annual Percentage Rate and Effective
Annual Rate
2.2. Present Value and Future Value
2.2.1. Present Value and Future Value
2.2.2. Net Present Value
2.2.3. Application of the Time Value of Money
2.2.3.1. Present Value and the Valuation
of Financial Instruments
2.2.3.2. Time Value of Money and Regular
Payments
3. Descriptive Statistics
3.1. Measures of Frequency and Average
3.1.1. Arithmetic Mean
3.1.2. Geometric Mean
3.1.3. Median
3.1.4. Mode
3.2. Measures of Dispersion
3.2.1. Range
3.2.2. Standard Deviation
3.2.3. Normal Distribution
3.3. Correlation
Summary
Chapter Review Questions
Answers
Module 4. Investment Instruments
Chapter 9. Debt Securities
Learning Outcomes
1. Introduction
2. Features of Debt Securities
Par value.
Coupon rate.
Maturity date.
Other features.
3. Seniority Ranking
Secured.
Unsecured.
4. Types of Bonds
Issuer.
Market.
Coupon rates.
4.1. Fixed-Rate Bonds
4.2. Floating-Rate Bonds
4.2.1. Inflation-Linked Bonds
4.3. Zero-Coupon Bonds
5. Bonds with Embedded Provisions
5.1. Callable Bonds
5.2. Putable Bonds
5.3. Convertible Bonds
6. Asset-Backed Securities
7. Valuation of Debt Securities
7.1. Current Yield
7.2. Valuation of Fixed-Rate and Zero-Coupon
Bonds
7.3. Yield to Maturity
7.4. Yield Curve
8. Risks of Investing in Debt Securities
8.1. Credit Risk
8.1.1. Credit Rating
8.1.2. Credit Spreads
8.2. Interest Rate Risk
8.3. Inflation Risk
8.4. Other Risks
Summary
Chapter Review Questions
Answers
Chapter 10. Equity Securities
Learning Outcomes
1. Introduction
2. Features of Equity Securities
Life.
Par Value.
Voting Rights.
Cash Flow Rights.
3. Types of Equity Securities
3.1. Common Stock
3.2. Preferred Stock
3.3. Convertible Bonds
3.4. Warrants
3.5. Depositary Receipts
4. Risk and Return of Equity and Debt Securities
5. Valuation of Common Shares
5.1. Discounted Cash Flow Valuation
5.2. Relative Valuation
5.3. Asset-Based Valuation
5.4. Implicit Assumptions of Valuation Approaches
6. Company Actions That Affect Equity Outstanding
6.1. Initial Public Offering
6.2. Seasoned Equity Offering
6.3. Share Repurchases
6.4. Stock Splits and Stock Dividends
6.5. Exercise of Warrants
6.6. Acquisitions
6.7. Spinoffs
Summary
Chapter Review Questions
Answers
Chapter 11. Derivatives
Learning Outcomes
1. Introduction
2. Uses of Derivatives Contracts
3. Key Terms of Derivatives Contracts
3.1. Underlying
3.2. Size and Price
3.3. Expiration Date
3.4. Settlement
4. Forwards and Futures
4.1. Forwards
4.2. Futures
4.3. Distinctions between Forwards and Futures
Trading and Flexibility of Terms.
Liquidity.
Counterparty Risk.
Transaction Costs.
Timing of Cash Flows.
Settlement.
5. Option Contracts
5.1. Call Options and Put Options
5.2. Factors that Affect Option Premiums
6. Swap Contracts
Summary
Chapter Review Questions
Answers
Chapter 12. Alternative Investments
Learning Outcomes
1. Introduction
2. Why Invest in Alternatives?
2.1. Advantages of Alternative Investments
Enhancing Returns.
Reducing Risk.
2.2. Limitations of Alternative Investments
3. Private Equity
3.1. Private Equity Strategies
3.1.1. Venture Capital
3.1.2. Growth Equity
3.1.3. Buyouts
3.1.4. Distressed
3.1.5. Secondaries
3.2. Structure and Mechanics of Private Equity
Partnerships
4. Real Estate
4.1. Commercial Real Estate Segments
4.1.1. Land
4.1.2. Offices
4.1.3. Multifamily Residential Dwellings
4.1.4. Retail Properties
4.1.5. Industrial Properties
4.1.6. Hotels
4.1.7. Other Segments
4.2. How To Invest in Real Estate?
4.2.1. Private Market Investments
4.2.2. Public Market Investments
5. Commodities
Purchase of the physical commodity.
Purchase of shares of natural resources or
commodity-related companies.
Purchase of commodity derivatives.
Summary
Chapter Review Questions
Answers
Module 5. Industry Structure
Structure of the investment industry.
Investment vehicles.
Functioning of financial markets.
Chapter 13. Structure of the Investment Industry
Learning Outcomes
1. Introduction
2. How the Investment Industry Promotes Successful
Investing
3. Financial Planning Services
4. Investment Management Services
4.1. Services for High-Net-Worth and Institutional
Clients
4.1.1. Investment Management Activities
4.1.2. Passive and Active Investment
Management
4.2. Services for Retail Clients
5. Investment Information Services
5.1. Investment Research Providers
5.2. Credit Rating Agencies
5.3. Data Vendors
6. Trading Services
6.1. Brokers
6.2. Dealers
6.3. Clearing Houses and Settlement Agents
6.4. Custodians and Depositories
6.5. Comparison of Providers of Trading Services
7. Organisation of Firms in the Investment Industry
7.1. Buy-Side and Sell-Side Firms
7.2. Front, Middle, and Back Offices
7.3. Leadership Titles and Responsibilities
7.4. Investment Staff
Summary
Chapter Review Questions
Answers
Chapter 14. Investment Vehicles
Learning Outcomes
1. Introduction
2. Direct and Indirect Investments
2.1. Comparison of Direct and Indirect Investments
2.2. Investment Control Problems
3. Pooled Investments
3.1. How Pooled Investment Vehicles Work
3.2. Open-End Mutual Funds
3.3. Closed-End Funds
3.4. Exchange-Traded Funds
3.5. Comparison of Pooled Investment Vehicles
3.5.1. Risks
3.5.2. Management Accountability
3.5.3. Costs
3.5.4. Tax Implication of Cash Distributions
3.5.5. Summary of Differences Between
Pooled Investment Vehicles
4. Index Funds
4.1. Security Market Indices
4.1.1. The Index Universe
4.1.2. How to Compute the Value of Indices
4.2. Index Funds
5. Hedge Funds
5.1. Characteristics
5.1.1. Availability
5.1.2. Lock-Up Agreements
5.1.3. Compensation
5.2. Risks
5.3. Legal Structure and Taxes
6. Funds of Funds
7. Managed Accounts
8. Tax-Advantaged Accounts and Managing Tax
Liabilities
8.1. Tax-Advantaged Accounts
8.2. Managing Tax Liabilities
Summary
Chapter Review Questions
Answers
Chapter 15. The Functioning of Financial Markets
Learning Outcomes
1. Introduction
2. Primary Security Markets
2.1. Public Offerings
2.2. Private Placements
2.3. Rights Offerings
2.4. Other Primary Market Transactions
3. Trading Venues
3.1. Exchanges
3.2. Alternative Trading Venues
3.3. Comparison of Trading Venues
4. Trading in Secondary Markets
4.1. Quote-Driven Markets
4.2. Order-Driven Markets
4.3. Brokered Markets
5. Positions
5.1. Short Positions
5.2. Leveraged Positions
6. Orders
6.1. Order Execution Instructions
6.2. Order Exposure Instructions
6.3. Order Time-in-Force Instructions
7. Clearing and Settlement
7.1. Clearing
7.2. Settlement
8. Transaction Costs
8.1. Explicit Trading Costs
8.2. Implicit Trading Costs
8.2.1. Bid–Ask Spread
8.2.2. Price Impact
8.2.3. Opportunity Costs
8.3. Minimising Transaction Costs
9. Efficient Financial Markets
Summary
Chapter Review Questions
Answers
Module 6. Serving Client Needs
Assessing client needs.
Choosing the appropriate asset allocation.
Adopting an Investment Management Approach.
Chapter 16. Investors and Their Needs
Learning Outcomes
1. Introduction
2. Types and Characteristics of Investors
2.1. Individual Investors
2.1.1. Retail Investors
2.1.2. High-Net-Worth Investors
2.1.3. Ultra-High-Net-Worth Investors and
Family Offices
2.2. Institutional Investors
2.2.1. Pension Plans
2.2.1.1. Defined Benefit Plans
2.2.1.2. Defined Contribution Pension
Plans
2.2.1.3. Comparison of Defined Benefit
and Defined Contribution Pension Plans
2.2.2. Endowment Funds and Foundations
2.2.3. Governments and Sovereign Wealth
Funds
2.2.4. Non-Financial Companies
2.2.5. Investment Companies
2.2.6. Insurance Companies
3. Factors That Affect Investors’ Needs
3.1. Required Return
3.2. Risk Tolerance
3.3. Time Horizon
3.4. Liquidity
3.5. Regulatory Issues
3.6. Taxes
3.7. Unique Circumstances
4. Investment Policy Statements
4.1. Institutional Investors and the Investment
Policy Statement
Summary
Chapter Review Questions
Answers
Chapter 17. Investment Management
Learning Outcomes
1. Introduction
2. Systematic Risk, Specific Risk, and Diversification
2.1. Systematic and Specific Risk
2.2. Diversification
3. Asset Allocation and Portfolio Construction
3.1. Strategic Asset Allocation
3.2. Tactical Asset Allocation
4. Passive and Active Management
4.1. Passive Management
4.2. Active Management
4.3. Factors Needed for Active Management to Be
Successful
4.4. Choosing between Passive and Active
Management
5. Identifying and Capturing Market Inefficiencies
5.1. Fundamental Analysis
5.2. Technical and Behavioural Analysis
5.3. Quantitative Analysis
Summary
Chapter Review Questions
Answers
Module 7. Industry Controls
Chapter 18. Risk Management
Learning Outcomes
1. Introduction
2. Definition and Classification of Risks
2.1. Definition of Risk
2.2. Classification of Risks
3. The Risk Management Process
3.1. Definition of Risk Management
3.2. Steps in the Risk Management Process
3.2.1. Set Objectives
3.2.2. Detect and Identify Events
3.2.3. Assess and Prioritise Risks
3.2.4. Select a Risk Response
3.2.5. Control and Monitor
3.3. Risk Management Functions
3.4. Benefits and Costs of Risk Management
4. Operational Risk
4.1. Managing People
4.2. Managing Systems
4.3. Complying with Internal Policies and
Procedures
4.4. Managing the Environment
4.4.1. Political Risk
4.4.2. Legal Risk
4.4.3. Settlement Risk
5. Compliance Risk
5.1. Framework for Legal and Regulatory
Compliance
5.2. Example of Key Compliance Risks
5.2.1. Corruption
5.2.2. Tax Reporting
5.2.3. Insider Trading
5.2.4. Anti-Money-Laundering
6. Investment Risk
6.1. Market Risk
6.2. Credit Risk
6.3. Liquidity Risk
7. Value at Risk
7.1. Use and Advantages of Value at Risk
7.2. Weaknesses of VaR
Summary
Chapter Review Questions
Answers
Chapter 19. Performance Evaluation
Learning Outcomes
1. Introduction
2. Measure Absolute Returns
2.1. Holding-Period Returns
2.2. Cash Flows and Time-Weighted Rates of
Return
3. Adjust Returns for Risk
3.1. Standard Deviation
3.2. Downside Deviation
3.3. Reward-to-Risk Ratios
4. Measure Relative Returns
4.1. Benchmarks and the Calculation of Relative
Returns
4.1.1. Benchmarks
4.1.2. Indices
4.1.3. Relative Returns
4.2. Tracking Error and Information Ratio
4.3. Skill vs. Luck
4.3.1. Market return
4.3.2. Luck
4.3.3. Skill
4.3.4. Distinguishing Between Sources of
Return
5. Attribute Performance
Summary
Chapter Review Questions
Answers
Chapter 20. Investment Industry Documentation
Learning Outcomes
1. Introduction
2. Objectives and Classification of Documentation
2.1. Objectives of Documentation
2.2. Document Classification Systems
3. Internal Documentation
3.1. Document Creation
3.2. Policy Documentation
3.3. Procedure and Process Documentation
4. External Documentation
4.1. Marketing
4.2. Client On-Boarding
4.3. Funding
4.4. Trading
4.5. Reporting
4.6. Investment Events
4.7. Redemption
5. Document Management
5.1. Information Technology
5.2. Access, Security, Retention, and Disposal of
Documents
Access.
Security.
Retention.
Disposal.
Summary
Chapter Review Questions
Answers
Looking Forward
Glossary
A
B
C
D
E
F
G
H
I
J
K
L
M
N
O
P
Q
R
S
T
U
V
W
Y
Z
How to Use
© 2018 CFA Institute. All rights reserved.
WELCOME!
CFA Institute welcomes you to the CFA Institute Investment Foundations®
certificate program. As a candidate, you can expect to gain a deeper
understanding of the functioning of the investment industry as well as of your
role and responsibility within it. We are confident that it will be a rewarding
learning experience that will increase your knowledge and support your
professional development.
HOW TO USE YOUR STUDY
MATERIALS
The Investment Foundations study materials are organised into seven
modules and contain 20 chapters. To assist with your learning, the chapters
include explanations of concepts and terminology used within the finance and
investment industries, illustrative examples, chapter review questions, and a
glossary of commonly-used terms.
The study materials explain the most important and globally relevant
principles for the profession of financial services and are based on input
from industry participants.
Learning Outcomes
Learning Outcomes are presented at the beginning of each chapter and
indicate what you should know after studying the material. The Learning
Outcomes, the chapters, and the chapter review questions are dependent on
each other, with the chapters and chapter review questions providing context
for understanding the Learning Outcomes.
You should use the Learning Outcomes to guide and focus your study because
each examination question is drawn from a chapter and one or more of the
Learning Outcomes.
Command Words
The command words used in the Learning Outcomes specify the level of
learning that you are expected to achieve after reading the chapter.
The Investment Foundations course of study makes use of seven official
command words. The following definitions explain the usage of the command
word in the Learning Outcomes; other usages, possibly relevant in other
contexts, are not given. Following each definition is an example in brackets
of a Learning Outcome that uses the command word.
Compare
To note the similarities and differences between two or
more things
[Compare spot and forward markets]
Define
To state exactly the meaning of
[Define gross domestic product (GDP)]
Describe
To portray in words
[Describe index funds, including their purposes and
construction]
Distinguish To point out differences between
[Distinguish between profit and net cash flow]
Explain
To make clear the meaning of
[Explain measures of relative performance]
Identify
To recognise and correctly name
[Identify specific types of regulation]
Interpret
To give the meaning of
[Describe and interpret correlation]
CUSTOMISE YOUR STUDY PROGRAM
An orderly, systematic approach to studying is critical. Although the time it
takes to study the Investment Foundations materials may vary based on your
prior education and experience, you should be ready to devote approximately
100 hours.
We recommend that you dedicate a consistent block of time every week to
studying the materials. You will probably spend more time on some chapters
than on others, but on average, you should plan on devoting four to five hours
per chapter. You should allow ample time for both an in-depth reading of all
chapters and additional concentration on those topics for which you feel least
prepared.
We encourage you to review the Learning Outcomes before and after you
study each chapter to ensure that you understand what you are expected to
learn and to complete all associated chapter review questions. You should
also use the Learning Outcomes to track your progress and highlight areas of
weakness for later review.
We strongly advise you to visit your candidate resources page to learn more.
Acronyms
While working in the finance and investment industries, you will encounter a
number of acronyms. The following list is not exhaustive but includes some
common abbreviations used in the Investment Foundations study materials.
APR
CAPM
CDS
CPI
DCF
EAR
EBIT
EBITDA
EPS
ETF
FDI
GAAP
GDP
GIPS
IFRS
IPO
IPS
KYC
Annual percentage rate
Capital asset pricing model
Credit default swaps
Consumer price index
Discounted cash flow
Effective annual rate
Earnings before interest and taxes
Earnings before interest, taxes, depreciation, and amortisation
Earnings per share
Exchange-traded fund
Foreign direct investment
Generally accepted accounting principles
Gross domestic product
Global Investment Performance Standards
International Financial Reporting Standards
Initial public offering
Investment policy statement
Know your client
LBO
Libor
NAV
NPV
OTC
P/E
PP&E
PPI
REIT
ROA
ROE
RPI
SWF
VaR
Leveraged buyout
London Interbank Offered Rate
Net asset value
Net present value
Over the counter
Price-to-earnings ratio
Property, plant, and equipment
Producer price index
Real estate investment trust
Return on assets
Return on equity
Retail price index
Sovereign wealth fund
Value at risk
WE WANT YOUR FEEDBACK
At CFA Institute, we are committed to delivering Investment Foundations
study materials that are timely, relevant, and globally applicable for those
working in the dynamic profession of financial services today. We rely on
feedback as we work to incorporate content, design, and packaging
improvements. Please send your comments to info@cfainstitute.org.
ACKNOWLEDGMENTS
CFA Institute extends its sincere thanks to Phil Davis, independent journalist
and contributor to the Financial Times on investment and pension issues, for
his substantial editorial contributions to the Investment Foundations study
materials. In addition, Andrew Tanzer, CFA, senior research analyst and
investment writer at Gerstein Fisher, provided valuable reviewing
assistance.
CFA Institute also thanks the following individuals for their contributions to
the chapter review questions:
Mark Bhasin, CFA
Dan Reeder, CFA
Julia C. Cunningham, CFA
Nivine Richie, CFA
Lee M. Dunham, CFA
Karen O’Connor Rubsam, CFA
Mary Erickson, CFA
Susan Ryan, CFA
Ryan Fuhrmann, CFA
Jennie I. Sanders, CFA
Greg Gocek, CFA
Gary Sanger, CFA
Daniel Hassett, CFA
Premalata Sundaram, CFA
Jeremy Heer, CFA
Don Taylor, CFA
Mark Henning, CFA
Barbara Valbuzzi, CFA
Lou Lemos, CFA
Bin Wang, CFA
Elbie Louw, CFA, CIPM
Michael Whitehurst, CFA
Richard Maringer, CFA
Lavone Whitmer, CFA
Module 1
Industry Overview
© 2014 CFA Institute. All rights reserved.
Chapter 1
The Investment Industry: A
Top-Down View
by Ian Rossa O’Reilly, CFA
© 2014 CFA Institute. All rights reserved.
LEARNING OUTCOMES
After completing this chapter, you should be able to do the following:
a. Describe the financial services industry;
b. Identify types of financial institutions, including banks and insurance
companies;
c. Define the investment industry;
d. Explain how economies benefit from the existence of the investment
industry;
e. Explain how investors benefit from the existence of the investment
industry;
f. Describe types and functions of participants of the investment industry;
g. Describe forces that affect the evolution of the investment industry.
1. INTRODUCTION
Like it or not, the vast majority of us have to work. We work to sustain
ourselves and our dependents. Often, we earn money for our labour and use
that money to purchase goods and services. But money can be used for more
than everyday needs. If we spend less than we earn, we have savings. If we
seek to earn a return on our savings, we are investing.
To explain how savers become investors, consider the example of a
Canadian entrepreneur who needs money to set up a new business. She needs
to find savers who are willing to invest in her business, so she spends weeks
asking her friends and neighbours until she eventually finds a friend who is
willing to invest. This friend believes he will get back more money than he
lends, so he is prepared to invest some of his savings.
The entrepreneur is happy because she can now start her business. But the
search for money has taken a long time; it could have been so much quicker
and easier for her to find the money if there was a system that connected
those who need money with those who have savings and are willing to invest
these savings. Well, there is such a system! It is called the financial system.
2. THE FINANCIAL SERVICES
INDUSTRY
The financial system helps link savers who have money to invest and
spenders who need money. Within the financial system, the financial
services industry offers a range of products and services to savers and
spenders and helps channel funds between them. Note that in this chapter
and in the rest of the curriculum, the terms money, cash, funds, and
financial capital (or capital) are used interchangeably.1
Savers include individuals (households), companies, and governments that
have money to invest. Spenders also include individuals, companies, and
governments. For example, individuals borrow to pay for houses, education,
and other expenses. Companies borrow to invest in land, buildings, and
machinery. Governments borrow when their current tax receipts are
insufficient to meet their current spending plans.
TERMINOLOGY
Typically, the term saver characterises those who have accumulated
savings. As illustrated in the example earlier, these savings are often
invested. When savers have made investments, they are typically called
investors and become providers of capital. If the investment is a loan—
that is, money that is expected to be repaid with interest—investors are
often referred to as lenders. Similarly, the term spender characterises
those who need money. When spenders have received the money they
need and start using it, they become users of capital. If they are
recipients of a loan, they are typically called borrowers. Note that
there are times when the terms savers/investors/lenders/providers of
capital or spenders/borrowers/users of capital are used
interchangeably.
Savings can be invested in a wide range of assets. Assets are items that
have value and include real assets and financial assets. Real assets are
physical assets, such as land, buildings, machinery, cattle, and gold. They
often represent a company’s means (or factors) of production and are
sometimes referred to as physical capital. In contrast, financial assets
are claims on real, or possibly other financial, assets. For example, a share
of stock represents ownership in a company. This share gives its owner, who
is called a shareholder, a claim to some of the company’s assets and
earnings. An investor’s total holdings of financial assets is usually called a
portfolio or investment portfolio.
Financial assets that can be traded are called securities. The two largest
categories of securities are debt and equity securities.
Debt securities are loans that lenders make to borrowers. Lenders
expect the borrowers to repay these loans and to make interest payments
until the loans are repaid. Because interest payments on many loans are
fixed, debt securities are also called fixed-income securities. They are
also known as bonds, and investors in bonds are referred to as
bondholders. More information about debt securities is provided in the
Debt Securities chapter.
Equity securities are also called stocks, shares of stock, or shares. As
mentioned earlier, shareholders (also known as stockholders) have
ownership in a company. The company has no obligation to either repay
the money the shareholders paid for their shares or to make regular
payments, called dividends. However, investors who buy shares expect
to earn a return by being able to sell their shares at a higher price than
they bought them and, possibly, by receiving dividends. Equity
securities are discussed further in the Equity Securities chapter.
Markets are places where buyers meet sellers to trade. Places where buyers
and sellers trade securities are known as securities markets, or financial
markets. How securities are issued, bought, and sold is explained in The
Functioning of Financial Markets chapter.
Exhibit 1 shows how the financial services industry helps channel funds
between those that have money to invest (the savers that become providers of
capital) and those that need money (the spenders that become users of
capital). Key industry participants and processes are described in more
detail later in this chapter.
Exhibit 1.
Overview of the Financial Services Industry
Providers and users of capital may interact through financial markets or
through financial intermediaries. The movement of funds through financial
markets is called direct finance because the providers of capital have a
direct claim on the users of capital. For example, if you own shares of
Nestlé, you have a claim on the assets and earnings of Nestlé.
Providers and users of capital often rely on financial intermediaries to find
each other and to channel funds between each other. This process is indirect
finance because financial intermediaries act as middlemen between
savers and spenders; the former do not have direct claims on the latter.
Financial intermediaries may also create new products and securities that
depend on other assets.
Financial intermediaries play an important role in the financial services
industry. Many savers do not have the time or the expertise to identify and
select individuals, companies, and governments to lend to or invest in. Once
savers have lent money, they have to monitor the borrower’s behaviour and
financial health to ensure that they will get their money back—a task that is
time consuming and costly. Matching savers and borrowers and monitoring
borrowers’ behaviour and financial health are functions that financial
intermediaries can perform better and more cheaply than most investors can
do on their own.
3. FINANCIAL INSTITUTIONS
Financial institutions are types of financial intermediaries. Their role is
to collect money from savers and to invest it in financial assets. The two
major types of financial institutions are banks and insurance companies.
3.1. Banks
Banks collect deposits from savers and transform them into loans to
borrowers. In doing so, they indirectly connect savers with borrowers. The
saver does not have a direct claim on the borrower but rather has a claim on
the bank through its deposit, and the bank has a claim on the borrower
through the loan. Banks are also called deposit-taking institutions (or
depository institutions) because they take deposits. In exchange for using the
depositors’ money, banks offer transaction services, such as check writing
and check cashing, and may pay interest on the deposit. Banks may also raise
money to make loans by issuing and selling bonds or stocks on financial
markets.
Banks vary in whom they serve and how they are organised. They may have
different names in different countries. Building societies (also called savings
and loan associations in some countries) specialise in financing long-term
residential mortgages. Retail banks provide banking products and services to
individuals and small businesses. These products and services include
checking and savings accounts, debit and credit cards, and mortgage and
personal loans. An increasing number of retail banking transactions are now
performed either electronically via automated teller machines (ATMs) or
over the internet. Commercial banks provide a wide range of products and
services to companies and other financial institutions.
Co-operative and mutual banks are financial institutions that their members
own and sometimes run. They may specialise in providing mortgages and
loans to their members. Some co-operative and mutual banks may offer a
wider range of products and services, similar to those offered by commercial
banks. Depositors benefit because they earn a return (in interest, transaction
services, dividends, or capital appreciation) on their capital without having
to locate the borrowers, check their credit, contract with them, and manage
their loans.
If borrowers default, banks still must pay their depositors and other lenders.
If the banks cannot collect sufficient money from their borrowers, the banks
will have to use their owners’ capital to pay their debts.2 The risk of losing
capital should focus the banks’ attention so that they do not offer credit
foolishly. However, notable lapses occasionally occur, such as in the run-up
to the financial crisis of 2008. Investors too often were not aware of,
ignored, or could not control the risks that banks were taking.
3.2. Insurance Companies
Insurance companies help individuals and companies offset the risks
they face. To protect themselves against a potential loss, individuals and
companies buy insurance contracts (also known as policies) that provide
payments in the event that losses occur. They typically pay insurance
companies upfront, non-refundable premiums when they purchase insurance
contracts. If the insured risks materialise, the insured individual or company
makes a claim to the insurance company and collects the insurance
settlement.
There are two main types of insurance companies: property and casualty
insurers that cover assets such as homes, cars, and businesses, and legal
liability and life insurers that pay out a sum of money upon death or serious
injury of the person insured.
Insurers are financial intermediaries because they connect buyers of their
insurance contracts with providers of capital that are willing to bear the
insured risks. The buyers of insurance contracts benefit because they can
transfer risk without searching for somebody who would be willing to
assume those risks. The providers of capital benefit because the insurance
company allows them to earn a return for taking on these risks without having
to manage the insurance contracts. The insurance company manages the
relationships with the insured individual and companies—primarily, the
collection of the premiums and the settlement of claims. In addition, the
insurance company hopefully controls various issues in insurance markets—
for example, fraud, moral hazard, and adverse selection. Fraud occurs when
people deliberately cause or falsely report losses to collect insurance
settlements. Moral hazard occurs when people are less careful about
avoiding losses once they have purchased insurance. Moral hazard
potentially leads to losses occurring more often with insurance than without.
Adverse selection occurs when only those who are most at risk buy
insurance, causing insured losses to be greater than average losses.
Insurers are not only financial intermediaries but also among the largest
investors. They usually invest a significant portion of the premiums they
receive from the buyers of insurance contracts in financial markets in order
to meet the cost of future claims.
4. HOW ECONOMIES BENEFIT FROM
THE EXISTENCE OF THE
INVESTMENT INDUSTRY
The investment industry is a subset of the financial services industry. It
comprises all the participants that are instrumental in helping savers invest
their money and helping spenders raise capital in financial markets. Major
investment industry participants, such as types of investors and service
providers, are presented in Section 6 of this chapter. The activities
performed by service providers are discussed further in the Structure of the
Investment Industry chapter.
4.1. Economic Systems
The investment industry and its participants do not exist in isolation; they
operate within economic systems that vary from country to country. Economic
systems can take many forms, from pure capitalism with free markets to
planned economies with centralised authorities. A goal of most economic
systems is the efficient allocation of scarce resources to their most
productive uses.
Resources, such as labour, real assets, and financial capital, are necessary to
produce goods and services. Desire for goods and services is unlimited, but
resources are limited. To illustrate this concept of scarcity, assume that an
individual has a limited budget; in other words, his financial capital is
scarce. Should he spend his money buying food, paying his mortgage,
purchasing a new car, or going on holiday? Similarly, should a company
focus its resources on an existing product or on a new one that might produce
a higher profit? And should governments spend money on health care,
education, defence, or infrastructure?
Because resources are scarce, decisions must be made regarding the
allocation of these resources. Participants in economic systems must address
three questions: (1) Which goods and services should be produced? (2) How
should the goods and services be produced? (3) Who should receive the
goods and services that are produced? The allocation of scarce resources is
efficient if the scarce resources are used to produce goods and services that
best satisfy the needs of consumers.
Capitalism is an economic system that promotes private ownership as the
means of production and markets as the means of allocating scarce resources.
In a pure, free market, capitalistic economy, there is no central authority, such
as a government, directing economic activity. Instead, individuals and
companies make their own decisions about what goods and services to
manufacture and provide, and they get to keep the profits from their
activities. When scarce resources are used in an efficient manner through the
markets, economies can grow and society benefits.
However, pure, free market capitalism exists only in theory. In the real
world, governments play a role in all economic systems. In some capitalistic
economies, such as in Western economies, the government’s role in business
may be relatively minimal. In economies largely dependent on the extraction
of natural resources, such as some former Soviet Republics and some Middle
Eastern, African, and South American countries, the government may
maintain significant control over key national industries. In transition
economies, which are moving from planned economies to market economies,
the government may play a significant role in business.
4.2. How the Investment Industry Fosters
Economic Growth
So, what role does the investment industry play in supporting the creation of
goods and services and, ultimately, enhancing the lives of consumers? As
mentioned previously, the investment industry is instrumental in channelling
funds between savers who have money to invest and those who need money
to finance businesses and projects.
The investment industry contributes to the efficient allocation of resources in
the economy. Without the investment industry, savers would have to spend
significant resources finding individuals, companies, and governments
offering suitable investment opportunities. Resources would also be spent on
the search for capital rather than on considering how to best use it, which
would result in less efficiency.
The investment industry plays an important role in providing and processing
information about investment opportunities. It helps investors collect and
analyse data about economies and information about individuals, companies,
and governments. It also assists investors in determining the value of real and
financial assets. The types of inputs and tools used by investment industry
participants are described in the chapters in the Inputs and Tools module.
Investment industry participants package investment opportunities so that they
satisfy the needs of investors. In particular, the investment industry offers a
wide range of services and products that makes it easier for savers to invest.
These investment services and products are discussed in the chapters in the
Industry Structure module.
The investment industry also provides liquidity. Liquidity refers to the ease
of buying or selling an asset without affecting its price. Some assets, such as
real estate (land and buildings), are inherently illiquid. For example, if you
want to sell your house, it will likely take some time to sell, even if it is
priced fairly compared with other houses in your neighbourhood. If you want
to sell your house quickly, you may have to sell it at a lower price than you
think is fair. Other assets are more liquid, such as shares that trade actively.
But an investor may hold a large number of shares and selling all the shares
quickly could have a negative effect on the share price. For example, if an
investor owns 100 shares in a company with actively traded shares, she will
likely be able to sell her shares quickly and not affect the share price. But if
she owns 100,000 shares, she may not be able to sell her shares quickly
without affecting the share price. As a result, she may have to accept a lower
price for some or all of the shares she wants to sell. Liquidity is a very
important aspect of well-functioning financial markets. Highly liquid markets
allow investors to complete a transaction quickly (and to reverse it quickly if
they change their minds) and to have confidence that they are getting a fair
price at that particular moment.
All of these benefits increase the willingness of savers to supply funds to
those who need them. Capital that is put to more productive use fosters
economic growth, which ultimately benefits society.
5. HOW INVESTORS BENEFIT FROM
THE EXISTENCE OF THE
INVESTMENT INDUSTRY
In a well-functioning investment industry, investors are treated fairly and
honestly. As a result, they have confidence to commit their savings to
investments. Ideally, investment industry participants compete fairly for
investors’ business, and they are competent and trustworthy in advising on
investment matters and managing investment products and portfolios.
5.1. How the Investment Industry Serves
Investors
Below are some of the most important features that define a well-functioning
investment industry and, in turn, benefit investors.
An important feature that characterises a well-functioning investment industry
is the availability of a broad range of investment opportunities that meets
investors’ needs. Investors can invest in debt and equity securities and they
can also invest in derivatives and alternative investments. These investments
are described in more detail in the Investment Instruments module. Investors
may also choose to save through investment vehicles that exist solely to hold
investments on behalf of their shareholders, partners, or unitholders (units
refer to shares and bonds for equity and debt securities, respectively). The
ownership interests of these companies are called pooled investment
vehicles because investors in these vehicles pool their money for common
management. Types and characteristics of investment vehicles are discussed
in the Investment Vehicles chapter.
Investment industry participants may also buy and sell various real and
financial assets and then package them to create new assets that suit the needs
of investors better than the original assets. Mortgage-backed securities are an
example; they represent a claim on the money generated by a large number of
mortgages that have been grouped together in a process called securitisation,
which is further discussed in the Debt Securities chapter.
In addition to being able to choose from many investment opportunities,
investors benefit from having access to a broad range of investment services
that help them make better decisions and implement those decisions. The
investment industry offers services of value to investors including planning,
management, information, and trading services. These services are discussed
in the Structure of the Investment Industry chapter. How investment industry
participants assess and serve the needs of investors is discussed further in
the chapters in the Serving Client Needs module.
Investors benefit when financial markets are competitive. Competitive
markets lead to fair prices, which ensure that buyers pay and sellers receive
a reasonable and satisfactory price. Markets in general and financial markets
in particular are competitive if a large number of participants compete with
one another without any one of them having an undue influence on supply or
demand. Supply refers to the quantity of a good or service sellers are willing
and able to sell, whereas demand refers to the quantity of a good or service
buyers desire to buy. More information about supply and demand and how
the interaction of supply and demand affects prices of goods and services is
presented in the Microeconomics chapter. Competitive markets promote
higher production efficiency and help keep the prices of goods and services,
including investment products and services, down.
Investors also benefit when financial markets are liquid and transaction costs
are low. As mentioned earlier, liquidity ensures that investors can quickly
buy or sell an asset without affecting its price. Transaction costs are the costs
associated with trading. Because transaction costs reduce the return savers
make on their investments, the lower the transaction costs, the better.
To make reasonable judgments about what to invest in, savers need relevant
and reliable information about the companies and governments to which they
provide or may provide capital. By helping collect and process financial
information, investment industry participants provide benefits to investors.
The timeliness of this information is also critical because securities prices
may change quickly in response to new, relevant information. For example,
the share price of an oil company that announces it has discovered a large
new oil field will likely increase as investors anticipate that the company
will make higher profit.
Another important feature of a well-functioning investment industry is the
ability to deal with risk. Risk refers to the effect of uncertain future events on
an organisation or on the outcomes the organisation achieves and is
discussed in greater detail in the Risk Management chapter. Risk is an
inherent element of investing, and investors should always consider both
return and risk when they make investment decisions. For example, the man
who lent his savings to help start his friend’s business faces the risk that the
friend’s business fails and he never gets his money back. Although the
friend’s business could turn out to be the next Apple, Google, or Microsoft,
the investor may decide not to lend money to his friend if losing his entire
investment would have a devastating effect on his lifestyle. The investment
industry can help him assess how risky the investment is.
The investment industry also provides ways of reducing risk. For example,
contracts and products that represent some form of insurance may be
available for purchase. Or industry professionals may provide advice on
how best to mitigate the risk of investments. Those who are willing and able
to take on risk may sell insurance or offer investments that allow others to
reduce their risks.
5.2. Need for Trust, Laws, and Regulations
The many benefits that the investment industry provides to the economy and
investors are not sustainable without trust, laws, and regulations.
Trust is essential to the proper functioning of the financial system in general
and the investment industry in particular. Savers should be confident that they
will be treated fairly by those they lend to or invest in as well as by those
who advise them, sell them investment products or services, and manage
their investments. If trust is lacking, savers will be reluctant to invest, and the
economy and society will suffer.
Laws and regulations are necessary to ensure that investors are treated fairly
and honestly. Usually, laws are passed by a legislative body, such as
Congress in the United States, Parliament in the United Kingdom, and the
Diet in Japan. Regulations are created by agencies, such as the Canadian
Securities Administrators in Canada, the Autorité des Marchés Financiers in
France, and the Securities & Futures Commission in Hong Kong SAR. Laws
and regulations must be enforceable to be effective.
The form and extent of laws and regulations vary between countries and
change over time, but a number of general principles are widely applied.
Laws and regulations are designed to
prevent fraud,
protect investment industry participants, in particular investors, and
promote and maintain the integrity, transparency, and fairness of
financial markets.
For example, trading based on non-public information that could affect a
security’s price—known as insider trading—is forbidden in most
jurisdictions. For example, an analyst who learns during a private meeting
with a company’s management that the company is about to acquire a
competitor is not allowed to buy or sell shares in the company or its
competitor until the company has officially announced the acquisition. If the
analyst trades before this information is available to all market participants,
he could gain from this inside information and the integrity and fairness of the
financial market would be compromised. In many jurisdictions, the analyst
could also face punitive legal or regulatory measures.
Although the investment industry is subject to laws and regulations, these
laws and regulations cannot cover every situation and cannot prevent fraud
or market abuse from happening. This risk is why it is important that
individuals who work in the investment industry behave ethically, in
accordance with a set of moral principles, and act professionally, and
organisations promote cultures of integrity.
Ethical behaviour on the part of investment industry participants is paramount
to protect the reputation of and maintain trust in the industry. Without trust,
savers are less likely to make investments, which would be detrimental to the
economy and society.
We return to the discussion of ethics and regulation in the chapters in the
Ethics and Regulation module. The Risk Management chapter addresses the
issue of compliance with laws and regulations.
6. INVESTMENT INDUSTRY
PARTICIPANTS
There are many investment industry participants who help spenders raise
capital and savers invest their money. Anybody working in the investment
industry or purchasing products and services provided by the investment
industry is likely to come in contact with a number of these participants. Key
participants are introduced in Sections 6.1 and 6.2. The rest of the curriculum
provides more information about how investment industry participants
operate and how they interact with investors and with one another.
As a way of introducing some of the main investment industry participants,
let us take a look at the Canadian entrepreneur’s company five years later.
Over that time, the company has been successful, and it now needs new
capital to continue growing. The money the company generated from its
operations is not enough to support its growth plans, and the company has to
turn to investors to provide additional capital. The financial services
industry can help the Canadian company raise the money it needs and allow
investors to participate in the company’s growth. We first introduce those
participants that can help the company to raise capital. Then, we discuss
investors and focus on the main investment industry participants that can help
them to invest their money.
6.1. How Companies and Governments Raise
Capital
The Canadian company wants to issue shares to raise capital. Until now, it
has been a private company; it has not raised money by issuing shares
publicly. It wants to take the opportunity to become a public company and
have its shares listed on the Toronto Stock Exchange. Stock exchanges are
organised and regulated financial markets that allow buyers and sellers to
trade securities with each other.
The company contacts an investment bank to help it. Investment banks,
also known as merchant banks, are financial intermediaries that have
expertise in assisting companies and governments raise capital. Investment
banks help companies organise equity and debt issuances—that is, the sale of
shares and bonds to the public. In the case of the Canadian company, the
equity issuance is called an initial public offering (IPO) because it is the first
time the company sells shares to the public. The Equity Securities and The
Functioning of Financial Markets chapters provide more details about IPOs
and other equity issuances.
Investment banks are specialists in matching investors with companies and
governments seeking capital. The investment banks pay close attention to the
types of investments that investors most want so that they can help companies
and governments design securities that will suit the needs of the company or
government and appeal to investors. By offering securities that investors
want to purchase, companies and governments are able to obtain capital at a
lower cost.
The investment bank will help the Canadian company determine the price at
which the new shares will be issued. To do so, the investment bank has to
gauge investor interest in purchasing the company’s shares. The investment
bank’s analysts—often called sell-side analysts because they work for the
organisation selling the securities—will collect and analyse information
about the company and its competitors and prepare a detailed report that can
be shared with potential investors.
When the Canadian company becomes a public company, it will have to
comply with the rules of the Toronto Stock Exchange and with relevant
Canadian laws and regulations. It will, for instance, have to file quarterly
financial statements and audited annual financial statements. Auditors will
evaluate the company’s internal controls and financial reporting and ensure
that investors receive relevant and reliable financial information, a key
feature of well-functioning financial markets. More information about
financial statements and the role of auditors is provided in the Financial
Statements chapter.
6.2. How the Investment Industry Helps
Savers Invest Their Money
The Canadian company may sell its shares to many investors whose needs
vary. A basic distinction is often made between individual and institutional
investors. The designation “individual investor” is self-explanatory; an
individual investor is simply a person who has investments. In contrast,
institutional investors are typically organisations that invest either for
themselves to advance their missions or on behalf of others.
Within each of these two categories of investors—individual and institutional
—there is further variation. For example, investment industry practitioners
typically distinguish between individual investors according to their total
amount of investable assets. There is no universal standard to classify
individual investors; the distinction between categories of individual
investors varies across countries, currencies, and investment firms. But as a
general rule, retail investors have the lowest amount of investable assets,
whereas high-net-worth investors have higher amounts of investable assets.
The services that the investment industry provides to individual investors
differ depending on the investor’s wealth and level of investment knowledge
and expertise, as well as on the regulatory environment. Retail investors tend
to receive standardised services, whereas wealthier investors often receive
services specially tailored to their needs.
Institutional investors that invest to advance their missions include the
following:
Pension plans, which hold and manage investment assets for the benefit
of future and already retired people, called beneficiaries.
Endowment funds, which are long-term funds of not-for-profit
institutions, such as universities, colleges, schools, museums, theatres,
opera companies, hospitals, and clinics.
Foundations, which are grant-making institutions funded by financial
gifts and by the investment income that they produce.
Sovereign wealth funds, which typically invest a government’s
surpluses. Governments may accumulate surpluses by collecting taxes in
excess of current spending needs, by selling natural resources, or by
financing the trade of goods and services. These surpluses are usually
invested. Some governments with significant surpluses have created
sovereign wealth funds to invest their surpluses for the benefit of current
and future generations of their citizens.
Institutional investors that invest on behalf of others include investment firms
and financial institutions, such as banks and insurance companies. Different
categories of investors and their needs are discussed further in the Investors
and Their Needs chapter.
Despite the differences between investors and their needs, many of the
services they require are common to all of them. Some of these services are
shown in Exhibit 2.
Exhibit 2.
Investor Services
When investors want to buy or sell shares, they need to find another investor
who is willing to sell or buy shares. Brokers and dealers are trading service
providers that facilitate this trading. Brokers act as agents—that is, they do
not trade directly with investors but help buyers and sellers find and trade
with each other. In contrast, dealers act as principals—that is, they use their
own accounts and their own capital to trade with buyers and sellers in what
is known as proprietary trading. They “make markets” in securities by acting
as buyers when investors want to sell and as sellers when investors want to
buy. They often have thousands of clients so if one client wants to sell shares
at a certain price, the dealer can usually identify another client who is
willing to buy the shares at a similar price. Brokers and dealers both provide
liquidity and help reduce transaction costs; as mentioned earlier, liquidity
and low transaction costs are beneficial to investors.
Other participants that provide trading services include clearing houses and
settlement agents, which confirm and settle trades after they have been agreed
on. Custodians and depositories hold money and securities on behalf of their
clients.
Institutional investors may employ analysts to review potential investments.
These analysts are called buy-side analysts because they work for the
organisation buying the securities. To gather data about a company and the
markets in which it operates, analysts often rely on investment information
providers, such as data vendors that provide information resources and
investment research providers that produce information reports.
Individual investors often do not have the time, the inclination, or the
expertise to manage the entire investment process on their own, so many of
them seek the help of investment professionals. Financial planning service
providers, such as financial planners, help their clients understand their
future financial needs and define their investment goals. Investment
management service providers, such as asset managers, make and help their
clients make investment decisions in order to achieve the clients’ investment
goals.
Many investors, particularly retail investors, are willing to invest but lack
sufficient financial resources to contract with an investment manager to look
after their investments. These investors often buy investment products created
and managed by investment firms, banks, and insurance companies. For
example, an individual who wants to plan for her retirement may need a
convenient and inexpensive way to invest money regularly. She may buy
shares in a mutual fund, a professionally managed vehicle that invests in a
range of securities.
MEET SOME OF THE INVESTMENT INDUSTRY
PARTICIPANTS
Zhang Li is a retail investor. She earns 5,000 Singapore
dollars a month and wants to save for a deposit on an
apartment in the suburbs of Singapore. She also wants to save
to pay for her son’s university education. She goes to her bank
for investment advice.
Mike Smith is a high-net-worth investor who lives in
California. He has recently sold his technology company and
has $10 million to invest. He hires a financial planner to help
him define his investment objectives in terms of return and
risk.
Anna Huber is an institutional investor for Euro Pension Fund,
which is located in Frankfurt, Germany. The fund receives
money to finance the retirement of the Euro Pension Plan
members, invests the money received, and pays out money to
the retired members. It has an asset management team that
devises its strategy and implements it, managing a €50 billion
portfolio invested in a wide range of assets. Huber is a
member of that team.
Peter Robinson is an asset manager for Aus Ltd., which is
based in Sydney. Aus Ltd. invests money on behalf of its
clients in shares, bonds, and alternative investments. It hires a
data vendor and two investment research providers to keep it
updated with the latest market developments. Aus Ltd. has a
broker that carries out trades on its behalf and a custodian that
safeguards clients’ money and assets.
Amina Al-Subari is a broker at Middle East Corp., which is
based in Dubai. Investors, such as Aus Ltd. and Euro Pension
Fund, ask her to find and trade assets in the market. Middle
East Corp. can find and trade these assets on an exchange and
also deal directly with other investors who want to sell their
assets.
James Armistead is with Big Bank Financial Services, a
custodian with offices all over the world. When an investor,
such as Euro Pension Fund or Aus Ltd., buys securities, the
trade is confirmed by a clearing house and settlement agent.
The custodian then holds the security on behalf of the investor
and makes sure a proper record is kept of the security and its
price.
7. KEY FORCES DRIVING THE
INVESTMENT INDUSTRY
Like most industries, the investment industry is not static. It is constantly
changing to meet new needs and to react to events and evolution in financial
markets. Some of these changes are driven internally—that is, by industry
participants. These internal forces are
Competition. Competition in the investment industry is fierce and
manifests itself through innovative investment product and service
offerings, pricing, and performance.
Technology. Technology, and computerisation in particular, has
dramatically decreased trade processing costs and increased trade
processing capacity. It has also spurred the development and analysis of
innovative types of investment products and vehicles.
Other changes are driven by external forces. These external forces are
Globalisation. Investors look outside their domestic markets to
diversify their investments and generate higher returns. These foreign
investments contribute to economic development and to the overall
profits of the investment industry.
Regulation. Globally, there is a trend toward greater regulation of the
financial services industry, including the investment industry.
International co-operation among financial regulators has played and
should continue to play an important role in raising global standards of
securities regulation.
SUMMARY
Without the financial services industry, money would have difficulty finding
its way from savers to individuals, companies, and governments that have
businesses and projects to finance but insufficient capital to do so
themselves. At its best, the industry efficiently matches those who need
money with those who have savings to invest, minimising the costs to each
and allowing money to support the most productive businesses and projects.
The investment industry acts on behalf of savers, helping them to navigate the
financial markets. When the investment industry is efficient and trustworthy,
economies and individuals benefit.
The points below summarise what you have learned in this chapter about the
financial services and investment industries.
The financial services industry exists to provide a link between
savers/lenders/providers of capital who have money to invest and
spenders/borrowers/users of capital who need money.
Financial intermediaries act as middlemen between savers and
spenders.
The main financial institutions are banks and insurance companies.
Banks collect deposits from savers and transform them into loans to
borrowers. Insurance companies are not only financial intermediaries
that connect buyers of insurance contracts with providers of capital who
are willing to bear the insured risks, but also among the largest
investors.
The investment industry, a subset of the financial services industry,
includes all participants that help savers invest their money and
spenders raise capital in financial markets.
A goal of economic systems is the efficient allocation of scarce
resources to their most productive uses. Financial markets and the
investment industry help allocate capital, a scarce resource, to the most
productive uses, which fosters economic growth and benefits society.
The investment industry provides numerous benefits to the economy,
including the efficient allocation of scarce resources, better information
about investment opportunities, products and services that are
appropriate for providers and users of capital, and liquidity.
The benefits for investors of a well-functioning investment industry
include a broad range of investment products and services that meet
their needs, competitive markets that provide liquidity and keep
transaction costs low, timely and efficient disclosure of information, and
the ability to modify their risk exposures.
Trust is essential to the functioning of the investment industry as well as
to the broader financial services industry. Laws and regulations are
necessary to protect investors and ensure the integrity, transparency, and
fairness of financial markets.
Companies and governments use investment (merchant) banks to help
them raise capital.
Key investment industry participants on the investing side include the
following:
Categories
Participants
Key Characteristics
Investors
Retail
investors
High-networth
investors
Institutional
investors
Individual investors with the least
amount of investable assets
Individual investors with a higher
amount of investable assets
Financial
advisory
service
providers
Financial
planners
Professionals who help their clients
understand their future financial needs
and define their investment goals
Investment
management
service
providers
Asset
managers
Professionals who help their clients
carry out investments to achieve their
investment goals
Investment
information
service
providers
Buy-side
analysts
Data
vendors
Professionals who review potential
investments
Organisations that provide information
resources
Organisations that invest to advance
their mission or on behalf of their
clients
Categories
Participants
Investment
research
providers
Key Characteristics
Organisations that produce information
reports
Trading
service
providers
Exchanges
Organised and regulated financial
markets that allow investors to trade
Professionals and their firms that
facilitate trading between investors,
acting as agents (they do not trade with
their clients)
Professionals and their firms that
facilitate trading between investors,
acting as principals (they trade with
their clients)
Organisations that confirm and settle
trades
Brokers
Dealers
Clearing
houses and
settlement
agents
Custodial
service
providers
Custodians
and
depositories
Organisations that hold money and
securities on behalf of their clients
Four key forces that drive the investment industry are competition,
technology, globalisation, and regulation.
CHAPTER REVIEW QUESTIONS
© 2014 CFA Institute. All rights reserved.
1. The financial services industry benefits the economy by providing a link
between providers of capital and:
A. savers.
B. lenders.
C. borrowers.
2. The investment industry benefits the economy by:
A. increasing risk.
B. decreasing liquidity.
C. increasing efficiency.
3. A major benefit of competition in financial markets for the individual
investor is:
A. risk transfer.
B. lower prices.
C. greater integrity.
4. Which of the following would most likely assist individuals in defining
their investment goals?
A. Dealers
B. Financial planners
C. Investment bankers
5. Which of the following is most likely to facilitate trading and help
reduce transaction costs?
A. Brokers
B. Analysts
C. Asset managers
6. An institutional investor that invests a government’s surpluses is a(n):
A. foundation.
B. endowment fund.
C. sovereign wealth fund.
7. A broker will act as a(n):
A. agent.
B. principal.
C. proprietary trader.
8. A sell-side analyst typically works for a(n):
A. pension plan.
B. investment bank.
C. endowment fund.
9. Which of the following forces that drive the investment industry
promotes transparency of financial markets?
A. Regulation
B. Competition
C. Computerisation
10. A force driving the investment industry that has led to decreased trade
processing costs is:
A. regulation.
B. technology.
C. globalisation.
11. Globally, regulation of the investment industry has:
A. increased.
B. decreased.
C. remained stable.
ANSWERS
1. C is correct. The financial services industry exists to provide a link
between providers of capital (also called savers, lenders, or investors)
that have funds to invest and users of capital (also called spenders or
borrowers) that need funds. A and B are incorrect because savers and
lenders are providers, not users, of capital.
2. C is correct. The investment industry helps savers invest their money
and borrowers get the funds they require. In doing so, it reduces the
resources that would be expended on the search rather than on
productive uses, thus increasing efficiency. A is incorrect because the
investment industry helps transform and transfer risk, not increase it. B
is incorrect because the investment industry increases rather than
decreases liquidity.
3. B is correct. Competition in financial markets promotes higher
efficiency and helps keep prices of investment products and services
down. A is incorrect because risk transfer does not deal with
competition, although it is a benefit for the individual investor. C is
incorrect because greater integrity is achieved by effective laws and
regulations and not through competition.
4. B is correct. Financial planners typically help individuals understand
their future financial needs and define their investment goals. A is
incorrect because dealers facilitate trading between investors. C is
incorrect because investment bankers help companies and governments
raise capital.
5. A is correct. Brokers are trading service providers who facilitate
trading between investors. B and C are incorrect because analysts and
asset managers are not trading services providers. Analysts are
primarily engaged in collecting and analysing information about
companies and their competitors and preparing detailed reports (sellside analysts) or reviewing potential investments (buy-side analysts).
Asset managers are professionals who help their clients with investment
decisions to achieve their investment goals.
6. C is correct. Sovereign wealth funds invest a government’s surpluses. A
is incorrect because a foundation is a grant-making institution funded by
financial gifts and investment income. B is incorrect because an
endowment fund is a long-term fund of a not-for-profit institution, such
as a university.
7. A is correct. Brokers act as agents and do not trade directly with
investors. B and C are incorrect because brokers do not use their own
accounts to trade as principals with buyers/sellers nor do they use their
own capital as proprietary traders.
8. B is correct. Investment (merchant) bank analysts are called sell-side
analysts because they work for the organisation selling securities. A and
C are incorrect because analysts who work for pension plans and
endowment funds are buy-side analysts.
9. A is correct. Regulation promotes transparency. B is incorrect because
competition, although one of the four forces that drive the investment
industry, does not promote transparency. C is incorrect because
computerisation, although also one of the four forces, does not promote
transparency. Regulation is the only one of the four forces that promotes
transparency.
10. B is correct. Technology, and computerisation in particular, is a force
driving the investment industry that has dramatically decreased trade
processing costs. A and C are incorrect because regulation and
globalisation are both forces affecting the evolution of the investment
industry that have not reduced trade processing costs.
11. A is correct. Globally, there has been a growing trend toward greater
regulation of the investment industry.
NOTES
1Bolded terms are glossary terms. Many important terms are introduced in this chapter, but only the
terms that are critical to your understanding of what is discussed in this chapter are bolded. The terms
that are discussed more thoroughly in subsequent chapters are bolded in those chapters.
2In many countries, depositors benefit from government-guaranteed deposit insurance. This insurance
gives depositors comfort that their savings are not at risk, although the amount that is guaranteed is
usually capped.
Module 2
Ethics and Regulation
© 2014 CFA Institute. All rights reserved.
CONSIDER THIS
In your work, have you ever encountered a situation that made you
feel uncomfortable? Maybe it was a colleague behaving
inappropriately toward fellow workers, customers, or suppliers.
Perhaps you were asked to do something that you considered
questionable. This module discusses ethical standards and
additional guidance, including rules, that will help you navigate
these types of situations.
Deciding how to respond to uncomfortable or questionable situations is not
always easy, and it may take time for you to realise something is not quite
right. But your response is important. The way that individuals behave can
have a profound effect on both investment companies and the industry as a
whole.
Why? In a word, trust. If investors trust the individuals and companies in the
investment industry and believe that markets are fair, they will be more
willing to invest their money. Without trust, investors are less likely to use
financial markets, which will, in turn, hamper economic growth.
Investors’ trust in financial markets relies on the actions and behaviours of
all of us working in the investment industry. The actions of Nick Leeson, who
worked in the Singapore office of the UK’s Barings Bank, are an example of
undesirable behaviour. In 1995, Leeson lost £827 million of his bank’s
money through unauthorised trading, and Barings disappeared overnight. The
bank had been in business since 1762 and was widely respected and trusted.
Such events as the sudden disappearance of a well-known financial
institution naturally worry investors and undermine trust in the industry.
The adoption and successful application of ethical and professional
standards, regulations, and corporate policies and procedures help
create trust in the investment industry.
The story of Barings Bank shows why individual behaviour is so important
in the investment industry. It is up to you, the individuals working in the
investment industry, to inspire the trust of investors by behaving ethically at
all times.
Ethics compose a personal moral philosophy that is related to an individual’s
upbringing and to his or her cultural, social, economic, and legal
environments. Because there are no universally agreed-on standards of
ethical behaviour, we need additional guidance. Guidance can take the
following forms:
Professional standards, including codes of ethics, which are established
by professional associations to guide the behaviour of individuals
within the profession.
Regulations, which carry the force of law and set standards for conduct.
Regulations can be used to reinforce ethical and professional standards.
Corporate policies and procedures, which are put in place by individual
companies to promote desired behaviours and guide employees.
Guidance may include rules that cover many situations but cannot reasonably
be expected to cover every contingency. It is important to recognise that
ethics and rules do not exist in isolation. They are interlinked: ethical
standards help guide the development of rules and, equally, rules help
individuals think about and form ethical standards.
A two-way feedback process between individual behaviour and rules is
critical to creating an ethical investment industry that inspires trust among
investors. After all, it is up to all of us to help shape an investment industry
that serves society. CFA Institute believes that fair and effective financial
markets, led by competent and ethically centred professionals (that is you!),
are essential to maintain trust and drive economic growth. The higher the
level of trust, the more likely investors are to invest, and the greater the
benefits to the economy and to society at large.
The two chapters in this module are: Chapter 2, Ethics and Investment and
Chapter 3, Regulation.
Chapter 2
Ethics and Investment
Professionalism
by Gerhard Hambusch, CFA
© 2014 CFA Institute. All rights reserved.
LEARNING OUTCOMES
After completing this chapter, you should be able to do the following:
a. Describe the need for ethics in the investment industry;
b. Identify obligations that individuals in the investment industry have to
clients, prospective clients, employers, and co-workers;
c. Identify elements of the CFA Institute Code of Ethics;
d. Explain standards of practice (professional principles) that are based
on the CFA Institute Code of Ethics;
e. Describe benefits of ethical conduct;
f. Describe consequences of conduct that is unethical or unprofessional;
g. Describe a framework for making ethical decisions.
1. INTRODUCTION
Ethics play an essential role in protecting financial market integrity and the
functioning of the investment industry. Financial market integrity refers to
financial markets that are ethical and transparent and provide investor
protection. Trust in the investment industry is enhanced when workers in the
industry make decisions that are ethically sound.
In 2013, a study by CFA Institute and Edelman examined trust by investors in
investment managers and explored the dimensions that influence that level of
trust.1 The study found that only about half of the surveyed investors trust
investment managers to act ethically. This result is troubling. As Alan M.
Meder, CFA, former chair of the CFA Institute Board of Governors, put it
earlier, “A tarnished reputation is difficult to clean. . . . The investment
profession is built on trust as much as it relies on expertise.”2
What do these words mean in practice? When trust is absent, investors are
less likely to participate in financial markets. Without investment, investors
may be unable to reach their financial goals. Without available capital for
companies, economic growth will slow. So, it is important that investors are
treated fairly because society benefits from well-functioning financial
markets.
The creation and maintenance of trust depends on the behaviour, actions, and
integrity of entities participating in the financial markets. These market
participants include companies and governments raising capital, investment
firms (companies in the investment industry), rating agencies, accounting
firms, financial planners and advisers, regulators, and institutional and
individual investors. Ultimately, trust relies on the actions of individuals
participating in financial markets, including those working in the investment
industry. In short, trust depends on everyone.
Rules are important to the effective functioning of financial markets too;
however, rules are unlikely to cover every problematic situation
encountered. An individual’s ability to identify, develop, and apply ethical
standards when there are no clear-cut rules is, therefore, critical. In the end,
trust depends on individuals choosing to comply with rules and to act
ethically.
Ethical standards, and some professional standards, are based on
principles that support and promote desired values or behaviours. Ethics is
defined as a set of moral principles, or the principles of conduct governing
an individual or a group. Professional organisations, such as CFA Institute,
establish codes of ethics and professional standards based on
fundamental ethical principles to guide practice. Ethics and rules are
intertwined; ethical standards help guide the development of rules, and rules
help individuals and groups, such as professional associations, think about,
develop, and apply ethical standards.
A culture of integrity based on ethical standards can be built and developed
at a personal and business level by applying the following four-step process,
as suggested by Meder. This process can be adapted to be relevant for
anyone:
1. Set high standards and put them in writing,
2. Get adequate and ongoing training on professional and ethical
standards,
3. Assess the integrity of individuals and groups you encounter, and
4. Take action when breaches of integrity and ethical standards are
observed.
These steps help individuals to identify, assess, and deal with ethical
dilemmas. Ethical dilemmas are situations in which values, interests,
and/or rules potentially conflict. Sometimes, the ethical dilemma and the
appropriate ethical response seem obvious. In other instances, neither the
ethical dilemma nor the appropriate ethical response is obvious. To identify
and deal with an ethical dilemma, it is useful to be able to consult a
framework that guides ethical decision making. An example of such a
framework is described in Section 6. Individuals following such a
framework are more likely to identify ethical dilemmas and to ensure that
they and others around them behave ethically.
2. WHY ETHICAL BEHAVIOUR IS
IMPORTANT
Global financial markets have grown in size and complexity over the last few
decades. Investment products and financial services offered have also
increased in breadth and complexity. Such growth and increased complexity
increase the likelihood of ethical dilemmas occurring. This likelihood is
further enhanced as organisations and individuals conduct business across
borders and under different regulatory and cultural frameworks.
Investment professionals help provide access to and information about these
investment opportunities and the financial markets. Investment professionals
are involved in making and helping clients make investment decisions and in
creating products that help with and add value to the investment decisionmaking process.
Individuals who work in the investment industry but outside of the investment
management functions are also critical to the functioning of the investment
industry. These individuals include employees working in fund
administration, securities trading and account services, and other support
activities—including legal, human resources, marketing, sales, and
information technology.
The decisions and actions of all the individuals in the investment industry
may directly or indirectly affect clients, prospective clients, employers,
and/or co-workers. So these individuals have a responsibility to make
ethical decisions and to act appropriately. In other words, they have to be
trustworthy.
For example, clients seeking wealth management advice trust that the
investment professionals they consult will provide suitable
recommendations. Typically, these professionals rely on the support of others
to provide investment services to clients. This support may be provided from
within the investment firm or, in some cases, by third parties, such as legal or
tax consulting firms. Such support also extends to the use of third-party
information, such as credit ratings and investment research. When using such
support and information, individuals working in the investment industry must
be careful and conduct due diligence to ensure the reliability of the
information and its sources. If all parties are committed to acting in the best
interests of the client, the client’s trust in the professional relationship is
more likely to be sustained.
It is critical that high ethical standards guide decisions and actions. Investors
are unlikely to have confidence in—and more broadly, the public is unlikely
to trust in—the fairness of financial markets if there is not a general belief
that individuals in the investment industry behave ethically. Some of the
factors, including success of the investment industry, affected by ethical
standards are shown in Exhibit 1. High ethical standards support these
factors, and a breach of ethical standards can undermine them. For example,
when investors hear about insider trading (trading while in possession of
information that is not publicly available and that is likely to affect the price,
often referred to as material, non-public information) or misrepresented
financial reports, it brings into question the integrity and fairness of financial
markets and lowers public trust and investor confidence in them.
Exhibit 1. Factors Affected by Ethical Standards in the
Investment Profession
3. OBLIGATIONS OF EMPLOYEES IN
THE INVESTMENT INDUSTRY
To establish and maintain high ethical standards, it is critical to understand
general obligations to clients, prospective clients, employers, and coworkers. Considering how to meet these obligations will help guide
behaviour. Failure of investment professionals to meet these obligations may
adversely affect clients, employers, co-workers, and even the financial
system as a whole. Negative effects can have far-reaching consequences
because of the interconnection among financial system participants. The
general obligations to clients, prospective clients, employers, and coworkers are similar for all employees in the investment industry.
3.1. Obligations to Clients
The client relationship is critical to the functioning of the investment industry.
Therefore, all individuals working in the investment industry, whether
involved directly or indirectly with clients, have an obligation to act
competently and carefully when fulfilling their responsibilities. Fulfilling this
obligation means using the required professional knowledge and skills,
managing risks that can affect client interests, safeguarding client
information, and treating clients consistently, fairly, and respectfully.
Identifying and managing conflicts of interest is a significant challenge. A
conflict of interest arises when either the employee’s personal interests
or the employer’s interests conflict with the interests of the client. Conflicts
of interest can also arise when the employee’s and the employer’s interests
conflict. Individuals working in the investment industry are expected to place
the client’s interests above their own and their employer’s interests. For
example, a financial planner or an investment adviser may help clients to
plan and achieve their personal financial goals by advising on investment,
risk, cash flow management, and retirement planning. Clients place great trust
and confidence in this advice. Financial planning and investment advice
result in a much higher level of responsibility than that associated with a
financial salesperson committed to selling specific investment products or
brands.
As an adviser, the investment professional should have detailed knowledge
of the range of investment products available in the market. The adviser also
has a professional obligation to exercise independent judgment when
identifying and advising on suitable investment products and to pursue the
best interest of the client at all times. Particular care must be taken to
ascertain whether an adviser’s interests have the potential to conflict with the
investment goals and best interest of a client. For example, an adviser
identifies a number of products that are suitable for a client. The adviser may
be tempted to recommend the product that generates the highest commission
to the adviser when some of the other products would actually be better
suited to the client’s investment goals. In this conflict of interest, the adviser
may inappropriately make a decision based on adviser interest and not act in
the client’s best interest.
The exception to the rule that those working in the investment industry should
put the interests of a client first is when this would harm the integrity of
financial markets. For example, trading on insider information on behalf of
clients will benefit client interests financially but ultimately will harm all
investors by eroding investor confidence in the financial markets.
Conflicts of interest are inevitable. They present ethical dilemmas that need
to be appropriately dealt with. Depending on the circumstances, they can be
dealt with in different ways. In some cases, an individual may choose to
avoid the conflict by rejecting an assignment. For example, an investment
professional may decline to prepare a research report on a company in which
the professional owns a significant number of shares. In other cases, an
individual may choose to disclose a conflict to other relevant parties who
can then decide what action is appropriate. The solution is important, but the
critical first step is to identify conflicts of interest and to recognise that they
result in potential ethical dilemmas.
Have you ever faced a conflict of interest in your work? Even if you have not
faced one yet, be aware that employees in all parts of the investment industry
face potential conflicts of interest. Investment professionals and support staff
alike must remain alert to conflicts that may arise.
Some examples of conflicts of interest are presented in Exhibit 2. In each
example, the individual chose to act in his or her own interest rather than that
of the client and/or employer. As you read these examples, consider how the
individual could have more appropriately responded to the conflict of
interest.
Exhibit 2.
Examples of Conflicts of Interest
The following are examples of conflicts of interest involving
investment professionals.
An investment manager excessively trades assets held in the
client’s portfolio in order to earn higher trading commissions.
This excessive trading (often referred to as churning) results
in high trading costs to the client and reduces the client’s
return after transaction costs and is not in the client’s best
interest.
A broker receives a large buy order from a client. Before
executing the client’s order, the broker executes a personal
buy order (also known as front running) in order to benefit
from increasing market prices caused by the client’s large buy
order.
The following are examples of conflicts of interest involving
support staff.
When learning about a change in a share recommendation, an
individual in the printing office of a research firm
immediately phones family members so they can act on the
information prior to the firm’s clients. The individual is not
acting in the best interest of his or her employer or the
employer’s clients.
A receptionist at an investment firm hears that a company’s
CEO will be fired. Anticipating downward pressure on the
company’s share price, the receptionist sells personal shares
in the company before the news is made public.
3.2. Obligations to Employers
Obligations to employers include providing services as agreed on in an
employment contract, following or executing supervisory directives as
required, and maintaining professional conduct.
Obligations also include loyalty, professional competence, and care.
Loyalty, in the context of the employment relationship, incorporates the
expectation that employees will work diligently on behalf of their employer,
will place their employer’s interests above their own, and will not
misappropriate company property. Misappropriation of company property,
whether small or large in monetary terms, is unethical. Examples of
misappropriation include making excessive claims on expense reports and
using company assets for personal purposes. Misappropriation may occur
when an employee has access to company assets that are difficult to protect,
particularly trade secrets and intangible assets, such as client lists, stock
selection models, the company’s employee compensation structure, or
portfolio management procedures.
Another aspect of loyalty is drawing attention to possible conflicts of interest
to prevent loss of client trust.
Employees are expected to carry out their assigned responsibilities with
competence and care. The efficient operation of the company can be
compromised if employees do not act competently and carefully. If an
employee does not feel capable of carrying out a task, he or she should either
develop the necessary skills, work with others to complete it, or decline the
task. This situation may not immediately seem like an ethical dilemma, but
when an individual accepts responsibility to complete a task, he or she has
an ethical obligation to be capable of completing the task efficiently and with
the appropriate level of knowledge, care, and skill.
3.3. Obligations to Co-Workers
Individuals in the investment industry are obliged not only to treat clients and
their employer with fairness and respect but also to apply the same
principles to their co-workers. It is also critical that individuals work
competently and carefully. If individuals do not perform their work carefully
and competently, they may adversely affect the tasks of co-workers and the
overall success of a team. In a worst-case scenario, the lack of competence
and care by one worker can reflect on others and result in the loss of trust in
one or more co-workers and perhaps even in their dismissal. These are farreaching consequences that co-workers should not have to face. By contrast,
ethical conduct—including competence, care, and respect towards coworkers—not only contributes to the achievement of client and employer
goals but can also enhance your career as you develop social and
communication skills and, in some cases, team leadership skills.
Obligations to co-workers extend beyond competent and careful work. In
addition to fostering your own professional development, you have an
obligation to support the professional development of co-workers, which
includes helping co-workers understand, promote, and follow ethical
practices as well as encouraging others to adhere to professional obligations,
such as the preservation of client confidentiality.
Some employees’ responsibilities in a company may include a supervisory
role. Supervisors are expected—in addition to fulfilling the obligations of all
employees—to execute supervisory duties responsibly, which includes
ensuring compliance with ethical, legal, professional, and organisational
standards. Supervisory obligations are important to preventing, detecting,
and managing violations of standards that put the client’s trust at risk.
Supervisory duties should only be assumed, however, if the work
environment provides the requisite structural and procedural controls to
prevent and detect violations. If there is a vulnerability or failure in
organisational structure or process that affects the ability to supervise others
responsibly, then supervisory obligations cannot be fulfilled. In such
circumstances, an employee should document all issues and refrain from
assuming supervisory duties until the required structural and procedural
controls have been established. Supervisory obligations can add significant
complexity to an investment professional’s legal and ethical obligations to
clients, employers, and co-workers.
3.4. Identifying Your Obligations
The complexity of the investment industry and the variety of roles, functions,
and services that constitute it can make identifying and fulfilling duties and
obligations to clients, employers and co-workers a challenge. You might
want to put the following questions to your supervisor or manager to help
identify key obligations and ethical dilemmas that may arise:
1. What is my role in the company and in what way do I contribute to its
success?
2. To whom do I owe a duty or an obligation?
3. What potential individual and organisational conflicts of interest should
I be aware of?
4. What measures do I need to take to ensure I have sufficient competence
to fulfil my role?
5. What supervision can I expect?
These questions are intended to identify major obligations, but they are not
comprehensive. They can be adapted to identify and consider standards
applicable to any employee’s work environment.
4. ETHICAL STANDARDS
Laws and regulations help to ensure that those working in the investment
industry fulfil their obligations. They also help protect the integrity of the
financial system and promote fairness and efficiency of financial markets.
However, laws and regulations alone are not sufficient to protect the
financial system. Some of the reasons for this include the following:
Laws and regulations may not extend to all areas of finance and can be
vague or ambiguous, making their interpretation a challenge.
Laws and regulations are often slow to catch up with market
innovations.
Activities that occur in different jurisdictions can be complicated by
inconsistencies in legal obligations in different countries.
Situations may arise in which no applicable law exists or the existing
law is inconclusive.
The effectiveness of laws and regulations depends on how market
participants interpret and comply with them.
The need for ethical standards is particularly apparent in situations in which
vague or ambiguous legal rules provide room for unethical behaviour that
could affect the integrity of the investment industry and result in a loss of
clients’ and/or investors’ trust. To protect the financial system in these cases,
ethical standards should guide the behaviour of market participants. The
principles embedded in codes of ethics and professional standards should
help guide the behaviour of industry participants and allow them to adapt to a
continuously changing investment industry.
Section 4.1 describes why codes of ethics and professional standards exist.
As an illustration, Section 4.1.1 describes the Code of Ethics and Standards
of Professional Conduct developed by CFA Institute to guide how investment
professionals are expected to behave. Section 4.1.2 describes how the code
can be adapted and applied to the behaviour of others working in the
investment industry.
4.1. Codes of Ethics and Professional
Standards
The topic of ethics is challenging to discuss because, to a large extent,
individuals’ ethical outlooks are personal moral philosophies. These ethical
outlooks are related to upbringing; culture; social, economic, and legal
environment; and personal and professional circumstances. One distinct
characteristic of a profession is adherence to a code of ethics and standards
of professional conduct that are typically set by a professional association.
This adherence helps ensure that common ethical standards are applied
across a wide group of people. Engineers, accountants, lawyers, and doctors,
for example, have ethical and professional standards they are expected to
adhere to. Standards vary around the world because professional
associations are not typically global in nature.
4.1.1. How the Code of Ethics Guides Investment
Professionals
In the investment industry, CFA Institute is recognised globally as the
association of investment professionals that awards the CFA (Chartered
Financial Analyst) charter. CFA Institute has developed its Code of Ethics
and Standards of Professional Conduct (Code and Standards) on the premise
that a fundamental set of ethical principles should govern and guide the
professional conduct of those participating in the investment industry. As a
preeminent global association for investment professionals, CFA Institute
requires its members and CFA and CIPM (Certificate in Investment
Performance Measurement) candidates to comply with the Code and
Standards, regardless of the country in which they live or the regulatory
regime under which they practice. The Code and Standards represent the
core values of CFA Institute and its members and have served as a model for
ethical standards of investment and other financial professionals since the
1960s.
The Code and Standards should be viewed and interpreted as an interwoven
tapestry of ethical requirements, outlining conduct that constitutes fair and
ethical business practices. Adhering to the ethical principles underlying the
Code and Standards will help protect the integrity of financial markets and
promote trust in the investment profession. The CFA Institute Code of Ethics
is shown in Exhibit 3; it reflects fundamental ethical principles applicable to
the investment industry professional. This code includes ethical principles
that can be adapted for use by others working in the investment industry.
These principles are described in Section 4.1.2.
It is important that individuals working in the investment industry understand
how investment professionals should behave because of the potential
consequences of any unethical or unprofessional actions.
Exhibit 3.
The CFA Institute Code of Ethics
Members of CFA Institute (including CFA charterholders) and
candidates for the CFA designation must:
Act with integrity, competence, diligence, respect, and in an
ethical manner with the public, clients, prospective clients,
employers, employees, colleagues in the investment
profession, and other participants in the global capital
markets.
Place the integrity of the investment profession and the
interests of clients above their own personal interests.
Use reasonable care and exercise independent professional
judgment when conducting investment analysis, making
investment recommendations, taking investment actions, and
engaging in other professional activities.
Practice and encourage others to practice in a professional
and ethical manner that will reflect credit on themselves and
the profession.
Promote the integrity and viability of the global capital
markets for the ultimate benefit of society.
Maintain and improve their professional competence and
strive to maintain and improve the competence of other
investment professionals.
The CFA Institute Standards of Professional Conduct, contained in the
Standards of Practice Handbook, expands on the Code and provides
guidance about important issues relevant to the investment professional.3
Fundamental ethical and professional principles that are applicable to the
investment industry professional include the following:
Client interests are paramount. As previously discussed, individuals
working in the investment industry have the obligation to place client
interests ahead of personal interests or the interests of employers. In
some circumstances, duty to maintain the integrity of capital markets
(financial markets) will take precedence.
Exercise diligence, reasonable care, and prudent judgment. In
fulfilling their professional responsibilities, those working in the
investment profession should strive to work to the best of their ability,
utilising the knowledge, skill, judgment, discretion, and experience that
they would apply in the management and disposition of their own
interests under similar circumstances.
Act with independence and objectivity. Those working in the
investment industry should carry out their professional responsibilities
in a thoughtful and objective manner, free from any obligations,
encumbrances, or biases, such as gifts or relationships that may
influence their judgment.
Avoid or disclose conflicts of interest. As discussed in Section 3.1,
conflicts between client interests and the personal interests of the
employee or employer should be avoided or managed through
disclosure so that all relevant stakeholders are aware of these conflicts
and their potential effects on the relationship with the client.
Disclosures must be prominent and made in plain language and in a
manner designed to effectively communicate the information.
Make full and fair disclosure. Transparency and good communication
are key elements in building trust with investors and allowing clients to
make intelligent and informed decisions. Those in the investment
industry who make false or misleading statements harm investors and
reduce investor confidence in financial markets.
Engage in fair dealing. All clients in similar situations should be
treated fairly regardless of whether one client has more assets, pays
more fees, or has a closer relationship. Fair treatment of all
stakeholders maintains the confidence of the investing public in the
investment industry.
Protect confidential information. Confidential information of clients,
employers, counterparties, and other stakeholders must be diligently
protected.
The Code and Standards, which are intended to guide the investment
professional, can help guide all participants in the investment industry to
identify, promote, and follow high ethical standards.
4.1.2. How the Code of Ethics May Guide All Employees
in the Investment Industry
The Code of Ethics and the ethical principles embedded in it may seem
overwhelming. Key aspects of potential relevance to you are summarised in
Exhibit 4. An explanation of each of the four aspects follows the exhibit.
Exhibit 4.
Ethics
Selected Aspects of the CFA Institute Code of
Act with integrity.
Use competence, diligence, and reasonable care.
Act with respect and in an ethical manner.
Use independent judgment.
The Code requires investment professionals to act with integrity and to
place the integrity of the financial markets and the investment profession
before personal or employer interests. Integrity also applies to the client
relationship. The obligations to avoid or manage conflicting interests and to
prioritize client interests serve this relationship and promote public trust in
the investment industry. It is important that all employees in the investment
industry act with integrity and act with the primacy of clients’ interests in
mind.
The Code requires investment professionals to act with competence,
diligence, and reasonable care. Because financial markets, investment tools,
and related services are constantly evolving, employees must continuously
strive to maintain and improve their knowledge and competence, as well as
that of others. Personal education and skill development will help employees
meet these responsibilities competently and diligently.
The Code requires the investment professional to respect clients, employers,
co-workers, and other investment professionals. Treating others with respect
is relevant to all investment industry employees. This requirement
complements the CFA Institute vision of promoting equitable, free, and
efficient financial markets. Acting respectfully and in an ethical manner
contributes to building and maintaining public trust in financial markets.
The Code requires investment professionals to subscribe to the fundamental
value of independent judgment, which is closely related to the values of
competence and care. Development and maintenance of independent
judgment is critical to protect clients’ trust in the investment industry and
financial markets. Work and opinions should be unaffected by any potential
conflict of interest or other circumstance adversely affecting objectivity and
independence. Potential conflicts of interest include, for example, gifts
offered to professionals by clients or related business partners or
compensation incentives to sell financial products and services. To maintain
independent judgment, the management of such circumstances includes
avoidance or disclosure of conflicts of interest and the personal maintenance
of impartial and honest judgment (i.e., objectivity).
Following ethical principles has benefits. Similarly, violating ethical
principles has consequences. The next section describes potential benefits of
ethical behaviour and potential consequences of unethical conduct.
5. BENEFITS OF ETHICAL CONDUCT
AND CONSEQUENCES OF UNETHICAL
CONDUCT
Unethical behaviour, whether legal or not, can have significant consequences
for the financial system and the economy. Compliance with ethical standards
is important to prevent financial crises that can affect economic development
and society’s welfare. Accordingly, one of the benefits of complying with
ethical standards is the increased stability of the financial system and thus of
the entire economy. Importantly, ethical standards complement existing legal
obligations, professional standards of conduct, and organisational policies
and procedures to prevent behaviour that can affect other industries and even
the global economy.
5.1. Benefits of Ethical Conduct
The liquidity, profitability, and efficiency of markets and economies are
rooted in trust.
Investment industry employees behaving ethically increase investors’ trust in
the industry and strengthen the fairness of financial markets. This trust
increases market participation and market efficiency (by which prices adjust
quickly to reflect new information about the value of assets in the market
place), which, in turn, helps investors achieve their investment goals.
Increased market participation benefits all market participants and
stakeholders. These benefits include increased liquidity (investors are able
to trade assets without affecting prices significantly) and increased market
efficiency. Increased market participation also promotes public awareness
and understanding of the financial system. This understanding, in turn, leads
to additional participation in and efficiency of financial markets.
Increased market efficiency and trust can increase access to equity and debt
funding and decrease the cost of capital for companies and governments
requiring capital. Increasing the availability of capital and decreasing the
cost of capital may positively influence the profitability and growth of
companies as well as the development of the investment industry and the
overall economy.
Increased market efficiency and participation can directly support the goals
of companies in the investment industry. These goals include economic
objectives, such as profitability and share value, and non-economic
objectives, such as reputation and customer satisfaction. In addition, an
employee following ethical standards is less likely to take excessive or
unauthorised risk or to misappropriate company assets. The misappropriation
can be of tangible assets (for example, using the company car for personal
trips without authorisation) or intangible assets (for example, sharing
information about customers or company research). If employees behave
ethically, their actions are less likely to have far-reaching (including legal)
consequences for their employer.
Compliance with ethical standards increases trust in investment
professionals and in the entire investment industry. Without trust, the public is
unlikely to use investment professionals to manage investments, to obtain
advice on issues related to financial goals, or to provide services to support
the overall investment process. Therefore, compliance may enhance
employment security and increase certainty in career development.
Complying with ethical standards may directly and positively affect a
professional’s position, compensation, and reputation. It may also provide
indirect benefits through the increased reputation and business success of a
professional’s team and entire firm, thereby providing long-term career and
skill set development opportunities. Compliance will be further discussed in
the Investment Industry Documentation chapter.
5.2. Consequences of Unethical Conduct
When ethical and professional standards are violated, there can be
significant consequences. These consequences include failure to achieve
goals on behalf of a client or an employer, negative effects on the entire
investment industry through reduced market participation, and a loss of trust
in the integrity of financial markets and the investment profession. Such
consequences can have long-lasting effects on the investment industry and the
economy.
5.2.1. Consequences for Industry and Economy
When people in the investment industry act unethically, it can lead to changes
in the behaviour of market participants. If investors lose trust in the
investment industry, they may cease to invest; potential consequences include
companies being unable to raise capital in financial markets, investment
firms losing business or even going out of business, and the economy slowing
down. Unethical and/or illegal behaviour can be responsible for these kinds
of negative consequences. For example, former US businessman Bernard L.
Madoff ignored his duty to put his clients’ interests first when he turned an
allegedly legitimate wealth management firm into a Ponzi scheme, in which
investors were paid with money from other investors as investment returns.4
Madoff thereby acted deceitfully and defrauded clients. The unveiling of this
fraud in 2008 resulted in Madoff being sentenced to 150 years in prison and
caused a widespread loss of investor trust in investment industry
professionals.
In addition to the immediate consequences of unethical behaviour on
companies in the investment industry and their clients, the transmission of
financial shocks from one company to another can be dangerous for
interconnected companies and, potentially, for the economy and the financial
system. Therefore, the consequences of unethical behaviour at one company
can affect other companies (and their clients) despite them not being
involved in the unethical behaviour. For example, if a company goes
bankrupt as a result of unethical behaviour, the company’s unfulfilled
liabilities could result in a widespread crisis for a larger group of related
companies, thereby potentially damaging the economy. Such spillover or
financial contagion may result in decreased economic output, increased
unemployment, and reduced long-term economic growth expectations.
An example of financial contagion occurred in 2008. As a consequence of
unethical behaviour, in the form of aggressive mortgage lending by some
market participants, along with other financial events, the US housing and
stock markets declined. As a result, the US-based global investment firm
Lehman Brothers went bankrupt.5 These events led to a liquidity crisis (a
shortage of available funds) in financial markets. The ensuing global
financial crisis almost resulted in the bankruptcy of American International
Group (AIG), a large multinational insurance company, which required a
regulatory bailout to survive. The crisis negatively affected many more
companies and reduced the output and growth expectations of several
economies around the world. This extreme case demonstrates how unethical
behaviour—such as aggressive mortgage lending—by some market
participants can lead to the bankruptcy of a company and a negative impact
on other interlinked companies, their clients, and the entire financial system.
5.2.2. Consequences for Clients
When people in the investment industry act unethically, clients may suffer
both financially and emotionally. They may receive inappropriate investment
advice or services, lose confidence in the investment profession and in
financial markets, lose personal wealth and current or future income, and
experience personal distress.
Unethical behaviour resulting in inappropriate investment advice or services
may expose clients to excessive risks, ownership of unsuitable assets, lack of
diversification, inflated costs of investment management services, and
unjustified transaction and management costs. For example, excessive trading
of client assets to maximise trading commissions will result in clients
incurring excessive transaction costs and may result in clients owning assets
that are not consistent with their objectives and needs. Because of the central
role of trust in a client relationship, the violation of legal and ethical
standards generally decreases a client’s trust in investment professionals and
possibly in the investment industry as a whole. Violations related to financial
market transactions (for example, insider trading) further decrease a client’s
trust in the integrity of financial markets.
In all of these cases of unethical behaviour, clients can lose wealth and
income. For example, if a client owns shares in an investment bank and there
is a trading scandal, the value of the shares may fall and the client may lose
money. The client may also suffer a decrease in current income because of
lower dividend payments. In addition, the client’s future income can be
reduced if retirement funds have been affected. Faced with financial damage
to wealth and income, clients can experience a great level of personal
distress along with severe mistrust in the investment industry, whether that
mistrust is justified or misplaced.
5.2.3. Consequences for Employers
From an employer’s point of view, the consequences of violations of ethical
standards include negative effects on current and future client relationships,
loss of reputation and company value, and legal liabilities and increased
scrutiny by regulators, which creates additional administrative and analysis
costs. The worst-case scenario includes going out of business. Often, ethical
violations become apparent externally only when the conduct results in legal
scrutiny, including threat of lawsuits, legal charges, and prosecution. Because
clients associate a company’s employees with the company’s brand, illegal
or unethical conduct can result in a loss of company reputation that can
damage or destroy current and future client relationships.
In some cases, an employer can face closure because of the unethical and/or
illegal behaviour of one or more individuals within the company. US energy
and commodity trading company Enron, for instance, collapsed in 2001 as a
result of unethical, aggressive accounting practices, which were later
identified to be illegal. As a result, Enron CEO Jeffrey K. Skilling received a
24-year prison sentence. In addition, Arthur Andersen, Enron’s audit firm,
was negatively affected and later dissolved because of questions of integrity
with respect to some of its partners involved in the Enron audit. In a different
case, unethical and ultimately illegal behaviour by former British derivatives
trader Nicholas Leeson single-handedly caused losses exceeding £800
million, resulting in the bankruptcy of the United Kingdom’s oldest
investment bank, Barings Bank, in 1995. Leeson, who had executed
unauthorised trades, was sent to prison for six-and-a-half years. Interestingly,
if the back-office accounting person had refused to comply with Leeson’s
orders on accounting matters, the losses might have been identified earlier,
when they were significantly lower. These extreme examples show how the
unethical behaviour of a few individuals can have detrimental effects on coworkers and employers.
A loss of reputation can result in a loss of company profits and a loss of
shareholder value. In cases of illegal conduct, a company in the investment
industry may be held liable for financial losses sustained by customers or
other market participants. If prosecuted, the employer may also be subject to
fines and loss of operating licences and may be obliged to pay compensation
to clients or other market participants for financial losses. These
consequences can result in additional loss of company value, which is
amplified if the company loses the right to provide some investment services.
The employer’s profits may further decrease as a result of expenditures
required to assess, manage, and prevent future occurrences of compliance
failures. Lastly, a company may become subject to increased regulatory
scrutiny and required to use company resources to administer and provide
additional costly analysis and information.
5.2.4. Consequences for Individuals
For the individual, the legal, professional, personal, and economic
consequences for violating ethical standards can be significant. In
circumstances where there has been a breach of ethical standards that results
in legal scrutiny, the individual may be subject to civil or criminal
prosecution. The consequences can include expenses to defend a prosecution,
fines, imprisonment, and loss of current and future employment in the
investment industry. Unethical behaviour resulting in legal offences includes
investment fraud, insider trading, accounting fraud, and unauthorised decision
making, all of which can result in significant prison sentences for the
perpetrator.
In addition to the previously mentioned cases involving Jeffrey Skilling of
Enron, Nicholas Leeson of Barings Bank, and Bernard Madoff, each of
whom received long prison sentences, other examples illustrate the
consequences of unethical and/or illegal behaviour for individuals. For
instance, US businesswoman Martha Stewart was accused of making false
statements to federal investigators about a suspiciously timed share sale.
Although she was not charged with insider trading, she was charged with
conspiracy, obstruction of justice, and perjury. In 2004, she was found guilty
of some of these charges and sentenced to a five-month prison term and fined
US$30,000. In 2007, she settled a civil action suit for insider trading brought
by the US Securities and Exchange Commission (SEC) by paying a fine of
US$195,000 and accepting a five-year ban on serving as an officer or
director of a public company.
Consequences of breaches of ethical and professional standards also include
disciplinary action by the employer and/or a professional or regulatory body
and disapproval from clients, colleagues, and the industry peer group. This
discipline can result in the decreased ability to advance a career because of
a loss of reputation, which has personal and economic consequences. In
particular, the individual can suffer a loss of income as a result of a
restricted ability to provide current or future services. The individual could
also face the loss of job and career and even alienation of family and friends.
6. FRAMEWORK FOR ETHICAL
DECISION MAKING
Given the potential consequences of unethical behaviour, it is important that
individuals use a framework to help them make ethical decisions. The fourstep process identified by Alan Meder, CFA (discussed in the Introduction)
represents a simple and useful framework. A more detailed framework is
shown in Exhibit 5. Note that even though the points in the framework are
numbered, they may be addressed in a different order depending upon the
situation. Reviewing the outcome should conclude the process and provide
feedback for the next time the framework is applied.
Exhibit 5.
A Framework for Ethical Decision Making
1. Identify the Ethical Issue(s) and Relevant Duties/Obligations
2. Identify Conflicts of Interest
3. Get the Relevant Facts
4. Identify Applicable Ethical Principles
5. Identify Factors That Could Be Affecting Judgment
6. Identify and Evaluate Alternative Actions
7. Seek Additional Guidance (this may occur earlier in the
decision making process or not at all)
8. Act and Review the Outcome
This framework is based on “A Framework for Thinking Ethically” from the Markkula
Center for Applied Ethics at Santa Clara University
(www.scu.edu/ethics/practicing/decision/framework.html).
Exhibit 6 illustrates the application of the framework using a scenario that is
fictional but realistic. Some guideline questions and possible responses are
included in Exhibit 6 to help you see how to use the framework. As you read
through the exhibit, consider how you would answer the questions posed and
go through the framework if you were in the situation. For example, are you
able to identify additional alternative actions?
Exhibit 6.
Making
Application of a Framework for Ethical Decision
Several colleagues and their friends from outside of the office go
out after work with Carlos, a newly hired employee. The more
experienced employees tell the “new guy” to charge the meal and
drinks to the company credit card. Carlos’s colleagues tell him the
friends are “prospective clients” and that they have charged
similar outings on the card before, and the boss always approves
the charges.
Carlos is confused. During orientation, the presenter from human
resources made it clear that it is against company policy to charge
personal expenses on the company’s credit card. Based on the
orientation, he wonders if using the company credit card would be
wrong. But if it is common practice at his firm, maybe it is okay?
Use of the framework may help him make an ethically sound
decision.
1. Identify the Ethical Issue(s) and Relevant Duties/Obligations
What is the ethical dilemma?
Is it appropriate to use the company credit card to pay
for the dinner with colleagues and their friends?
To whom is a duty owed, or who might be affected by
the decision? Often a decision is easier if you can put a
face to the party that might be affected.
Carlos owes a duty to his employer, which includes
displaying loyalty, following its policies, and acting
with integrity. His decision will potentially affect his
relationships with his employer, his boss, and his
colleagues.
Are any duties in conflict, and which duty takes
precedence?
In some situations, duties to multiple parties may exist
for the individual facing the dilemma. In this case,
Carlos’s sole duty is to his employer.
2. Identify Conflicts of Interest
Are personal interests affecting the decision/action?
In this case, Carlos may struggle with wanting to fit in
with his new colleagues versus following his
understanding of the policies of the employer.
3. Get the Relevant Facts
What are the relevant facts in the situation?
During the orientation, limitations on the use of the
company credit card were identified.
During the dinner, more experienced colleagues have
told him it is okay to use the card for business expenses
of this nature. The friends were identified by them as
prospective clients.
Are there any facts not known that should be known?
Carlos would like to know the company policies on
allowable client entertainment expenses and for
classifying and documenting someone as a potential
client. He would like to know if the friends are in fact
prospective clients.
Other questions that might be asked in fact gathering
include, What resources are available to learn more
about the situation? Is there enough available information
to make a decision?
In this situation, Carlos does not have the luxury of
gathering more information about the policy. Carlos
may wonder if the friends actually represent
prospective clients for the company but may find it
difficult to question his colleagues further. As a result
of the orientation, Carlos is concerned that charging
the meal to the card may be in violation of the company
policy and be unethical.
4. Identify Applicable Ethical Principles
What are the fundamental ethical principles involved in
the situation?
Carlos is expected to act with integrity in using the
resources of his employer. He should use reasonable
care in determining if the friends represent prospective
clients. He should use independent judgment. He
should treat his colleagues with respect, but this does
not mean he cannot question their guidance.
5. Identify Factors That Could Be Affecting Judgment
What factors are affecting judgment? Outside factors,
such as authority figures, a vocal group, and incentives,
can affect judgment. Internal factors, such as
overconfidence and rationalization, can also affect
judgment.
Carlos may be influenced by his more experienced
colleagues. He may rationalise that it is just one
dinner and unimportant. He should pause and think
through his decision before acting.
6. Identify and Evaluate Alternative Actions
What are the options? Have creative options been
identified?
Carlos’s options include
complying with his colleagues’ request and
charging the dinner to the company card.
complying with his colleagues’ request and
charging the dinner to the company card but
indicating that he will speak to the boss about it
the next day.
charging the dinner to his personal card.
charging the dinner to his personal card and
indicating that he will speak to the boss about it
the next day.
declining and suggesting that it is better for a
more senior colleague to charge the dinner.
declining and suggesting that those in attendance
split the bill.
What criteria affect choosing among options? How
should conflicts of interest be managed? How will an
alternative affect the relevant parties identified in Step
1?
Carlos wants to behave ethically and abide by
company policy. He also wants to be on good terms
with his colleagues. If Carlos chooses to pay with
either the company card or his personal credit card
and talk to the boss, he may end up paying the entire
bill personally. He may not be willing or able to do
this. Furthermore, if he ends up paying the entire bill
personally, he may distrust his colleagues and their
advice in future. If he indicates that he is going to
speak with the boss or declines to pay, it has
consequences for his relationships with his colleagues.
They may not view him as a trusted member of the
team. Speaking to the boss may affect his colleagues.
Paying also has consequences for his relationships.
The colleagues may lose respect for him and his boss
may disapprove. This consequence may result in
censure or even dismissal.
If a particular alternative was shared with a respected
individual or reported to a wider audience, what is the
expected response?
The orientation should lead him to understand that
using the company card is unacceptable and would
reflect poorly upon him. Carlos might be
uncomfortable sharing the decision to charge the
company card. Carlos might feel more comfortable
sharing other decisions.
7. Seek Additional Guidance
Would discussing the issues with a supervisor,
colleagues, or legal (compliance) personnel be
appropriate or helpful?
Seeking guidance to gather more facts about company
policy or discussing the issue with a supervisor,
colleague, or compliance officer would be helpful but
not possible in this case. Carlos has to make a decision
and act now based on the decision available.
8. Act and Review the Outcome
How did the decision turn out, and what has been
learned from this specific situation?
This framework is based on “A Framework for Thinking Ethically” from the Markkula
Center for Applied Ethics at Santa Clara University
(www.scu.edu/ethics/practicing/decision/framework.html).
A framework for ethical decision making and the application of ethical
principles will hopefully assist individuals in addressing ethical dilemmas.
Exhibit 7 includes further examples of ethical dilemmas to which this
framework might be applied. As you read them, consider how you would
apply the framework and what actions you would take in the circumstances
described.
Exhibit 7.
Examples of Ethical Dilemmas
An employee in the sales and marketing department of an
investment adviser is asked by his supervisor to prepare a
marketing brochure highlighting a particular investment
product that generates higher fees for the adviser than
comparable investment products.
An administrative assistant for a portfolio manager is asked
by one of the manager’s long-time clients, who the assistant
knows well, to provide him with the manager’s investment
recommendations before other clients.
An operations manager for an investment firm is responsible
for hiring a consultant to address internet security issues. She
is considering hiring a consulting company that is owned and
operated by a college friend.
An individual in the printing office of a research firm is
considering phoning friends and family to inform them of
changed investment recommendations so they can act on the
information before the firm’s clients can.
A consultant for a public pension fund completes a
preliminary analysis of investment firms that responded to a
request for proposal of services. He is told to include on the
shortlist a firm that provides sporting event tickets to pension
plan personnel.
An employee in the accounting/billing department of an
investment firm is asked by the senior partner of the firm, who
also sits on the board of a local charity, to provide names and
contact information of all the firm’s clients for the purpose of
soliciting charitable donations to that charity.
A paralegal in the legal department of a bank that is assisting
with bankruptcy filings for one of the bank’s clients owns
shares of the client and is considering selling them before the
news is made public.
A portfolio manager tells her assistant that she and 7 of the 10
other portfolio managers in the firm are leaving to form their
own firm. She asks the assistant to join the new firm and to
put together a list of current clients with their phone numbers
and other personal details.
A research assistant for a pension fund is considering sharing
some investment research and economic forecasts received by
the fund with the advisory board of the endowment for his
church.
A long-time assistant is asked by a senior manager, who is
being let go, to copy several company files for the manager’s
job search. The files contain research reports that the manager
wrote, marketing presentations containing the manager’s
performance record, and spreadsheets that the manager
created.
An employee in the operations department of an investment
firm responsible for negotiating cell phone service for
company employees is considering renewing the contract with
the firm’s existing carrier without any further investigation.
He is familiar with their service, comfortable with the
customer service representative of the carrier, and very busy
with the pending move of the firm’s offices.
An employee in the accounting department is responsible for
processing expense reports for a senior manager. Because the
manager often does not have receipts for such items as meals
and cab fare, the employee has learned to override the
accounting system for these minor expenses. The manager
asks the associate to process his latest expense report, which
does not have receipts for larger expenses. When the
employee asks for the receipts, the manager tells him he lost
them and to “just override the system like you usually do.”
While attending the sponsor’s exhibit area at an investment
industry conference, an employee of the compliance
department of a large investment firm visits the booth of a
compliance software vendor and enters her name into a raffle
by dropping her business card into a jar. The employee wins
an iPad from the vendor. The employee discovers that her
firm and the vendor are in the final stages of negotiating a
long-term business relationship.
An employee receives a check made out to him from a hotel
as reimbursement for an uncomfortable night at the hotel. The
employee’s company paid for the hotel stay.
In each of these examples, at least one person is facing an ethical dilemma.
Using a framework for ethical decision making and applying ethical
principles may help those individuals to first identify the ethical dilemmas
and then to navigate their way through them.
SUMMARY
Trust is essential to the functioning of the investment industry—trust in
the behaviour, actions, and integrity of participants in the financial
markets. Trust depends on participants complying with rules and acting
ethically.
Rules are helpful but are unlikely to cover every situation encountered.
In the absence of clear rules, ethical principles can help guide decision
making and behaviour.
Ethical reasoning and decision making become more important as
increased opportunities for ethical dilemmas arise in increasingly
complex expanding and globally interconnected financial markets.
A culture of integrity, at a business or personal level, can be built using
a four-step process:
1. Set high standards and put them in writing
2. Get adequate and ongoing professional and ethics training
3. Assess the integrity of individuals and groups encountered
4. Take action when integrity breaches are observed
Investment professionals have to meet various obligations to serve their
clients’ interests and to comply with applicable laws, rules, regulations,
and ethical standards. Compliance with ethical standards benefits
financial markets, clients, employers, co-workers, and employees
within the investment industry.
The CFA Institute Code of Ethics sets ethical standards for investment
professionals.
Fundamental ethical and professional principles applicable to the
investment industry include the following:
Make client interests paramount.
Exercise diligence, reasonable care, and prudent judgment.
Act with independence and objectivity.
Avoid or disclose conflicts of interest.
Make full and fair disclosure.
Engage in fair dealing.
Protect confidential information.
All employees in the investment industry should act with integrity; use
competence, diligence, and reasonable care; act respectfully and
ethically; and use independent judgment.
Benefits of ethical conduct in the investment industry are many but begin
with trust. Increased trust in the fairness of financial markets and the
ethical conduct of market participants leads to increased market
participation. Increased market participation leads to increased
liquidity, increased market efficiency, and increased availability of
capital at a reduced cost. As a result, the overall economy thrives.
Violations of legal and ethical standards can have significant negative
consequences for clients, investment professionals, investment firms,
the investment industry, financial markets, and the global economy.
A framework for ethical decision making, such as the one listed here,
can help individuals make ethical decisions:
1. Identify the ethical issue(s) and relevant duties and obligations.
2. Identify conflicts of interest.
3. Get the relevant facts.
4. Identify applicable ethical principles.
5. Identify factors that could be affecting judgment.
6. Identify and evaluate alternative actions.
7. Seek additional guidance.
8. Act and review the outcome.
CHAPTER REVIEW QUESTIONS
© 2014 CFA Institute. All rights reserved.
1. Maintaining high ethical standards in the investment industry will most
likely result in:
A. decreased market efficiency.
B. fewer conflicts of interest.
C. increased market participation.
2. Maintaining high ethical standards in the investment industry will most
likely:
A. increase the fairness of financial markets.
B. decrease the stability of the financial system.
C. decrease the complexity of financial markets.
3. Which of the following most likely represents potential violation of
ethical principles due to a conflict of interest?
A. An analyst writes a research report about a company for which he
owns a significant number of shares.
B. A financial salesperson, who sells specific investment products,
recommends an investment product to a client and is paid a
commission on the sale.
C. An employee sells her own shares of a company after placing a
client’s order to sell shares of the same company.
4. In fulfilling obligations to their employer, employees should:
A. be careful in carrying out their responsibilities.
B. accept and diligently complete any assigned task.
C. balance their personal interests with their employer’s interests.
5. If the required structural and procedural controls have not been
established, then an employee should:
A. refrain from assuming supervisory duties.
B. notify the appropriate regulatory authorities.
C. perform their supervisory duties with utmost care.
6. Which of the following outcomes of acting with high ethical standards
will most likely directly benefit both clients and investment
professionals?
A. Enhanced employment security
B. Reduced risk of adverse legal consequences
C. Increased trust in the fairness of financial markets
7. For individuals working in the investment industry, ethical standards are
most needed when:
A. legal obligations are ambiguous.
B. market innovations are infrequent.
C. different jurisdictions have unambiguous and similar laws.
8. According to fundamental ethical and professional principles
applicable to the investment industry, which group should have their
interests ranked first?
A. Clients
B. Employers
C. Co-workers
9. The fundamental ethical principle to act with independence and
objectivity is best upheld when:
A. client confidentiality is maintained.
B. personal education and professional development are undertaken.
C. work and opinions are unaffected by any potential conflict of
interest.
10. According to fundamental ethical and professional principles for the
investment industry, trading on insider information on behalf of clients
is:
A. not allowed.
B. allowed only if the trade benefits the client.
C. allowed only if the trade is disclosed as a conflict of interest.
11. Which of the following is most likely a potential effect of unethical
behaviour by people in the investment industry?
A. Increased employment
B. Decreased economic output
C. Decreased regulatory scrutiny
12. Unethical behaviour by investment professionals may lead to higher:
A. employment.
B. long-term growth expectations for the economy.
C. cost of capital for those companies requiring capital.
13. The last step in an ethical decision-making process should be to:
A. assess how a decision turned out and learn from it.
B. assess how others might view a possible course of action.
C. determine whether the decision is affected by outside factors.
14. A breach of ethical standards most likely results in:
A. higher public trust.
B. reduced financial market efficiency.
C. fulfilment of clients’ investment goals.
15. According to fundamental ethical and professional principles for the
investment industry, conflicts of interest with:
A. clients should be avoided.
B. clients and employers should be avoided.
C. clients and employers should be avoided or disclosed.
16. Decreased cost of capital may lead to the growth of:
A. only the investment industry.
B. only companies seeking capital in financial markets.
C. the investment industry, companies seeking capital in financial
markets, and the overall economy.
17. Which of the following best describes an internal factor that could
affect judgment in ethical decisions?
A. Incentives
B. Rationalization
C. Authority figures
ANSWERS
1. C is correct. By maintaining high ethical standards, trust in the fairness
of financial markets will increase, thereby increasing market
participation. A is incorrect because the end result of maintaining high
ethical standards should be increased market efficiency. B is incorrect
because high ethical standards help individuals deal with potential
conflicts of interest but do not affect the quantity of those inherent
conflicts.
2. A is correct. By maintaining high ethical standards, investors’ trust in
the investment industry will increase as will trust in the fairness of
financial markets. B is incorrect because high ethical standards help
prevent financial crises and increase the stability of the financial
system. C is incorrect because high ethical standards do not affect the
complexity of financial markets. The increasing complexity of global
financial markets increases the need for high ethical standards to deal
with the resulting increase in ethical dilemmas.
3. A is correct. The analyst preparing a research report about a company
when there is an ownership interest, unless the interest is clearly
insignificant, has a conflict of interest. The analyst’s personal interests
might affect his or her ability to write an unbiased, objective report,
which is contrary to the interests of his or her employer and the
employer’s clients. B is incorrect because there is a different level of
responsibility associated with a financial salesperson, who is
committed to selling specific investment products, and an investment
adviser, who is helping clients to plan and achieve their personal
financial goals. C is incorrect because although acting prior to executing
a client’s order (front running) represents a violation of an ethical
principle due to a conflict of interest, it may be appropriate for an
employee to act after executing the client’s order.
4. A is correct. Being careful in carrying out their responsibilities is an
obligation of all employees. The efficient operations of a company can
be compromised if employees do not act competently and carefully. B is
incorrect because employees should not accept a task if they lack the
appropriate level of knowledge or skill to carry it out, if they have a
conflict of interest, or if they are concerned about an ethical issue. C is
incorrect because loyalty, an obligation owed to employers, includes an
expectation that employees act in their employer’s interests when
fulfilling their work obligations.
5. A is correct. Supervisory duties should only be assumed when the work
environment provides the requisite structural and procedural controls to
prevent and detect violations. Supervisors are expected to execute
supervisory duties responsibly, which includes ensuring compliance
with ethical, legal, professional, and organisational standards. B and C
are incorrect because if deficiencies are detected, the employee should
document all issues and refrain from assuming supervisory duties until
controls have been established. The employee does not necessarily have
an obligation to notify the appropriate regulatory authorities.
6. C is correct. Acting with high ethical standards increases clients’ trust
in the fairness of financial markets, thus promoting market efficiency,
which, in turn, helps clients achieve their investment goals. This
outcome also benefits investment professionals because increased trust
from clients increases the likelihood that clients will seek their advice,
thus enhancing the security of their employment. A and B are incorrect
because enhanced employment security and the reduced risk of adverse
legal consequences benefit investment professionals directly and only
indirectly may benefit clients.
7. A is correct. Ethical standards are most needed when legal obligations
are ambiguous. The need for ethical standards is particularly apparent
in situations in which vague or ambiguous legal rules provide
opportunities for unethical behaviour. B is incorrect because laws and
regulations are often slow to catch up with market innovations. So, in
the case of frequent market innovations, the need for ethical standards
would be great. But in an environment with infrequent market
innovations, the need is not so apparent. C is incorrect because
activities that occur in different jurisdictions can be complicated by
inconsistencies in legal obligations, which would make the need for
ethical standards important. But in different jurisdictions where legal
obligations are unambiguous and similar, the need for ethical standards
is not as great.
8. A is correct. Individuals working in the investment industry have the
obligation to place client interests ahead of personal interests or the
interests of employers. B and C are incorrect because although
individuals in the investment industry have an obligation to employers
and co-workers, the clients’ interests come first.
9. C is correct. Conflicts of interest can adversely affect objectivity and
independence by creating a bias that may affect judgment. A is incorrect
because maintaining client confidentiality is related to the fundamental
ethical principle of protecting confidential information. B is incorrect
because undertaking personal education and professional development
is related to the fundamental ethical principle of acting with diligence
and reasonable care.
10. A is correct. Trading on insider information is not allowed because it
will harm all investors by eroding investor confidence in the trading
markets. B is incorrect because trading on insider information is a case
in which the duty to maintain the integrity of financial markets takes
precedence over the client’s interests. Therefore, even if the trade
would benefit the client, it is a violation of fundamental ethical and
professional principles. C is incorrect because trading on insider
information is not allowed whether or not it is disclosed. A conflict of
interest may not be present and is not the issue.
11. B is correct. Unethical behaviour in the investment industry may lead to
a loss of investor confidence, which may reduce the availability of
capital to companies and lead to decreased economic output. A is
incorrect because decreased rather than increased employment is a
potential result of unethical behaviour in the investment industry. C is
incorrect because unethical behaviour typically results in an increase in
regulatory scrutiny.
12. C is correct. Unethical behaviour by investment professionals may lead
to companies finding it difficult to raise capital in financial markets,
thereby leading to a higher cost of capital. If high ethical standards are
maintained, access to equity and debt funding will likely increase and
the cost of capital for companies requiring capital will decrease. A and
B are incorrect because unethical behaviour by investment
professionals may result in lower economic output, lower employment,
and reduced long-term growth expectations for the economy.
13. A is correct. The last step in an ethical decision-making process should
be to assess how a decision turned out and to learn from it. B and C are
incorrect because assessing how others might view a possible course of
action and determining whether the decision is affected by outside
factors occur earlier in the decision-making process.
14. B is correct. A breach of ethical standards can undermine the factors,
such as market efficiency, affected by ethical standards. A and C are
incorrect because both higher public trust and fulfilment of clients’
investment goals are supported by high ethical standards.
15. C is correct. Conflicts of interests with clients and employers may arise
in the course of business. Conflicts should be avoided or managed
through disclosure so that all relevant stakeholders are aware of these
conflicts and their potential effects on the relationship. A and B are
incorrect because, although it is preferable to avoid conflicts of interest,
it is not always possible to avoid or eliminate them. In situations
lacking that ability, an employee should prominently disclose the
conflicts in plain language to effectively communicate the information.
16. C is correct. Decreased cost of capital may positively influence the
growth of the companies requiring capital as well as growth in the
investment industry and the overall economy. A and B are incorrect
because the benefits of lower cost of funds is not limited to only the
companies raising funds and the investment industry.
17. B is correct. Internal factors that may affect judgment include
overconfidence and rationalization. A and C are incorrect because they
are both external factors, not internal. External factors that affect a
person’s judgment include authority figures, vocal groups, and
incentives.
NOTES
1CFA Institute and Edelman, “CFA Institute & Edelman Investor Trust Study” (2013):
www.cfainstitute.org/learning/products/publications/ccb/Pages/ccb.v2013.n14.1.aspx.
2Alan M. Meder, “Creating a Culture of Integrity,” CFA Institute (2011):
www.cfainstitute.org/learning/products/publications/contributed/Pages/creating_a_culture_of_i
ntegrity.aspx.
3The Standards of Practice Handbook can be accessed at
www.cfapubs.org/toc/ccb/2014/2014/4.
4Ponzi schemes are named after Charles Ponzi, who defrauded many people in the United States in the
1930s. Typically in a Ponzi scheme, a plausible but semi-secretive method for earning returns is
presented but, in fact, there is no such method. Fictitious returns are reported and payments are made to
investors using cash receipts from other investors. The scheme falls apart and is revealed when there
are no new investors and/or investors begin to request withdrawals rather than reinvesting their
supposed earnings.
5A 2,200-page, 9-volume report issued 11 March 2010 by the court-appointed examiner of Lehman
Brothers identified various questionable, but not necessarily illegal, activities undertaken by the firm.
Chapter 3
Regulation
by James J. Angel, PhD, CFA
© 2014 CFA Institute. All rights reserved.
LEARNING OUTCOMES
After completing this chapter, you should be able to do the following:
a. Define regulations;
b. Describe objectives of regulation;
c. Describe potential consequences of regulatory failure;
d. Describe a regulatory process and the importance of each step in the
process;
e. Identify specific types of regulation and describe the reasons for each;
f. Describe elements of a company’s policies and procedures to ensure the
company complies with regulation;
g. Describe potential consequences of compliance failure.
1. INTRODUCTION
Rules are important to the investment industry. Without rules, customers
could be sold unsuitable products and lose some or all of their life savings.
Customers can also be harmed if a company in the investment industry
misuses customer assets. Furthermore, the failure of a large company in the
financial services industry, which includes the investment industry, can lead
to a catastrophic chain reaction that results in the failure of many other
companies, causing serious damage to the economy.
Recall from the Investment Industry: A Top-Down View chapter that
regulation is one of the key forces driving the investment industry. Regulation
is important because it attempts to prevent, identify, and punish investment
industry behaviour that is considered undesirable. Financial services and
products are highly regulated because a failure or disruption in the financial
services industry, including the investment industry, can have devastating
consequences for individuals, companies, and the economy as a whole.
Regulations are rules that set standards for conduct and that carry the force
of law. They are set and enforced by government bodies and by other entities
authorised by government bodies. This enforcement aspect is a critical
difference of regulations with ethical principles and professional standards.
Violations of ethical principles and professional standards have
consequences, but those consequences may not be as severe as those for
violations of laws and regulations. Therefore, laws and regulations can be
used to reinforce ethical principles and professional standards.
It is important that all investment industry participants comply with relevant
regulation. Companies and employees that fail to comply face sanctions that
can be severe. More important, perhaps, than the effects on companies and
employees, failure to comply with regulations can harm other participants in
the financial markets as well as damage trust in the investment industry and
financial markets.
Companies set and enforce rules for their employees to ensure compliance
with regulation and to guide employees with matters outside the scope of
regulation. These company rules are often called corporate policies and
procedures and are intended to establish desired behaviours and to ensure
good business practices.
An understanding of the regulatory environment and company rules is
essential for success in the investment industry. In this chapter, many of the
examples are drawn from developed economies primarily because the
regulatory systems in these economies have had longer to evolve. Many of
these systems have been adjusted over many years, so they not only protect
investors and the financial system but also allow the investment industry to
innovate and prosper.
2. OBJECTIVES OF REGULATION
Regulators act in response to a perceived need for rules. Regulation is
needed when market solutions are insufficient for a variety of reasons.
Understanding the objectives of regulation makes it easier for industry
participants to anticipate and comply with regulation.
The broad objectives of regulation include the following:
1. Protect consumers. Consumers may be able to quickly determine the
quality of clothing or cars, but they may not have the skill or the
information needed to determine the quality of financial products or
services. In the context of the financial services industry, consumers
include borrowers, depositors, and investors. Regulators seek to protect
consumers from abusive and manipulative practices—including fraud—
in financial markets. Regulators may, for instance, prevent investment
firms from selling complex or high-risk investments to individuals.
2. Foster capital formation and economic growth. Financial markets
allocate funds from the suppliers of capital—investors—to the users of
capital, such as companies and governments. The allocation of capital
to productive uses is essential for economic growth. Regulators seek to
ensure healthy financial markets in order to foster economic
development. Regulators also seek to reduce risk in financial markets.
3. Support economic stability. The higher proportion of debt funding used
in the financial services industry, particularly by financial institutions,
and the interconnections between financial service industry participants
create the risk of a systemic failure—that is, a failure of the entire
financial system, including loss of access to credit and collapse of
financial markets. Regulators thus seek to ensure that companies in the
financial services industry, both individually and as an industry, do not
engage in practices that could disrupt the economy.
4. Ensure fairness. All market participants do not have the same
information. Sellers of financial products might choose not to
communicate negative information about the products they are selling.
Insiders who know more than the rest of the market might trade on their
inside information. These information asymmetries (differences in
available information) can deter investors from investing, thus harming
economic growth. Regulators attempt to deal with these asymmetries by
requiring fair and full disclosure of relevant information on a timely
basis and by enforcing prohibitions on insider trading. Regulators seek
to maintain “fair and orderly” markets in which no participant has an
unfair advantage.
5. Enhance efficiency. Regulations that standardise documentation or how
to transmit information can enhance economic efficiency by reducing
duplication and confusion. An efficient dispute resolution system can
reduce costs and increase economic efficiency.
6. Improve society. Governments may use regulations to achieve social
objectives. These objectives can include increasing the availability of
credit financing to a specific group, encouraging home ownership, or
increasing national savings rates. Another social objective is to prevent
criminals from using companies in the financial services industry to
transfer money from illegal operations to other, legal activities—a
process known as money laundering. As a consequence of the
transfer, the money becomes “clean”. Regulations help prevent money
laundering, detect criminal activity, and prosecute individuals engaged
in illegal activities.
Specific regulations are developed in response to the broad objectives of
regulation. A regulation can help to achieve multiple objectives. For
example, rules about insider trading protect consumers (investors) and
promote fairness in financial markets. Specific types of regulation are
discussed in Section 4 of this chapter.
3. CONSEQUENCES OF REGULATORY
FAILURE
Inadequate regulation and failure to enforce regulation can have a variety of
consequences, including failing to meet the objectives above. The results of a
regulatory breakdown can harm customers and counterparties as well as
damage trust in the financial services industry, which includes the investment
industry. Customers may lose their life savings when sold unsuitable
products or customers could be harmed if an investment firm misuses
customer assets. Furthermore, the failure of one large company in the
financial services industry can lead to a catastrophic chain reaction
(contagion) that results in the failure of many other companies, causing
serious damage to the economy.
4. A TYPICAL REGULATORY
PROCESS
The processes by which regulations are developed vary widely from
jurisdiction to jurisdiction and even within jurisdictions. This section
describes steps involved in a typical regulatory process and compares
different types of regulatory regimes.
Exhibit 1 shows steps in a typical regulatory process, from the need for
regulation to its implementation and enforcement.
Exhibit 1.
The Regulatory Process
1. Identification of perceived need. Regulations develop in response to a
perceived need. The perception of need can come from many sources.
There may, for instance, be political pressure on a government to react
to a perceived flaw in the financial markets, such as inadequate
consumer protection. Forces within the investment industry, such as
lobbying groups, may also attempt to influence regulators to enact rules
beneficial to their or their clients’ interests. Regulation may be
developed proactively in anticipation of a future need; or regulation
may be developed reactively in response to a scandal or other problem.
2. Identification of legal authority. Regulatory bodies need to have the
authority to regulate. Sometimes more than one regulator has authority
and can respond to the same perceived need.
3. Analysis. Once a need is identified, regulators conduct a careful
analysis. The regulators should consider all the different regulatory
approaches that can be used to achieve the desired outcome. Possible
approaches include mandating and/or restricting certain behaviours,
establishing certain parties’ rights and responsibilities, and imposing
taxes and subsidies to affect behaviours. The analysis also needs to
carefully weigh the costs and benefits of the proposed regulation, even
though the benefits are often difficult to quantify. In other words, does
the cure cost more than the disease? Regulations impose costs, including
the direct costs incurred to hire people and construct systems to achieve
compliance, monitor compliance, and enforce the regulations. These
costs increase ongoing operating costs of regulators and companies,
among others. A regulation may be effective in leading to desired
behaviours but very inefficient given the costs associated with it.
In some countries, regulators explicitly consider the competitive
position of their country’s financial services industry, which includes
the investment industry, when they are developing regulation.1
Regulators are aware of the need for innovation and try not to arbitrarily
stifle new ideas.
4. Public consultation. Regulators often ask for public comment on
proposed regulations. This public consultation gives those likely to be
affected by the regulations an opportunity to make suggestions and
comments, on such issues as costs, benefits, and alternatives, to improve
the quality of the final regulations. A regulation may go through several
rounds of proposal, consultation, and amendment before it is adopted.
5. Adoption. The regulation is formally adopted by the regulator.
Regulators may clarify formal rules by publishing guidelines, frequently
asked questions (FAQs), staff interpretations, and other documents.
Companies or individuals that do not comply with these published
pronouncements put themselves at risk of violating regulations.
6. Implementation. Regulations need to be implemented by the regulator
and complied with by those who are affected by them. Some regulations
go into effect immediately and some are phased in over time. Because
companies have a duty to comply with relevant new regulations, they
need to monitor information from regulators and act on any changes.
Sometimes regulators will contact companies directly about a new
regulation, but not always.
7. Monitoring. Regulators monitor companies and individuals to assess
whether they are complying with regulation. Monitoring activities
include routine examinations of companies, investigation of complaints,
and routine or special monitoring of specific activities. Routine
examinations may check for compliance with such items as net capital
requirements and safeguarding of customer assets. Regulators may
check whether a company has compliance procedures in place and
whether the company is actually following these procedures. Regulators
may also have systems in place for receiving and investigating
complaints about violations. They may also monitor for certain
prohibited or required activities. For example, regulators may routinely
investigate all purchases just before a takeover announcement to
determine whether there has been any insider trading.
8. Enforcement. For a regulatory system to be effective, it must have the
means to identify and punish lawbreakers. Punishments include ceaseand-desist orders and monetary fines, fees, and settlements. In the case
of individuals, punishments also may involve the loss of licences, a ban
from working in the investment industry, and even prison terms. The
loss of reputation resulting from regulatory action, even when the
individual is not convicted or punished, can have significant effects on
individuals and companies.
9. Dispute resolution. When disputes arise in a market, a fair, fast, and
efficient dispute resolution system can improve the market’s reputation
for integrity and promote economic efficiency. Mechanisms that provide
an alternative to going to court to resolve a dispute—often known as
alternative dispute resolutions—have been developed globally. These
typically use a third party, such as a tribunal, arbitrator, mediator, or
ombudsman, to help parties resolve a dispute. Using alternative dispute
resolutions may be faster and less expensive than going to court.
10. Review. Regulations can become obsolete as technology and the
investment industry change. For this reason, a good regulatory system
has procedures in place for regularly reviewing regulations to
determine their effectiveness and whether any changes are necessary.
Although the creation of regulation often involves the processes just outlined,
regulations can be created less formally. Sometimes, regulators will issue
informal guidance that may not have the formal legal status of written
regulations but will affect the interpretation and enforcement of regulations.
Enforcement officials may decide, for instance, that a previously acceptable
practice has become abusive and start sanctioning individuals and companies
for it. This potential is one of the reasons why individuals and companies
should maintain ethical standards higher than the legal minimums.
4.1. Classification of Regulatory Regimes
The type of regulation that an individual or company encounters will affect
how they respond to and comply with it. The way that regulations are
classified can differ between countries, so it is important to understand the
types of regulatory regimes, particularly if your company operates at a global
level.
Regulatory regimes are often described as “principles-based” or “rulesbased”. In a principles-based regime, regulators set up broad principles
within which the investment industry is expected to operate. This avoids
legal complexity and allows regulators to interpret the principles on a caseby-case basis. Rules-based regimes provide explicit regulations that, in
theory, offer clarity and legal certainty to investment industry participants.
However, real-world regulatory regimes are usually hybrids of these two
types. For example, US regulation is often described as rules-based. One
such rule is that insider trading is banned. Yet, the rule includes no statutory
definition of insider trading—prosecutions are made under the broad antifraud provisions of US law that outlaw any type of fraud or manipulation.2
Equally, UK regulation is often described as principles-based, yet some
regulations—such as those for credit unions—are very detailed.
Regulatory systems can also be designed as “merit-based” or “disclosurebased”. In merit-based regulation, regulators attempt to protect investors
by limiting the products sold to them. For example, a regulator may decide
that a hedge fund product is highly risky and should only be available to
investors that meet certain criteria. Investing in hedge funds is usually
restricted to investors that have a certain level of resources and/or
investment expertise. Disclosure-based regulation seeks to ensure not
whether the investment is appropriate for investors, but only whether all
material information is disclosed to investors. The philosophy behind
disclosure-based regulation is that properly informed investors can make
their own determinations regarding whether the potential return of an
investment is worth the risk.
Again, the real world regulatory environment is often a hybrid of these two
types of regulation. For example, although US regulation is mostly
disclosure-based, US regulators sometimes impose extra burdens of
disclosure and restrict access to products that they think lack merit, are
highly risky, or are poorly understood.
5. TYPES OF FINANCIAL MARKET
REGULATION
The broad objectives of regulation discussed in Section 2 are used by
regulators to create sets of rules. Each set of rules focuses on a type of
investment industry activity. These rules include the following:
Gatekeeping rules
Operations rules
Disclosure rules
Sales practice rules
Trading rules
Proxy voting rules
Anti-money-laundering rules
Business continuity rules
5.1. Gatekeeping Rules
Gatekeeping rules govern who is allowed to operate as an investment
professional as well as if and how products can be marketed.
Personnel.
One of the primary activities of regulators is screening investment industry
personnel to ensure that they meet standards for integrity and competency.
Even honest people can do tremendous damage if they are untrained or
incompetent. For this reason, regulators in most financial markets require
individuals to pass licensing exams to make sure that industry personnel have
an understanding of the financial laws and of financial products in general.
Financial products.
Financial products must generally comply with numerous regulations before
they can be sold to the public. In disclosure-based regimes, the regulators
monitor the accuracy of the disclosures; in merit-based regimes, the
regulators pass judgement on the merits of the investments.
Gatekeeping rules are necessary because some financial products are
complicated to understand, and sellers of these products may have incentives
to offer and recommend the wrong products to a client. For example,
between 2002 and 2008, Hong Kong SAR banks and brokerage firms sold a
total of HK$14.7 billion of Lehman Brothers’ investment products—mainly
unlisted notes linked to the credit of various companies—to about 43,700
individual investors. After Lehman’s bankruptcy in 2008, investors lost most,
if not all, of the principal amount they had invested.
5.2. Operational Rules
Regulations may dictate some aspects of how a company operates.
Net capital.
It is important that companies in the financial services industry have
sufficient resources to honour their obligations. History shows that highly
leveraged companies (companies with a high amount of debt relative to
equity) pose a risk not only to their own shareholders, but also to their
customers and the economy as a whole. Bankruptcies of even small
companies in the financial services industry can be disruptive. The aggregate
effects of a large number of small collapses can have a serious impact on the
overall economy.
The collapse of larger entities can result in global financial contagion, a
situation in which financial shocks spread from their place of origin to other
locales or markets. Contagion occurred in the 1997 Asian crisis—a crisis
that began in some Asian countries and spread across the globe. Contagion
also took place during the financial crisis of 2008. Regulators seek to
prevent excessive risk taking by imposing capital requirements that limit the
amount of leverage that companies in the financial services industry,
particularly a financial institution, can use. More information about the effect
of leverage on a company’s performance is provided in the Financial
Statements chapter.
Handling of customer assets.
Most jurisdictions impose rules that require customer assets to be strictly
segregated from the assets of an investment firm. Even with regulations,
however, companies may be tempted to use these valuable assets in ways that
have not been approved by the customer. Even if there is no intentional
diversion of customer funds, mishandling or poor internal control of these
assets exposes customers to the risk of loss. Any reported problems in this
area may damage the reputation of the entire investment industry.
5.3. Disclosure Rules
In order for markets to function properly, market participants require
information, including information about companies and governments raising
funds, information about the specific financial instruments being sold and
traded, and information about the markets for those instruments. Rules
specify what information is included and how the information is disclosed.
Corporate issuers.
Regulators typically require corporate issuers of securities to disclose
detailed information to potential buyers before the offering of securities. This
requirement is to ensure that investors have enough information about what
they are buying to make informed decisions. The disclosures generally
include audited financial statements, information about the general business
of the company, the intended use of the proceeds, information about
management, and a discussion of important risk factors.
Market transparency.
Information about what other investors are willing to pay for a security, or
the price they just paid, is valuable to investors because it helps them assess
how much a security is worth. But investors generally do not want to reveal
private information. Regulation requires the dissemination of at least some
information regarding the trading environment for securities.
Disclosure triggers.
A company may be exposed to various types of compulsory regulatory
disclosure requirements. Stock exchanges and market regulators typically
have a range of disclosures, which may be required as soon as a trigger event
occurs or a threshold is reached. For holdings in a particular stock, there can,
for example, be significant shareholder disclosures designed to inform the
market of potential takeover activity, directors’ dealings in shares of the
company, or short positions.
5.4. Sales Practice Rules
Some consumers seeking financial advice find it difficult to assess the quality
of the advice they are receiving. These consumers may be vulnerable to
abusive sales practices by sellers who are more concerned about their own
profit than the customers’ best interests. For instance, some providers may be
inclined to push products that pay the highest commission. Regulators deal
with potential sales practice abuses in various ways.
Advertising.
Regulators may control the form and content of advertising to ensure that
advertising is not misleading. For example, regulators often disapprove of
such advertised promises as “guaranteed” returns and “sure win” situations.
Providers of products and services to investors may be tempted to exaggerate
past performance by displaying only winning time periods or winning
strategies. Regulators seek to counteract this tendency by creating standards
for the reporting of past performance.
Fees.
Regulators may impose price controls to limit the commissions that can be
charged on the sale of various financial products as well as to limit the markups and mark-downs that occur when investment firms trade securities with
their customers out of their own inventories.
Information barriers.
Many large firms in the investment industry offer investment banking services
to corporate issuers and, at the same time, publish investment research and
provide financial advice. This situation creates potential conflicts of interest.
For instance, firms may publish biased investment advice in order to win
more lucrative investment banking business. Similarly, research analysts may
be under pressure to publish favourable research reports on securities in
which the firm has large positions in its own inventory. Regulators attempt to
resolve conflicts of interest by requiring firms to create barriers—virtual and
physical—between investment banking and research.
Suitability standards.
Regulation seeks to hold those in the investment industry accountable for the
advice that they give to their clients. Any advice or recommendation should
be suitable for the client (consistent with the client’s interests). Some
participants in the investment industry are held to an even higher standard,
frequently called a fiduciary standard. Under this standard, any advice or
recommendation must be both suitable for the client and in the client’s best
interests. In order to advise or make recommendations, it is critical to “know
your customer”—gather information about a client’s circumstances, needs,
and attitudes to risk.
Restrictions on self-dealing.
Many firms in the investment industry sell financial products such as
securities directly to investors out of their own inventories. This practice
allows them to provide faster service and better liquidity to their customers
as well as to provide access to proprietary financial products that may not be
available elsewhere. However, self-dealing potentially creates a conflict of
interest because the firm’s interests may differ from those of the consumer.
The firm wants to charge the highest price to the customer, who wants to pay
the lowest price. There can also be confusion among customers as to whether
the firm is acting as a principal (the firm is taking the other side of the trade)
or an agent (the firm is working for the client, but not trading with that client).
Regulators may deal with the potential conflict in a number of ways. They
may impose “best execution” requirements, require disclosure of the conflict,
or ban self-dealing with customers.
5.5. Trading Rules
Regulations are often designed to set investment industry standards as well
as to prevent abusive trading practices.
Market standards.
Government regulation can be used to set, for example, the standard length of
time between a trade and the settlement of the trade (typically three business
days for equities in most global markets).
Market manipulation.
Regulators attempt to prevent and prosecute market manipulation. Market
manipulation involves taking actions intended to move the price of a stock
to generate a short-term profit.
Insider trading.
A market in which some participants have an unfair advantage over other
participants lacks legitimacy and thus deters investors. For this reason, most
jurisdictions have rules designed to prevent insider trading. Because
material non-public information flows through companies in the financial
services industry about the financial condition of their clients and their
trading, regulators often expect companies to have policies and procedures in
place to restrict access to such information and to deter parties with access
from trading on this information.
Front running.
As with insider trading, regulators may ensure that companies have
procedures in place to deter front running and to monitor employees’
personal trading. Front running is the act of placing an order ahead of a
customer’s order to take advantage of the price impact that the customer’s
order will have. For example, if you know a customer is ordering a large
quantity that is likely to drive up the price, you could take advantage of this
information by buying in advance of that customer’s order.
Brokerage practices.
In some countries, investment managers may use arrangements in which
brokerage commissions are used to pay for external research. These are
referred to as soft money (soft dollar) arrangements. Rather than paying cash
for the research, the broker directs transactions to a provider. The payment of
commissions on those transactions, possibly made from client accounts, give
the brokerage firm access to the research produced by the provider.
Regulators may have regulations regarding the use of such arrangements
because client transactions could be directed to gain access to research
rather than being used in clients’ interests.3
5.6. Proxy Voting Rules
In some countries, brokers are required to distribute voting materials to their
customers, gather voting instructions, and submit them for inclusion in the
counting of votes. In other countries, corporate issuers distribute materials
directly to shareholders. Regulation determines what procedures are used for
conducting proxy votes.
5.7. Anti-Money-Laundering Rules
Companies in the financial services industry can be used by criminals to
launder money, to facilitate tax evasion, and to fund terrorism. Governments
naturally want to deter such activities and they may use their regulatory
power over companies in the financial services industry to do so.
Regulations may require companies to confirm and record the identity of
their clients; to report payments, such as dividends, to tax authorities; and to
report various other activities, such as large cash transactions.
5.8. Business Continuity Planning Rules
Given the essential nature of financial services to the economy, regulators
may be concerned about business continuity in the event of disasters, such as
fires, floods, earthquakes, and epidemics. Regulators want to be assured that
customer records are adequately backed up and that companies have plans in
place to recover from a disaster.
Regulations affect all aspects of the investment industry, from entry into it to
exit from it.
6. COMPANY POLICIES AND
PROCEDURES
Companies within the investment industry, like all companies, are expected
to have policies and procedures (also referred to as corporate policies
and procedures) in place to ensure employees’ compliance with applicable
laws and regulations. Policies are principles of action adopted by a
company. Procedures are what the company must do to achieve a desired
outcome. Although company policies and procedures do not have the force of
law, they are extremely important for the survival of companies. Policies and
procedures establish desired behaviours, including behaviours with respect
to regulatory compliance. Indeed, companies may be sanctioned or even
barred from the investment industry for not having policies and procedures in
place that ensure compliance with regulations. Policies and procedures also
guide employees with matters outside the scope of regulation. Recall from
the Ethics and Investment Professionalism chapter that policies and
procedures are important in helping to prevent undesirable behaviour.
Companies use a similar process as regulators when setting corporate
policies and procedures. Typically, corporate policies and procedures
respond to a perceived need. Companies establish systems to make
employees aware of new policies and procedures, to monitor compliance,
and to act on failures to comply. It is important to document policies and
procedures so that the company can prove it is in compliance when inspected
by regulators. It is also important to document that the company follows and
enforces its policies and procedures.
Regulators also expect supervisors of subordinate employees to make sure
that the employees are in compliance with the company’s policies and
procedures and with relevant regulation. Regulators may discipline higherlevel executives for misdeeds within a company because the executives did
not supervise their employees properly, even when the executives had no
involvement whatsoever in the misdeeds.
6.1. Supervision within Companies
Just as it is important for regulators to supervise companies in the investment
industry, it is also vital that companies supervise their employees. With large
amounts of money at stake, a single rogue employee can cause significant
harm or even bring down a company.
Supervision starts even before a new employee joins a company. The
company should conduct background checks to make sure that the prospective
employee is competent and of good character. The employee’s initial
orientation and training should emphasise the importance of compliance with
corporate policies and procedures and with relevant regulations.
It is not enough to train new employees. It is important to also provide
continuing education to reinforce the mission-critical nature of compliance
with corporate policies and procedures and with relevant regulations. It is
also important to have documented systems in place to ensure that employees
follow the company’s compliance procedures. For example, a company may
have rules in place to deter insider trading and front running.
A company must also be able to prove to regulators that it has established
good corporate policies and procedures and that they are being followed.
Good documentation, such as keeping records of employees’ continuing
education, is essential to prove compliance and enforcement. The Investment
Industry Documentation chapter provides a discussion of documentation in
the context of the investment industry.
6.2. Compensation Plans
Companies need to be aware of the potential effects of compensation plans
on employees’ behaviour. For example, bonuses for reaching target sales
levels may motivate employees to make more sales, but they may also
motivate employees to break rules and engage in deception to make those
sales. Adherence to good compliance practices should be a standard part of
employees’ performance reviews and a factor in determining bonuses.
6.3. Procedures for Handling Violations
No matter how honest and well-meaning employees are, sooner or later,
there will be some rule violations. A culture of cover-up is dangerous for a
company because once unethical employees discover that it is possible to
hide problems, they will be tempted to take advantage of that. Companies
need to have procedures in place for employees to report problems without
fear of retribution, as well as procedures for handling problems in an
effective manner.
7. CONSEQUENCES OF COMPLIANCE
FAILURE
Failure to comply with regulations and policies and procedures can have
significant consequences for employees, managers, customers, the company,
the investment industry, and the economy. Companies may fire employees and
managers that fail to comply with regulations and policies and procedures.
When a regulatory action occurs, even if no formal charges are brought, the
legal costs to individuals and firms involved in dealing with it can be high.
Regulators have many ways of disciplining firms and individuals that violate
informal rules. Sanctions for individuals may include fines, imprisonment,
loss of licence, and a lifetime ban from the investment industry. When
subordinates violate rules, managers may also face consequences for failure
to supervise. Even long after the issue is resolved, the regulatory sanctions
remain a matter of public record that can haunt the individuals involved for
the rest of their lives. The economic damage from loss of reputation can be
huge.
Companies also face sanctions including fines, loss of licences, and forced
closure. A company may be forced to spend significant resources in
corrective actions, such as hiring outside consultants, to demonstrate
compliance. Companies interact with regulators on an ongoing basis, so
running afoul of a regulator’s opinion in one area can lead to problems in
other areas.
Compliance failures affect more than just the company and its employees.
Customers and counterparties can be harmed and trust in the investment
industry and financial markets damaged. Customers may lose their life
savings and counterparties may suffer losses. At the extreme, the failure of
one large company in the financial services industry can lead to a
catastrophic chain reaction (contagion) that results in the failure of many
other companies, causing serious damage to the economy.
SUMMARY
If every individual and every company acted ethically, the need for regulation
would be greatly reduced. But the need would not disappear altogether
because regulation does not just seek to prevent undesirable behaviour but
also to establish rules that can guide standards that can be widely adopted
within the investment industry. The existence of recognised and accepted
standards is important to market participants, so trust in the investment
industry depends, in no small measure, on effective regulation.
Some important points to remember include the following:
Regulations are rules carrying the force of law that are set and enforced
by government bodies and other entities authorised by government
bodies. It is important that all investment industry participants comply
with relevant regulation. Those that fail to do so face sanctions that can
be severe.
Financial services and products are highly regulated because a failure
or disruption in the financial services industry, which includes the
investment industry, can have catastrophic consequences for
individuals, companies, and the economy as a whole.
Regulation is necessary for many reasons, including to protect
consumers; to foster capital formation and economic growth; to support
economic stability; to promote fair, efficient, and transparent financial
markets; and to improve society.
A typical regulatory process involves determination of need by a legal
authority; analysis, including costs and benefits; public consultation on
proposals; adoption and implementation of regulations; monitoring for
compliance; enforcement, including penalties for violations; dispute
resolution; and review of the effectiveness of regulation.
Regulation may be principles-based or rules-based and merit-based or
disclosure-based.
The types of regulations that have been developed in response to
perceived needs include rules on gatekeeping, operations, disclosure,
sales practice, trading, proxy voting, anti-money-laundering, and
business continuity planning.
Corporate policies and procedures are rules established by companies
to ensure compliance with applicable laws and regulations, to establish
processes and desired behaviours, and to guide employees.
Documentation is important for demonstrating regulatory compliance.
Employees’ activities can have negative consequences for managers
(supervisors) and companies. It is vital to make sure that employees are
competent and of good character. They should receive training to ensure
that they are familiar with their regulatory responsibilities, corporate
policies and procedures, and ethical principles. Employees’ behaviour
and actions should be adequately supervised and monitored.
Failure to comply with regulation and policies and procedures can have
significant consequences for employees, managers, customers, the firm,
the investment industry, and the economy.
CHAPTER REVIEW QUESTIONS
© 2014 CFA Institute. All rights reserved.
1. Consequences are most severe for market participants who violate
which of the following?
A. Regulations
B. Ethical principles
C. Professional standards
2. Regulations that affect the financial services industry are most likely
needed because:
A. power is equally distributed among industry participants.
B. the same information is available to all industry participants.
C. a high number of interconnections exists among industry
participants.
3. Which of the following best describes a broad objective of regulation in
the context of the financial services industry?
A. To protect consumers
B. To eliminate financial risk
C. To enforce corporate policies and procedures
4. Regulations to ensure that companies in the financial services industry
do not engage in practices that could cause failures in the financial
markets most likely have:
A. a social objective.
B. an efficiency objective.
C. an economic stability objective.
5. Regulations intended to increase the national savings rate and encourage
home ownership most likely have:
A. a social objective.
B. a fairness objective.
C. an economic stability objective.
6. In working toward ensuring fairness in the markets, regulators most
likely attempt to:
A. increase information asymmetries.
B. maintain fair and orderly markets.
C. prevent public release of insider information.
7. Which of the following is most likely a regulatory failure?
A. Only inadequate regulation
B. Only failure to enforce regulation
C. Both inadequate regulation and failure to enforce regulation
8. The step in the regulatory process at which regulators weigh the costs
and benefits of a proposed regulation is the:
A. analysis.
B. identification of perceived need.
C. dispute resolution process.
9. In establishing a merit-based rule, regulators are most likely to:
A. restrict access to specific products deemed to be risky.
B. mandate disclosure of information relevant to decision making.
C. establish broad principles within which the industry is expected to
operate.
10. Which of the following is most likely the first step in a typical
regulatory process?
A. Public consultation
B. Compliance monitoring
C. Perceived need identification
11. In the regulatory process, regulators must assess whether firms and
individuals are complying with regulations. This step in the regulatory
process is best described as:
A. monitoring.
B. enforcement.
C. implementation.
12. Insider trading is best defined as:
A. trading for internal company accounts before placing a customer’s
order.
B. trading based on material, non-public information that is likely to
affect prices.
C. taking actions intended to move the price of a security to generate a
short-term profit.
13. Regulations that require large financial firms to create virtual and
physical barriers between investment banking activities and research
activities are examples of:
A. trading rules.
B. gatekeeping rules.
C. sales practice rules.
14. Regulations that attempt to prevent market manipulation are examples
of:
A. trading rules.
B. operational rules.
C. sales practice rules.
15. An objective of establishing corporate policies and procedures is to:
A. promote economic growth and stability.
B. ensure compliance with laws and regulations by employees.
C. set standards for employee conduct that carry the force of law.
16. With respect to corporate policies and procedures, when should
supervision of employees begin?
A. Before an employee is hired
B. During an employee’s orientation
C. During an employee’s job training
17. The consequences of failure to comply with regulations and corporate
policies and procedures:
A. include costs to only the firm and employees.
B. range from individual costs to damage to the global economy.
C. are borne by the employee who failed to comply and not by the
employee’s supervisor or employer.
18. Regulatory sanctions against firms include:
A. only financial penalties.
B. only financial penalties and loss of licences.
C. financial penalties, loss of licences, and forced closure.
ANSWERS
1. A is correct. Consequences are most severe for violations of
regulations. B and C are incorrect because violations of ethical
principles and professional standards have consequences, but those
consequences may not be as severe as those for violations of
regulations, which carry the force of law.
2. C is correct. Regulations that affect the financial services industry are
needed because a high number of interconnections exist among industry
participants. The interconnections between industry participants create
the risk of a systemic failure. A and B are incorrect because there are
differences in the relative power and access to information among
industry participants, which creates a need for regulation.
3. A is correct. The protection of consumers is a broad objective of
regulation in the context of the financial services industry. B is incorrect
because the reduction of risk may be an objective of regulation, but the
elimination of risk in the financial services industry is not possible. C is
incorrect because corporate policies and procedures are set by
companies and are intended to ensure good business practices and
compliance with regulation; however, the enforcement of internal
company policies is not an objective of regulation.
4. C is correct. Regulations to ensure that companies in the financial
services industry do not engage in practices that could cause failures in
the financial market have an economic stability objective. A is incorrect
because social objectives of regulation include increasing the
availability of credit to a specific group, encouraging home ownership,
increasing national savings rates, and preventing criminal activity. B is
incorrect because efficiency objectives of regulation are intended to
reduce costs and increase economic efficiency. For example, the
adoption of rules to standardise documentation or how to transport
information.
5. A is correct. Regulations intended to increase the national savings rate
and encourage home ownership have a social objective. B is incorrect
because the fairness objective of regulation seeks to promote fair and
orderly markets in which no participant has an unfair advantage. C is
incorrect because economic stability objectives seek to ensure that
companies in the financial services industry do not engage in practices
that could disrupt the economy.
6. B is correct. Regulations seek to maintain fair and orderly markets by
promoting rules that eliminate unfair advantages to select participants.
A is incorrect because information asymmetries refers to some market
participants having more information relevant to an investment than
other participants. Regulations seek to reduce information asymmetries,
not to increase them. C is incorrect because regulations seek to prevent
participants from trading on inside information to the detriment of other
market participants. Public release, or dissemination, reduces the unfair
advantage of insider information.
7. C is correct. Both inadequate regulation and failure to properly enforce
regulations are examples of regulatory failure, potentially resulting in
harm to market participants and the industry as a whole.
8. A is correct. Analysis is the step in the regulatory process at which
regulators weigh the costs and benefits of a proposed regulation. B is
incorrect because the identification of perceived need is the step at
which a future need or a previous problem is perceived to exist and
leads to regulation. C is incorrect because the dispute resolution
process is the step that identifies how disputes may be handled.
9. A is correct. In a merit-based regulatory system, regulators attempt to
protect consumers by limiting the products sold to them. B is incorrect
because disclosure-based, not merit-based, regulatory systems mandate
disclosure of information relevant to decision making. In a disclosurebased system, regulators do not decide whether a product is good or
bad for consumers, but merely ensure that consumers have sufficient
information to make their own decisions. C is incorrect because
principles-based, not merit-based, regulatory systems establish broad
principles within which the industry is expected to operate. In fact, most
regulatory systems are hybrids that draw on each of the four
approaches: rules-based, principles-based, merit-based, and
disclosure-based. As a result, some regulations will be very detailed,
some will establish broad principles, some will attempt to protect
consumers by limiting access to products considered risky or harmful,
and some will focus on ensuring that appropriate information is
provided.
10. C is correct. In a typical regulatory process, the first step is
identification of a perceived need. Perceived need for regulation may
be proactive in anticipation of need or in response to a current situation.
A is incorrect because public consultation is part of the regulatory step,
but it comes after the identification of a need, identification of legal
authority, and analysis. B is incorrect because compliance monitoring
occurs after the regulation is in place.
11. A is correct. In a typical regulatory process, the step that involves
monitoring firms and individuals for compliance, including such things
as examinations and investigations, is the monitoring step. B is incorrect
because the enforcement step of the regulatory process involves
regulators identifying and punishing compliance violations. C is
incorrect because the implementation step of the regulatory process is
when a new regulation goes into effect and may include informing firms
and individuals about the new regulations.
12. B is correct. Insider trading is trading based on material, non-public
information. A is incorrect because trading for internal company
accounts before placing a customer’s order is front running. C is
incorrect because taking actions intended to move the price of a stock to
generate a short-term profit is market manipulation.
13. C is correct. Regulations that require large financial firms to create
virtual and physical barriers between investment banking activities and
research activities are examples of sales practice rules. Sales practice
rules attempt to address potential conflicts of interest when financial
service providers have a financial stake in the decisions that their
clients make. Such regulation also includes controls on advertising and
pricing. A is incorrect because trading rules focus on trading practices
in the market and trading activity of financial participants to ensure fair,
organised, and efficient markets. B is incorrect because gatekeeping
rules are intended to ensure that industry personnel meet standards for
competency and integrity and that financial products offered meet
certain standards.
14. A is correct. Regulations that attempt to prevent market manipulation
are examples of trading rules. Trading rules focus on trading practices
in the market and trading activity of financial participants to ensure fair,
organised, and efficient markets. Market manipulation involves
investors taking actions intended to move the price of a stock to
generate a short-term profit. B is incorrect because operational rules are
related to how a company operates; operation rules include rules with
respect to financial leverage and how customer accounts are handled. C
is incorrect because sales practice rules are intended to ensure that
industry professionals treat clients appropriately with regard to the
products recommended and fees charged. Furthermore, such rules are
intended to reduce potential conflicts of interest an industry professional
might face in the sale and recommendation of a financial product.
15. B is correct. An objective of establishing corporate policies and
procedures is to ensure compliance with laws and regulations by
employees. A is incorrect because promoting economic growth and
stability are broad objectives of regulation. C is incorrect because
corporate policies and procedures do not carry the force of law.
16. A is correct. Supervision begins before employees are hired; the
company should conduct background checks to ascertain the competence
and character of prospective employees. B and C are incorrect because
initial orientation and training should emphasise the importance and role
of corporate policies and procures as well as regulatory compliance,
but those occur after the employee has been hired.
17. B is correct. The consequences of failure to comply with regulations
and corporate policies and procedures can have far-reaching
consequences. A is incorrect because these failures affect more than just
the company and its employees. C is incorrect because supervisors and
the employer may be assigned some responsibility for the failure.
18. C is correct. Failure to comply with regulations and internal policies
may result in regulatory sanctions, including fines, loss of licences, and
forced closure. A and B are incorrect because sanctions can include
fines, loss of licences, and forced closure.
NOTES
1For example, the United Kingdom’s Financial Services Authority took into account “the desirability of
maintaining the competitive position of the UK”
(www.fsa.gov.uk/pages/About/Aims/Principles/index.shtml).
2To be precise, US prosecutions for insider trading are typically made under US SEC Rule 10b-5, which
does not mention insider trading directly. It states, “It shall be unlawful for any person, directly or
indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any
facility of any national securities exchange,
a. To employ any device, scheme, or artifice to defraud,
b. To make any untrue statement of a material fact or to omit to state a material fact necessary in order
to make the statements made, in the light of the circumstances under which they were made, not
misleading, or
c. To engage in any act, practice, or course of business which operates or would operate as a fraud or
deceit upon any person, in connection with the purchase or sale of any security.”
3CFA Institute also has ethical standards for the use of soft dollars. See CFA Institute, CFA Institute
Soft Dollar Standards: Guidance for Ethical Practices Involving Client Brokerage (2011):
www.cfapubs.org/doi/pdf/10.2469/ccb.v2004.n1.4005.
Module 3
Inputs and Tools
© 2014 CFA Institute. All rights reserved.
CONSIDER THIS
Which of these events do you think are relevant to the work of
investment professionals?
Asian stock markets suddenly fall by 5%.
A European computer company creates a new tablet device
and doubles its sales.
Bad weather damages Florida’s orange crop.
If you thought all of them, you would be right.
They are typical of the kinds of events that you might read about in
newspapers or hear about on the news. But for investment professionals, they
are more than just news. They form a valuable part of the inputs, or
information, needed to make decisions. It is the job of investment managers
to gather information from a wide variety of sources (including the news) and
to analyse the information to assess its potential effect on companies,
industries, and markets. The analysis is carried out with the help of a number
of investment tools, or techniques, that investment professionals combine
with their experience and judgment to make decisions.
This module discusses the different types of inputs and tools as well as the
relationships between them. It will help you understand how investment
professionals identify relevant information and how the analysis of that
information affects their investment and financing decisions.
Economics is an important input in these decisions. Economics affects each
of you in your daily lives and in your jobs. The three key branches of
economics are
microeconomics, which focuses on the decisions made by individual
consumers and companies.
macroeconomics, which focuses on the economy as a whole and
considers the effect of such factors as inflation, interest rates, and
unemployment on economic activity.
international trade, which focuses on the exchange of products, services,
and capital across borders.
Financial statements provide valuable information about companies. When
deciding whether to invest in a particular company or security, investors
usually analyse the financial statements issued by the company. They assess
the company’s performance over time and compare it with the performance
of other companies. The financial statements often contain information that
provides clues to the likely future performance of the company.
Investment professionals analyse economic information and financial
statements to inform their decisions. Knowledge of quantitative concepts is a
key tool for performing this analysis. These concepts allow investment
professionals to summarise and interpret economic and financial data. In
particular, quantitative concepts form a basis for valuing investment
opportunities and assessing their risks.
It should be noted that inputs and tools are not always distinct from one
another; there are overlaps and links between information and the analysis of
it. Financial statement analysis provides an example of how investment
professionals combine inputs and tools to standardise financial information
and to help them determine a company’s value as an investment.
The five chapters in this module are: Microeconomics, Chapter 4;
Macroeconomics, Chapter 5; The Economics of International Trade, Chapter
6; Financial Statements, Chapter 7; and Quantitative Concepts, Chapter 8.
Chapter 4
Microeconomics
by Michael J. Buckle, PhD, James Seaton, PhD,
Sandeep Singh, PhD, CFA, CIPM, and Stephen
Thomas, PhD
© 2014 CFA Institute. All rights reserved.
LEARNING OUTCOMES
After completing this chapter, you should be able to do the following:
a. Define economics;
b. Define microeconomics and macroeconomics;
c. Describe factors that affect quantity demanded;
d. Describe how demand for a product or service is affected by substitute
and complementary products and services;
e. Describe factors that affect quantity supplied;
f. Describe market equilibrium;
g. Describe and interpret price and income elasticities of demand and their
effects on quantity and revenue;
h. Distinguish between accounting profit and economic profit;
i. Describe production levels and costs, including fixed and variable
costs, and describe the effect of fixed costs on profitability;
j. Identify factors that affect pricing;
k. Compare types of market environment: perfect competition, pure
monopoly, monopolistic competition, and oligopoly.
1. INTRODUCTION
Would you prefer to buy a new car, to have more leisure time, or to be able
to retire early? Can you afford to do all three? If not, you will need to
prioritise.
Prioritising is what individuals and organisations do all the time, and it
involves trade-offs. An individual only has so many hours in a week and so
much money. A city may want to build new schools, better recreation
facilities, and a bigger industrial park. If it decides to build new schools, it
may have to cut back spending on recreation or industrial facilities.
Alternatively, the city could try to increase its share of resources by
increasing taxes or borrowing money.
Individuals and organisations have numerous wants and must prioritise them.
In The Investment Industry: A Top-Down View chapter, we learned that
resources to meet these wants are often limited or scarce—such resources as
labour, real assets, financial capital, and so on are not unlimited. Thus,
individuals and organisations have to make decisions regarding the
allocation of these scarce resources.
Economics is the study of production, distribution, and consumption or the
study of choices in the presence of scarce resources, and it is divided into
two broad areas: microeconomics and macroeconomics. Microeconomics
is the study of how individuals and companies make decisions to allocate
scarce resources, which helps in understanding how individuals and
companies prioritise their wants. Macroeconomics is the study of an
economy as a whole. For example, macroeconomics examines factors that
affect a country’s economic growth. Macroeconomics is discussed further in
the next chapter.
This chapter focuses on factors that influence the supply and demand of
products and services. Many of the explanations and examples focus on
products, but they are equally applicable to services. Supply refers to the
quantity of a product or service sellers are willing to sell, whereas demand
refers to the quantity of a product or service buyers desire to buy. The
interaction of supply and demand is a driving force behind the economy and
is part of the “invisible hand”1 that, over time, should lead to greater
prosperity for individuals, companies, and society at large.
Understanding microeconomics is useful to companies when considering
such issues as how much to charge for their products and services and what
reaction they may see from competitors. Microeconomics helps investment
analysts assess the profitability of a company under different scenarios. For
example, the analyst may want to determine whether a company has the
ability to increase revenues by cutting the prices of its products and
increasing the quantity sold. To do so, the analyst will have to consider
demand for the company’s products and the degree of competition in the
company’s market environment.
Similarly, microeconomic concepts help investors allocate their savings.
Investors try to provide capital to companies that will make the most efficient
use of it. As noted in The Investment Industry: A Top-Down View chapter,
efficient allocation of capital benefits investors and the economy as a whole.
Knowing how microeconomics affects a company’s revenues, costs, and
profit is vital to understanding the health of a company and its value as an
investment.
2. DEMAND AND SUPPLY
Buyers demand a product, and sellers supply the product. Consumers buy
products, such as cars, books, and furniture, from manufacturers and
retailers, who sell them in markets. These markets can take the form of
physical structures, such as supermarkets or shops, or they can be virtual,
internet-based markets, such as eBay or Amazon. Properly functioning
markets are essential to capitalism because the interaction of buyers and
sellers determines the price and quantity of a product or service traded.
The organisation of markets is important in microeconomics. In some
markets, there is a single provider of a product or service, whereas in other
markets, there are many companies providing the same or similar products or
services. For example, there may be only one regional power company
supplying electricity, but there may be many companies providing home
insurance. How markets are organised can affect how the companies
operating in these markets set prices and is discussed further in Sections 5
and 6.
We will start by defining demand and discussing factors that affect the
demand for products and services. Then we will discuss factors that affect
the supply of products and services. We will also describe how the
interaction of supply and demand determines the equilibrium price, which is
the price at which the quantity demanded equals the quantity supplied.
2.1. Demand
When economists refer to demand, they mean the desire for a product or
service coupled with the ability and willingness to pay a given price for it.
Consumers will demand and pay for a product as long as the perceived
benefit is greater than its cost or price.
2.1.1. The Law of Demand
It is logical that if the price of a product goes up, consumers will normally
buy less of the product. For instance, if the price of fuel rises, car owners
will use their cars less and so buy less fuel. Quantity demanded and price of
a product are usually inversely related, which is known as the law of
demand.
At the beginning of the chapter, we indicated that individuals satisfy wants
through the choices they make regarding scarce resources. Economists term
this satisfaction of want as utility; utility is a measure of relative
satisfaction. For example, consumers derive utility or satisfaction from eating
pizza. According to the law of diminishing marginal utility, the marginal
(additional) satisfaction derived from an additional unit of a product
decreases as more of the product is consumed. For example, the satisfaction
a consumer gets from eating each additional slice of pizza diminishes as the
total amount eaten increases. As demonstrated in Exhibit 1, a consumer may
enjoy eating one slice of pizza when his or her stomach is empty, but as the
consumer’s stomach fills, eating a second slice of pizza typically brings less
satisfaction.
Exhibit 1.
Diminishing Marginal Utility
2.1.2. The Demand Curve
The law of demand can be represented on a graph, with quantity demanded
on the horizontal axis and price of the product on the vertical axis. The curve
that shows the quantity demanded at different prices is the demand curve.
Exhibit 2 shows a consumer’s hypothetical demand curve for pizza.2
Exhibit 2.
Hypothetical Demand Curve for Pizza
The demand curve in Exhibit 2 shows the quantities of pizza that the
individual is willing to buy at various prices over a given period, if all other
factors affecting demand remain constant. Note that the demand curve slopes
downward from left to right, indicating that as the price of pizza decreases,
the quantity the individual is willing to buy increases. Factors affecting
supply, such as input costs, do not affect the demand curve at all.
If the price of pizza changes, there is a change in the quantity demanded,
which is represented by a move along the demand curve. So, as shown in
Exhibit 2, at a price of 3.0 the individual demands two slices of pizza. But
for three slices of pizza, the individual is only willing to pay the lower price
of 2.5. Effectively, the individual is only willing to pay an additional 1.50 [ =
(3 × 2.5) – (2 × 3.0)] for the third slice.
Note that when the only thing that changes is the price, the quantity demanded
changes, but the demand curve itself does not change—that is, a change in the
price of a product leads to a move along the demand curve, not a shift in the
demand curve. However, if one or more other factors that affect demand
change, the overall level of demand for the product at any given price may
change. If so, the demand curve itself shifts. The demand curve in Exhibit 2
may shift if the individual’s income changes, if the prices of other food or
non-food products change, or if the individual stops liking pizza as much.
A change in a factor may make the product more attractive—for instance, if
the price of sandwiches, a substitute for pizza, increases relative to the price
of pizza. In this case, demand will shift to the right, meaning that people will
demand more of the product at a given price. The range of prices of the
product has not changed, but the quantity demanded at each price has
increased. Alternatively, a change in a factor may make the product less
attractive—for instance, if people’s tastes change and they stop liking pizza
as much. In this case, demand will shift to the left, meaning that people will
demand less of the product at a given price. The range of prices for the
product has not changed, but the quantity demanded at each price has
decreased.
Exhibit 3 illustrates how a change in a factor that has made the product more
attractive shifts the demand curve to the right from D to D1.
Exhibit 3.
Shift in the Demand Curve to the Right
Now we will take a closer look at the major factors that affect the demand
curve.
2.1.3. Effect of Income on Demand
A change in demand for a product resulting from a change in purchasing
power is called the income effect.
A change in a consumer’s income may shift a product’s demand curve. For
most goods—called normal goods—if income increases, demand
increases too. Meat is an example of a normal good in most emerging
economies. For inferior goods, the relationship works in the opposite
direction. That is, demand for inferior goods decreases as income increases.
Grain is often considered an inferior good. So, when incomes are higher,
people consume more meat relative to grain.
Recessions offer an example of when demand for inferior products increases.
During a period of decline in economic activity, consumers tend to switch to
lower-cost brands and shop more at discount stores than at department
stores. So, during recessions, investors may focus on companies that sell
inferior goods to identify stocks that may perform better.
2.1.4. Effect of the Expected Future Price of a Product
on Demand
There is a positive relationship between the expected future price of a
product and its current demand—that is, both the expected future price and
current demand move in the same direction. For example, if consumers
expect that the price of rice will increase as a result of a shortage, the current
quantity of rice demanded may increase as consumers accumulate it to avoid
paying a higher price in the future. The quantity demanded at all prices will
rise in anticipation of the price increase, leading to a shift in the demand
curve to the right. In contrast, if the price of a product is expected to fall in
the future, current demand may go down as consumers wait for the price to
decrease before purchasing.
2.1.5. Effect of Changes in General Tastes and
Preferences on Demand
Changes in consumers’ general tastes and preferences may also affect a
product’s demand curve. For example, if a report that links eating chocolate
to better health is published, demand for chocolate bars may increase. In that
case, the demand curve for chocolate will shift to the right. Investors and
analysts often consider demographic trends and shifts in consumers’ tastes
and preferences when evaluating an investment.
2.1.6. Effect of Prices of Other Products on Demand
As we saw earlier, if the price of sandwiches increases, people may eat
more pizza instead. The effect of a change in the prices of other products on a
product’s demand curve depends on the type of relationship between the
products.
2.1.6.1. Substitute Products
A substitute product or substitute is a product that could generally
take the place of (substitute for) another product. For many consumers, Coke
and Pepsi are considered fairly close substitutes.
Consumers substitute relatively cheaper products for relatively more
expensive ones. So, if the price of a substitute product decreases, demand for
the substitute may increase and demand for the original product may
decrease. Example 1 describes this effect using Coke and Pepsi.
EXAMPLE 1. EFFECT OF A CHANGE IN COKE’S PRICE ON
THE DEMAND FOR COKE AND PEPSI
If the price of Coke decreases, there is likely to be an increase in
demand for Coke and a decrease in demand for Pepsi. If a bottle of
Coke and Pepsi each sell for $1, people will have no preference based
on price. But if the Coca-Cola Company decides to try to increase its
market share, it might cut—perhaps just temporarily—the price of a
bottle of Coke to 90 cents. Although there will still be many loyal Pepsi
consumers, there will probably be a number of people who will buy
Coke instead of Pepsi because it is now cheaper. Coca-Cola hopes that
some of these people then develop a preference for Coke over Pepsi
and become loyal Coke drinkers. So, if Coca-Cola subsequently returns
its price to $1, it hopes that it has a larger loyal customer base that will
choose Coke over Pepsi.
2.1.6.2. Complementary Products
Complementary products or complements are products that are
frequently consumed together. When the price of a product decreases, it leads
to an increase in demand for both the product and for its complementary
products. For example, printing paper and ink cartridges are complementary
products. If the price of ink cartridges decreases, consumers may print more
and purchase both more ink cartridges and printing paper.
2.1.6.3. Unrelated Products
Demand for a particular product may be affected by prices of other products
that are not substitute or complementary products. For example, a substantial
increase in oil prices often causes demand for unrelated products, including
pizzas, to decrease. The reason is because many people use cars to go to
work, school, or shopping and will have to pay more to put fuel in their cars
if the price of oil rises. As a result, they will have less money to buy other
products.
Psychology is often involved in a consumer’s decision-making process,
which makes it difficult to quantify exactly the effect of a change in other
products’ prices on the demand for a particular product. For example,
because people often buy oil-related products, they closely watch price
changes in oil and may overall consume less if oil prices increase. Yet, an
increase in the price of cars—which is a much more expensive product that
will have a greater effect on the household budget—may not lead to a
reduction in demand. The reason is because consumers tend to pay less
attention to price changes of products that are purchased infrequently.
Evaluating these types of psychological factors helps investors understand
whether, for instance, a pizza company may see a decrease in sales when oil
prices increase.
2.2. Supply
The supply curve represents the quantity supplied at different prices. The
law of supply states that when the price of a product increases, the quantity
supplied increases too. Thus, the supply curve is upward sloping from left to
right. The law of supply and the supply curve are illustrated in Exhibit 4. S
and S1 are supply curves.
Exhibit 4.
Supply Curve
The principles that apply to the demand curve also apply to the supply curve.
A change in the price of a product leads to a move along the supply curve,
not a shift in the supply curve.
Factors other than the product’s price that may lead to a shift in the supply
curve include production costs, technology, and taxes. Higher production
costs and taxes will result in reduced supply at each price and shift the
supply curve to the left, meaning that the supplier is willing to offer the same
quantity at higher prices or a smaller quantity at the same prices. This is
shown in the move from S to S1 in Exhibit 4.
Lower production costs, which may be the result of improvements in
technology, lower costs of inputs such as raw materials or labour, or lower
taxes, will result in increased supply for a given price. The supply curve will
shift to the right.
Changes in the supply curve are of considerable interest to investors and
analysts. A shift in the supply curve caused by higher or lower costs can
affect the profits generated by a company. For example, a car manufacturer
that faces higher steel prices may be willing to produce fewer cars at a given
price level, which changes the supply curve. Whether a company can pass on
any cost increases to customers helps investors assess the company’s future
profits.
A company that cannot cover its costs and earn a profit at prices along
certain parts of the supply curve will not supply products at those prices.
Companies may view factors affecting the supply curve as temporary and be
willing to continue operations despite short-term losses. But if the mismatch
between revenues and costs persists for longer periods, it can cause
companies to file for bankruptcy or shut down. Many airlines have
encountered this problem when their production costs, such as the cost of
fuel, increased. Their ability to increase fares was limited because customers
may have chosen an alternative airline or mode of travel. Equally, they could
not easily add or reduce the number of seats on their planes. So, some
airlines accumulated large losses and were forced to declare bankruptcy.
2.3. Market Equilibrium
To determine how prices are set in a world of supply and demand, it is
important to understand the concept of economic equilibrium. Market
equilibrium occurs at the price where quantity demanded equals quantity
supplied. At the equilibrium price, demand and supply in the market are
balanced, and neither buyers nor sellers have an incentive to try to change the
price, all other factors remaining unchanged.
As illustrated in Exhibit 5, the interaction between the demand and supply
curves determines the equilibrium price of a product. The equilibrium
price (EP) is the price at which the quantity demanded (D) equals the
quantity supplied (S). In other words, it is the point at which the demand and
supply curves intersect.
Exhibit 5.
Interaction of Demand and Supply Curves
At any price above the equilibrium price (EP) in Exhibit 5, suppliers are
willing to produce more of a product than consumers are willing to buy. A
price that is higher than the equilibrium price may result in increasing
inventories, which provides an incentive for suppliers to cut prices to reduce
their inventories. Prices will thus move back toward the equilibrium price.
Conversely, if the price is below the equilibrium price, consumers will
demand more of a product than suppliers find it profitable to produce. To
meet consumers’ higher demand, suppliers’ inventories may be depleted.
Once inventories are depleted, suppliers have an incentive to raise prices
and increase production. Prices will thus move back toward the equilibrium
price. The only price at which suppliers and consumers are both content,
with no imbalance between the quantity produced and the quantity demanded,
is at the equilibrium price.
What factors—other than the price of the product—affect the market
equilibrium price? If demand increases because of an increase in consumers’
income, and the supply curve stays the same, the result is an increase in the
equilibrium price and quantity, which is shown in Exhibit 6. A shift in the
demand curve to the right, from D to D1, could also be the result of an
increase in the price of a close substitute, a decrease in the price of a close
complement, or an advertising campaign that successfully changes
consumers’ tastes and preferences.
Exhibit 6. Shift in the Demand Curve to the Right with the
Supply Curve Unchanged
The supply curve can shift while the demand curve remains unchanged. An
increase in taxes could lead to a shift in the supply curve to the left, as could
any increase in production costs, such as wages or energy costs. A decrease
in these costs would have the opposite effect and shift the supply curve to the
right, leading to increased production at each price. For example, if the
government decreases the taxes companies have to pay for their workers’
salaries, companies may hire more people and increase production as a
result. Companies’ costs will be lower, so they will be willing to produce
more of a given product at the current price. This strategy was used in India
and Ireland after the global financial crisis that started in 2008. The Indian
and Irish governments cut taxes in an effort to stimulate their economies,
resulting in companies increasing output (quantity produced) and hiring
workers because the costs of doing so were lower.
So, looking at the supply and demand curves is useful when analysing factors
driving company, industry, and consumer behaviour.
3. ELASTICITIES OF DEMAND
Although supply and demand curves are essential to an understanding of
price and quantity changes, they are less useful in assessing the magnitude of
these changes. To gauge the change in quantities demanded by consumers and
supplied by producers, we use elasticity measures.
In economics, elasticity refers to how the quantity demanded or supplied
changes in response to small changes in a related factor, such as price,
income, or the price of a substitute or complementary product. There are
many important uses for elasticity for companies, investors, and the overall
economy. For example, if the demand for certain products rises substantially
as incomes increase, investors and analysts may be able to identify the
companies and industries that will grow the quickest as the economy grows.
Elasticity of demand thus has relevance to anticipate which companies and
industries will be successful in the future.
3.1. Price Elasticity of Demand
Price elasticity of demand allows for the comparison of the responsiveness
of quantity demanded with changes in prices. Two widely used measures are
own price elasticity of demand and cross-price elasticity of demand.
3.1.1. Own Price Elasticity of Demand
The own price elasticity of demand is the percentage change in the
quantity demanded of a product as a result of the percentage price change in
that product. It is calculated as the percentage change in the quantity
demanded of a product divided by the percentage change in the price of that
product. Because a proportional change in one variable is divided by a
proportional change in another, the effect is to remove the unit of measure. So
price elasticity is unit free, as are other elasticity concepts.
Examples of own price elasticity of demand are provided in Example 2.
EXAMPLE 2.
OWN PRICE ELASTICITY OF DEMAND
The own price elasticity of demand for a product is
.
If a 10% decrease in the price of cars leads to a 15% increase in the
quantity demanded, then the own price elasticity of demand for cars is
If a 10% increase in the price of hotel rooms leads to a 20% decrease in
the quantity demanded, then the own price elasticity of demand for hotel
rooms is
When looking at elasticities, two elements matter: the sign and the magnitude.
The sign of price elasticity of demand provides information about how the
quantity demanded changes relative to a change in price. As illustrated in
Example 2, own price elasticity of demand is usually negative, reflecting the
law of demand discussed in Section 2.1.1—that is, the inverse relationship
between price and quantity demanded.
The magnitude of price elasticity of demand provides information about the
strength of the relationship between quantity demanded and changes in price.
When price elasticity is less than –1, such as in the car and hotel room
examples, the price elasticity of demand is high, or elastic. This means that a
small change in price produces a disproportionally larger change in demand.
Conversely, if price elasticity is between –1 and 0, the price elasticity is
low, or inelastic. Changes in prices for inelastic products are accompanied
by less than proportional changes in the quantity demanded, which means
demand is not very price sensitive. If the price elasticity of demand is exactly
–1, it is said that demand is unit elastic. In this case, a percentage change in
price is accompanied by a similar, but opposite, percentage change in the
quantity demanded.
Products for which demand increases as price increases have positive own
price elasticities. This result usually indicates that the product is a luxury
product. For luxury products, such as expensive cars, watches, and
jewellery, an increase in price may lead to an increase in quantity demanded.
Exhibit 7 summarises what the sign and magnitude of own price elasticity
mean.
Exhibit 7.
Sign and Magnitude of Own Price Elasticity
Sign and
Magnitude
Description
Less than –
1
Negatively, highly elastic: For a given percentage
increase in price, the quantity demanded will
decrease by a greater percentage than the increase
in price.
–1
Negatively unit elastic: For a given percentage
increase in price, the quantity demanded will
decrease by the same percentage.
Greater
than –1 to
0
Inelastic: For a given percentage increase in price,
the quantity demanded will decrease by a lesser
percentage than the increase in price.
Greater
than 0 but
less than 1
Inelastic: For a given percentage increase in price,
the quantity demanded will increase by a lesser
percentage than the increase in price.
+1
Positively unit elastic: For a given percentage
increase in price, the quantity demanded will
increase by the same percentage.
Greater
than +1
Positively, highly elastic: For a given percentage
increase in price, the quantity demanded will
increase by a greater percentage than the increase
in price.
The sign and magnitude of the own price elasticity helps a company set its
pricing strategy. In setting prices, a company needs to know whether a small
percentage increase in price will lead to a decrease in sales and if it does,
whether it is a large or small percentage decrease in sales. Cutting the price
of a product whose own price elasticity is less than –1 tends to lead to an
increase in total revenue. Total revenue is usually measured as price times
quantity of products sold. So, when elasticity is highly negative, the decrease
in price is more than offset by a greater increase in quantity. By contrast,
cutting the price of a product with inelastic demand leads to a decrease in
total revenue because the percentage increase in quantity is less than the
percentage decrease in price.
Uniform, non-differentiated products, such as fuel or flour, are typically
products with highly negative own price elasticities of demand. Companies
with many competitors selling similar products may find that increasing
prices leads to a reduction in revenue.
Perfectly inelastic demand indicates that quantity demanded will not change
at all, even in the face of large price increases or decreases. Perfectly
inelastic demand may occur with products that have no substitutes and are
necessities, such as drugs under patent. If the drug is beneficial and under
patent protection, the manufacturer should be able to charge a higher price
without losing sales. Once the patent expires and cheaper generic drugs
become available, the manufacturer may have to lower its price to maintain
sales.
Another example of a price inelastic product is one that has a well-defined
identity, such as the Apple iPad. The reason is because, in the mind of many
consumers, other tablets do not compare with the iPad; there are no
perceived substitute products. As a result, the quantity sold may be
insensitive to price increases and an increase in price of the iPad may lead to
higher revenues for Apple.
3.1.2. Cross-Price Elasticity of Demand
Own price elasticity of demand shows the change in the quantity demanded
of a product as a result of a price changes in that product. But investors and
analysts are also interested in the change in the quantity demanded of a
product in response to a change in the price of another product. This is
known as cross-price elasticity of demand. It is the percentage change
in the quantity demanded of a product in response to a percentage change in
the price of another product.
Examples of cross-price elasticity of demand are provided in Example 3.
EXAMPLE 3.
COMPLEMENTARY PRODUCTS
The cross-price elasticity of demand for a product is
.
If a 5% increase in the price of coffee leads to a 7% decrease in the
quantity demanded of cream, then the cross-price elasticity of demand is
If a 5% increase in the price of coffee leads to a 7% increase in the
quantity demanded of tea, then the cross-price elasticity of demand is
A negative cross-price elasticity of demand, as in the case of coffee and
cream, indicates complementary products. For complementary products, an
increase in the price of one product is usually accompanied by a reduction in
the quantity demanded of the other product. Conversely, a positive crossprice elasticity of demand characterises substitute products in many, but not
all, cases; it depends on how close of a substitute one product is for the other
product. For example, coffee and tea are substitutes in the eyes of some
people, but not all. So, there will be some cross-price elasticity between
coffee and tea, but it might not be represented by a high number. Coke and
Pepsi are considered closer substitutes and have a larger cross-price
elasticity of demand. As discussed in Section 2.1.6.1, a decrease in the price
of Coke may be accompanied by a reduction in the quantity demanded of
Pepsi.
3.1.3. Interpreting Price Elasticities of Demand
Own and cross-price elasticities of demand are important in understanding
the demand for products. If a product is easy to substitute because similar
products exist, then the own price elasticity will be large and negative—that
is, demand is elastic. If a product has no immediate substitutes, such as a new
drug, or if use of the product is deeply entrenched by habit, such as tobacco,
demand is inelastic.
Elasticity of demand helps market participants assess the effects of price
changes. Investors and analysts use elasticity of demand to assess a
company’s potential as an investment. As discussed in Section 3.1.1, whether
a company will see its sales increase or decrease as a result of a change in
prices, and by how much, helps investors and analysts understand what
drives a company’s profit, which, in turn, affects its stock valuation.
Consider Coke and Pepsi again. Although each has its own brand loyalty
among customers who are committed to one or the other, there are plenty of
substitutes, including tap water. Some people are indifferent about the two
brands and consider neither brand to be a necessity. If one of the two
companies seeks to take market share from the other by cutting prices, what
might happen? If Coca-Cola lowers its price, it might increase the number of
units sold at the expense of Pepsi’s sales, as discussed earlier. The lower
price may also encourage some people to switch from tap water to Coke,
providing even more new customers. But, assuming that Coke’s production
costs are still the same, the profit Coca-Cola makes on each unit sold is less.
If Coca-Cola cuts its price too much, it may even incur a loss on each unit
sold. Even though Coca-Cola might gain market share, it becomes a less
attractive investment if it is a less profitable company. Thus, elasticities of
demand are often a prime consideration for investors and analysts when they
consider the pricing power of a company or industry and the potential effect
on a company’s bottom line (profit) if it tries to gain market share by cutting
prices.
3.2. Income Elasticity of Demand
Income elasticity of demand is the percentage change in the quantity
demanded of a product divided by the corresponding percentage change in
income. It measures the effect of changes in income on quantity demanded of
a product when other factors, such as the price of the product and the prices
of related products, remain the same.
Most products have positive income elasticities, meaning that as consumers’
income increases, they purchase a greater quantity of the product. As
described in Section 2.1.3, products with positive income elasticities are
called normal goods. In contrast, if consumers purchase less of a product as
their income increases, the income elasticity is negative and the products are
called inferior goods. Consumers demand fewer inferior goods as their
income increases and they substitute more expensive and desirable products,
such as meat instead of potatoes or rice.
Income elasticity of demand also enables investors to distinguish between
luxuries and necessities. A luxury product usually has an income elasticity of
greater than one. A necessity product may have an income elasticity of
approximately zero. Demand will not change with a change in income.
Luxury items may include foreign travel and a golf club membership. What is
perceived as a luxury item may change over time because income elasticities
will change as a society’s income improves. So, although a smartphone may
be a luxury product at a certain income level, it may become a necessity
product at another.
Exhibit 8 shows graphically the distinction between inferior, necessity,
normal, and luxury products based on their income elasticity of demand.
Exhibit 8.
Demand
Type of Product Based on Income Elasticity of
4. PROFIT AND COSTS OF
PRODUCTION
We have focused on supply and demand curves and how they influence
equilibrium quantity and price. We have also looked at quantifying demand
changes by using the elasticity concept. Now, we shift our attention to a
company’s production costs and how these costs influence the company’s
profitability. This is important because investors and analysts need to assess
a company’s potential to make profits.
4.1. Accounting Profit vs. Economic Profit
Although accountants and economists agree that profit is the difference
between the revenues generated from selling products and services and the
cost of producing them, they disagree about how to measure profit, primarily
because they do not necessarily consider the same types of costs.
The difference between accounting profit and economic profit is best
illustrated by an example. Consider the owner of a restaurant in France. For
a particular period, the restaurant has revenues of 5,000,000 euros. The costs
of operating the restaurant, which include renting the premises, paying the
salaries of the staff, and buying the raw food, is 3,000,000 euros. The
accounting profit considers only the explicit costs and is, in this example,
2,000,000 euros (5,000,000 euros –3,000,000 euros).
Economists, however, take a broader view of costs and also deduct implicit
costs from revenues and explicit costs to arrive at economic profit. The
owner of the restaurant risks her capital by operating the restaurant. That is,
if the restaurant fails, she loses all her money. She could have used her skills
and risked her capital differently. Assume that the restaurant’s owner could
find employment, invest her capital and earn 1,600,000 euros from receiving
a salary and from investing her capital elsewhere. The amount she would
receive from these activities represents what economists call an opportunity
cost. An opportunity cost is the value forgone by choosing a particular
course of action relative to the best alternative that is not chosen. Because the
owner forgoes 1,600,000 euros by operating the restaurant, the restaurant’s
accounting profit should be at least equal to this. Otherwise, operating the
restaurant is an inefficient allocation of its owner’s resources.
In this example, the economic profit from operating the restaurant is 400,000
euros—that is, the accounting profit of 2,000,000 euros minus the opportunity
cost of 1,600,000 euros.
In conclusion, to calculate accounting profit, only explicit costs are
considered. To calculate economic profit, both explicit costs and the implicit
opportunity costs are considered.
4.2. Fixed Costs vs. Variable Costs
Companies combine labour, capital equipment, raw materials, and
managerial skills to produce products and services. Costs that do not
fluctuate with the level of output of the company are called fixed costs or
overhead, as shown in Exhibit 9A.
Exhibit 9A.
Fixed Costs
Fixed costs include costs associated with buildings and machinery,
insurance, salaries of full-time employees, and interest on loans. In contrast,
costs that fluctuate with the level of output of the company are called
variable costs, as illustrated in Exhibit 9B.
Exhibit 9B.
Total Costs
For example, raw materials tend to be a variable cost because the more units
the company produces, the more raw materials it needs. The sum of fixed
costs and variable costs gives total costs, illustrated by the green line in
Exhibits 9B and 9C.
Exhibit 9C.
Revenue Costs
The blue line in Exhibit 9C shows the company’s revenues. If the revenues
are higher than the total costs—the right side of the graph—the company is
making a profit. By contrast, if the revenues are lower than total costs—the
left side of the graph—the company is suffering a loss. The point at which the
revenue and total costs lines intersect is called the breakeven point. It
reflects the number of units produced and sold at which the company’s profit
is zero—that is, revenues exactly cover total costs.
In the long run, all factors of production can be changed and some costs that
are regarded as fixed become variable because, for instance, a company can
relocate its facilities or purchase new equipment. Some costs, such as
advertising, may be fixed but are also discretionary, meaning that the
company can adjust spending on this.
When production first starts, fixed costs related to production will be
incurred. As production increases, the average fixed costs or fixed costs per
unit of output will decrease because the fixed costs are spread over more
units. For example, the same building is used to produce more units of output.
Average variable costs or variable costs per unit of output may also decrease
a little but are generally fairly constant. Thus, average total costs or total
costs per unit of output, which are the sum of both average fixed costs and
average variable costs, should decrease as output expands.
The decrease in total costs per unit will continue until one or more factors of
production reaches full capacity or breaks down and additional resources
must be added. For example, machinery being used continuously, allowing no
time for servicing, is likely to break down. Breakdowns result in reduced
output, expensive repairs, and increased overtime as workers shift
production to functioning machines. When this happens, additional fixed
costs may be incurred, such as the purchase of a new machine. So, total costs
per unit decrease until the point of full capacity and then increase as new
fixed costs are incurred.
Economies of scale are cost savings arising from a significant increase in
output without a comparable rise in fixed costs. These cost savings lead to a
reduction in total costs per unit as a result of increased production.
Economies of scale can be obtained if, for example, staff, buildings and
machinery are unchanged but output increases, which results in lower fixed
costs per unit and lower total costs per unit.
But although adding variable inputs of one factor, such as labour, to fixed
inputs of production, such as machinery, increases total output, the gain in
output will increase at a decreasing rate even if the fixed inputs of production
remain unchanged. This economic principle is known as the law of
diminishing returns and is illustrated in Exhibit 10. For example,
suppose a factory has a fixed number of machines and hires additional
workers to operate them and make more products. Total output may rise quite
rapidly at first—the first area of increasing marginal returns. But the rate at
which total output rises will eventually decline as the workers have to share
the machines—the second area of diminishing marginal returns. Hiring more
workers means that they will have to stand in line waiting for their turn at
operating the machines. Hiring still more workers means that they may get in
each other’s way, potentially making the contribution of the additional
workers negative—the area of negative marginal return. According to the
law of diminishing returns, adding ever more variable inputs, such as
workers, is self-defeating.
Exhibit 10.
Law of Diminishing Returns
4.3. Effect of Fixed Costs on Profitability
The relative level of fixed and variable costs has a significant effect on
profitability. Imagine the investment needed to construct a steel mill (a
factory or plant that produces steel). If production levels are very low, the
fixed costs are massive relative to the revenues, and the steel mill will make
a low profit or even suffer a loss. As production increases, variable costs
will increase as a result of using additional inputs to the steelmaking process,
such as purchasing raw materials and using additional electricity. But as
discussed before, the total costs per unit of steel produced will decrease
because average fixed costs will fall. The steel mill will be increasingly
profitable as output rises and its fixed costs are spread over more units.
The term operating leverage (or operational gearing) refers to the extent
to which fixed costs are used in production. Companies with high fixed costs
relative to variable costs, such as the steel mill, have high operating
leverage. For these companies, higher output leads to lower total costs per
unit until the full capacity is reached or breakdowns happen, at which point
costs increase.
Companies and industries with high fixed costs thus have greater potential
for increased profitability by increasing output. Examples of high-fixed-cost
projects include the construction of a major gold or coal mine or the
construction of a large-scale shipbuilding facility. Companies may add
capacity by incurring additional fixed costs. For example, an airline can buy
an additional aircraft and landing rights, or a retailer may open a new store.
In these cases, economies of scale occur as fixed costs are spread over more
passengers or retail customers.
As total costs per unit of a product decrease, profitability should improve,
assuming that the appropriate price has been established. The cost to the
company of producing an incremental or additional unit is known as the
marginal cost. The amount of money a company receives for that
additional unit is known as its marginal revenue. The general rule is that
the marginal cost can be increased up to the point that it equals the marginal
revenue. Producing to the point at which marginal revenue equals marginal
cost will, in theory, maximise profit.
5. PRICING
So far, we have discussed key factors that affect the price at which a product
can be sold, such as the product’s characteristics, own price and cross-price
elasticities of demand, income elasticity of demand, cost, supply, and the
degree of competition. We will discuss competition and how it affects
pricing decisions more thoroughly in Section 6.
If a product has no unique characteristics, substitute products can be easily
found. Competitors may face price cuts by their rivals because substitute
products compete mainly on price. Consider again the example of Coke and
Pepsi. It is unlikely that the companies will be able to charge much more than
it costs them to produce their products, because the competition between
them forces prices to the lowest possible point at which profits can be made
in the medium to long term.
However, if a product has a unique identity, it is less price sensitive, which
gives its producer the ability to charge higher prices and obtain higher
profits. For example, one bottle of water may be very similar to another in
terms of taste and chemical composition, but experience indicates that
consumers perceive that there is a difference. Some marketers of bottled
water have achieved substantial product differentiation and are able to
charge a higher price for their water. Although most people think of pricing
as a product’s production cost plus a mark-up chosen by the producer, the
mark-up is in fact determined by the product’s uniqueness and
substitutability.
In addition, if demand for a product is greater than the amount supplied,
competing products will benefit. Suppliers of similar products will be able
to raise their prices and achieve a higher mark-up or profit.
Income levels and elasticity also influence the pricing of products. Producers
within an industry, such as mobile communications, may have more pricing
power as a group as disposable income increases. But which companies
benefit the most depends on the existence of close substitutes and consumer
perceptions. The perceived superiority of the Apple iPhone, for example,
may give Apple greater pricing power than companies that manufacture
similar phones that are regarded as inferior in quality.
Prices also increase when supply is limited. If the supply of oil is interrupted
by a war, for example, buyers frantically chase the limited supplies and bid
up prices. Fuel and heating oil prices will be affected because the underlying
cost of the product—the raw material oil—is more expensive. Oil is unique
in that consumers and companies cannot easily find substitutes in the short
term. In summary, an investor’s or analyst’s need to evaluate the uniqueness
and substitutability of a product in assessing its pricing power.
6. MARKET ENVIRONMENT
The market environment in which a company operates influences its pricing,
supply, and efficiency. It may be categorised according to the degree of
competition. At one extreme, where there is a high degree of competition, a
market is said to be perfectly competitive. At the other extreme, where there
is no competition, a market is said to be a monopoly. Most markets lie
between these two extremes.
6.1. Perfect Competition
A perfectly competitive market consists of buyers and sellers trading a
uniform product—for example, trading wheat or rice. No single buyer or
seller can affect the market price by buying or selling or by indicating their
willingness to buy or sell a certain quantity. Buyers in perfectly competitive
markets are said to be price takers. Equally, a seller cannot charge more than
the market price because buyers can obtain whatever quantity they demand at
the market price.
In a perfectly competitive market, marketing, research and development,
advertising, and sales promotions play little or no role in driving demand and
setting prices. Companies usually earn normal profits, which compensate the
owners of the companies for their opportunity cost. Although it is possible in
a perfectly competitive market for a company that creates a new product to
earn abnormal profits—that is, profits in excess of the opportunity cost—it
usually only lasts for a short time.
Barriers to entry are obstacles, such as licences, brand loyalty, or control
of natural resources, that prevent competitors from entering the market.
Barriers to entry in a perfectly competitive market are low to non-existent,
meaning that other companies can easily enter the market. The entry of other
companies causes an increase in the market supply and in the long run,
abnormal profits are eliminated and only normal profits are earned.
The advantages of a perfectly competitive market are that resources are more
likely to be allocated to their most efficient use and companies operate at
maximum efficiency.
6.2. Pure Monopoly
Consider an industry with a single company that produces a product for
which there are no close substitutes. There are significant barriers to entry
that prevent other companies from entering the industry. Such an industry is
called a pure monopoly. For example, Microsoft provides the majority of
operating systems for personal computers. Although it is not a pure
monopoly, Microsoft is close to being one. Utility companies, such as
electricity, water, and natural gas, tend to be natural monopolies.
Natural monopolies exist when competition is not possible for various
reasons. Consider, for instance, the large amount of capital that is needed to
set up a competing nuclear power plant. A potential competitor may not want
to or may not be able to enter the market because of the huge amount of
capital required.
Because such companies as utility companies provide essential services,
many monopolies are regulated and the government approves their prices,
sometimes called rates. Typically, the government allows the company to set
prices that will yield what is called a fair return. Examples of governmentregulated monopolies include power companies and companies that provide
national postal services.
A monopolistic company has an advantage in its ability to command higher
prices and generate relatively larger profits. But a potential benefit to
consumers is that the monopolistic company may conduct considerable
research and development in order to innovate and maintain its monopoly.
These innovations may benefit consumers. For example, a pharmaceutical
company that generates abnormal profits may try to develop as many unique
and useful drugs as it can to drive profit growth.
Often, the large scale of their operations also enables monopolistic
companies to exploit economies of scale that may lower costs to consumers.
However, compared with companies operating in a perfectly competitive
market, a monopolistic company is likely to charge higher prices and have a
lower total volume of products and services.
6.3. Monopolistic Competition
Monopolistic competition is distinct from a monopolistic company.
Monopolistic competition characterises a market where there are many
buyers and sellers who are able to differentiate their products to buyers.
Thus, products trade over a range of prices rather than at a single market
price. There are typically no major barriers to entry.
Each company may have a limited monopoly because of the differentiation of
its product. Examples of companies in this type of market include restaurants,
clothing shops, hotels, and consumer service businesses. For example, there
may be a number of clothing shops in a shopping centre, but there may be
only one that sells a particular fashion brand. That particular fashion brand
may compete with other fashion brands, but for people who desire only that
brand, only one shop will satisfy their demand. That shop is a monopoly
market for this customer. But customers who have no preference have a
choice between different merchandise sold at different price points, so all the
clothing shops in the shopping centre can compete for these customers.
6.4. Oligopoly
An oligopoly is a market dominated by a small number of large companies
because the barriers to entry are high. As a consequence, companies are able
to make abnormal profits for long periods. Oligopolies exist in the oil
industry, telecommunications industry, and in some countries, the banking
industry.
Because of the large size of each company in the market, one company’s
actions affect other companies significantly. A company that cuts prices will
need to consider the possible reactions of the other companies in the industry.
Given this degree of interdependence, there is a tendency for collusion in
markets characterised as oligopolies. Collusion in this setting is often an
agreement between competitors to try to raise prices. This practice is usually
illegal or prohibited by regulators because competition is a necessary
ingredient for functioning capitalism; unfair advantages caused by collusion
make markets less efficient and are detrimental to consumers, who are forced
to pay prices that may be excessive. However, laws and regulations cannot
prevent occasional cases of competitors colluding by limiting production or
setting high prices.
A cartel is a special case of oligopoly in which a group jointly controls the
supply and pricing of products or services produced by the group. An
example of a cartel is the Organization of the Petroleum Exporting Countries
(OPEC), which sets the production and pricing of oil.
SUMMARY
Every time you buy or sell a product, or try to assess the value of a product
or service, you are effectively applying microeconomics. You may directly
use microeconomics in your everyday work. Even if you do not, it is very
likely to be used by others in your workplace to make business and
investment decisions. Microeconomics is an important concept in investing,
so knowing about it will help you better understand the industry in which you
work.
Some important points to remember about microeconomics include the
following:
Economics is the study of production, distribution, and consumption.
Microeconomics is the study of how individuals and companies make
decisions to allocate scarce resources.
Macroeconomics is the study of an economy as a whole.
Demand is the desire for a product or service coupled with the ability
and willingness to pay a given price for it.
The law of demand states that the quantity demanded and price of a
product are usually inversely related.
The demand curve shows the quantity of a product demanded at
different prices. It is usually downward sloping from the left to the right,
with quantity demanded on the horizontal axis and price of the product
on the vertical axis.
When the only thing that changes is the price, the change in the price of a
product leads to a move along the demand curve, not a shift in the
demand curve.
Factors that may cause the demand curve to shift include consumers’
income, the expected future price of the product, changes in general
tastes and preferences, and the prices of other products. If the change in
a factor makes a product more attractive, the demand curve will shift to
the right, meaning that people will demand more of the product at a
given price. Alternatively, if the change in a factor makes the product
less attractive, the demand curve will shift to the left, meaning that
people will demand less of the product at a given price.
According to the income effect, if consumers have more purchasing
power, the quantity of products purchased may increase. Increases in
income lead to an increase in demand for normal products and a
decrease in demand for inferior products.
If consumers expect that the price of a product will increase in the
future, the current quantity demanded may increase as consumers
accumulate the product to avoid paying a higher price in the future.
If consumers’ tastes and preferences change and they stop liking the
product as much, the quantity demanded at each price will decrease.
A substitute product is a product that could generally take the place of
another product. According to the substitution effect, consumers
substitute relatively cheaper products for relatively more expensive
ones.
Complementary products are products that are frequently consumed
together. When the price of a product decreases, it may lead to an
increase in demand for the product and its complementary products.
The supply curve represents the quantity supplied at different prices.
The law of supply states that when the price of a product increases, the
quantity supplied increases too. Thus, the supply curve is upward
sloping from left to right.
Market equilibrium occurs when, at a particular price, no buyer or
seller has any incentive or desire to change the quantity demanded or
supplied, all other factors remaining unchanged.
The price at which the quantity demanded equals the quantity supplied
in a market is known as the equilibrium price. This price is the one at
which the demand and supply curves intersect and it is the only price at
which suppliers and consumers are both content, with no desire to
change the quantity produced or bought.
Elasticity refers to how the quantity demanded or supplied changes in
response to small changes in a related factor, such as price, income, or
the price of a substitute or complementary product. If a product’s
quantity demanded or supplied is responsive to changes in a factor, its
demand or supply is said to be elastic. Demand or supply is said to be
inelastic if a product’s quantity demanded or supplied does not change
significantly in response to a change in the factor.
Own price elasticity of demand is the percentage change in the quantity
demanded of a product as a result of a percentage price change in that
product. The sign and magnitude of the own price elasticity helps a
company set its pricing strategy.
Cross-price elasticity of demand is the percentage change in the quantity
demanded of a product in response to a percentage price change in the
price of another product. A negative cross-price elasticity of demand
indicates complementary products, whereas a positive cross-price
elasticity of demand characterises substitute products in many but not all
cases.
Income elasticity of demand measures the effect of changes in income on
quantity demanded of a product when other factors, such as the price of
the product and the prices of related products, remain the same.
Products with positive income elasticities are called normal products,
whereas products with negative income elasticities are called inferior
products. Income elasticity of demand also enables investors to
distinguish between luxuries, which have income elasticity greater than
one, and necessities, which have an income elasticity of approximately
zero.
Profit is the difference between the revenue generated from selling
products and services and the cost of producing them. Accounting profit
considers only the explicit costs, whereas economic profit takes into
account both explicit costs and the implicit opportunity costs.
Opportunity costs capture the value forgone by choosing a particular
course of action relative to the best alternative that is not chosen.
Fixed costs do not fluctuate with the level of output, whereas variable
costs do. As production increases, average total costs, which include
both average fixed costs and average variable costs, decrease because
the fixed costs are spread over more units. Increased production allows
producers to benefit from economies of scale, the cost savings arising
from a significant increase in output without a simultaneous increase in
fixed costs.
Companies with high fixed costs relative to variable costs have high
operating leverage and have greater potential for increased profitability
by increasing output.
Producing to the point at which marginal revenue, the amount of money
a company receives for an additional unit, equals marginal cost, the cost
to the company of producing the additional unit, will in theory maximise
profit.
Key factors that affect the price at which a product can be sold are its
characteristics, own price and cross-price elasticities of demand,
income elasticity of demand, cost, supply, and the degree of
competition.
The market environment in which a company operates influences its
pricing, supply, and efficiency. It may be categorised according to the
degree of competition. A perfectly competitive market is one extreme, a
monopoly is the other extreme, and most markets lie between these two
extremes.
In a perfectly competitive market, buyers and sellers trade a uniform
non-differentiated product, and no single buyer or seller can affect the
market price. Barriers to entry are low, the degree of competition is
high, and companies usually earn normal profits.
In a pure monopoly, a single company produces a product for which
there are no close substitutes. There are significant barriers to entry that
prevent other companies from entering the industry. A monopolistic
company is likely to charge higher prices, have a lower total volume of
products and services, and may earn higher profits.
In monopolistic competition, there are many buyers and sellers who are
able to differentiate their products to buyers. Each company may have a
limited monopoly because of the differentiation of its products. Thus,
products trade over a range of prices rather than a single market price.
There are typically no major barriers to entry.
An oligopoly is a market dominated by a small number of large
companies because the barriers to entry are high. As a consequence,
companies are able to make abnormal profits for long periods. A cartel
is a special case of oligopoly.
CHAPTER REVIEW QUESTIONS
© 2014 CFA Institute. All rights reserved.
1. Economics is the study of:
A. an economy as a whole.
B. choices in the presence of limited or scarce resources.
C. how individuals and companies make decisions to allocate limited
resources.
2. If the price of chocolate increases, the quantity of chocolate demanded
will most likely:
A. increase.
B. decrease.
C. remain unchanged.
3. Which of the following would most likely cause a steel manufacturer to
increase the quantity supplied? An increase in:
A. input costs.
B. corporate taxes.
C. the price of steel.
4. If consumers demand more of a good than sellers find profitable to
produce, then sellers’ inventories will tend to:
A. deplete.
B. pile up.
C. remain unchanged.
5. Holding all other factors constant, if the price of a product increases,
the demand for a substitute product is most likely to:
A. increase.
B. decrease.
C. remain unchanged.
6. Holding all other factors constant, if the demand for printers increases,
the demand for ink cartridges is most likely to:
A. increase.
B. decrease.
C. remain unchanged.
7. Market equilibrium is a state in the market when, at a particular price
and with all other factors remaining unchanged, no buyer or seller has
any incentive or desire to change the:
A. quality of a product that is demanded or supplied.
B. market for a product that is demanded or supplied.
C. quantity of a product that is demanded or supplied.
8. Which of the following statements best describes price inelasticity? A
small change in price produces a:
A. proportional change in demand.
B. less than proportional change in demand.
C. disproportionally larger change in demand.
9. If revenues decrease when the price of a good increases, the price
elasticity of this good is most likely:
A. elastic.
B. inelastic.
C. unit elastic.
10. For a particular period, a golf course generated revenues of
$10,000,000 and incurred costs of $5,000,000. In addition, the implicit
costs were $1,000,000. The accounting profit is most likely:
A. lower than the economic profit.
B. the same as the economic profit.
C. higher than the economic profit.
11. Which of the following costs is most likely a variable cost for a
manufacturing plant?
A. Energy costs
B. Interest expense
C. Insurance expense
12. Which of the following statements best describes the effect of lower
production on a manufacturing plant’s costs per unit? Average:
A. total cost will decrease.
B. fixed cost will decrease.
C. variable cost will remain fairly constant.
13. Which of the following factors is most likely to affect the pricing of a
service?
A. Production costs
B. Average age of the workforce
C. Availability of complementary products
14. An industry dominated by a small number of large companies is most
likely a(n):
A. monopoly.
B. oligopoly.
C. perfect competition.
ANSWERS
1. B is correct. Economics is the study of choices in the presence of
limited or scarce resources (labour, real assets, financial capital, etc.).
Macroeconomics is the study of an economy as a whole.
Microeconomics is the study of how individuals and companies make
decisions to allocate limited resources.
2. B is correct. The law of demand states that the quantity demanded and
the price of a product are inversely related. If the price of chocolate
increases, then the quantity of chocolate demanded should decrease. A
and C are incorrect because the law of demand suggests that as the price
of a product increases, the quantity demanded will decrease, not
increase or remain unchanged.
3. C is correct. The law of supply states that when prices increase, the
quantity supplied by companies will increase. Movements along the
supply curve occur when only the price changes. A is incorrect because
an increase in input costs would cause the supply curve to shift to the
left and the manufacturer to offer the same quantities of steel at higher
prices or smaller quantities at the same prices. B is incorrect because
an increase in corporate taxes would cause the supply curve to shift to
the left and the manufacturer to offer the same quantities of steel at
higher prices or smaller quantities at the same prices.
4. A is correct. When the price of a good is below the equilibrium price,
consumers will demand more of the good than producers will find
profitable to sell and inventories will be depleted. B is incorrect
because inventories pile up when companies are willing to supply more
of a good than consumers are willing to buy. C is incorrect because
sellers’ inventories are affected by consumer demand and will not
remain unchanged.
5. A is correct. When the price of a product increases, the demand for
substitute products also increases. B is incorrect because the demand
for a complementary product, not a substitute product, will decrease if
the price of the product increases. C is incorrect because the demand for
a substitute product will increase if the price of a product increases.
6. A is correct. Printers and ink cartridges are complementary products.
Thus, if the demand for printers increases, the demand for ink cartridges
increases as well. B is incorrect because the demand for ink cartridges
would decrease if the demand for printers increased if printers and ink
cartridges were substitute products, not complementary products. C is
incorrect because printers and ink cartridges are complementary
products. Thus, an increase in demand for printers will increase the
demand for ink cartridges.
7. C is correct. Market equilibrium is a state in the market when at a
particular price, no buyer or seller has any incentive or desire to change
the quantity of a product that is demanded or supplied, all other factors
remaining unchanged. A is incorrect because market equilibrium is a
price at which there is no excess supply or demand and it does not
consider the quality of the product. B is incorrect because market
equilibrium relates to the quantity of a product that is demanded or
supplied at a particular price, not the market for the product.
8. B is correct. If price elasticity is low or inelastic, changes in price are
accompanied by less than proportional changes in the quantity
demanded. This means demand is not very price sensitive. A is
incorrect because a small change in prices would produce a
proportional change in demand for a good exhibiting unit elasticity. C is
incorrect because a small change in price would produce a
disproportionally larger change in demand for a good exhibiting high
price elasticity.
9. A is correct. For elastic goods, an increase in price will lead to a
greater percentage decrease in quantity and a decrease in revenues. B is
incorrect because for inelastic goods, a decrease in price will lead to a
decrease in revenues. C is incorrect because price changes do not affect
total revenue for goods that are unit elastic.
10. C is correct. Accounting profit considers only explicit costs and would
be derived from the difference between revenues and direct costs
($10,000,000 − $5,000,000 = $5,000,000). A is incorrect because
economic profit deducts implicit costs from accounting profit
($10,000,000 − $5,000,000 − $1,000,000 = $4,000,000). B is incorrect
because accounting profit and economic profit are not the same when
there are implicit costs.
11. A is correct. Energy costs are variable costs that are sensitive to the
level of production. B is incorrect because interest expense is often a
fixed cost and does not vary with the level of production. C is incorrect
because insurance expense is often a fixed cost and does not vary with
the level of production.
12. C is correct. Average variable cost or variable cost per unit of output is
generally constant as production changes. A is incorrect because
average total cost should increase as output decreases. B is incorrect
because average fixed cost will increase. The fixed costs are being
spread over fewer units of production.
13. A is correct. Production costs are considered when pricing the service.
B is incorrect because the average age of the workforce does not affect
pricing. C is incorrect because the availability of substitute products
will affect pricing, not the availability of complementary products.
14. B is correct. Oligopolies are dominated by a small number of large
companies because the barriers to entry are high. A is incorrect because
a monopoly is a market with a single company that produces a product
for which there are no close substitutes and with significant barriers to
entry. C is incorrect because in perfect competition there are many
buyers and sellers trading in a uniform commodity and there are no
major barriers to entry.
NOTES
1A term from Adam Smith’s 1776 book, An Inquiry into the Nature and Causes of the Wealth of
Nations, in which the invisible hand refers to the role of the markets in allocating scarce resources.
2For simplicity, we assume in this exhibit and the following discussion that the demand curve is based on
an individual’s demand. In reality, the demand curve reflects what economists call aggregate demand—
that is, the sum of all the individuals’ demands.
Chapter 5
Macroeconomics
by Michael J. Buckle, PhD, James Seaton, PhD, and
Stephen Thomas, PhD
© 2014 CFA Institute. All rights reserved.
LEARNING OUTCOMES
After completing this chapter, you should be able to do the following:
a. Describe why macroeconomic considerations are important to an
investment firm and how macroeconomic information may be used;
b. Define gross domestic product (GDP) and GDP per capita;
c. Identify basic components of GDP;
d. Describe economic growth and factors that affect it;
e. Describe phases of a business cycle and their characteristics;
f. Explain the global nature of business cycles;
g. Describe economic indicators and their uses and limitations;
h. Define inflation, deflation, stagflation, and hyperinflation, and describe
how inflation affects consumers, businesses, and investments;
i. Describe and compare monetary and fiscal policy;
j. Explain limitations of monetary policy and fiscal policy.
1. INTRODUCTION
Many news programmes and articles contain items about the economy. You
may hear that “the economy is booming”, “the economy is depressed”, or
“the economy is recovering”. The term economy is widely used but rarely
defined. Have you ever stopped to think about what it actually means?
Although it is often referred to as a single entity, in fact the economy
represents millions of purchasing and selling and lending and borrowing
decisions made by individuals, companies, and governments.
Macroeconomics is the study of the economy as a whole. Macroeconomics
considers the effects of such factors as inflation, economic growth,
unemployment, interest rates, and exchange rates on economic activity. The
effects of these factors on business, consumer, and government economic
decisions represent an intersection of micro- and macroeconomics.
Macroeconomic conditions affect the actions and behaviour of businesses,
consumers, and governments. Macroeconomic considerations also affect
decisions made by investment firms. Some investments, for instance, benefit
from slow economic growth and low inflation, whereas others do well
during periods of relatively strong economic growth with moderate inflation.
Investment professionals use macroeconomic data to forecast the earnings
potential of companies and to determine which asset classes may be more
attractive. An asset class is a broad grouping of similar types of
investments, such as shares, bonds, real estate, and commodities. More
details on these types of investments are provided in the Investment
Instruments module.
2. GROSS DOMESTIC PRODUCT AND
THE BUSINESS CYCLE
“GDP” is another term we hear frequently without necessarily pausing to
think about what it means. Gross domestic product—more commonly
known as GDP—is the total value of all final products and services
produced in a country over a period of time. It is an important concept in
macroeconomics. GDP may also be referred to as total output. Economists
may express it on a per person or per capita basis; GDP per capita is
equal to GDP divided by the population. This measure allows comparisons
of GDP between countries or within a country over time because it is
adjusted to reflect different population levels among countries or changes in
population levels within a country.
For countries with the highest total GDP, GDP is partly a function of their
populations. When GDP is adjusted for the size of population, smaller but
relatively wealthy countries rise to the top of the list. In other words,
although the United States is the world’s wealthiest country, the average
citizen of Monaco or Norway is relatively wealthier than the average citizen
of the United States.
GDP can be calculated in two ways:
By using an expenditure (spending) approach
By using an income approach
We can estimate GDP by summing either expenditures or incomes. Under the
income approach, the sum can be referred to as gross domestic income.
Gross domestic income should equal gross domestic product; after all, what
one economic entity spends is another economic entity’s income. This
equivalence relationship is a useful cross check when statisticians are
measuring economic activity because, in practice, GDP is hard to measure
and subject to error. The results of the two approaches can be compared to
ensure that the estimate of GDP provides a fair reflection of the economic
output of an economy.
Using the expenditures approach, GDP is estimated with the following
equation:
GDP = C + I + G + (X – M)
The equation shows that GDP is the sum of the following components:
consumer (or household) spending (C)
business spending (or gross investment) (I)
government spending (G)
exports (or foreign spending on domestic products and services) (X)
imports (or domestic spending on foreign products and services) (M)
The term (X – M) represents net exports. Exports result in spending by other
countries’ residents on domestically produced products and services,
whereas imports involve domestic residents spending money on foreignproduced products and services. So, exports are included as spending on
domestic output and are added to GDP, whereas imports are subtracted from
GDP. Household spending (or consumer spending) is often the largest
component of total spending and may represent up to 70% of GDP. Exhibit 1
shows the percentage shares of the GDP components for the United States
and Japan in 2010. You can see that for both countries, consumer spending
was the largest component. Japan’s net exports represented 1% of GDP
whereas imports exceeded exports for the United States and net exports
represented –3% of GDP.
Exhibit 1.
in 2010
GDP Components for the United States and Japan
Source: Based on data from www.bea.gov for the United States and www.stat.go.jp for
Japan.
GDP changes as the amount spent changes. Changes in the amount spent could
be the result of changes in either the quantity purchased or the prices of
products and services purchased. If a change in GDP is solely the result of
changes in prices with no accompanying increase in quantity of products and
services purchased, then the economic production of the country has not
changed. This result is equivalent to a company increasing its prices by 5%
and reporting a subsequent 5% increase in sales. In fact, the company’s
production has not increased, so looking at nominal (reported) sales would
not accurately reflect the change in output. Similarly, nominal GDP, which
reflects the current market value of products and services, unadjusted for
price changes, may over- or understate actual economic growth. Real GDP
is nominal GDP adjusted for changes in price levels. Changes in real GDP,
which reflect changes in actual physical output, are a better measure of
economic growth than changes in nominal GDP.
In the United States, when GDP is expressed in real terms, it may be referred
to as constant dollar GDP. Other countries use similar terminology to
differentiate between nominal and real data. Exhibit 2 shows the growth in
real GDP per capita in the United States from 1981 to 2010. Over the period,
GDP per capita, adjusted for changes in price level, generally exhibited a
steady increase. It appears that living standards, as measured by real GDP
per capita, rose over the time period.
Exhibit 2.
2010
Real GDP per Capita for the United States, 1981–
Source: Based on data from the World Bank.
2.1. Economic Growth
Economic growth is measured by the percentage change in real output
(usually real GDP) for a country. Real GDP measures the products and
services available to the citizens of that country. Real GDP per capita is a
useful measure to assess changes in wealth and living standards.
The “trend” rate of GDP growth is determined at its most simplistic level by
growth in the labour force plus productivity gains, subject to the availability
of capital to produce more products and services. That is, GDP growth is
determined by
growth of the labour force, which represents the increase of labour in
the market;
productivity gains, which represent growth in output per unit of
labour; and
availability of capital, which represents inputs other than labour
necessary for production.
The GDP growth rate depends to a large extent on productivity gains. For
example, if a worker assembles two cell phones in an hour instead of one,
productivity has doubled. If that increase is applied across the economy, the
economy will grow more rapidly, provided that there is a market for the
additional products and services produced.
Productivity is a function of the efficiency of a worker and also the
availability of technology. As technological progress occurs, capital will be
more efficiently used and productivity and output will increase. For example,
without technological change, a worker may be able to increase production
from one cell phone per hour to two cell phones per hour. That is, the worker
is more efficient. But with a technological advance, a worker may be able to
produce three cell phones per hour.
The increase in productivity is because of increased worker efficiency and
the availability of new technology. There are many real-world examples of
this relationship. Decades ago, for instance, typesetting allowed the mass
production of printed material and factories increased productivity in the
textile industry through the use of machines. More recently, computer
technology has revolutionised business operations. For example, some
aspects of automobile production are computerised, and the internet allows
consumers to perform tasks they formerly outsourced to service companies,
such as airline travel agents. But although technology has boosted economic
productivity, it is also disruptive in the sense that while new occupations
have been created, other occupations have been rendered irrelevant.
Productivity gains can result in a lower demand for labour and increased
unemployment unless the productivity gains are offset by increases in demand
for products and services.
We will now discuss the effects of growth in the labour force and
productivity gains on GDP. Developed countries typically have ageing
populations and low birth rates, so their potential labour force will grow
slowly or even decline. This means GDP will grow more slowly unless this
slowing labour force growth is offset by productivity gains. Exhibit 3 shows
the annual GDP growth rate for a sample of countries from 1971 to 2010.
The growth rate in the developed countries shown—Germany to Canada—
was in the range of 2.0%–3.0%. However, the growth rate in the emerging
countries of Brazil, India, and China, where productivity gains are relatively
large, was much higher. Over time, as economies grow and make the
transition from emerging to developed, the GDP growth rates are expected to
move toward the 2.0%–3.0% range.
Exhibit 3. Annual GDP Growth Rates at Market Prices
Based on Local Currency, 1971–2010
China
India
Brazil
United States
Canada
Japan
France
9.1%
5.4
4.0
2.9
2.9
2.6
2.3
United Kingdom
Germany
World
2.2
2.0
3.2
Source: Based on data from the World Bank.
Some developed countries, such as Japan, are experiencing a decline in
population. Such declines will require increases in productivity or a
technological revolution if GDP is to remain at the long-term trend rate.
Demographic change is another reason why GDP per capita may be a more
useful measure than GDP for evaluating the economic well-being of a
country’s citizens. If GDP grows at a faster rate than the population growth
rate or if GDP shrinks at a lower rate than the population shrinkage rate, it
will result in higher GDP per capita.
2.2. The Business (or Economic) Cycle
Analysts and economists spend a great deal of energy trying to predict real
GDP, which is affected by business cycles. Economy-wide fluctuations in
economic activity are called business cycles. Although we refer to the
fluctuations as cycles, they are neither smooth nor predictable. These cycles
typically last a number of years. Economic activity may fluctuate in the short
term though because of seasonal variations in output, but a true business
cycle is a fluctuation that affects a large segment of the economy over a
longer time period.
Phases of an economic cycle may include the following:
1. Expansion
2. Peak
3. Contraction
4. Trough
5. Recovery
There is no universal agreement on what the phases of business cycles are
and when they begin and end. For example, some economists view recovery
as the start of an expansion phase, whereas others view recovery as the end
of a trough phase. Exhibit 4 shows a stylised representation of a business
cycle. The level of national economic activity is measured by the GDP
growth rate.
Exhibit 4.
Representation of a Business Cycle
Aspects of the expansion, peak, contraction, trough, and recovery phases are
described in the following paragraphs.
Expansion.
During an economic expansion, production increases and inflation (a
general rise in prices for products and services) and interest rates both tend
to rise. A high rate of employment (a low rate of unemployment) means that
employees can demand higher wages, putting upward pressure on costs and
prices. Interest rates climb as more people and companies demand credit to
finance their spending or investments. When an economy is growing faster
than its resources might allow, inflation typically emerges and unemployment
tends to fall; the increased demand for both products and services and labour
can create inflationary pressures.
Peak.
At a peak, economic growth reaches a maximum level and begins to slow, or
contract. Each country has a central bank that serves as the banker for the
government and other banks. Central banks may implement policies to slow
the economy and control inflation. These policies are discussed in Section
4.1. Other factors contributing to the end of an expansion include a drop in
consumer or business confidence caused by events such as rising oil prices,
falling real estate prices, and/or declining equity markets. Shocks, such as
natural disasters, or geopolitical events, such as a war, can also contribute to
the end of an expansion.
Contraction.
During a contraction, the rate of economic growth slows. If economic
activity, as gauged by total real GDP or some other measure, declines
(negative growth), a recession may occur. In a contraction, inflation and
interest rates tend to fall because of market forces and central bank actions,
whereas unemployment tends to increase. In this scenario, central banks often
implement policies to try to stimulate economic growth. On some occasions,
federal governments may seek to stimulate the economy through direct
spending programmes to combat economic weakness. Government and
central bank policies are discussed in Section 4.
WHAT IS A RECESSION?
There are different definitions associated with the term “recession”. In
Europe, a recession is typically defined as two consecutive quarters of
negative growth. In the United States, the National Bureau of Economic
Research (NBER) defines a recession as a significant decline in
economic activity spread across the economy, lasting more than a few
months, normally visible in real GDP, real income, employment,
industrial production, and wholesale–retail sales.
Trough and recovery.
A trough marks the end of the contraction phase and the beginning of
recovery. In a trough, the rate of economic growth stabilises and there is no
further contraction. Eventually, companies need to replace obsolete
equipment and individuals need to purchase new household items, spurring
more spending. Lower interest rates may encourage more borrowing to
finance spending. Finally, the economic growth rate begins to improve and
the economy enters a recovery phase.
2.3. Causes of Business Cycles
Why does GDP move through cycles rather than rising in a straight line? To
answer that, recall the four basic components of GDP:
Consumer spending
Business spending
Government spending
Net exports (exports minus imports).
A contraction in any of these components can cause a reduction in the
economic growth rate. Furthermore, the effect of a change in one component
is often amplified because the components are interrelated. Example 1
describes how some of these components may be affected by changes in the
housing sector.
EXAMPLE 1.
CYCLE
THE HOUSING SECTOR AND THE BUSINESS
When consumer confidence is high, consumer spending increases,
including spending on housing. Because of increased demand, housing
prices increase. This increases wealth and further consumer
(household) spending and investing takes place. As consumer spending
increases, business spending increases too because of the increased
demand for products and services and increased availability of capital
due to increased consumer investing. The economy expands and
advances toward a peak. If the demand for housing stabilises or
declines and consumers begin to think that home prices are too high, the
price of homes may decline. So, a period of contraction begins.
Consumer confidence and wealth both decline along with the decline in
housing prices. This decline results in reduced consumer spending and
investing, and companies see a decline in demand for goods and
services and a reduction in the availability of capital. Meanwhile,
governments experience a reduction in tax revenues and an increased
demand for social services as unemployment rises.
Governments and central banks will then usually take action to try to
stimulate the economy. When that happens, consumer confidence
increases again along with consumer spending, and the economy begins
a period of recovery (expansion).
Changes in the business cycle can be driven by many factors other than
changes in the housing sector. A decrease or increase in the price of a key
commodity, such as oil, can also affect spending. A decrease or increase in
the stock market or the financial services sector can be transmitted through to
the components of GDP. The decline in a sector can be very dramatic; an
extreme decline is often described as a bubble bursting.
As described in Example 1, during periods of economic contraction,
governments may engage in fiscal stimulus programmes to stimulate
aggregate demand. Central banks may increase access to credit (provide
liquidity) and reduce borrowing costs to help the economy stabilise and
recover. By taking these actions, central banks inject money into the
economy, which encourages consumers and businesses to increase spending.
Those who benefit from this additional spending, in turn, increase their own
spending. This is known as the multiplier effect.
As the economy moves from trough to expansion, companies begin to hire.
Other consumers who witness job gains may become more confident in their
own employment prospects, even if they are already employed. With
unemployment declining and confidence growing, consumers increase their
spending. So, we see that psychology and consumer confidence have a
significant effect on spending decisions.
2.4. Global Nature of Business Cycles
With the growth of international trade, mobility of labour, and more closely
connected financial markets, movements in the business cycles of countries
have become more closely aligned with each other. In Exhibit 5, which
shows growth rates in real GDP for Germany, the United Kingdom, and the
United States, we can see that similar patterns emerge. The cycles are
transmitted between countries through trade and integrated financial markets.
One country’s economic growth, for instance, often leads to a higher level of
imports, which creates a larger export market for other countries. Increased
exports will lead to economic growth in the exporting countries.
Investing and borrowing occur in increasingly integrated global financial
markets. Financial panics can spread rapidly throughout the global economy,
as the world experienced in the financial crisis that started in 2008.
Economic policies of governments also create alignment between the
business cycles of various countries. Policies can be co-ordinated through
the promotion of greater integration of financial markets and through
international policy forums, such as the G–20. The G–20 is a group with
representatives from 19 countries, the European Union, the International
Monetary Fund, and the World Bank that meets to discuss economic and
financial policy issues.
Exhibit 5.
International Business Cycles, 1971–2010
Note: Annual percentage growth of GDP is calculated at market prices based on constant
local currency.
Source: Based on data from the World Bank.
2.5. Economic Indicators
We noted earlier in this chapter that economic growth is not easy to measure.
Real GDP is typically estimated quarterly and is an important measure of the
wealth of a country. However, it is rarely 100% accurate when published
because all necessary information is not yet available. It is estimated with a
substantial time lag and is subject to revisions over time as more data
become available. In fact, revisions can occur well over a year after the
original report date.
Economic indicators are measures that offer insight regarding economic
activity and are reported with greater frequency than GDP. Economic
indicators are estimated and reported by governments and private
institutions. Economic indicators can be used to guide forecasts of future
economic activity as well as forecasts of activity and performance in the
financial markets and exchange rates.
Industrial production, for example, is available monthly and reports the
output of the industrial sector of the economy—principally the output of
manufacturing, mining, and utility companies. Industrial production excludes
the agricultural and service sectors, which can also be significant
contributors to economic activity. Other indicators of economic activity
include
average weekly hours of production workers,
initial claims for unemployment insurance,
durable products orders (such as new orders of high-priced
manufacturing items),
retail sales,
construction spending for commercial and residential properties,
sentiment surveys covering the manufacturing and consumer sectors.
Sentiment surveys attempt to measure the confidence that economic entities,
such as manufacturers and consumers, have in the economy and their intended
levels of activity. Sentiment surveys may be useful as predictors of spending
plans, but they have limitations:
They measure only general attitudes about economic conditions rather
than actual spending or output.
The sample may not be representative. For example, only large
companies may be sampled, or the sample of consumers may be
pedestrians at a single street corner. Therefore, because of sampling
error, these surveys might not reflect data on an economy-wide basis.
The survey may only ask respondents to choose between more, the
same, or fewer sales, employment, output, and so on. So, the responses
may show only the direction of the expected change but not its
magnitude.
Economic indicators are often categorised as lagging, coincident, or leading,
based on whether they signal or indicate that changes in economic activity
have already happened, are currently underway, or are likely to happen in the
future.
Lagging indicators signal a change in economic activity after output has
already changed. An example of a lagging indicator is the employment rate,
which tends to fall after economic activity has already declined.
Coincident indicators reveal current economic conditions, but do not
have predictive value. Examples of coincident indicators include industrial
production and personal income statistics.
Leading indicators usually signal changes in the economy in the future,
and are considered useful for economic prediction and policy formulation.
Examples of leading indicators include money supply (the amount of money
in circulation) and broad stock market indices, such as the S&P 500 Index,
the FTSE Index, and the Hang Seng Index.
A number of organisations publish indices of leading economic indicators.
An index of leading economic indicators combines different
indicators to signal what might happen to GDP in the future. In the United
States, the Conference Board publishes a monthly index of leading economic
indicators. In Europe, similar indices are also published.
Exhibit 6 shows economic indicators provided by the Economist magazine at
the end of each issue. The Economist includes them for a number of
countries, but Exhibit 6 shows them only for the five largest economies.
Exhibit 6.
Economic Indicators
Output, Prices, and Jobs (% change on year ago)
Gross Domestic Product
Industrial
Production
Qtr* 2013†
2014†
Latest
Latest
China
France
Germany
Japan
United
States
+7.7
Q4
+0.2
Q3
+0.6
Q3
+2.4
Q3
+2.0
Q3
+7.4
+7.7
+7.3
+9.7 Dec
–0.5
+0.2
+0.8
+1.5 Nov
+1.3
+0.5
+1.7
+3.5 Nov
+1.1
+1.7
+1.5
+4.8 Nov
+4.1
+1.8
+2.7
+3.7 Dec
L
*% change on previous quarter, annual rate.
†The Economist poll or Economist Intelligence Unit estimate/forecast.
§ Not seasonally adjusted.
Source: “Economic Indicators”, The Economist, January 25th–31st, 2014. The Economist
is citing data from Haver Analytics.
3. INFLATION
Have you noticed that your food costs tend to increase every year? Food that
cost on average $100 a week last year, may cost on average $110 a week this
year.
Inflation is a general rise in prices for products and services. Changing
inflation has implications for economic activity and national
competitiveness. Companies must monitor increases in costs and prices.
They assess their competitive environment to decide how to respond to rising
costs and prices. Consumers use changes in prices to make their buying
decisions. So, accurate measurement of inflation is important.
3.1. Measuring Inflation
There are many different measures of inflation based on different price
indices. A price index tracks the price of a product or service, or a basket of
products and services (typically referred to as a basket of goods) over time.
The basic measure of inflation is the percentage change in an index from one
period to another.
Consumer price index.
A consumer price index (CPI) is used to measure the change in price of a
basket of goods typically purchased by a consumer or household over time.
A CPI is constructed by determining the weight—or relative importance—of
each product and service in a typical household’s spending in a particular
base year and then measuring the price of the basket of goods in subsequent
years.
Weights in this index can be altered when long-term consumer trends change.
For example, computers and technology-related products may not have been
part of a typical household budget in the past, so they were not included in
baskets of goods. Today their weighting in a basket of goods may be
relatively high. Inflation measured by a CPI may overstate or understate
inflation for a particular consumer or household depending on how their
spending patterns compare with the basket of goods.
In different countries, terminology may vary, and the basket of goods is likely
to vary. For example, in the United Kingdom, at least two CPIs are reported:
a retail price index (RPI) based on a basket of goods that includes housing
costs, and a CPI with a smaller basket of goods that does not include housing.
Inflation rates as measured by the UK RPI and CPI are typically not the same.
Indices based on core inflation, such as the US Core CPI, exclude the effects
of temporary volatility in commodity (including food and energy) prices.
Policymakers, such as governments and central banks, find these indices
useful. The reported core inflation can differ from what households and
companies are experiencing.
Producer price index.
Another measure of inflation is a producer price index (PPI). PPIs
measure the average selling price of products in the economy. They are
broader than CPIs in that they include the price of investment products, but
they are simultaneously narrower in that they do not include services. PPIs
can be reported by individual industries, commodity classifications, or stage
of processing of products, such as raw material and finished products.
Inflation rates and price indices.
Different indices can produce different inflation measures, even in the same
country over the same period. As you can see in Exhibit 7, which shows
inflation rates based on different price indices for the United Kingdom and
the United States, inflation rates over the same period can vary noticeably
depending on the price index used.
Exhibit 7. Inflation Rates in the United States and the United
Kingdom, 1989–2010
Source: Based on data from the Federal Reserve Bank of St. Louis and the Office of
National Statistics.
The relationship between CPIs and PPIs is sometimes used to determine the
degree to which producers’ costs are passed on to consumers. If consumer
prices (or costs to consumers) are static and producer prices (or costs to
producers) are rising, then producers seem unable to pass on the costs to
consumers. Examining increases in production costs relative to consumer
price increases can indicate whether profit margins are expanding or
contracting.
Implicit GDP deflator.
Another way of measuring inflation is to estimate what would happen if the
weight of each good in the index is changed each year to reflect actual
spending on that good. Such a measure is known as an implicit deflator and is
widely used to estimate changes in GDP. The implicit GDP deflator is
simply defined as nominal GDP divided by real GDP and is the broadestbased measure of a nation’s inflation rate.
3.2. The Effects of Inflation on Consumers,
Businesses, and Investments
Changes in price levels can affect economic growth because consumers and
businesses may change the timing of their purchases, the amount of their
spending, and their saving and borrowing decisions based on anticipated
changes in prices. The value of investments may also be affected by changes
in price levels.
Consumers.
If consumers expect prices to increase, they may buy now rather than save.
Or they may choose to borrow to increase spending. Borrowers benefit from
inflation because they repay loans with money that is worth less (has lower
purchasing power).
Inflation can prompt economic growth if consumers respond to expectations
of price increases by making purchases now rather than delaying them.
However, the added spending may only benefit economic growth in the short
run because some of those purchases would have been made anyway. So,
inflation may simply shift demand from the future to the current time period.
This added short-term demand can further increase inflationary pressure.
During times of inflation, wages may not increase at the same rate as the
prices of products and services. If wages increase by a lesser amount,
consumers may have less money to spend as their budgets are squeezed.
Additionally, if unemployment is high, labour’s bargaining power declines,
and real consumer spending (consumer spending adjusted for inflation) may
weaken. This scenario may help break the inflationary cycle.
Businesses.
What is the impact of inflation on business? Generally, inflation will have a
negative effect on business planning and investment. Budgeting becomes
more difficult because of the uncertainty created by rising prices and costs.
Consumers spend rather than invest, so access to capital is reduced for
companies, which results in reduced business spending on physical
(productive) capital. Companies’ profits may decline as costs rise,
particularly if companies are unable to pass on the higher costs to consumers
in the form of higher prices. If inflation becomes established, overall
economic performance may deteriorate as companies raise prices and are
potentially unable to invest in capital and seek productivity improvements.
Investments.
Finally, inflation affects the values of financial investments. Any investment
paying a fixed cash amount will decline in value if interest rates rise. As
inflation increases, interest rates generally rise, so higher inflation will lead
to lower values for fixed-income investments, such as bonds. Inflation tends
to benefit borrowers, as described earlier, and hurt lenders.
Shares, on the other hand, may be a good hedge (protection) against inflation
if companies are able to increase the selling prices of their products or
services as their input prices increase. A more detailed discussion of bonds,
shares, and other investments will be covered in the Investment Instruments
module.
3.3. Other Changes in the Level of Prices
Inflation is a key economic concern for investors. Three additional scenarios
related to price level changes are deflation, stagflation, and hyperinflation.
Inflation is more typical but deflation, stagflation, and hyperinflation can be
equally or even more problematic for consumers, companies, policymakers
in central banks and governments, and economies.
Deflation.
A persistent and pronounced decrease in prices across most products and
services in an economy is called deflation. Deflation was experienced in
the 1930s during the Great Depression in the United States and more recently
in Japan. If consumers expect prices to fall, they may choose to save, even if
they earn zero interest, and delay purchases until prices decrease further. As
a result, demand drops, companies reduce production and labour, and
unemployment increases. Encouraging consumption and breaking this vicious
cycle is very difficult. Japan, for instance, has experienced deflation for
much of the past 20 years.
Stagflation.
Inflation usually occurs in periods of high economic growth. However, high
inflation can occur in times of little or no economic growth and this scenario
is termed stagflation. Stagflation is typically associated with inflation that
originates outside the domestic economy. Many developed economies
experienced stagflation in the 1970s and early 1980s because oil prices
suddenly and dramatically increased. Higher oil prices caused inflation
through increased costs of production for suppliers of products and services.
Investment spending by businesses declined. Simultaneously, consumer
spending on other products decreased as consumers adapted to increased oil
prices. As a result, unemployment rates increased and consumers had even
less money to spend. Central banks and governments were faced with a
dilemma: stimulate the economy and risk further inflation or fight inflation
and risk further declines in economic growth. Finally, most central banks
chose to fight inflation by raising interest rates, resulting in a period of global
recession. Only when inflation was under control was action taken to
stimulate the economy.
Hyperinflation.
Hyperinflation involves price increases so large and rapid that consumers
find it hard to afford many products and services. Consumers try to spend
money as quickly as they get it, anticipating increases in prices of products
and services and preferring to hold real assets rather than money. Often
products and services are not available because producers hold back
anticipating further price increases. Although most commonly associated
with emerging markets, Germany experienced hyperinflation following
World War I. Hyperinflation causes severe damage to an economy and cannot
be readily counteracted by governments and central banks. Fortunately, cases
of hyperinflation are relatively rare.
4. MONETARY AND FISCAL POLICIES
Economic growth, inflation, and unemployment are major concerns for
central banks and governments. They each use different financial tools to
affect economic activity. Central banks, which are often independent from
governments, use monetary policy. Governments use fiscal policy.
4.1. Monetary Policy
Monetary policy refers to central bank activities that are directed toward
influencing the money supply (the amount of money in circulation) and credit
(the amount of money available for borrowing and at what cost or interest
rate) in an economy. The ultimate goal is to influence key macroeconomic
targets:
Output or GDP
Price stability
Employment
Most central banks have a mandate of maintaining price stability (controlling
inflation while avoiding deflation), which has indirect effects on other
macroeconomic targets, such as employment and output. Many central banks
have additional responsibilities to sustain employment levels and to
stimulate or slow down economic growth. Focussing on these only may result
in lack of price stability; increased employment and high economic growth is
often accompanied by inflation.
Consumers and companies should, in theory, be encouraged by lower interest
rates to borrow and spend more and thus stimulate the economy. As interest
rates fall, the stock market may seem a more attractive place to invest,
leading to increases in share prices and a general sense of increased wealth.
This sense of increased wealth should prompt consumers to spend more and
save less and thus further stimulate the economy. So, reducing interest rates
may increase output and employment, thereby meeting two of the key
macroeconomic targets of policymakers. Similarly, increased interest rates
may slow the economy.
The tools used for monetary policy include the following:
Open market operations
Changes in the central bank lending rate
Changes in reserve requirements for commercial banks
4.1.1. Open Market Operations
Open market operations involve the purchase and sale of government
notes and bonds. If a central bank wants to increase the supply of money and
credit in order to stimulate the economy, it can do so by purchasing financial
assets, generally short-term government instruments, held by commercial
banks. The banks give up short-term government instruments for cash from
the central bank, which puts more money in circulation. The injection of
money allows banks to lower interest rates and make more loans because
they now have more cash reserves at the central bank. Note that the central
bank does not set the interest rates, but rather uses open market operations to
influence the interest rates.
To reduce the supply of money and credit in circulation in order to slow an
economy, the central bank sells these instruments to the commercial banks.
The commercial banks now have lower balances at the central bank and
more short-term government instruments. The decrease in cash balances
reduces the credit available to the private sector. Interest rates rise as
consumers and companies compete for a smaller amount of credit.
By conducting open market operations, the central bank creates a shortage or
surplus of money. Effectively, the central bank is compelling commercial
banks to change their lending rates.
QUANTITATIVE EASING
The policy of quantitative easing (QE), used in a number of countries
after the financial crisis of 2008, is similar to open market operations,
but on a much larger scale and it involves the purchase of instruments
other than short-term government instruments. In the United States, QE
differed from open market operations in that it involved the purchase of
mortgage bonds as well as large-scale purchases of longer-term US
Treasury securities. The intent was to decrease longer-term interest
rates for bonds and across a variety of credit products, induce bank
lending, and thereby increase real economic activity. It has proven
difficult to evaluate the effectiveness of QE because there were other
simultaneous stimulus programmes in the wake of the financial crisis.
Additionally, policymakers are concerned about financial contagion
because of the interconnectedness of global financial markets. Financial
contagion can occur when financial shocks spread from their place of origin
to other locales—in essence, a declining sector or economy infects other
healthier sectors and economies. For this reason, sometimes policymakers
from different countries co-ordinate their open market operations.
4.1.2. Central Bank Lending Rates
An obvious expression of a central bank’s intentions is the interest rate it
charges on loans to commercial banks. This lending rate is the rate at which
banks borrow directly from the central bank of the country. It is used to affect
short-term interest rates as well as to indirectly influence longer-term and
other commercial rates. The belief is that changes in interest rates can
influence economic activity and affect inflation and economic growth. When
a central bank wants to stimulate the economy, it may reduce its lending rate.
When a central bank wants to slow the economy, it may increase its lending
rate.
If a central bank announces an increase in its lending rate, then commercial
banks will normally increase their lending base rates at the same time.
Through its lending rate and its money market operations, a central bank can
influence the availability and cost of credit. Generally, the higher the central
bank lending rate, the higher the rate that banks, if they run short of funds,
will have to pay to not only the central bank but to other banks that loan to
them as well. The higher the central bank lending rate, the more likely banks
are to reduce lending and thus decrease the money supply. So, higher central
bank lending rates are expected to slow down economic activity. Similarly,
lower central bank lending rates are expected to stimulate economic activity.
4.1.3. Reserve Requirements
Central banks can affect the amount of money available for borrowing in an
economy by changing bank reserve requirements. The reserve
requirement is the proportion of deposits that must be held by a bank rather
than be lent to borrowers. By increasing the reserve requirement, central
banks reduce access to credit in the economy because bank lending is
reduced. When they lower the reserve requirement, central banks increase
access to credit because commercial banks are able to make more loans. In
practice, this tool is not often used by central banks.
4.1.4. Limitations of Monetary Policy
The effectiveness of monetary policy is subject to debate. Economists who
question its effectiveness cite evidence of slow growth in some economies
where interest rates are very low. This result may occur because consumers
and companies do not respond to lower interest rates by spending more.
Instead, they may prefer to
add to their cash balances because they believe either that the economy
will slow further and they need protective funds or that prices may drop
and offer better purchase opportunities later.
pay down debt, in a process referred to as deleveraging.
Thus, the psychology and likely responses of consumers and companies must
be considered. Consider a scenario in which the central bank raises interest
rates to reduce consumer spending and demand because it is concerned about
inflationary pressures. If an economy is doing well, general optimism about
income, employment, and business profits may be high. In that case, increases
in borrowing costs are less effective in deterring spending. At other times, an
increase in interest rates may be effective because optimism is less
established. So, the levels of consumer and business confidence influence the
effectiveness of monetary policy.
4.2. Fiscal Policy
Governments use fiscal policy to affect economic activity. Fiscal policy
involves the use of government spending and tax policies. Fiscal policy may
be aimed at stimulating a weak economy through increased spending or
decreased taxes and slowing an overheating economy through decreased
spending or increased taxes.
4.2.1. Role and Tools of Fiscal Policy
One way fiscal policy works is by reducing or increasing taxes on
individuals or companies. Governments can also affect GDP directly by
spending more or less itself.
An expansionary policy, which aims to stimulate a weak economy, can in
essence,
reduce taxes on consumers or businesses with the objective of
increasing consumer and business spending and aggregate demand.
increase public spending on social goods and infrastructure, such as
hospitals and schools, which increases spending and aggregate demand
directly. An expansionary policy can also increase spending and
aggregate demand indirectly because it can increase the personal
income of workers and increase the revenues of companies hired for
those public projects. Those individuals and companies may then
increase spending and aggregate demand.
The effectiveness of these policies will vary over time and among countries
depending on circumstances. For example, in a recession with rising
unemployment, cuts in the income tax will not always raise consumer
spending because consumers may want to increase their savings in
anticipation of further deterioration in the economy.
4.2.2. Limitations of Fiscal Policy
The effectiveness of fiscal policy is limited by the following:
Time lags
Unexpected responses by consumers and companies
Unintended consequences
Time lags.
There can be a significant time lag between when a change in economic
conditions occurs and when actions based on fiscal policy changes affect the
economy. A variety of events have to occur in the interim period. These
events include recognition of the economic change that requires fiscal policy
action, a decision on the fiscal policy response, implementation of the
decision, and responses to the changed fiscal policy. In other words, it takes
time for policymakers to recognise that a problem exists, for decisions to be
made and implemented, and for actions to occur that affect the economy. By
the time the actions affect the economy, economic conditions may have
already changed.
Unexpected responses.
As with monetary policy, consumers and companies may not respond as
expected to changes in fiscal policy. For example, when a tax reduction is
announced, private sector spending is expected to increase. But spending
may remain unchanged or even decrease if the private sector chooses to save
the funds or pay down debt rather than spend. On the other hand, spending
may increase by more than expected. Similarly, if government spending
increases, consumer and business responses may counteract the effects of the
change in government spending on GDP by reducing their own spending.
Unintended consequences.
Changes in fiscal policy may also have unintended consequences. For
example, if the government increases spending with the intent of increasing
aggregate demand and GDP, the increased aggregate demand may increase
employment and lead to a tightening labour market and rising wages and
prices. So the economy (GDP) grows as planned, but inflation also
increases. Policymakers may be reluctant to implement fiscal policy to
stimulate an economy given the risk of inducing inflation. In another example
of unintended consequences, crowding out may occur. Crowding out is when
the government borrows from a limited pool of savings and competes with
the private sector for funds so the government “crowds out” private
companies. As a result, the cost of borrowing may rise and economic growth
and investment by the private sector may decline.
4.3. Fiscal or Monetary Policy
Both governments and central banks are concerned with economic growth,
inflation, and unemployment. Each entity has different tools at its disposal to
affect economic activity. Government tools include taxes and government
spending. Central bank tools include open market operations, central bank
lending rates, and reserve requirements.
Each entity is subject to much the same limitations: time lags between when a
change in economic conditions occurs and when policy actions take effect;
unexpected responses by consumers and companies; and unintended
consequences, such as successfully stimulating the economy but at the same
time increasing inflation. However, the time lag for monetary policy may be
shorter because central banks may be able to act more quickly than
governments.
Economists are generally divided into two camps regarding the effectiveness
of monetary and fiscal policies. Keynesians, named after British economist
John Maynard Keynes (pronounced “canes”), believe that fiscal policy can
have powerful effects on aggregate demand, output, and employment when
there is substantial spare capacity in an economy. Some economists believe
that changes in monetary variables under the control of central banks can only
affect monetary targets, such as inflation, and will not lead to changes in
output or employment. This is a subject of intense debate between
economists.
Monetarists believe that fiscal policy has only a temporary effect on
aggregate demand and that monetary policy is a more effective tool for
affecting economic activity. Monetarists advocate the use of monetary policy
instead of fiscal policy to control the cycles in real GDP, inflation, and
employment.
In practice, both governments and central banks are likely to act in response
to economic conditions. This is particularly true when economic conditions
are extremely worrisome—for example, when a recession is identified or
when either inflation or unemployment is high. The modern economy is a
complex system of human behaviour and interactions. To encourage growth
in real GDP requires considerable insight into the effects of interest rate or
tax changes on decisions by consumers and companies. After all, the
economy represents the collective action of many millions of consumers,
companies, and governments around the globe.
SUMMARY
Investment professionals consider macroeconomic factors when evaluating
companies’ earnings potential and the relative attractiveness of asset classes.
It is no easy task, and few investment professionals are able to measure and
assess the combined effect of macroeconomic factors with any degree of
certainty.
Some important points to remember about macroeconomics include the
following:
Gross domestic product is the total value of all final products and
services produced in an economy over a particular period of time.
Nominal GDP uses current market values, and real GDP adjusts
nominal GDP for changes in price levels.
GDP can be estimated by using an expenditure approach or an income
approach. In the expenditure approach, the components of GDP are
consumer spending, business spending, government spending, and net
exports.
GDP per capita is equal to GDP divided by the population. It allows
comparisons of GDP between countries or within a country.
Economic growth is the annual percentage change in real output. It is
also sometimes expressed in per capita terms.
Economic activity and growth rates tend to fluctuate over time. These
fluctuations are referred to as business cycles. Phases of a business
cycle include expansion, peak, contraction, trough, and recovery.
Changes in the business cycle can be driven by many factors, such as
housing, the stock market, and the financial services sector.
With the growth of international trade, mobility of labour, and more
closely connected financial markets, movements in the business cycles
of countries have become more closely aligned with each other.
Economic indicators—measures of economic activity—are regularly
reported and analysed. These measures may be leading, lagging, or
coincident indicators.
Inflation is a general rise in the prices of products and services.
Measures of inflation include consumer price indices, producer price
indices, and implicit GDP deflators.
Changes in price levels can affect economic growth because consumers,
companies, and governments may change the timing of their purchases,
the amount of their spending, and their saving and spending decisions
based on anticipated changes in prices.
Three additional price level changes investors also consider are
deflation, stagflation, and hyperinflation.
Economic growth, inflation, and unemployment are major concerns of
central banks and governments. They each use different financial tools
to affect economic activity. Central banks, which are often independent
from governments, use monetary policy. Governments use fiscal policy.
Monetary policy refers to central bank activities that are directed
toward influencing the money supply and credit in an economy. Its goal
is to influence output, price stability, and employment.
Fiscal policy involves the use of government spending and tax policies
to influence the level of aggregate demand in an economy and thus the
level of economic activity.
Both fiscal and monetary policies have limitations: they are affected by
time lags and the responses to and consequences of each may not be as
expected.
CHAPTER REVIEW QUESTIONS
© 2014 CFA Institute. All rights reserved.
1. Gross domestic product (GDP) is best defined as the total:
A. output of a country.
B. output of a country per person.
C. changes in real output of a country.
2. Which of the following best measures the relative wealth of citizens of
different countries?
A. Real GDP
B. GDP per capita
C. Nominal GDP
3. In a given year, if a country’s GDP per capita decreases while total
GDP is unchanged, then the population of the country has:
A. decreased.
B. remained the same.
C. increased.
4. The largest component of total GDP is most likely to be:
A. gross investment.
B. government spending.
C. consumer or household spending.
5. Holding all other factors constant, an increase in imports would most
likely cause total GDP to:
A. decrease.
B. remain the same.
C. increase.
6. If all other factors remain the same, which of the following changes
would most likely cause an increase in the growth rate of a country’s
GDP?
A. An increase in productivity
B. An increase in unemployment
C. A decrease in the availability of capital
7. Which stage of the business cycle is most often characterised by rising
interest rates and higher wages?
A. Recession
B. Expansion
C. Contraction
8. Which of the following will most likely decrease when an economy is
in the expansion phase of the business cycle?
A. Production
B. Unemployment rate
C. Consumer spending
9. Which of the following phases of the business cycle most likely follows
the peak phase?
A. Trough
B. Recovery
C. Contraction
10. Integrated global financial markets have most likely caused business
cycles between countries to be:
A. less aligned.
B. unrelated.
C. more aligned.
11. Financial panics are most likely:
A. limited to specific countries.
B. limited to specific securities markets.
C. easily spread throughout the global economy.
12. More closely aligned movements in the business cycles between
countries is best explained by:
A. reduced international trade.
B. decreased mobility of labour.
C. increasingly connected financial markets.
13. Which of the following indicators is most appropriate to use in
forcasting future economic activity?
A. Lagging economic indicators
B. Leading economic indicators
C. Coincident economic indicators
14. Current economic conditions are best shown by:
A. lagging economic indicators.
B. leading economic indicators.
C. coincident economic indicators.
15. If consumers anticipate an inflationary environment, it may lead to
consumer spending:
A. decreasing.
B. remaining unchanged.
C. increasing.
16. An economy experiencing deflation is most likely characterised by:
A. delayed consumption.
B. increased production.
C. reduced unemployment.
17. Tools of fiscal policy include:
A. government spending.
B. open market operations.
C. changes in the central bank lending rate.
18. Monetary policy is similar to fiscal policy in that:
A. legislation is required to implement policy decisions.
B. a time lag may occur before it affects economic growth.
C. commercial banks tend to react immediately by changing their
lending terms.
19. Fiscal policy that is intended to stimulate the economy includes
decreases in:
A. tax rates.
B. interest rates.
C. public spending.
20. Which of the following is a monetary policy tool?
A. Changes in tax rates
B. Open market operations
C. Decreases in government spending
21. Which of the following best describes a limitation of monetary policy?
A. Crowding out of private borrowers
B. Long time lags until implementation
C. Unexpected responses from consumers
22. Time lags until policies affect the economy are most likely associated
with:
A. only fiscal policy.
B. only monetary policy.
C. both fiscal policy and monetary policy.
ANSWERS
1. A is correct. GDP is the total output of a country. It is the total value of
final goods and services produced within a country over a period of
time. B is incorrect because the total output of a country per person
measures GDP per capita. C is incorrect because total changes in real
output of a country is a measure of economic growth.
2. B is correct. GDP per capita is defined as a country’s total GDP
divided by population and describes the average wealth of each citizen
of a country. A and C are incorrect because GDP—real and nominal—
is a measure of total wealth of a country, which can be highly dependent
on total population.
3. C is correct. GDP per capita is calculated as total GDP divided by the
population. A lower GDP per capita with an unchanged total GDP
implies that the population has increased.
4. C is correct. Consumer or household spending is the largest component
of total spending, and may be as high as 70% of total GDP.
5. A is correct. Imports involve domestic residents spending money on
foreign goods. Higher imports would cause GDP to decrease as defined
by the following equation: GDP = C + I + G + (X – M), where C is
consumer spending, I is gross investment, G is government spending, X
is exports, and M is imports.
6. A is correct. An increase in productivity will lead to an increase in
GDP, all other factors remaining the same. B is incorrect because an
increase in unemployment (a decrease in the employed labour force)
will lead to a decrease in GDP, all other factors being unchanged. C is
incorrect because a decrease in the availability of capital will lead to a
decrease in GDP, all other factors being unchanged.
7. B is correct. During an economic expansion, production, inflation,
interest rates, employment, and investment spending all tend to rise.
Employees have more bargaining power in demanding higher wages. A
and C are incorrect because inflation and interest rates tend to decline
and unemployment tends to increase during a contraction. A recession is
a significant economic contraction.
8. B is correct. Unemployment tends to fall when an economy is in the
expansion phase of the business cycle. A and C are incorrect because
production and consumer spending tend to increase during the expansion
phase of the business cycle.
9. C is correct. The business cycle can vary, but it typically follows a
pattern of expansion, peak, contraction, trough, recovery, and back to
expansion. Therefore, an economic peak is most likely followed by a
contraction phase. A and B are incorrect because the trough and
recovery phases typically occur following the contraction cycle.
10. C is correct. Integrated global financial markets have caused business
cycles of various countries to become more closely aligned.
11. C is correct. As financial markets are increasingly global, financial
panics are easily spread throughout the global economy. A and B are
incorrect because financial panics generally do not remain contained to
specific markets or countries, but spread globally as experienced from
2007 to 2009.
12. C is correct. Movements in the business cycles of countries have
become more closely aligned as a result of increasingly connected
financial markets. A and B are incorrect because increased mobility of
labour and growth in international trade result in economies becoming
more closely aligned.
13. B is correct. Leading indicators usually signal changes in the economy
in the future and, therefore, are considered useful for economic
prediction and policy formulation. A is incorrect because lagging
indicators signal a change in economic activity after it has already
changed. C is incorrect because coincident indicators reveal current
economic conditions but do not have predictive value.
14. C is correct. Coincident indicators reveal current economic conditions
but do not have predictive value. A is incorrect because lagging
indicators signal a change in economic activity after it has already
changed. B is incorrect because leading indicators usually signal
changes in the economy in the future.
15. C is correct. Consumers may change the timing of their purchases in
response to expected price changes. If they expect prices to increase
(inflation), they may buy now rather than save (a lower savings rate).
16. A is correct. In a deflationary environment, consumers may expect
prices to continue falling and delay purchases (consumption). B and C
are incorrect because companies, as a result of reduced consumer
spending, are likely to reduce production, which leads to increased
unemployment.
17. A is correct. Government spending and tax policies are tools of fiscal
policy. B and C are incorrect because open market operations and
changes in the central bank lending rate are tools of monetary policy.
18. B is correct. There can be a time lag before the effects of monetary and
fiscal policies are realised. A is incorrect because fiscal policy is set
by lawmakers whereas monetary policy is usually set by a central bank,
which is often independent from other government branches and may not
require legislative action. C is incorrect because commercial banks tend
to respond quickly to monetary policy but not to fiscal policy.
19. A is correct. A decrease in tax rates is a fiscal policy intended to
stimulate an economy by increasing spending and aggregate demand. B
is incorrect because a decrease in interest rates is an example of
monetary policy intended to stimulate the economy. C is incorrect
because a decrease in public spending is an example of a fiscal policy
intended to slow an economy.
20. B is correct. Monetary policies are typically carried out by central
banks and include such tools as open market operations, changes in
central bank lending rates, and changes in reserve requirements for
commercial banks. A and C are incorrect because both are examples of
fiscal policy tools.
21. C is correct. Monetary policies are intended to change the behaviour of
businesses and consumers to stimulate or slow the economy. One of the
drawbacks is that consumers and businesses may not respond as
expected, leading to ineffective policies. A and B are incorrect because
both are limitations of fiscal policy. Increased government borrowing
and spending may crowd out private borrowers. Unlike fiscal policy,
monetary policy can be implemented quickly.
22. C is correct. Both monetary policies and fiscal policies can have a
significant time lag between a change in policy and when actions based
on policy changes affect the economy.
Chapter 6
Economics of International
Trade
by Michael J. Buckle, PhD, James Seaton, PhD, and
Stephen Thomas, PhD
© 2014 CFA Institute. All rights reserved.
LEARNING OUTCOMES
After completing this chapter, you should be able to do the following:
a. Define imports and exports and describe the need for and trends in
imports and exports;
b. Describe comparative advantages among countries;
c. Describe the balance of payments and explain the relationship between
the current account and the capital and financial account;
d. Describe why a country runs a current account deficit and describe the
effect of a current account deficit on the country’s currency;
e. Describe types of foreign exchange rate systems;
f. Describe factors affecting the value of a currency;
g. Describe how to assess the relative strength of currencies;
h. Describe foreign exchange rate quotes;
i. Compare spot and forward markets.
1. INTRODUCTION
When you walk into a supermarket where you can buy Scottish salmon,
Kenyan vegetables, Thai rice, South African wine, and Colombian coffee,
you are experiencing the benefits of international trade. Without international
trade, consumers’ needs may not be fulfilled because people would only
have access to products and services produced domestically. Certain
products and services may be missing—perhaps food, vaccines, or insurance
products.
International trade is the exchange of products, services, and capital
between countries. The growth in international trade, from $296 billion in
1950 to $18.2 trillion in 2011,1 can be viewed as both a cause and
consequence of globalisation, one of the four key forces driving the
investment industry discussed in the Investment Industry: A Top-Down View
chapter.
Consider the effect of international trade on a multinational company such as
Nestlé. At the end of 2013, the Switzerland-based company had factories in
86 countries and sold its products in 196 countries.2 International trade has
contributed significantly to Nestlé’s growth in sales and profit. But it also
comes with challenges. One of those challenges is the risk associated with
foreign exchange rate fluctuations, changes in the relative value of different
countries’ currencies. Multinational companies, such as Nestlé, do business
in several currencies, so they are affected by changes in exchange rates.
Thus, investment professionals who try to forecast Nestlé’s future sales and
profits must consider foreign exchange rate fluctuations.
Today, the factors driving supply and demand, and thus prices, are global. An
understanding of how international trade and foreign exchange rate
fluctuations affect economies, companies, and investments is important. We
discussed in the Microeconomics chapter how companies and individuals
make decisions to allocate scarce resources. In the Macroeconomics chapter,
we discussed the factors that affect economies, such as economic growth,
inflation, and unemployment. We now bring into the discussion the
international dimension of economics, which investment professionals must
also take into account before deciding which assets to invest in.
This chapter will give you a better understanding of how international trade
and foreign exchange rate fluctuations affect both your daily life and the work
of investment professionals.
2. IMPORTS AND EXPORTS
The flow of goods and services in international trade between countries is
primarily measured by imports and exports. Imports refer to products and
services that are produced outside a country’s borders and then brought into
the country. For example, many countries in the European Union import
natural gas from Russia. Exports refer to products and services that are
produced within a country’s borders and then transported to another country.
For example, Japan exports consumer electronics to the rest of the world.
Imports and exports represent the flow of products and services in
international trade. They are important components of a country’s balance of
payments, which is discussed in Section 4.
2.1. The Need for Imports and Exports
Imports and exports arise for a variety of reasons, including the following:
Gain access to resources
Create additional demand for products and services
Provide greater choice to customers
Improve quality and/or reduce the prices of products and services
A common reason for international trade is to gain access to resources for
which there is no or insufficient supply domestically. For example, Japanese
manufacturers need access to such resources as metals and minerals,
machinery and equipment, and fuel to produce the cars and consumer
electronics that they then export to the rest of the world. Imports are a way
for Japanese manufacturers to gain access to those resources for which there
is no or insufficient supply domestically. Japanese manufacturers may import
metals and minerals from Australia, Canada, and China; machinery and
equipment from Germany; and fuel from the Middle East.
International trade creates additional demand for products and services that
are produced domestically. For example, if Japanese manufacturers could not
sell cars and consumer electronics abroad, they would have to limit their
production to the quantity that can be consumed in Japan, which is a
relatively small market. This lower production would translate into lower
sales and profits for the Japanese manufacturers, which would probably have
a negative effect on the Japanese economy—GDP may be lower and
unemployment higher.
International trade provides consumers with a greater choice of products and
services. Imports give consumers access to goods and services that may not
be available domestically. For example, consumers in the United Kingdom
would not be able to enjoy bananas or a cup of tea if importing these
products was not possible. Imports may also enable consumers to access
products and services that better suit their needs.
Imported products and services may be less expensive and/or of better
quality than domestically produced ones. By increasing competition between
suppliers of products and services, international trade promotes greater
efficiency, which helps keep prices down. International trade also stimulates
innovation, which generates better-quality products and services.
2.2. Trends in Imports and Exports
Two major trends have promoted international trade: fewer trade barriers
and better transportation and communications.
Trade barriers are restrictions, typically imposed by governments, on the
free exchange of products and services. These restrictions can take different
forms. Common trade barriers include the following:
Tariffs: Taxes (duties) levied on imported products and services. They
allow governments not only to establish trade barriers, often to protect
domestic suppliers, but also to raise revenue.
Quotas: Limits placed on the quantity of products that can be
imported.
Non-tariff barriers: These barriers include a range of measures, such
as certification, licensing, sanctions, or embargoes, that make it more
difficult and expensive for foreign producers to compete with domestic
producers.
International trade barriers have steadily been reduced since the passage of
the General Agreement on Tariffs and Trade (GATT) in 1947 and the
creation of the World Trade Organization (WTO) in 1995. The WTO, with
more than 150 member nations, is designed to help countries negotiate new
trade agreements and ensure adherence to existing trade agreements. The
WTO also provides a dispute resolution process between countries. In
addition, international trade has been promoted by the creation of regional
trade agreements, such as the Association of Southeast Asian Nations’
(ASEAN) Free Trade Area (AFTA), the North American Free Trade
Agreement (NAFTA), the Southern Common Market (MERCOSUR), and the
African Continental Free Trade Area (AfCFTA).
Improvements in transportation and communications have also helped
international trade. Large shipping containers allow manufacturers to
transport non-perishable products more easily on ships, trains, and trucks,
while jumbo jets transport perishable products quickly around the globe. The
ability to communicate digitally has also contributed to the increase in the
trade of services.
3. COMPARATIVE ADVANTAGES
AMONG COUNTRIES
Rather than producing everything themselves, countries often specialise in
products and services for which they have a comparative advantage—
that is, products and services that they can produce relatively more
efficiently than other countries. They then trade these products and services
in which they have a comparative advantage for other products and services
that another country can produce more efficiently. According to the theory of
comparative advantage, countries export products and services in which they
have a comparative advantage and they import products and services in
which they do not have a comparative advantage. The combination of
specialisation and international trade ultimately benefits all countries,
leading to a better allocation of resources and increased wealth.
The source of a comparative advantage can be related to natural, human, or
capital resources. Some countries have access to natural resources, such as
fossil fuels, metals, or minerals. Meanwhile, other countries can produce
products and services less expensively than others or make products that
require more expertise. For example, the United States imports clothing and
toys, but exports high technology products, such as airplanes and power
turbines.
Example 1 illustrates how and why comparative advantage works.
EXAMPLE 1.
COMPARATIVE ADVANTAGE
Consider two fictional countries, Growland and Makeland, where there
is demand for two different types of products, shoes and kettles. The
number of units of labour it takes in each country to make shoes and
kettles is as follows:
Growland
Makeland
Shoes
Kettles
10 units
20 units
10 units
40 units
No Reason to Trade?
It may appear that there is no reason why Growland would want to trade
with Makeland because Growland is able to produce both shoes and
kettles less expensively than Makeland. Growland has what is called an
absolute advantage over Makeland. An absolute advantage is when
a country is more efficient at producing a product or a service than other
countries—that is, it needs less resources to produce the product or
service.
Growland for Kettles, Makeland for Shoes
According to the theory of comparative advantage, however, both
countries will be better off if Growland produces kettles, Makeland
produces shoes, and then they trade with each other. In Growland, it
takes the same number of units of labour to produce shoes and kettles.
So making an additional kettle requires giving up the production of one
pair of shoes. In Makeland, by contrast, it takes twice the number of
units of labour to produce kettles than to produce shoes. So making an
additional kettle requires giving up the production of two pairs of shoes.
The opportunity cost of producing an additional kettle is less in
Growland (one pair of shoes) than in Makeland (two pairs of shoes),
which indicates that Growland is more efficient than Makeland at
producing an additional kettle. Thus, Growland has what is called a
comparative advantage in producing kettles compared with Makeland.
Similarly, the opportunity cost of producing a pair of shoes is one kettle
in Growland and half a kettle in Makeland. Thus, Makeland has a
comparative advantage in producing shoes compared with Growland.
Specialising and Trading Is a Winning Combination
Our example implies that Growland should specialise in producing
kettles, Makeland should specialise in producing shoes, and the
countries should trade with each other. The combination of
specialisation and international trade maximises productivity and
increases consumption opportunities in both countries, which ultimately
benefits both economies.
4. BALANCE OF PAYMENTS
The balance of payments tracks transactions between a country and the
rest of the world over a period of time, usually a year. According to the
International Monetary Fund (IMF), an international organisation whose
mission includes facilitating international trade, “transactions consist of
those involving goods, services, and income; those involving financial
claims on, and liabilities to, the rest of the world; and those (such as gifts)
classified as transfers”.3 The balance of payments shows the flow of money
in and out of the country as a result of exports and imports of products and
services. It also reflects financial transactions and financial transfers
between resident and non-resident economic entities. Economic entities
include individuals, companies, governments, and government agencies.
Resident entities are based in the country (domestic), whereas non-resident
entities are based in other countries (foreign).
Analysing a country’s balance of payments helps in understanding the
country’s macroeconomic environment. Questions that can be answered by
analysing a country’s balance of payments include, “How much does the
country consume and invest compared with how much it saves?” and “Does
the country depend on foreign capital to fund its consumption and
investments?”
The balance of payments includes two accounts:
The current account indicates how much the country consumes and
invests (outflows) compared with how much it receives (inflows). It is
primarily driven by the trade of products and services with the rest of
the world—that is, exports and imports.
The capital and financial account records the ownership of assets. In
particular, it reflects investments by domestic entities in foreign entities
and investments by foreign entities in domestic entities. These
investments can be acquisitions of production facilities or purchases
and sales of financial securities, such as debt and equity securities.
In theory, the sum of the current account and the capital and financial account
is equal to zero. In other words, the balance of payments should sum to zero.
Before explaining why this is the case, we need to understand what drives
each account.
4.1. Current Account
As illustrated in Exhibit 1, the current account includes three components:
Products (often referred to as goods in this context) and services
Income
Current transfers
Exhibit 1.
Components of the Current Account
4.1.1. Components of the Current Account
The goods and services account is usually the largest component of a
country’s current account. It reflects the flow of money in and out of the
country as a result of the trade of products and services—that is, the inflow
of money (positive number) from exports of products and services from
domestic entities to foreign entities and the outflow of money (negative
number) from imports of products and services by domestic entities from
foreign entities.
The difference between exports and imports of products and services is
called net exports, also referred to as the balance of trade or trade
balance.4 If the value of exports is equal to the value of imports—that is, if
net exports are zero—the country’s trade is balanced. In reality, this is rarely
the case. If the value of exports is higher than the value of imports—that is, if
net exports are positive—the country has a trade surplus. Alternatively, if
the value of exports is lower than the value of imports—that is, if net exports
are negative—the country has a trade deficit.
The income account reflects the flow of money in and out of the country from
salaries and from income on financial investments. For example, if a
domestic company has a debt or equity investment in a foreign company, any
income—such as interest payments on debt or dividend payments on equity—
received by the domestic company is included in income in the country’s
current account. In this example, the interest or dividend payments are
reported as inflows because they represent money coming into the country
from other countries.
The current transfers account includes unilateral transfers, such as gifts or
workers’ remittance. Gifts of aid from one country are outflows for that
country and inflows for the receiving country. Money sent home by migrant
workers is an outflow from the country where they work and an inflow to the
country to which the money is sent.
The sum of the goods and services account, the income account, and the
current transfers account gives the current account balance. A positive
current account balance is called a current account surplus, whereas a
negative current account balance is called a current account deficit. For
most countries, the goods and services account is larger than the sum of the
income account and the current transfers account. In other words, the trade
balance tends to dominate the current account balance. So, countries that
have a trade surplus because they export more than they import tend to have a
current account surplus. In contrast, countries that have a trade deficit
because they import more than they export tend to have a current account
deficit.
4.1.2. Importance of the Current Account
Exhibit 2 lists the five countries with the largest estimated current account
surpluses and the five countries with the largest estimated current account
deficits in 2013.
Exhibit 2. Countries with the Largest Estimated Current
Account Surpluses and Deficits in 2013
Country
Rank
(out of 193)
Current Account Balance
Surplus (+) or Deficit (–)
($US billions)
Largest estimated current account surpluses
Germany
1
+257.1
China
2
+176.6
Saudi Arabia
3
+132.2
Netherlands
4
+82.9
Russia
5
+74.8
Largest estimated current account deficits
Canada
189
–59.5
India
190
–74.8
Brazil
191
–77.6
United Kingdom
192
–93.6
Country
United States
Rank
(out of 193)
Current Account Balance
Surplus (+) or Deficit (–)
($US billions)
193
–360.7
Source: Based on data from https://www.cia.gov/library/publications/the-worldfactbook/rankorder/2187rank.html (accessed 6 March 2014).
A current account surplus indicates that the country is saving. That is, the
country has more inflows than outflows, so it has the ability to lend to or
invest in other countries. As can be seen in Exhibit 2, Germany, China, Saudi
Arabia, the Netherlands, and Russia had current account surpluses in 2013.
By contrast, a country that is running a current account deficit spends more
than it earns so it needs to borrow or receive investments from other
countries. As indicated in Exhibit 2, the United States, the United Kingdom,
Brazil, India and Canada had current account deficits in 2013.
4.2. Capital and Financial Account
The current account indicates whether a country has a surplus or a deficit.
The follow-up questions are, How does a country with a current account
surplus invest its savings? and How does a country with a current account
deficit fund its needs? These questions are answered by analysing the capital
and financial account.
As the name suggests, the capital and financial account refers to the
combination of two accounts:
The capital account, which primarily reports capital transfers
between domestic entities and foreign entities, such as debt forgiveness
or the transfer of assets by migrants entering or leaving the country.
The financial account, which reflects the investments domestic
entities make in foreign entities and the investments foreign entities
make in domestic entities.
Exhibit 3.
Components of the Capital and Financial Account
As illustrated in Exhibit 3, the financial account includes four components:
Direct investments are long-term investments between domestic entities
and foreign entities. For example, if a Brazilian company purchases a
production facility in the United Kingdom, the transaction will be
reported as an inflow to the financial account in the United Kingdom
because it is money coming in from other countries. The same
transaction will be reported as an outflow from the financial account in
Brazil because it is money sent abroad.
Portfolio investments reflect the purchases and sales of securities, such
as debt and equity securities, between domestic entities and foreign
entities.
Other investments are largely made up of loans and deposits between
domestic entities and foreign entities.
The reserve account shows the transactions made by the monetary
authorities of a country, typically the central bank.
4.3. Relationship between the Current
Account and the Capital and Financial
Account
The capital and financial flows move in the opposite direction of the goods
and services flows that give rise to them. As stated earlier, the sum of the
current account balance and the capital and financial account balance should
in theory be equal to zero. If a country has a current account surplus, it should
have a capital and financial account deficit of the same magnitude—the
country is a net saver and ends up being a net lender to the rest of the world.
Alternatively, if a country has a current account deficit, it should have a
capital and financial account surplus of the same magnitude—the country is a
net borrower from the rest of the world.
In practice, however, the capital and financial account balance does not
exactly offset the current account balance because of measurement errors. All
the items reported in the balance of payments must be measured
independently by using different sources of data. For example, data are
collected from customs authorities on exports and imports, from surveys on
tourist numbers and expenditures, and from financial institutions on capital
inflows and outflows. Some of the inputs are based on sampling techniques,
so the resulting figures are estimates.
Because measuring the items reported in the balance of payments is difficult,
it is in practice rare, if not impossible, to end up with a capital and financial
account balance that exactly offsets the current account balance. So, there is a
need for a “plug” figure that makes the sum of all the money flows in and out
of a country equal to zero. This plug figure is called errors and omissions.
Exhibit 4 shows a simplified version of the balance of payments of Germany
in 2012.
Exhibit 4.
Balance of Payment of Germany in 2012
Accounts
Amount (€ billions)
Current account
Exports of goods
Imports of goods
+1,097.3
–909.1
Net exports of goods
Supplementary trade items
Net exports of services
Trade surplus
Income
+188.2
–27.3
–3.1
+157.8
+64.4
–36.8
Current transfers
Current account surplus
+185.4
Capital and financial account
Capital account surplus
Direct investments
+0.0
–47.0
Accounts
Portfolio investments
Other investments
Reserve account
Financial account deficit
Capital and financial account deficit
Errors and omissions
Total
Amount (€ billions)
–65.7
–120.9
–1.3
–234.9
–234.9
+49.5
0.0
Source: Based on data from
http://www.bundesbank.de/Redaktion/EN/Downloads/Publications/Monthly_Report
_Articles/2013/2013_03_balance.pdf?__blob=publicationFile (accessed 6 March
2014).
Exhibit 4 shows that in 2012, Germany had a current account surplus of
€185.4 billion and was thus a net saver. The current account surplus was
primarily driven by a trade surplus of €157.8 billion, indicating that
Germany exported more than it imported during the year. As a consequence
of its current account surplus, Germany is a net lender to other countries
through a combination of direct, portfolio, and other investments. In 2012,
Germany’s capital and financial account deficit was €234.9 billion.
The difference of €49.5 billion between the current account balance and the
capital and financial account balance labelled errors and omissions is the
plug figure that is needed because of measurement errors. The plug figure is
often a large amount, indicating how difficult it is to measure accurately the
items reported in the balance of payments.
4.4. Why Does a Country Run a Current
Account Deficit and How Does It Affect Its
Currency?
We saw in Exhibit 2 that some countries, such as the United States, the
United Kingdom, Brazil, India, and Canada, run large current account
deficits. Is running a current account deficit a bad sign, and should all
countries aim at maximising their current account balance? The answer to
both questions is, not necessarily. First, the sum of the current account
balances of all countries is, by definition, equal to zero. In other words, an
inflow for one country is an outflow for another country. So, it is impossible
for all countries to have a current account surplus.
Second, a current account deficit must be put in context before drawing
conclusions. A developing country may run a current account deficit because
it needs to import many products (such as machinery and equipment) and
services (such as communication services) to help its economy evolve. As
the initial period of heavy investment ends and the economy gets stronger, the
developing country may experience a decrease in imports and an increase in
exports, progressively reducing or even eliminating the current account
deficit. This scenario can also apply to transition economies that are moving
from a socialist planned economy to a market economy. In such a scenario,
the current account deficit may only be temporary. Alternatively, a mature
economy may run a current account deficit because its consumption far
exceeds its production and its ability to export. Thus, when reviewing the
economic outlook for a country running a current account deficit, an
investment professional must factor in the country’s stage of economic
development and understand what drives the current account balance.
There is a long-running debate about the risk for a country of running a
persistent current account deficit. As mentioned earlier, a current account
deficit means that the country spends more than it earns and makes up the
difference by borrowing or receiving investments from other countries. Some
economists argue that as long as foreign entities are willing to continue
holding the assets and the currency of the country with a current account
deficit, running a current account deficit does not matter. But what if foreign
entities become unwilling to hold the assets and the currency of the country
running a current account deficit?
Consider the example of the country running the largest current account
deficit, the United States. Because the United States has a large trade deficit
with many countries, those countries hold US dollars. These US dollars can
be held as bank deposits in the United States or they can be invested. For
example, foreign companies may use their US dollars to acquire US
companies, or they may invest in debt and equity securities issued by US
companies. Other governments may also invest in bonds (debt securities)
issued by the US government—these bonds are called US Treasury securities
or US Treasuries.
But if other countries decide that they want to reduce their exposure to the
United States, they may start selling US assets, which will have a negative
effect on the price of these assets. In addition, they may decide to convert
their US dollars into other currencies, which will cause a depreciation of
the US dollar relative to other currencies—that is, the US dollar will get
weaker and a unit of the US currency will buy less units of foreign
currencies. Put another way, foreign currencies will get stronger relative to
the US dollar, a situation referred to as an appreciation of foreign
currencies relative to the US dollar. To encourage entities in other countries
to invest in the United States, the Federal Reserve Board (or the Fed), which
is the US central bank, may increase interest rates. An increase in interest
rates would increase the cost of financing for individuals, companies, and the
government in the United States. So, the combination of lower asset prices, a
weaker US dollar, and higher interest rates would likely hurt the US
economy, potentially leading to a lower GDP, maybe even a recession, and
higher unemployment.
5. FOREIGN EXCHANGE RATE
SYSTEMS
International trade requires payments. These payments involve an exchange
of currencies and are thus affected by foreign exchange rates and foreign
exchange rate systems. The rate at which one currency can be exchanged for
another is called the foreign exchange rate or exchange rate, and it is
expressed as the number of units of one currency it takes to convert into the
other currency.
International trade payments can be made in the country’s domestic currency
or in a foreign currency. For example, assume a supermarket chain located in
France imports dairy products from the United Kingdom and has to pay the
UK producers in British pounds. The exchange rate between the pound and
the euro is usually stated in euros per pound (€/£). An exchange rate of
€1.20/£1 means that it takes 1 euro and 20 cents to convert into 1 pound. If
the French supermarket chain has to pay the UK dairy producers £100,000, it
will have to convert €120,000 (£100,000 × €1.20/£1).
The exchange rates between world currencies, such as the US dollar (US$),
euro, British pound, and Japanese yen (¥) are just like prices of products and
services. As discussed in the Microeconomics chapter, prices change
continuously depending on supply and demand. If a lot of people want to buy
a particular currency, such as the euro, demand for the euro will increase and
the price of the euro will rise. It will take more of the other currency to buy a
euro. In this case, the euro is said to appreciate (get stronger) relative to
other currencies. Alternatively, if a lot of people want to sell the euro,
demand for the euro will decrease and the price of the euro will fall. It will
take less of the other currency to buy a euro. In this case, the euro is said to
depreciate (get weaker) relative to other currencies.
There are three main types of exchange rate systems:
Fixed rate
Floating rate
Managed floating rate
At the Bretton Woods conference in 1944, the major nations of the Western
world agreed to an exchange rate system in which the value of the US dollar
was defined as $35 per ounce of gold. So, a dollar was equivalent to one
thirty-fifth of an ounce of gold. All other currencies were defined or
“pegged” in terms of the US dollar. Such a system of exchange rates, which
does not allow for fluctuations of currencies, is known as a fixed
exchange rate system or regime.
The advantage of a fixed exchange rate system is that it eliminates currency
risk (or foreign exchange risk), which is the risk associated with the
fluctuation of exchange rates. In a fixed-rate regime, importers and exporters
know with greater certainty the amount that they will pay or receive for the
products and services they trade. A disadvantage is that, as the
competitiveness of economies changes over time, an economy that becomes
uncompetitive will see its current account balance worsen because its
currency becomes overvalued; its exports are too expensive from the buyer’s
perspective and its imports are too cheap from the seller’s perspective.
Under a fixed exchange rate system, the only solution to this problem is for
the country to formally devalue its currency. Devaluation is the decision
made by a country’s central bank to decrease the value of the domestic
currency relative to other currencies, an action that many governments are
reluctant to take.
To overcome the disadvantages of a fixed exchange rate system, the Bretton
Woods system was abandoned in 1973 and currency values were left to
market forces. Thus, since 1973, the major currencies, such as the US dollar,
the euro, and the British pound, have existed under a floating exchange
rate system. In a pure floating exchange rate system, a country’s central
bank does not intervene and lets the market determine the value of its
currency. That is, the exchange rate between the domestic currency and
foreign currencies is only driven by supply and demand for each currency.
In a managed floating exchange rate system, a central bank
intervenes to stabilise its country’s currency. To do so, it buys its domestic
currency using foreign currency reserves to strengthen the domestic currency
or it buys foreign currency using domestic currency to weaken the domestic
currency. For example, in the wake of the European sovereign debt crisis in
2012, many investors converted their euros to Swiss francs, viewing the
Swiss franc as a safer currency than the euro. The strengthening of the Swiss
franc started eroding the competitiveness of Swiss exporters and pushed the
Swiss National Bank, Switzerland’s central bank, to intervene. To drive the
price of the Swiss franc down, the Swiss National Bank sold its domestic
currency and bought foreign currencies, such as the euro; the Swiss National
Bank did the opposite of what investors were doing. In the process, it
accumulated foreign currency reserves. This example shows that central
banks do not usually aim for a completely fixed exchange rate, but typically
try to maintain the value of their country’s currency within a certain range.
Central banks typically intervene infrequently, so generally, such a system
operates as a floating exchange rate system.
6. CURRENCY VALUES
This section identifies some major factors that affect the value of a currency
and then describes how to assess the relative value of currencies.
6.1. Major Factors That Affect the Value of a
Currency
Major factors that influence the value of a currency include the country’s
balance of payments,
level of inflation,
level of interest rates,
level of government debt, and
political and economic environment.
6.1.1. Balance of Payments
As discussed earlier, an important factor that affects the value of a currency
is the current account balance. In a floating exchange rate system, the
exchange rate should adjust to correct an unsustainable current account
deficit or surplus. So, if a country has a large current account deficit, the
domestic currency should depreciate relative to foreign currencies. The
relative price of that country’s exports in overseas markets should fall,
making exports more competitive. At the same time, the relative price of
imports in the country should rise, making imports more expensive. Exporting
more and importing less should in theory reduce the current account deficit
and could even turn it into a surplus. In contrast, if a country has a large
current account surplus, the domestic currency should appreciate relative to
foreign currencies. The domestic currency’s appreciation should have a
negative effect on exports and a positive effect on imports, reducing the
current account surplus. So, a floating exchange rate system tends to be selfadjusting.
But, as discussed earlier, the self-adjusting mechanism does not always work
in practice because there are many factors other than international trade that
influence exchange rates. In addition, the natural correction that should lead
to a reduction of the current account deficit or surplus may not occur if the
country belongs to a single currency zone. For example, as of March 2014,
the euro is the common currency used by 18 European countries. Some
countries, such as France, Belgium, and Italy, run large current account
deficits. The self-adjusting mechanism should lead to a depreciation of the
euro and reduce the current account deficits of these countries. But the euro is
also the currency used by Germany, the country running the largest current
account surplus, as shown in Exhibit 2. Because 18 European countries use
the same currency but face very different economic environments, it makes it
difficult, if not impossible, for natural corrections to take place.
6.1.2. Level of Inflation
As discussed in the Macroeconomics chapter, inflation erodes the purchasing
power of a country’s currency—that is, as prices increase, a unit of domestic
currency buys less foreign products and services. Example 2 illustrates the
effect of inflation on the purchasing power of a country’s currency.
EXAMPLE 2.
CURRENCY
EFFECT OF INFLATION ON A COUNTRY’S
The following table shows the price of identical loaves of bread in
Ireland and in the United Kingdom in January and in June.
Ireland United Kingdom Exchange Rate
January
June
€1.20
€1.20
£1.00
£1.10
€1.20/£1
€1.09/£1
In January, the loaf of bread costs €1.20 in Ireland and £1.00 in the
United Kingdom, which implies an exchange rate of €1.20/£1. If
inflation in the United Kingdom drives the price of the bread to £1.10 in
June, but the price remains €1.20 in Ireland, then the purchasing power
of the pound is lower in June than it was in January. The exchange rate
has moved from €1.20/£1 to €1.20/£1.10 or €1.09/£1. A pound buys
fewer euros, so the pound has depreciated relative to the euro.
A country with a consistently high level of inflation will see the value of its
currency fall compared with a country that has a consistently low level of
inflation.
6.1.3. Level of Interest Rates
Higher interest rates, unless they are driven by inflation, usually increase
capital flows into a country because they make investments in that country
more attractive, all other factors being equal. Increased investments in the
country create a demand for the country’s currency. Thus, higher interest rates
push the value of the currency higher.
As discussed in the Macroeconomics chapter, raising interest rates is a way
for central banks to control inflation. When a central bank raises interest
rates, it may attract more foreign investors to buy that currency, making the
currency appreciate. The appreciating currency makes imports less
expensive and thus helps reduce inflation.
In addition, some countries that have balanced economic growth and higher
relative interest rates may see an increase in capital flows into their
currency. This increase occurs because many investors see higher interest
rates as a way of achieving a higher yield. But high interest rates can also
reduce capital inflows if investors believe they might lead to higher inflation
and potential currency depreciation.
6.1.4. Level of Government Debt
If it appears that a government is over-indebted and may be unable to make a
promised payment of interest or principal—that is, it may default on its
payments—investors may decide that they no longer want to hold the bonds
issued by that government. If investors sell the government bonds they hold
and take their money out of the country, it will cause a depreciation of the
country’s currency.
6.1.5. Political and Economic Environment
Capital tends to flow to countries with political stability and strong
economic performance. Countries with political instability and/or poor
economic prospects, such as low growth or high unemployment, are likely to
see the value of their currencies decrease. As an economy grows, capital
flows will also often increase. Over the past few years, such countries as
Australia and Canada have received increased capital flows because of their
strong economic prospects.
Government policies toward foreign investors also affect capital flows.
Capital flows usually increase when a country becomes more open to outside
investors and liberalises foreign direct investments (FDIs)—that is,
direct investments made by foreign investors and companies. For example,
India is slowly allowing foreign ownership in some of its domestic
companies.
Exhibit 5 summarises the major factors that affect the value of a currency.
Exhibit 5.
Major Factors Affecting the Value of a Currency
Factor
Balance of
payments
Level of
inflation
Level of
interest rates
Level of
government
debt
Political and
economic
environment
Effect on the Value of the Currency
A current account deficit tends to lead to a
depreciation of the domestic currency.
High inflation tends to lead to a depreciation
of the domestic currency.
High interest rates tend to lead to an
appreciation of the domestic currency.
High government debt tends to lead to a
depreciation of the domestic currency.
Political instability and poor economic
prospects tend to lead to a depreciation of the
domestic currency.
There may be factors other than the ones listed in Exhibit 5 that affect the
value of a currency, particularly if the currency has the status of reserve
currency, which is the case of the US dollar. A reserve currency is a
currency that is held in significant quantities by many governments and
financial institutions as part of their foreign exchange reserves. A reserve
currency also tends to be the international pricing currency for products and
services traded on a global market and for commodities, such as oil and
gold. Because the US dollar is a reserve currency, the demand for US
financial assets and for US dollars is higher than it would be based on the
country’s macroeconomic outlook alone. Many economists believe that a
decline in the demand for US financial assets and for US dollars may take
place over many years as alternative reserve currencies emerge. However,
major foreign investors holding US financial assets and substantial US dollar
reserves—such as non-US central banks—do not want to cause the value of
their holdings to drop by embarking on large sales of these assets.
6.2. Relative Strength of Currencies
The concept of purchasing power parity has long been used to explain
relative currency valuations—that is, whether currencies are fairly valued
relative to each other. Purchasing power parity is an economic theory based
on the principle that a basket of goods in two different countries should cost
the same after taking into account the exchange rate between the two
countries’ currencies.
Example 3 illustrates what happens if two identical products have different
prices and how prices and the exchange rate should adjust.
EXAMPLE 3.
ARBITRAGE OPPORTUNITY
Assume that the exchange rate is currently 10 Mexican pesos for 1 US
dollar (M$10/$1). In the United States, a particular car sells for
$30,000, whereas in Mexico, the same car sells for M$270,000. Given
the exchange rate, the car costs $30,000 in the United States but the
equivalent of $27,000 [M$270,000/(M$10/$1)] in Mexico. In other
words, it is cheaper for a US citizen to buy the car in Mexico.
The fact that the same product sells for different prices presents an
arbitrage opportunity—that is, an opportunity to take advantage of
the price difference between the two markets. If consumers are able to
do this without incurring extra costs, then the following may happen:
1. US consumers will demand Mexican pesos to buy cars in Mexico.
This demand will cause the Mexican peso to appreciate relative to
the US dollar.
2. Demand for the car sold in Mexico will increase, so the price
Mexican retailers charge will also increase.
3. By contrast, demand for the car sold in the United States will
decrease because consumers will go to Mexico to buy it. Thus, the
price US retailers charge for the car will decrease.
Eventually, these events should cause the prices in the two countries and
the exchange rate to change until the price difference vanishes. But the
adjustment process may take time.
In practice, buying the car in Mexico and bringing it to the United States may
not be as advantageous as it seems in theory. Anything that limits the free
trade of goods will limit the opportunities people have to take advantage of
these arbitrage opportunities and will influence currency valuations. The
following are examples of three such limits:
Import and export restrictions. Restrictions, such as tariffs, quotas, and
non-tariff barriers discussed in Section 2.2, may make it difficult to buy
products in one market and bring them into another. If the United States
imposes a tax on cars imported from Mexico, then it may no longer be
advantageous to buy the car in Mexico instead of in the United States.
Transportation costs. The gains from arbitrage are limited if it is
expensive to transport products from one market to another.
Transportation costs may be limited for US consumers going to Mexico
to buy a car, but costs would be much higher if they had to ship a car
from Germany or Japan.
Perishable products. It may be impractical or difficult to transfer
products from one market to another. There may be a place that sells
low-priced sandwiches in France, but that may not help consumers who
live in Italy.
Purchasing power parity is the concept behind the Economist’s Big Mac
index. On a regular basis, the Economist records the price of McDonald’s
Big Mac hamburgers in various countries around the world, and then it
estimates what the exchange rates should be to make the price of Big Macs
the same in all the countries. This exchange rate relies on purchasing power
parity and assumes that an identical product, the Big Mac, should have the
same price everywhere. Otherwise, there would be an arbitrage opportunity,
such as the one described in Example 3. The Economist constructs a table
of purchasing power parity exchange rates relative to the US dollar and then
compares them with the actual exchange rates to help identify whether
currencies are under- or overvalued relative to the US dollar.
Example 4 illustrates how the Economist uses Big Macs to calculate
purchasing power parity exchange rates and how it determines which
currencies are under- and overvalued relative to the US dollar.
EXAMPLE 4.
RATES
PURCHASING POWER PARITY EXCHANGE
In January 2014,
Cost of a Big Mac in the United States
Cost of a Big Mac in South Africa (in rands)
Implied exchange rate
US$4.62
R23.50
R5.09/US$1
In January 2014, a Big Mac cost US$4.62 in the United States and
R23.50 in South Africa, which implies a purchasing power parity
exchange rate of R5.09/US$1 (R23.50/US$4.62). The actual exchange
rate in January 2014 was R10.88/US$1. This means that, based on
purchasing power parity, the South African rand is undervalued relative
to the US dollar because it takes more South African rand than
purchasing power parity implies to buy a US dollar. Put another way, if
in January 2014 a Big Mac cost R23.50 in South Africa and the actual
exchange rate was R10.88/US$1, the cost of a Big Mac in the United
States should be US$2.16. But the cost was US$4.62, which means that
the South African rand was undervalued by more than 50%; converting
R23.50 to US dollars would only give us US$2.16, which is not enough
to buy a Big Mac in the United States.
Exhibit 6 shows the currencies identified by the Economist as the most
under- and overvalued as of January 2014.
Exhibit 6.
The Economist’s Big Mac Index
Source: “Big Mac Index,” Economist, http://www.economist.com/content/big-macindex (accessed 6 March 2014).
As of January 2014, the most undervalued currencies were the Indian rupee,
the South African rand, and the Malaysian ringgit. The most overvalued
currencies were the Norwegian krone, the Venezuelan peso, and the Swiss
franc. The British pound and the New Zealand dollar were fairly valued
compared with the US dollar.
The purchasing power parity exchange rates constructed using Big Macs are
only loosely representative of actual exchange rates because they are based
on just one product. In reality, purchasing power parity exchange rates should
reflect a representative basket of goods, but the Big Mac index serves as an
easily understandable proxy.
Although purchasing power parity provides a way to explain relative
currency valuations, it has limitations. Two of these limitations are the
difficulty of identifying a basket of goods for comparison between countries
and, as discussed earlier, the barriers to international trade. These problems
help explain why evidence suggests that purchasing power parity does not
hold very well in the short to medium term. But in the long term, deviations
of actual exchange rates from purchasing power parity rates eventually
correct themselves. In other words, purchasing power parity tends to apply
only in the long term.
7. FOREIGN EXCHANGE MARKET
The foreign exchange market is where currencies are traded. It is a very
active and liquid market with an average of $5 trillion traded globally every
day. It is not in a centralised location but is a highly integrated decentralised
network that connects buyers and sellers via information and computer
technology.
7.1. Foreign Exchange Rate Quotes
If you have ever converted money, maybe at the airport when visiting a
country that uses a different currency than your home country, you are aware
that the bank or currency dealer always displays two exchange rates for a
particular currency.
The bid exchange rate (or bid rate) is the exchange rate at which the
bank or currency dealer will buy the foreign currency.
The offer exchange rate (or offer rate), also called the ask
exchange rate (or ask rate), is the exchange rate at which the bank or
dealer will sell the foreign currency.
The difference between the bid and offer (ask) rates is known as the bid–
offer spread (bid–ask spread). The bid–offer spread is how the bank or
currency dealer makes money—these intermediaries make a profit by buying
a unit of currency more cheaply than they sell it. The bid–offer spread will
vary from bank to bank, from currency to currency, and according to market
conditions. The more a currency is traded, the smaller the bid–offer spread.
Example 5 shows how bid and offer rates are used to convert currencies.
Remember that you are not responsible for calculations. The presentation of
formulas and illustrative calculations in Examples 5 and 6 may enhance
your understanding.
EXAMPLE 5. CONVERTING CURRENCIES USING BID AND
OFFER RATES
A currency dealer in a US airport indicates the following bid and offer
rates:
British pound (£)
Bid
Offer
$1.50/£1
$1.60/£1
Customer A, who has just arrived from the United Kingdom, wants to
convert £1,000 into US dollars. Customer B, who is leaving shortly for
the United Kingdom, wants to convert $1,600 into pounds.
From the US perspective, the British pound is the foreign currency and
the US dollar is the domestic currency. Customer A wants to sell the
foreign currency (£) and buy the domestic currency ($), which means
that the currency dealer has to buy the foreign currency (£). Thus, the
currency dealer applies the bid rate of $1.50/£1 and Customer A will
receive $1,500 (£1,000 × ($1.50/£1) for the £1,000.
Customer B wants to sell the domestic currency ($) and buy the foreign
currency (£), which means that the currency dealer has to sell the
foreign currency (£). Thus, the currency dealer applies the offer rate of
$1.60/£1 and Customer B will receive £1,000 [$1,600/($1.60/£1)] for
the $1,600.
The currency dealer made a profit of $100. It received £1,000 from
Customer A and passed the entire amount to Customer B. At the same
time, the currency dealer received $1,600 from Customer B but passed
only $1,500 to Customer A. So, the currency dealer is left with a profit
of $100. This profit is the result of the bid–offer spread.
If you are ever confused, just remember that the exchange rate works to the
advantage of the dealer; a dealer will pay as little as possible for any
currency.
7.2. Spot and Forward Markets
Foreign exchange transactions may take place in the spot market or in the
forward market. The spot market is where currencies are traded now and
delivered immediately. The exchange rate for the transaction is called the
spot exchange rate or spot rate. In contrast, the forward market is where
currencies are traded now but delivered at some future date, such as one
month or three months from now. The exchange rate for the transaction is
called the forward exchange rate or forward rate, and there are as many
forward rates as there are delivery dates. For example, there is a one-month
forward rate for delivery in one month, a two-month forward rate for
delivery in two months, and so on.
In Example 5, both currency transactions were spot transactions: Customers
A and B wanted to convert currencies immediately. However, in many
instances, investors or companies want to determine now the exchange rate
for a currency transaction that will occur at a later date.
Let us return to the example of the French supermarket chain importing dairy
products from the United Kingdom that has to pay its UK dairy producers
£100,000. If the French supermarket needs to make the payment now and
convert euros into pounds immediately, the exchange rate at which the
conversion takes place is the spot rate. Assuming a spot rate of €1.20/£1, the
French supermarket chain has to convert €120,000 to pay its invoice today,
as shown earlier.
In the business world, however, many suppliers give credit to their
customers. Assume that the French supermarket chain has two months to pay
its UK dairy producers. Because the conversion of euros into pounds is not
required now but in two months, the French supermarket chain faces
uncertainty about the exchange rate that will prevail in two months and thus
the amount it will have to give its bank or currency dealer to get the
£100,000 necessary to pay its UK dairy producers. In other words, the
French supermarket chain is exposed to currency risk because of the potential
fluctuation of the exchange rate between the euro and the pound during the
next two months.
Example 6 shows the effect of both an appreciation and a depreciation of
the euro relative to the pound on the amount the French supermarket chain
would have to pay its UK dairy producers.
EXAMPLE 6. CURRENCY APPRECIATION AND
DEPRECIATION
A French supermarket chain imports dairy products from the United
Kingdom and has to pay its UK dairy producers £100,000.
Spot
exchange
rate
€1.20/£1
French
supermarket
chain must
pay
£100,000 ×
€1.20/£1 =
€120,000
Exchange rate changes to
€1.15/£1
It takes 5 cents less to buy
1 pound. Thus, the euro
appreciated relative to the
pound.
French supermarket chain
must pay
£100,000 × €1.15/£1 =
€115,000
Euro appreciation relative
to the pound is beneficial
for the French importer.
Exchange rate changes to
€1.25/£1
It takes 5 cents more to
buy 1 pound. Thus, the
euro depreciated relative
to the pound.
French supermarket
chain must pay
£100,000 × €1.25/£1 =
€125,000
Euro depreciation
relative to the pound is
detrimental for the
French importer.
The French supermarket may want to determine today how many euros it will
have to give its bank or currency dealer to get £100,000 in two months when
it converts the euros into pounds. By using the forward market today, the
French supermarket chain can lock in (fix) the exchange rate at which it will
pay the invoice in two months. For example, if the two-month forward rate
for delivery in two months is €1.21/£1, the French supermarket chain can use
the forward market to lock in this exchange rate and determine today that it
will need €121,000 to get the £100,000 necessary to pay its UK dairy
producers. In doing so, it eliminates the currency risk—no matter how much
the euro fluctuates relative to the pound in the next two months, the French
supermarket chain has certainty about the amount it will pay its UK dairy
suppliers. Reducing or eliminating risk such as currency risk is often called
hedging and is further discussed in the Derivatives chapter.
Gaining certainty is important for companies because it enables them to
ensure that they can meet future cash outflows, such as operating expenses
and interest payments. Also, most companies prefer to focus on trading their
products and services profitably, rather than focus on the intricacies of
buying and selling currencies.
SUMMARY
The next time you walk into a supermarket, you may look at the types and
prices of products, such as wine, coffee, and rice, in a new light. This
chapter has hopefully allowed you to see how imports and exports affect the
types of products you find in shops and the prices you pay for those products.
International trade and foreign exchange fluctuations are relevant to your
everyday life and also to the work of investment professionals who try to
assess how they will affect the valuation of assets.
Key points to remember about the economics of international trade include:
Countries trade with each other by importing products and services that
are produced in other countries and by exporting products and services
produced domestically.
Companies trade across borders to gain access to resources, to create
additional demand for products and services produced domestically, to
provide consumers with a greater choice of products and services, and
to improve the quality and/or reduce the price of products and services.
International trade has benefited from the reduction in trade barriers,
such as tariffs, quotas, and non-tariff barriers, and from better
transportation and communications.
Countries tend to specialise in products and services for which they
have a comparative advantage, and then they trade to get access to
products and services that other countries can produce relatively more
efficiently. The combination of specialisation and international trade
ultimately benefits all countries, leading to a better allocation of
resources and increased wealth.
The balance of payments tracks transactions between residents of one
country and residents of the rest of the world over a period of time,
usually a year. Analysing a country’s balance of payments helps in
understanding the country’s macroeconomic environment.
The balance of payments includes two accounts: the current account and
the capital and financial account.
The current account reports trades of imported and exported goods and
services as well as income and current transfers. A country where the
value of exports is higher than the value of imports has a trade surplus.
By contrast, a country where the value of exports is lower than the value
of imports has a trade deficit. Because the trade balance tends to
dominate the current account balance, countries that have a trade surplus
tend to have a current account surplus, whereas countries that have a
trade deficit tend to have a current account deficit.
The capital account primarily reports capital transfers between
domestic entities and foreign entities. The financial account includes
direct investments, portfolio investments, other investments, and the
reserve account.
In theory, the sum of the current account and the capital and financial
account is equal to zero. Thus, a country that has a current account
surplus will have a capital and financial account deficit of the same
magnitude—the country is a net saver and ends up being a net lender to
the rest of the world. Alternatively, a country that has a current account
deficit will have a capital and financial account surplus of the same
magnitude—the country is a net borrower from the rest of the world.
However, in practice, the capital and financial account balance does not
exactly offset the current account balance because of measurement
errors reflected in the balance of payments in errors and omissions.
A country may run a current account deficit because it needs to import
many goods to help its economy evolve or because its consumption far
exceeds its production and its ability to export. A persistent current
account deficit may cause a depreciation of the country’s currency
relative to other currencies.
An exchange rate is the rate at which one currency can be exchanged for
another. It can also be considered as the value of one country’s currency
in terms of another currency.
Three main types of exchange rate systems are fixed exchange rate,
floating exchange rate, and managed floating exchange rate systems. A
fixed exchange rate system does not allow for fluctuations of currencies.
By contrast, a floating exchange rate system is driven by supply and
demand for each currency, allowing exchange rates to adjust to correct
imbalances, such as current account deficits. In practice, pure floating
exchange rate systems are rare. Managed floating exchange rate systems,
in which a central bank will intervene to stabilise its country’s currency,
are more common although intervention is uncommon.
Major factors that affect the value of a currency include the balance of
payments, inflation, interest rates, government debt, and the political
and economic environment. A current account deficit, high inflation,
low interest rates, high government debt, political instability, and poor
economic prospects tend to lead to a depreciation in value of the
domestic currency relative to foreign currencies; it will take more of the
domestic currency to buy a unit of foreign currency.
One of the simplest models for determining the relative strength of
currencies is purchasing power parity, which is based on the principle
that a basket of goods in two different countries should cost the same
after taking into account the exchange rate between the two countries’
currencies. Purchasing power parity has limitations because of the
difficulty of identifying a basket of goods for comparison between
countries and barriers to international trade.
Two exchange rates are quoted in the market: the bid rate and the offer
rate. The bid rate is the rate at which the dealer will buy the foreign
currency, and the offer rate is the rate at which the dealer will sell the
foreign currency. The bid–offer spread is how the dealer makes money.
Foreign exchange transactions may take place with immediate delivery
via the spot market or with future delivery via the forward market.
The forward market allows importers and exporters to eliminate
currency risk by fixing today the exchange rate at which they will trade
in the future.
CHAPTER REVIEW QUESTIONS
© 2014 CFA Institute. All rights reserved.
1. The country of Australia classifies products departing from the port of
Melbourne to other countries as:
A. exports.
B. imports.
C. net exports.
2. International trade most likely:
A. helps keep prices down.
B. reduces competition.
C. reduces demand for domestic products and services.
3. Which of the following would most likely be reduced if India imposed a
tariff on goods from Japan?
A. India’s exports
B. India’s imports
C. Japan’s imports
4. Which of the following would most likely promote international trade?
A. Increased tariffs
B. Higher transportation costs
C. Faster transport of products and services
5. Country A can produce 1 electric turbine using 10 units of labour and 4
refrigerators using 10 units of labour. Country B can produce 1 electric
turbine using 7 units of labour and 4 refrigerators using 12 units of
labour. According to the theory of comparative advantage, Country A
should produce:
A. refrigerators and trade with Country B for electric turbines.
B. electric turbines and trade with Country B for refrigerators.
C. electric turbines and refrigerators and not trade with Country B.
6. Payments from a computer company in the United Kingdom to a
company in India that operates a call centre to answer questions from
the computer company’s customers are most likely included in the
United Kingdom’s:
A. current account.
B. capital account.
C. financial account.
7. Countries with exports greater than imports most likely have a current
account:
A. deficit.
B. surplus.
C. in balance.
8. If a country has a current account surplus, it most likely has a capital
and financial account:
A. deficit.
B. surplus.
C. in balance.
9. A central bank’s intervention aimed at stabilising the value of its
currency within a certain range best describes a:
A. fixed exchange rate system.
B. pure floating exchange rate system.
C. managed floating exchange rate system.
10. A company imports goods and pays for them in a foreign currency.
Which of the following exchange rate systems would eliminate currency
risk for the company?
A. Fixed
B. Pure floating
C. Managed floating
11. Which of the following is most likely to cause a country’s currency to
appreciate?
A. High inflation
B. Political instability
C. A current account surplus
12. A country’s currency will most likely depreciate when the country
experiences high:
A. interest rates.
B. government debt.
C. economic growth.
13. A currency dealer makes more money when the:
A. bid–offer spread is wide.
B. bid–offer spread is narrow.
C. bid rate is equal to the offer rate.
14. The most likely objective of an exporter using the forward market in
currencies is to:
A. reduce risk.
B. increase profit.
C. increase currency exposure.
15. Which of the following is a foreign exchange transaction involving the
forward market?
A. A company writes a cheque in foreign currency.
B. A tourist converts US$1,000 into euros at an airport.
C. A company agrees to buy US$100,000 for ¥7,500,000 in 60 days.
ANSWERS
1. A is correct. Exports are products and services that are produced within
a country’s borders and then transported to another country. B is
incorrect because imports are products and services that are produced
outside a country’s borders and then brought into the country. C is
incorrect because net exports represent the difference between exports
and imports of products and services.
2. A is correct. International trade promotes greater efficiency, which
helps keep prices down. B and C are incorrect because international
trade tends to increase competition and increase demand for domestic
products and services.
3. B is correct. A tariff tends to make imported goods more expensive.
Goods imported from Japan would likely be more expensive, which
would reduce India’s imports (and Japan’s exports).
4. C is correct. Improvements in transportation, including faster transport,
help international trade. A is incorrect because tariffs are trade barriers;
they are effectively taxes (duties) levied on imported goods and
services. Increased trade barriers limit international trade. B is
incorrect because higher transportation costs increase the cost of
importing and exporting goods, which limits international trade.
5. A is correct. Country A has both an absolute and a comparative
advantage in the production of refrigerators. It only takes 2.5 units of
labour (10 units of labour divided by 4 refrigerators) to produce a
refrigerator in Country A compared with 3.0 units of labour (12 units of
labour divided by 4 refrigerators) in Country B. By contrast, Country B
has both an absolute and a comparative advantage in the production of
electric turbines. It only takes 7 units of labour to produce an electric
turbine in Country B compared with 10 units of labour in Country A.
Thus, according to the theory of comparative advantage, both countries
will be better off if Country A makes refrigerators, Country B makes
electric turbines, and they trade with each other.
6. A is correct. Answering questions at a call centre in India to service a
computer company’s customers in the United Kingdom is an export of
service from India and an import of service for the United Kingdom.
The flow of money for service is included in the current account in the
balance of payments.
7. B is correct. A country with exports greater than imports has positive
net exports, or a trade surplus. The trade balance tends to dominate the
current account balance, so this country most likely has a current
account surplus.
8. A is correct. If a country has a current account surplus, it will have a
capital and financial account deficit—the country is a net saver and
ends up being a net lender to the rest of the world.
9. C is correct. Under a managed floating exchange rate system, a country’s
central bank intervenes to stabilise its currency within a certain range.
To do so, it buys its domestic currency using its foreign currency
reserves to strengthen its domestic currency or buys foreign currency
using its domestic currency to weaken its domestic currency.
10. A is correct. The advantage of a fixed exchange rate system is that it
eliminates currency risk (or foreign exchange risk), which is the risk
associated with the fluctuation of foreign exchange rates. Under a fixed
exchange rate system, the company will know with certainty the amount
it will pay for the imported goods. B and C are incorrect because under
pure or managed floating exchange rate systems, the company faces
currency risk.
11. C is correct. A current account surplus tends to lead to an appreciation
of a country’s currency. A and B are incorrect because high inflation and
political instability tend to lead to a depreciation of a country’s
currency.
12. B is correct. High government debt tends to lead to a depreciation of a
country’s currency. A and C are incorrect because high interest rates and
high economic growth tend to lead to an appreciation of the country’s
currency.
13. A is correct. The bid exchange rate (or bid rate) is the exchange rate at
which the currency dealer will buy the foreign currency, and the offer
exchange rate (or offer rate) is the exchange rate at which the currency
dealer will sell the foreign currency. The currency dealer makes a profit
by buying a unit of currency more cheaply than it sells it. Thus, the
wider the bid–offer spread, the more money the currency dealer makes.
14. A is correct. An exporter is most likely to use the forward market in
currencies to reduce the currency risk associated with a future cash flow
in a foreign currency. Using the forward market allows the exporter to
gain predictability about future cash flows exposed to currency risk.
Thus, the exporter can focus on its core business activities rather than
worry about currency risk. B is incorrect because the exporter does not
use the forward market in currencies to increase profits but to reduce
currency risk. C is incorrect because by using the forward market, the
exporter is trying to decrease, rather than increase, currency exposure.
15. C is correct. An agreement to convert one currency into another in the
future is a foreign exchange transaction that involves the forward
market. A and B are incorrect because writing a cheque in a foreign
currency and converting US dollars into euros at the airport are foreign
exchange transactions conducted in the spot market.
NOTES
1Data are from www.wto.org/english/res_e/booksp_e/anrep_e/wtr12-1_e.pdf (accessed 12
September 2012).
2Information is from http://www.nestle.com/aboutus/annual-report (accessed 24 March 2014).
3IMF, “Chapter II”, in Balance of Payments Manual, International Monetary Fund (2012):6
(www.imf.org/external/pubs/ft/bopman/bopman.pdf, accessed 11 September 2012).
4Balance of trade may be used by some to refer only to the difference between exports and imports of
goods. In this chapter, when we refer to balance of trade, we include both goods and services.
Chapter 7
Financial Statements
by Michael J. Buckle, PhD, James Seaton, PhD, and
Stephen Thomas, PhD
© 2014 CFA Institute. All rights reserved.
LEARNING OUTCOMES
After completing this chapter, you should be able to do the following:
a. Describe the roles of standard setters, regulators, and auditors in
financial reporting;
b. Describe information provided by the balance sheet;
c. Compare types of assets, liabilities, and equity;
d. Describe information provided by the income statement;
e. Distinguish between profit and net cash flow;
f. Describe information provided by the cash flow statement;
g. Identify and compare cash flow classifications of operating, investing,
and financing activities;
h. Explain links between the income statement, balance sheet, and cash
flow statement;
i. Explain the usefulness of ratio analysis for financial statements;
j. Identify and interpret ratios used to analyse a company’s liquidity,
profitability, financing, shareholder return, and shareholder value.
1. INTRODUCTION
The financial performance of a company matters to many different people.
Management is interested in assessing the success of its plans relative to its
past and forecasted performance and relative to its competitors’
performance. Employees care because the company’s financial success
affects their job security and compensation. The company’s financial
performance matters to investors because it affects the returns on their
investments. Tax authorities are interested as well because they may tax the
company’s profits. An investment analyst will scrutinise a company’s
performance and then make recommendations to clients about whether to buy
or sell the securities, such as shares of stocks and bonds, issued by that
company.
One way to begin to evaluate a company is to look at its past performance.
The primary summary of past performance is a company’s financial
statements, which indicate, among other things, how successful a company
has been at generating a profit to repay or reward investors. Companies
obtain funds from investors from either the sale of debt securities (bonds) or
the sale of equity securities (shares of stock, sometimes referred to as stocks
or shares). The value of the debt and equity securities to investors depends
on a company’s future success along with its ability to repay its debt and to
create returns for shareholders to compensate for the risks they assume.
Financial statements are historical and forward-looking at the same time;
they focus on past performance but also provide clues about a company’s
future performance. Accountants collect relevant financial information and
then communicate that information to various stakeholders, such as investors,
management, employees, and competitors. This information is communicated
through financial statements, including the balance sheet, the income
statement, and the cash flow statement. These financial statements show the
monetary value of the economic resources under the company’s control and
how those resources have been used to create value. Financial statements
also include notes that describe the accounting methods selected, significant
accounting policies, and other information critical to interpreting a
company’s results. These notes are an important component of a
shareholder’s evaluation.
Reading a company’s financial statements can provide information on
important matters such as how profitable the company is and how efficiently
it manages its resources and obligations. Financial statements provide clues
to the company’s future success by telling the story about its past
performance. They are read and used by a wide variety of people for a wide
variety of purposes; sooner or later, it will help you and your career to know
how to make sense of them.
2. ROLES OF STANDARD SETTERS,
AUDITORS, AND REGULATORS IN
FINANCIAL REPORTING
The existence of standard setters, regulators, and auditors help ensure the
consistency of financial information reported by companies.
Standards for financial reporting are typically set at the national or
international level by private sector accounting standard-setting bodies. One
set of standards that details the “rules” of financial reporting is the
International Financial Reporting Standards (IFRS), published by the
International Accounting Standards Board (IASB). As of 2013, most
countries require or allow companies to produce financial reports using
IFRS. In the United States, US-based publicly traded companies must report
using US generally accepted accounting principles (US GAAP), but non-USbased companies may report using IFRS. There is a movement to have
accounting standards converge and to create a single set, or at least a
compatible set, of high-quality financial reporting standards worldwide. In
countries that have not adopted IFRS, efforts to converge with or transition to
IFRS are taking place.
When standards allow some choice, the accounting method that a company
chooses affects the earnings reported in the company’s financial statements.
A company may use aggressive accounting methods that boost reported
earnings in the current period or it may use conservative accounting methods
that dampen reported earnings in the current period. For example, a company
may recognise more or less revenue—and thus show more or less profit—
depending on the methods allowed by accounting standards and the
company’s interpretation of these standards. In other words, despite the use
of standards to guide companies in how to prepare financial statements, there
is still scope for flexibility in choosing and interpreting the standards.
Where there are alternative acceptable accounting methods, the choices of
methods are reported in the notes to the financial statements. The notes
accompany the statements and explain much of the information presented in
the statements, as well as the accounting decisions behind the presentation.
The notes are an aid to understanding the financial statements.
Regulators support financial reporting standards by recognizing, adopting,
and enforcing them and by implementing and enforcing rules that complement
them. Companies that issue securities traded in public markets are typically
required to file reports that comply with specified financial reporting
standards with their country’s regulatory bodies, such as the Securities and
Exchange Commission (SEC) in the United States, the Prudential Regulation
Authority (PRA) in the United Kingdom, and the Financial Services
Commission in South Korea. Such reports include the financial statements as
well as explanatory notes and additional reports documenting company
activities.
Before they can be published, the financial statements must first be reviewed
by independent accountants called auditors. The auditor issues an opinion on
their correctness and presentation, which indicates to the reader how
trustworthy the statements are in reflecting the financial performance of the
company. Opinions can range from an unqualified or clean opinion, meaning
that the financial statements are prepared in accordance with the applicable
accounting standards, to an adverse opinion, which indicates that the
financial statements do not comply with the accounting standards and,
therefore, do not provide a fair representation of the company’s performance.
Note that a clean audit report does not always imply a financially-sound
company, but only verifies that the financial statements were created and
presented correctly. In other words, an audit opinion is not a judgement on
the company’s performance but on how well it accounted for its performance.
3. FINANCIAL STATEMENTS
A company is required to keep accounting records and to produce a number
of financial reports, which include the following:
The balance sheet (also called statement of financial position or
statement of financial condition) shows what the company owns (assets)
and how it is financed. The financing includes what it owes others
(liabilities) and shareholders’ investment (equity).
The income statement (also called statement of profit or loss, profit and
loss statement, or statement of operations) identifies the profit or loss
generated by the company during the period covered by the financial
statements.
The cash flow statement shows the cash received and spent during the
period.
Notes to the financial statements provide information relevant to
understanding and assessing the financial statements.
Other reports may be required. For example, in the United Kingdom,
companies are required to file a report from the directors as well as a report
from the auditors. The directors’ report contains information about the
directors of the company, their remuneration and a review of the performance
of the business during the reporting year. It also provides a statement of
whether the company complies with corporate governance codes of conduct.
In the United States, a 10-K report must be filed annually with the Securities
and Exchange Commission. The 10-K report includes not only the financial
statements, but also such other information as the management’s discussion
and analysis of financial conditions and results of operations as well as
quantitative and qualitative disclosures about the risks the company faces.
3.1. The Balance Sheet
The balance sheet (also called statement of financial position or statement
of financial condition) provides information about the company’s financial
position at a specific point in time, such as the end of the fiscal year or the
end of the quarter. Essentially, it shows
the resources the company controls (assets),
its obligations to lenders and other creditors (liabilities or debt), and
owner-supplied capital (shareholders’ equity, stockholders’ equity, or
owners’ equity).
The fundamental relationship underlying the balance sheet, known as the
accounting equation, is
Total assets = Total liabilities + Total shareholders’ equity
Another way of looking at the balance sheet is that total assets represent the
resources available to the company for generating profit. Total liabilities
plus shareholders’ equity indicate how those resources are financed—by
creditors (liabilities) or by shareholders (equity). The value of the assets
must be equal to the value of the financing provided to acquire them. In other
words, the balance sheet must balance!
The values of many of a company’s assets are reported at historical cost,
which is the actual cost of acquiring the asset minus any cost expensed to
date. An alternative is to report the value of an asset at its fair value, which
reflects the amount the asset could be sold for in a transaction between
willing and unrelated parties, called an “arm’s length transaction”. Fair value
accounting is applied only to a few assets, such as some financial
instruments. Most companies choose to report assets, where allowed, at
historical cost.
Let’s rearrange the accounting equation to calculate shareholders’ equity:
Total shareholders’ equity = Total assets – Total liabilities
Equity reflects the residual value of the company’s shares. Note that this is
not the same as the company’s current market value—that is, the value that
the market believes the company is currently worth or how much investors
are willing to pay to own the shares of the company. The balance sheet rarely
shows the current market value of the assets or the company itself because, as
mentioned earlier, most of the assets are reported at their historical cost
rather than fair market value. The balance sheet values are commonly known
as the book values of the company’s assets, liabilities, and equity.
To illustrate the basic structure of a balance sheet, Exhibit 1 shows the
balance sheet for hypothetical company ABC. Two years of information are
displayed to reflect the values of the company’s assets, liabilities, and equity
on 31 December 20X1 and 20X2. Most companies will report the most
recent period’s information in the first column of numbers, but occasionally
companies will report the most recent period’s information in the far-right
column. Although it is common practice to use parentheses or minus signs to
indicate subtraction, some companies will assume that the reader knows
which numbers are generally subtracted from others and will not use minus
signs or parentheses.
Exhibit 1.
ABC Company Statement of Financial Position
As of 31 December
($ millions)
Assets
20X2
20X1
As of 31 December
Cash
Accounts receivable
Inventories
Other current assets
Total current assets
Gross property, plant, and
equipment
Accumulated depreciation
Net property, plant, and
equipment
Intangible assets
20X2
25
40
95
5
$165
370
(120)
$300
100
$250
100
Total assets
Current portion of long-term debt
Total non-current liabilities
Total liabilities
Common stock
Retained earnings
Total owners’ equity
Total liabilities and equity
$400
$350
$565
$496
54
36
10
Total current liabilities
Long-term debt
$146
460
(160)
Total non-current assets
Liabilities and Equity
Accounts payable
Accrued liabilities
20X1
16
35
90
5
50
36
10
$100
232
$96
200
$232
$332
85
148
$200
$296
85
115
$233
$200
$565
$496
Balance sheets typically classify assets as current and non-current. The
difference between them is the length of time over which they are expected to
be converted into cash, used up, or sold. Current assets, which include
cash; inventories (unsold units of production on hand called stocks in some
parts of the world); and accounts receivable (money owed to the
company by customers who purchase on credit, sometimes called debtors),
are assets that are expected to be converted into cash, used up, or sold within
the current operating period (usually one year). A company’s operating
period is the average amount of time elapsed between acquiring inventory
and collecting the cash from sales to customers. Non-current assets
(sometimes called fixed or long-term assets) are longer term in nature. Noncurrent assets include tangible assets, such as land, buildings, machinery, and
equipment, and intangible assets, such as patents. These assets are used over
a number of years to generate income for the company. The tangible assets
are often grouped together on the balance sheet as property, plant, and
equipment (PP&E). Non-current assets may also include financial assets,
such as shares or bonds issued by another company.
When a company purchases a long-term (non-current) asset, it does not
immediately report that purchase as an expense on the income statement.
Instead, the purchase amount is capitalised and reported as an asset on the
balance sheet. For a capitalised, long-term asset, the company allocates the
cost of that asset over the asset’s estimated useful life. This process is called
depreciation. The amount allocated each year is called the depreciation
expense and is reported on the income statement as an expense. The
purchase amount represents the gross value of the asset and remains the same
throughout the asset’s life. The net book value of the long-term asset,
however, decreases each year by the amount of the depreciation expense.
Net book value is calculated as the gross value of the asset minus
accumulated depreciation, where accumulated depreciation is the sum of the
reported depreciation expenses for the particular asset. Details about the
original costs, depreciation expenses, and accumulated depreciation of
property, plant, and equipment can be found in the notes to the financial
statements.
Other assets that might be included on a company’s balance sheet are longterm financial investments, intangible assets (such as patents), and
goodwill. Goodwill is recognised and reported if a company purchased
another company, but paid more than the fair value of the net assets (assets
minus liabilities) of the company it purchased. The additional value reflected
in goodwill is created by other items not listed on the balance sheet, such as
a loyal customer base or skilled employees. The process of expensing the
costs of intangible assets over their useful lives is called amortisation; this
process is similar to depreciation.
The other balance sheet items—liabilities and equity—represent how the
company’s assets are financed. There are two fundamental types of financing:
debt and equity. Debt is money that has been borrowed and must be repaid at
some future date; therefore, debt is a liability—an obligation for which the
company is liable. Equity represents the shareholders’ (owners’) investment
in the company.
Debt can be split into current (short-term) liabilities and long-term debt.
Current liabilities must be repaid in the next year and include operating
debt, such as accounts payable (credit extended by suppliers, sometimes
called creditors), short-term borrowing (for example, loans from banks), and
the portion of long-term debt that is due within the reporting period. Unpaid
operating expenses, such as money due to workers but not yet paid, are often
shown together as accrued liabilities. Long-term debt is money
borrowed from banks or other lenders that is to be repaid over periods
greater than one year.
Shareholders are the residual owners of the company; that is, they own the
residual value of the company after its liabilities are paid. The amount of the
company’s equity is shown on the balance sheet in two parts: (1) the amount
received from selling stock to common shareholders, which are direct
contributions by owners when they purchase shares of stock; and (2)
retained earnings (retained income), which represents the company’s
undistributed income (as opposed to the dividends that represent distributed
income). Retained earnings are an indirect contribution by owners who
allow the company to retain profits.
Retained earnings represent a link between the company’s income statement
and the balance sheet. When a company earns profit and does not distribute it
to shareholders as a dividend, the remaining profit adds value to the
company’s equity. After all, the company exists to make a profit; when it
does, that makes the company more valuable. Likewise, if the company
experiences a net loss, that decreases the value of its retained earnings and
thus its equity; the company becomes less valuable because it has lost, rather
than earned, value.
3.2. The Income Statement
The income statement (sometimes called statement of profit or loss,
profit and loss statement, or statement of operations) identifies the profit or
loss generated by a company during a given time period, such as a year.
Generating profit over time is essential for a company to continue in
business. In practice, the income statement may be referred to as the “P&L”.
To illustrate the basic structure of an income statement, Exhibit 2 shows the
income statement for the hypothetical company ABC for the year ending 31
December 20X2. Note that the net income of $76 million minus the dividend
paid of $43 million equals $33 million, the same amount as the change in
retained earnings from 20X1 to 20X2 as shown on the balance sheet in
Exhibit 1 ($148 million – $115 million = $33 million).
Exhibit 2. ABC Company Income Statement for Year Ending
31 December 20X2
($ millions)
Revenues
Cost of sales
$650
(450)
Gross profit
Other operating expenses
Selling expenses
$200
$(30)
General and administrative expenses
Depreciation expense
(20)
(40)
Total other operating expenses
(90)
Operating income
Interest expense
$110
(15)
Earnings before taxes
Income taxes
$95
(19)
Net income
$76
Additional information:
Dividends paid to shareholders
Number of shares outstanding
Earnings per share
Dividend per share
$43
50 million
$1.52
$0.86
The income statement shows the company’s financial performance during a
given time period, which is one year in Exhibit 2. It includes the revenues
earned from the company’s operation and the expenses of earning those
revenues. The difference between the revenues and the expenses is the
company’s profit. In its most basic form, the income statement can be
represented by the following equation:
Profit (loss) = Revenues – Expenses
Expenses are the cost of company resources—cash, inventories,
equipment, and so on—that are used to earn revenues. Expenses can be
divided into different categories that reflect the role they play in earning
revenues. Typical categories include
Operating expenses, which include the cost of sales (or cost of goods
sold); selling, general, and administrative expenses; and depreciation
expenses
Financing costs, such as interest expenses
Income taxes
Different measures of profit can be calculated by subtracting different
categories of expenses from revenues. These measures are sometimes
reported on the income statement. For example, subtracting the cost of sales,
which represents the cost of producing or acquiring the products or services
that are sold by a company, from revenues gives gross profit.
Gross profit = Revenues – Cost of sales
Cost of sales is not the only cost incurred by the company in its effort to sell
products or services. There are other operating expenses, such as marketing
expenses (costs of promoting the products or services to customers),
administrative expenses (costs of running the company that are not directly
related to production or sales, such as salary of executives, office stationery,
and lighting), and depreciation expenses (non-cash expenses that represent
annual allocated costs of long-term assets, such as equipment). Subtracting
these additional costs from gross profit gives operating income, or
operating profit.
Operating income = Gross profit – Other operating expenses
Operating income is often referred to as earnings before interest and taxes
(EBIT).1 Operating income is the income (earnings) generated by the
company before taking into account financing costs (interest) and taxes.
Another important measure of income is earnings before interest, taxes,
depreciation, and amortisation (EBITDA). EBITDA is operating income
before depreciation and amortisation expenses are deducted. The amounts of
depreciation and amortisation are not cash flows, and they are determined by
the choice of accounting method rather than by operating decisions. EBITDA
is useful because it offers a closer approximation of operating cash flow than
EBIT. It is an indicator of the company’s operating performance and its
management’s ability to generate revenues and control expenses that are
related to its operations. EBITDA may be a better measure than EBIT of
management’s ability to manage the revenues and expenses within its control.
This measure does not appear, as such, on a company’s income statement.
EBITDA = EBIT (or operating income) + Depreciation and Amortisation
If the company has borrowed money to help finance its activities, it will have
to pay interest. Deducting interest expense from operating income determines
the earnings before taxes (or profit before tax).
Earnings before taxes = EBIT (or operating income) – Interest expense
The income taxes owed by the company on its earnings are then deducted to
arrive at net income (or net profit or profit after tax).
Net income = EBIT (or operating income) – Interest expense – Tax
expense
= Earnings before taxes – Tax expense
Net income represents the income that the company has available to retain
and reinvest in the company (retained earnings) or to distribute to owners in
the form of dividends (disbursements of profit).
The company’s owners (shareholders) are interested in knowing how much
income the company has created per share, which is called earnings per
share (EPS). It is approximated as net income divided by the number of
shares outstanding. Existing and potential investors are also interested in the
amount of dividends the company pays for each share outstanding, or
dividend per share. The importance of earnings per share and dividend
per share in valuing a company is discussed in the Equity Securities chapter.
3.3. Profit and Net Cash Flow
The income statement shows a company’s profit, but profit is not the same as
net cash flow—that is, how much cash the company generated during the
period. Revenue is considered earned when a sales transaction is identified
by certain conditions—for example, whether the products have been shipped
to the customer. But the cash flow from the transaction—the cash received
when the customer pays its bill—usually occurs later, a common situation
when the customer buys on credit. In this case, there is initially revenue
without cash. A company acquiring or producing a unique item for a
customer may require payment before the sales transaction is completed and
the revenue earned. In this case, there is cash without revenue. Likewise, an
expense can be incurred and accounted for without being paid if a supplier
extends credit, or an expense can be paid for before it is actually incurred
(prepaid).
On the income statement, profits are measured on an accrual basis, which
means that revenues are recorded when the revenues are earned rather than
when they are received in cash and that related expenses may be recognised
before or after they are paid out in cash. Because of the timing difference
between when revenues are earned and when customers pay their bills, the
cash received during a particular period is not likely to be the same amount
as the revenues earned during that period, unless all sales are for cash.
Equally, the cash paid for expenses during the period is not likely to be the
same amount as the expenses recognised on the income statement. Thus,
profits and net cash flow are typically not the same amount.
There are other reasons why the profits measured on the income statement
are not the same as cash flows. For example, the balance sheet reports longterm assets when they are acquired, but there is no “long-term asset” expense
shown immediately on the income statement. Instead, the use of the long-term
asset is expensed on the income statement over its useful life by using
depreciation expense. This depreciation expense does not correspond to a
cash flow; the cash flow for the asset acquisition happens up front, when the
asset is acquired.
A company must eventually generate profits to provide returns to
shareholders, but it must generate cash to keep itself going. Suppliers,
employees, expenses, and debts must be paid for the company to keep
operating. The income statement indicates how good a company is at creating
profit, but it is also critical to see how good the company is at generating
cash. A company can be profitable but have negative cash flows—for
example, if it is slow at collecting cash from its customers. Or a company
may operate at a loss but have positive cash flows—for example, if the
company has high depreciation and amortisation expenses. A company can
operate at a loss as long as the owners allow it, provided the company can
generate cash flows to support its survival. But a company cannot survive
long with negative cash flows, no matter how profitable it seems to be.
Negative cash flows may cut off access to resources, such as material and
labour, and can cause a company to become bankrupt.
The use of accrual accounting on the income statement creates a need for a
separate statement to track the company’s cash. This separate statement is the
cash flow statement to which we now turn.
3.4. The Cash Flow Statement
The statement of cash flows (or cash flow statement) identifies the
sources and uses of cash during a period and explains the change in the
company’s cash balance reported on the balance sheet. To illustrate the basic
structure of a cash flow statement, Exhibit 3 shows the statement of cash
flows for hypothetical company ABC for the year ending 31 December
20X2.
Exhibit 3. ABC Company Statement of Cash Flows for Year
Ending 31 December 20X2
($ millions)
Operating activities
Net Income
Plus depreciation expense
Minus increase in accounts receivable
Minus increase in inventories
$76
40
(5)
(5)
Plus increase in accounts payable
Net cash flow from operating activities
Investment activities
Minus investment in property, plant, and
equipment
Net cash flow used in investing activities
Financing activities
Cash inflows from borrowing (long-term debt)
Cash inflows from new share issues
Minus dividends paid to shareholders
Net cash flow used in financing activities
4
$110
$(90)
$(90)
$32
0
(43)
$(11)
Net increase (decrease) in cash
Beginning cash
$9
16
Ending cash
$25
The classification of cash flows as operating, investing, or financing is
critical to show investors and others not only how much cash was generated,
but also how cash was generated. Operating activities are usually recurring
activities: they relate to the company’s profit-making activities and occur on
an on-going basis. In contrast, investing and financing activities may not
recur; the purchase of equipment or issuance of debt, for example, does not
occur every year. So, knowing how the company generates cash—by
recurring or non-recurring events—is important for estimating a company’s
future cash flows.
The cash inflows and outflows of a company are classified and reported as
one of three kinds of activities.
1. Cash flows from operating activities reflect the cash generated from a
company’s operations, its main profit-creating activity. Cash flows from
operating activities typically include cash inflows received for sales
and cash outflows paid for operating expenses, such as cost of sales,
wages, operating overheads, and so on. When the specific cash inflows
and outflows listed in the previous sentence are reported in cash flows
from operating activities, the company is reporting using the direct
method.
When the company reports net income and then makes adjustments to
arrive at the cash flow from operating activities, it is using the indirect
method. The indirect method shows the relationship between income
statement and balance sheet changes and cash flow from operating
activities.
In Exhibit 3, ABC uses the indirect method. Depreciation expense,
which is a non-cash item, is added to net income. The depreciation
expense of $40 million is found on the income statement in Exhibit 2.
The increase of $5 million in accounts receivable in Exhibit 1 is
subtracted from net income because that cash is not available to ABC. It
can be viewed as a use of cash (negative cash flow)—that is, increasing
inventories by $5 million used cash. The increase in accounts payable
of $4 million is a source (positive cash flow) of cash for ABC because
it has not yet paid its suppliers (used cash) for a service or product.
2. Cash flows from investing activities are typically cash outflows
related to purchases of long-term assets, such as equipment or buildings,
as the company invests in its long-term resources. Sales of long-term
assets are reported as cash inflows from investing activities. Exhibit 1
shows an increase in ABC’s gross property, plant, and equipment of $90
million. This amount matches the cash used in (outflow for) investing
activities.
3. Cash flows from financing activities are cash inflows resulting from
raising new capital (an increase in borrowing and/or issuance of
shares) and cash outflows for payment of dividends, repayment of debt,
or repurchase of shares (also known as share buybacks, which are
discussed in the Equity Securities chapter). ABC shows an inflow from
borrowing of $32 million, which matches the increase in long-term debt
from 20X1 to 20X2. The dividend payment of $43 million is shown at
the bottom of the income statement and is included in the change in
retained earnings from 20X1 to 20X2 on the balance sheet.
Each net cash flow from operating, investing, and financing activities will be
positive or negative depending on whether more cash came in (positive) or
went out (negative). The net cash flows from operating activities, investing
activities, and financing activities are added together to arrive at the net cash
flow during the accounting period. The net cash flow corresponds to the
change in the amount of cash reported on the balance sheet. For ABC, net
cash flow of $9 million corresponds to the increase in cash from year-end
20X1 to year-end 20X2 as reported on the balance sheet in Exhibit 1 ($25
million – $16 million = $9 million).
3.5. Links between Financial Statements
Although each major financial statement—balance sheet, income statement,
and cash flow statement—offers different types of financial information, they
are not entirely separate. For example, the income statement is linked to the
balance sheet through net income and retained earnings. In the case of ABC,
the net income of $76 million (shown on the income statement and the starting
point of the cash flow statement) is separated into dividends paid to
shareholders of $43 million (an outflow of cash on the cash flow statement)
and an increase in retained earnings of $33 million (shown as an increase in
retained earnings on the balance sheet between the end of 20X1 and the end
of 20X2).
The income statement is linked to the balance sheet in many ways. The
revenues and expenses reported on the income statement that have not been
settled in cash are reflected on the balance sheet as current assets or current
liabilities. In other words, the revenues not yet collected are reflected in
accounts receivable, and the expenses not yet paid are reflected in accounts
payable and accrued liabilities. Another example of linkages is when a
company purchases fixed assets, such as equipment or buildings. These cash
expenditures are shown as an increase in the gross fixed assets on the
balance sheet ($90 million) and a cash outflow on the cash flow statement,
but they only show up on the income statement when the cost of the fixed
asset is expensed or depreciated over time. As noted earlier, depreciation is
a non-cash expense representing the annual expense for the fixed assets.
The balance sheet reflects financial conditions at a certain point in time,
whereas the income and cash flow statements explain what happened
between two points in time. So, although the three financial statements show
different kinds of information and have different purposes, they are all
related to each other and should not be read in isolation.
Some links between ABC’s financial statements are described in Exhibit 4
and in the table below.
Exhibit 4.
Links between Financial Statements
On the balance sheet, the increase in cash from 20X1 to
20X2 is $9 million.
20X2 cash – 20X1 cash = Net increase in cash
$25 million – $16 million = $9 million
The cash flow statement explains this change in cash. The $9
million is shown as an increase in cash for the year.
On the balance sheet, the company has invested $90 million
in gross plant, property, and equipment (PP&E) from 20X1
to 20X2.
20X2 PP&E – 20X1 PP&E = Investment in PP&E
$460 million – $370 million = $90 million
On the cash flow statement, the $90 million is shown as an
investment in PP&E.
The net income of $76 million (shown on the income
statement and the starting point of the cash flow statement) is
separated into dividends paid to shareholders of $43 million
(an outflow of cash on the cash flow statement) and
additions to retained earnings of $33 million.
Net income – Dividends paid = Additions to retained
earnings
$76 million – $43 million = $33 million
On the balance sheet, the additions to retained earnings
(when a company earns a profit and does not distribute it to
shareholders as a dividend) from 20X1 to 20X2 is $33
million.
20X1 retained earnings + Additions to retained earnings =
20X2 retained earnings
$115 million + $33 million = $148 million
In additional information on the income statement, the
amount of dividends paid to shareholders is $43 million.
4. FINANCIAL STATEMENT ANALYSIS
Financial statement analysis involves the use of information provided by
financial statements and also by other sources to identify critical
relationships. These relationships may not be observable by reading the
financial statements alone. The use of ratios allows analysts to standardise
financial information and provides a context for making meaningful
comparisons. In particular, investors can compare companies of different
sizes as well as the performance of the same company at different points in
time.
Ratios help managers of the company or outside creditors and investors
answer the following questions that are important to help determine a
company’s potential future performance:
How liquid is the company?
Is the company generating enough profit from its assets?
How is the company financing its assets?
Is the company providing sufficient return for its shareholders?
4.1. How Liquid Is the Company?
In accounting, liquidity refers to a company’s ability to pay its outstanding
obligations in the short term. Two ratios commonly used in assessing a
company’s liquidity are
and
Liquidity ratios measure a company’s ability to meet its short-term
obligations. The current ratio measures the current assets available to
cover one unit of current liabilities. A higher ratio indicates a higher level of
liquidity; there is a greater availability of short-term resources to cover
short-term obligations. If the current ratio is greater than 1, current assets are
greater than current liabilities and the company appears to be able to cover
its debts in the short term. But not every current asset is easily or quickly
convertible into cash, so a current ratio of 2 is frequently used as a minimum
desirable standard. Another liquidity ratio, the quick ratio, excludes
inventories, which are the least liquid current asset. This ratio is a better
indicator than the current ratio of what would happen if the company had to
settle with all its creditors at short notice. A quick ratio of 1 or higher is
often viewed as desirable. However, a high current or quick ratio is not
necessarily indicative of a problem-free company. It may also indicate that
the company is holding too much cash and not investing in other resources
necessary to create more profit.
How would you characterise the liquidity of ABC based on the
information below?
ABC’s current ratio =
ABC’s quick ratio =
ABC’s current ratio of less than 2 and its quick ratio of less than 1
indicate that the company may have difficulties meeting its obligations
in the short term. But it is not necessarily a source of concern because
ABC may have access to resources, such as a line of credit from its
bank, that do not appear on the balance sheet and these resources may
be used to meet ABC’s obligations.
As is the case for most ratios, comparison with industry norms (average
ratios for the industry), ratios for comparable companies, or past ratios gives
a deeper context for interpreting the ratio.
4.2. Is the Company Generating Enough
Profit from Its Assets?
A widely used ratio for measuring a company’s profitability is the net
profit margin.
This ratio measures the percentage of revenues that is profit—that is, the
percentage of revenues left for the shareholders after all expenses have been
accounted for. Generally, the higher the net profit margin, the better.
How would you interpret ABC’s net profit margin based on the
information below?
ABC’s net profit margin =
ABC’s net profit margin of 11.69% means that for every dollar of
revenue, ABC earns $0.1169 of profit.
Another ratio used to assess profitability is return on assets (ROA).
Return on assets indicates how much return, as measured by net income, is
generated per monetary unit invested in total assets. Generally, the higher the
return on assets, the better.
Some analysts may choose to use operating income rather than net income
when calculating return on assets. Recall from an earlier discussion that
operating income is the income generated from a company’s assets excluding
how those assets are financed. When calculated using operating income, a
better name for the ratio is operating return on assets or basic earning
power. The basic earning power ratio compares the profit generated from
operations with the assets used to generate that income.
Whatever ratio is chosen to measure profitability per unit of assets, it should
be used consistently when making comparisons.
How would you assess the profitability of ABC, knowing that the
average return on assets and basic earnings power of companies that are
similar to ABC and operate in the same industry are 10% and 15%,
respectively?
ABC’s return on assets =
ABC’s basic earning power =
ABC’s ratios are higher than the industry averages so it appears to be
generating more income from its assets than comparable companies.
This result reflects well on the company’s management because the
company is using its assets more efficiently to generate income; it is
able to earn more income for each dollar’s worth of assets.
To investigate how the company generates more income from its assets than
comparable companies, return on assets can be separated into two
components:
Similarly, the basic earning power ratio can be separated into two
components:
The first component is a measure of profitability: net profit margin in the
return on assets and a ratio called operating profit margin in the basic
earning power ratio. Net profit margin and operating profit margin show how
good the company is at turning revenues into net income or operating income;
in other words, how good the company is at controlling its expenses or the
costs of generating its revenues.
The second component of return on assets and the basic earning power ratio
is a measure of asset utilisation and is known as asset turnover. This ratio
is expressed as a multiple and indicates the volume of revenues being
generated by the assets used in the business, or how effectively the company
uses its assets to generate revenues. An increasing ratio may indicate
improving performance, but care should be taken in interpreting this figure.
An increasing ratio may also indicate static revenues and decreasing assets
attributable to depreciation; in other words, sales are not growing and the
company is not reinvesting to keep its plant and machinery up to date. It is
important to assess the cause of changes in a ratio.
Take a look at the three ratios for ABC shown below. What might these
ratios tell you about how ABC generates its profits?
ABC’s net profit margin =
ABC’s operating profit margin =
ABC’s asset turnover =
The first two ratios indicate that for each dollar of revenue, the
company generates $0.1169 of net profit (net income) and $0.1692 of
operating profit (operating income). The net and operating profit
margins should be compared with previous years’ profit margins or
with the profit margins of similar companies to evaluate how well the
company is doing. For example, if the net and operating profit margins
for ABC the previous year were 10.20% and 15.10%, respectively, it
suggests that the company has become more profitable because it has
better control of its expenses.
ABC’s asset turnover is 1.15 times in the year; in other words, for every
$1 of assets, $1.15 of revenues is generated. If the asset turnover ratio
for similar companies in the same industry averages 1.80, then ABC
does not appear to be using its assets as effectively as those companies
to generate revenues.
4.3. How Is the Company Financing Its
Assets?
A common accounting ratio used for assessing financial leverage, which is
the extent to which debt is used in the financing of the business, is the debtto-equity ratio:
This ratio measures how much debt the company has relative to equity.
Typically, the debt considered is only interest-bearing debt, including shortterm borrowing, the portion of long-term debt due within the reporting
period, and long-term debt. It does not include accounts payable and accrued
expenses that do not require an interest payment.
Another common ratio is the financial leverage or equity multiplier ratio.
This equity multiplier measures the amount of total assets supported by one
monetary unit of equity. The greater the value of the assets relative to equity,
the more debt is being used as financing. A company with a low financial
leverage or equity multiplier is one predominantly financed by equity.
Try to assess from the ratios below whether ABC has a high level of
debt. What does this level tell you about the riskiness of ABC?
ABC’s debt-to-equity ratio =
ABC’s equity multiplier =
A debt-to-equity ratio close to 1 indicates that debt and equity provide
approximately equal amounts of financing to ABC. An equity multiplier
close to 2 shows that ABC’s asset value is more than twice the amount
of equity. To interpret these leverage ratios, a comparison should be
made with other companies in the same industry. If ABC is found to
have a higher proportion of debt than the industry average, then it may
indicate a greater financial risk for ABC.
Having a higher proportion of debt is riskier because a company is obligated
to service its debt (pay interest) but does not have a similar obligation to
service its equity (pay dividends). If a company faced more obligations due
to relatively more debt, there is a risk that it will not be in a position to meet
those obligations or respond as quickly as its competitors to new
opportunities.
In some countries, the use of debt financing is referred to as gearing rather
than leverage. Highly leveraged or geared companies are often referred to as
being less solvent. Thus, leverage and solvency are concepts that are
inversely related. A company that uses little debt financing is generally
considered to be more solvent than a company that uses a large amount of
debt financing—that is, a company that is highly leveraged.
4.4. Is the Company Providing Sufficient
Return for Its Shareholders?
It is important to determine whether the return made by the company is
sufficient from the perspective of the shareholders. That is, is the return high
enough for investors to still want to own the share? One ratio commonly used
to answer this question is return on equity (ROE).
This ratio indicates how much return, as measured by net income, is
available to a monetary unit of equity. This measure can be compared with
the return on equity over time, with the return on equity for other companies,
and with the relevant industry average return on equity.
Return on equity can be decomposed in three components: net profit margin,
asset turnover, and financial leverage. You can see this algebraically as
or
Return on equity = ROE
= Net profit margin × Asset turnover × Financial leverage
You could simply calculate the return on equity by dividing net income by
equity, but the point here is not the algebra itself but the meaning it reveals.
The first two components give the return on assets. The other component that
potentially affects the return on equity is the amount of leverage or debt used.
The assets of the company are financed by debt and equity. A company that
has a higher level of debt in its total capital will have a higher return on
equity as long as the debt returns more than it costs—that is, as long as its
return on assets is greater than its after-tax cost of debt (the cost of its debt
net of tax). This is why the financial leverage ratio is also known as the
equity multiplier ratio.
In summary, a company’s ability to create return for its shareholders (as
measured by the return on equity) depends on three factors—its ability to
efficiently
generate profits from revenues, expressed as net profit margin =
;
generate revenues from assets, expressed as asset turnover =
; and
use borrowing to finance its assets, expressed as financial leverage =
.
When any of these ratios increase, all else being equal, the return on equity
increases. Although it makes intuitive sense that a company’s performance
improves when generating more profit from revenues and more revenues
from its assets, a company also increases its return on equity by
supplementing its equity with borrowing (using leverage). But borrowing
may not always be a sound strategy depending on the company’s ability to
afford its debt. In other words, an increase in return on equity due to
borrowing comes with increased risk. This scenario is why ratio analysis
(breaking the ratio into components) is useful because it allows analysts to
better understand why the company’s return on equity is changing and to
interpret the sources of that change.
Although each ratio measures an aspect of performance, gaining insight into a
company’s performance depends on the ability to view the ratios in the larger
context of overall competitive and historical performance.
What does the decomposition of ABC’s return on equity into its three
key components tell you about the company’s overall performance?2
ABC’s return on equity (ROE) =
Broken into its components
ABC’s return on equity = Net profit margin × Asset turnover ×
Financial leverage
=
= 11.69% × 1.15 × 2.42 = 32.53%
Or
ABC’s return on equity =
=
ABC’s return on assets, as discussed in Section 4.2, is approximately
13.45%. ABC’s return on assets of 13.45% is probably greater than its
after-tax cost of debt. So increasing the leverage of the company, or
borrowing to finance assets, has generated a larger return on equity for
shareholders. But as noted earlier, the high level of leverage brings
greater risks.
4.5. Summary of Ratios
Exhibit 5 shows most of the ratios discussed in Sections 4.1 to 4.4, the
formula for each ratio, ABC’s value for each ratio for the year ending 31
December 20X2, and the average value for the relevant industry for 20X2.
Exhibit 5.
Ratios, Formulas, ABC’s Value, and Industry Value
ABC’s
20X2
Value
20X2
Industry
Value
Current ratio
1.65
1.92
Quick ratio
0.70
0.75
Ratio
Formula
ABC’s
20X2
Value
20X2
Industry
Value
Return on
assets
13.45%
10.00%
Basic earning
power
19.47%
15.00%
Return on
equity
32.62%
27.30%
Net profit
margin
11.69%
5.56%
Operating
profit margin
16.92%
8.33%
Asset turnover
1.15
1.80
Financial
leverage
2.42
2.73
Ratio
Formula
Ratios are used to standardise financial data for comparisons and create a
context for comparing the numbers. By themselves, the ratios for ABC in
Exhibit 4 reveal some information about the company’s performance. But
when compared with industry averages, specific competitors, or previous
years’ performances, they become a powerful tool for assessing a company’s
relative performance.
These ratios allow us to see that ABC is less liquid than the industry
average. We can also see that ABC’s return on assets, basic earning power,
and return on equity are higher than the industry average, which is desirable.
Looking into what causes these ratios to be higher, we find that it is
attributable to higher net and operating profit margins. ABC does not turn
over its assets as frequently as the industry average, but it compensates with
higher profit margins. ABC uses less debt than the industry average, as
reflected in the lower financial leverage ratio, which means it is taking on
less financial risk. In spite of the lower financial risk, ABC has a higher
return on equity as a result of its higher return on assets. Overall, our ratio
analysis suggests that ABC appears to be performing better than the industry
average.
4.6. Market Valuations
So far, we have talked about assessing the performance of a company’s
management using only financial statement data. Another approach is to look
at management’s performance in terms of creating or destroying value for the
company’s shareholders. Two ratios, both based on a company’s share
(market) price, are commonly used. The first ratio compares a company’s
share price with its earnings per share:
This ratio is expressed as a multiple. A price-to-earnings ratio
(generally called a P/E in practice) of, for example, 15 tells us that investors
are willing to pay $15 for every $1 of earnings per share. If the price-toearnings ratio is higher for one company compared with another one in the
same industry, it may indicate that investors think that the company with the
higher price-to-earnings ratio has stronger growth potential. Alternatively,
the company with the lower price-to-earnings ratio may be undervalued by
the market. The use of price-to-earnings ratio in valuing companies is further
discussed in the Equity Securities chapter.
The second ratio is the price-to-book ratio. It compares the company’s
share price with the company’s book value per share:
where
Equity book value per share =
The book value of equity primarily reflects historical costs and measures the
amount shareholders have invested in the company through its lifetime. A
ratio greater than 1 indicates that investors believe the company is worth
more in the long run than the amount shareholders have invested in it. In other
words, the company’s management has created value for shareholders since
their original investment. A ratio less than 1 is an indication that the
company’s managers have destroyed value.
SUMMARY
Financial statements are important in investors’ decisions about whether to
purchase securities issued by companies. Careful analysis of a company’s
financial statements can provide useful information about how a company has
performed. The financial statements themselves indicate, for example, how
profitable a company is and how much cash it is generating. Financial ratios
are critical for putting this information in context by showing performance
over time and making comparisons with other companies in the same
industry. Financial statement analysis may also be useful in identifying
additional questions about a company, its likely future performance, and its
ultimate value as an investment.
The points below recap what you have learned in this chapter about financial
statements:
Financial statements are read and analysed by many people to assess a
company’s past and forecasted performance.
Accounting standards guide the gathering, analysis, and presentation of
information in financial statements.
Regulators support accounting standards by recognising them and
enforcing them.
Auditors are independent accountants who express an opinion about the
financial statements’ preparation and presentation. This opinion helps
determine how much reliance to place on the financial statements.
The three primary financial statements are the balance sheet, the income
statement, and the cash flow statement. They are accompanied by notes
that provide information that helps investors understand and assess the
financial statements.
The balance sheet (or statement of financial position or statement of
financial condition) provides a statement of the company’s financial
position at one point in time. The balance sheet shows the company’s
assets, liabilities, and equity.
The accounting equation underlying the balance sheet is Total assets =
Total liabilities + Total shareholders’ equity.
The income statement (or profit and loss statement or statement of
operations) identifies the profit (or loss) generated by a company during
a given time period.
The profits reported on the income statement are not the same as net
cash flows. Revenues and expenses, which are used to calculate profit,
are measured on an accrual basis rather than when they are received or
paid in cash.
The statement of cash flows identifies the sources and uses of cash
during a period and explains the change in the company’s cash balance
reported on the balance sheet.
The statement of cash flows shows how much cash was received or
spent, as well as for what the cash was received or spent. Cash inflows
and outflows are classified into three kinds of activities on the cash
flow statement: operating, investing, and financing.
The three financial statements have different purposes and provide
different kinds of information but they are all related to each other.
Financial analysis involves the use of information provided by financial
statements and other sources to identify critical relationships.
Financial ratios standardise financial information and provide a context
for making comparisons, including to other companies and over time.
Financial ratios help answer the following types of questions:
1. How liquid is the company?
2. Is the company generating enough profit from its assets?
3. How is the company financing its assets?
4. Is the company providing sufficient return to its shareholders?
Ratios based on a company’s share price help assess management’s
performance in terms of creating or destroying value for the company’s
shareholders.
Below is a recap of the financial ratios discussed in the chapter:
Ratio
Current ratio
Quick ratio
Return on assets
Formula
Ratio
Basic earning power
Return on equity
Net profit margin
Operating profit margin
Asset turnover
Financial leverage
Formula
CHAPTER REVIEW QUESTIONS
© 2014 CFA Institute. All rights reserved.
1. Accounting standard setters help ensure the consistency of reported
financial information by:
A. recognising and enforcing financial reporting standards.
B. establishing how financial reports should be prepared and
presented.
C. expressing an opinion on the application of financial reporting
standards.
2. The financial statement that provides information about a company’s
financial position at a specific point in time is the:
A. balance sheet.
B. income statement.
C. cash flow statement.
3. Which of the following best shows the accounting equation?
A. Total assets = Total liabilities + Total shareholders’ equity
B. Total assets + Total liabilities = Total shareholders’ equity
C. Total shareholders’ equity – Total assets = Total liabilities
4. The values of assets on the balance sheet are reported:
A. only at historical cost.
B. only at fair market value.
C. at a mix of historical cost and fair market value.
5. Which of the following accounts is most likely classified as a current
asset?
A. Goodwill
B. Inventory
C. Property, plant, and equipment
6. Shareholders’ equity, as reported on the balance sheet, includes:
A. cash.
B. common stock.
C. long-term debt.
7. Accounts payable are classified as:
A. assets.
B. liabilities.
C. shareholders’ equity.
8. Net property, plant, and equipment is included in:
A. shareholders’ equity.
B. long-term debt.
C. non-current assets.
9. The profit or loss generated by a company over a year is presented in
the:
A. balance sheet.
B. income statement.
C. cash flow statement.
10. Which of the following is an example of an operating expense?
A. Dividends paid to shareholders
B. Interest payments made on a bank loan
C. Depreciation expenses for plant and equipment
11. Gross profit represents revenue minus:
A. all expenses.
B. cost of sales.
C. operating expenses.
12. Income that is available to reinvest in the company or distribute to
owners is:
A. net income.
B. operating income.
C. earnings before taxes.
13. Which financial statement is not prepared on an accrual basis?
A. Income statement
B. Cash flow statement
C. Profit and loss statement
14. Net cash flow is most likely:
A. equal to net income over a reporting period.
B. equal to operating income over a reporting period.
C. different from profit depending on the timing of the cash flows.
15. Operating income and cash flow from operating activities are reported,
respectively, on the:
A. income statement and the balance sheet.
B. balance sheet and the cash flow statement.
C. profit and loss statement and the cash flow statement.
16. The statement of cash flows presents:
A. revenues and expenses over a period of time.
B. sources and uses of cash over a period of time.
C. assets, liabilities, and owners’ equity at a point in time.
17. Which of the following is best described as an investing activity on the
cash flow statement?
A. Cash inflow from the issuance of new shares of equity
B. Cash outflow from the payment of dividends to stockholders
C. Cash outflow from the purchase of property, plant, and equipment
18. Dividends:
A. increase shareholders’ equity.
B. are a distribution of net income.
C. are an expense on the income statement.
19. A net loss during an accounting period will cause shareholders’ equity
to:
A. increase.
B. decrease.
C. remain unchanged.
20. Which of the following sentences is most accurate?
A. The income statement and cash flow statement are unrelated.
B. Net income is often the starting point for the cash flow statement.
C. The income statement presents information for a period of time,
whereas the cash flow statement presents information at a point in
time.
21. If a company is profitable, then its cash flow from operating activities:
A. is positive.
B. is negative.
C. can be positive or negative.
22. Cash paid for salaries would be included as a component of cash flows
from:
A. financing activities.
B. investing activities.
C. operating activities.
23. Cash flow from financing activities is most likely related to:
A. the payment for inventory.
B. the purchase of a machine.
C. the issuance of long-term debt.
24. A manufacturing company recently sold one of its buildings. The
proceeds from the sale are classified as a cash flow from:
A. financing activities.
B. investing activities.
C. operating activities.
25. Ratio analysis is used to:
A. compare companies of different sizes.
B. identify the uses of cash during the period.
C. determine profit or loss associated with operations.
26. The ratio that best measures a company’s ability to meet its short-term
obligations is:
A. the quick ratio.
B. the asset turnover ratio.
C. the debt-to-equity ratio.
27. Ratio analysis provides analysts:
A. information about only the past financial performance of a
company.
B. information about only the valuation of a company based on the
market price of its shares.
C. information about both the past financial performance of a
company and the valuation of a company based on the market price
of its shares.
28. The return on equity for a company and the industry in which it operates
are 10.3% and 9.6%, respectively. The company is most likely
performing:
A. better than the industry.
B. the same as the industry.
C. worse than the industry.
29. Which of the following is used to evaluate how a company is financing
its assets?
A. Current ratio
B. Debt-to-equity ratio
C. Return on assets
30. Which of the following values of a company’s quick ratio indicates the
best liquidity?
A. 0.50
B. 1.00
C. 1.50
31. A company’s return on equity (ROE) can be broken down into which of
the following components?
A. Asset turnover, liquidity, and financial leverage
B. Net profit margin, liquidity, and financial leverage
C. Net profit margin, asset turnover, and financial leverage
ANSWERS
1. B is correct. Standard setters help ensure the consistency of reported
financial information by detailing the “rules” of financial reporting.
They establish how financial reports should be prepared and presented.
A is incorrect because regulators recognise and enforce financial
reporting standards. C is incorrect because auditors express an opinion
on a company’s application of financial reporting standards.
2. A is correct. The balance sheet provides information about a company’s
financial position at a specific point in time. It shows the resources the
company controls (assets), its obligations to lenders and other creditors
(liabilities or debt), and its owner-supplied capital (shareholders’
equity, stockholders’ equity, or owners’ equity) at a specific point in
time. B is incorrect because the income statement shows the company’s
financial performance over a given time period. It identifies the profit
or loss generated by a company over the period. C is incorrect because
the cash flow statement identifies the sources and uses of cash over a
given time period. It explains the change in the company’s cash balance
reported on the balance sheet over the period.
3. A is correct. The fundamental relationship of a company’s financial
position, as represented by the balance sheet, is known as the
accounting equation and is noted as: Total assets = Total liabilities +
Shareholders’ equity. B and C are incorrect because they represent
incorrect algebraic rearrangements of the equation.
4. C is correct. Most balance sheet items are reported at historical cost,
but some assets, such as financial instruments, may be reported at fair
market value. A and B are incorrect because the values of assets on the
balance sheet are reported at a mix of historical cost or fair market
value.
5. B is correct. Inventory is generally classified as a current asset. Current
assets are expected to be converted into cash, used, or sold within the
current operating period. A is incorrect because goodwill is generally a
non-current (long-term) asset. Goodwill is recognised and reported if a
company purchased another company but paid more than the fair value
of the net assets (assets minus liabilities) of the company it purchased.
C is incorrect because property, plant, and equipment is generally a
non-current asset that is used over a number of years to generate
revenue for the company.
6. B is correct. Common stock is a component of shareholders’ equity.
Shareholders’ equity includes the amount received from selling stock to
common shareholders and retained earnings (retained income). A is
incorrect because cash is an asset. C is incorrect because long-term
debt is a liability.
7. B is correct. Accounts payable (credit extended by suppliers) are
current liabilities—obligations that must be repaid in the next year. A is
incorrect because assets are what the company owns. C is incorrect
because shareholders’ equity represents the owners’ investment in the
company.
8. C is correct. Net property, plant, and equipment is included in noncurrent assets. It is used over a number of years to generate revenue for
the company. A is incorrect because shareholders’ equity represents the
owners’ investment in the company and includes common stock and
retained earnings. B is incorrect because long-term debt is money
borrowed from banks and other lenders to be paid back over periods of
longer than a year.
9. B is correct. The income statement identifies the profit or loss generated
by a company over a given time period, such as a year. A is incorrect
because the balance sheet provides information about a company’s
financial position at a specific point in time. C is incorrect because the
cash flow statement identifies the sources and uses of cash over a given
time period.
10. C is correct. Operating expenses report expenses incurred by the regular
operations of a business and include such items as cost of sales,
administrative expenses, and depreciation expenses. A is incorrect
because dividend payments are not expenses and are not incurred in the
operations of the company. Dividend payments are reported as a
financing activity on the cash flow statement. B is incorrect because
interest payments are reported on the income statement as a financing
expense, not as an operating expense.
11. B is correct. Gross profit is calculated as revenues minus the cost of
sales. It represents the cost of producing or acquiring the goods or
services provided or sold by the company. A is incorrect because
revenue minus all expenses represents net income, not gross profit. C is
incorrect because revenue minus operating expenses represents
operating income (or profit), not gross profit.
12. A is correct. Net income is calculated as revenues minus all expenses
and represents income that a company has available to retain or reinvest
in the company or to distribute to owners in the form of dividends. B is
incorrect because interest and tax expenses must be subtracted from
operating income to arrive at the amount that is available to reinvest in
the company or distribute to owners. C is incorrect because taxes must
be subtracted from earnings before taxes to arrive at the amount that is
available to reinvest in the company or distribute to owners.
13. B is correct. The cash flow statement is prepared on a cash, not accrual,
basis. A and C are incorrect because the income statement (also called
the profit and loss statement) is prepared on an accrual basis. The
accrual basis requires revenues to be recorded when the revenues are
earned rather than when they are received in cash. Recognition of
related expenses on the income statement does not necessarily coincide
with when they are paid in cash. Expenses may be recognised before, at
the same time, or after they are paid for.
14. C is correct. Net cash flow most likely differs from profit because
revenues and expenses, which are used to calculate profit, are
accounted for on an accrual basis (when the revenue is earned or the
expense incurred). Cash flows for revenues and expenses are accounted
for when cash is actually exchanged. Thus, profit and cash flow
generally differ in the timing of recognition of revenues and expenses. A
and B are incorrect because revenue, expenses, and measures of income
such as net and operating income are accounted for on an accrual basis.
There are non-cash expenses, such as amortisation and depreciation,
included when calculating income. The related cash flows were
reported when they were made to acquire the long-term assets.
15. C is correct. Operating income is reported on the income statement, or
profit and loss statement. Cash flow from operating activities is
reported on the cash flow statement. A and B are incorrect because the
balance sheet does not report either operating income or cash flow from
operating activities. The balance sheet reports the value of a company’s
assets, liabilities, and shareholders’ equity at a specific point in time.
16. B is correct. The statement of cash flows presents the sources and uses
of cash over a period of time. A is incorrect because revenues and
expenses over a period of time are presented on the income statement. C
is incorrect because assets, liabilities, and shareholders’ equity at a
point in time are presented on the balance sheet or statement of financial
position.
17. C is correct. The statement of cash flows identifies the purchase of
property, plant, and equipment as a cash outflow in investing activities.
A and B are incorrect because issuing new shares and paying dividends
are financing activities.
18. B is correct. Dividends represent the amount of net income distributed
to shareholders. A is incorrect because dividends decrease
shareholders’ equity; dividends reduce retained earnings, a component
of shareholders’ equity. C is incorrect because dividends are not
reported as an expense on the income statement.
19. B is correct. A net loss during an accounting period decreases a
company’s retained earnings and will thus cause shareholders’ equity to
decrease.
20. B is correct. When preparing a cash flow statement, many companies
use an indirect method and begin with the net income reported on the
income statement and make adjustments to arrive at cash flows from
operations. A is incorrect because the income statement and cash flow
statement are related. C is incorrect because both the income statement
and cash flow statements present information for a period of time. It is
the balance sheet that presents information at a point in time.
21. C is correct. If a company is profitable, its cash flow from operating
activities can be positive or negative. Profit and net cash flow from
operating activities may differ in sign because profits are measured on
an accrual basis. For example, revenues may be included on the income
statement before the cash is collected.
22. C is correct. Cash paid for salaries is an operating cash outflow.
Operating activities relate to the company’s profit-making activities and
occur on an ongoing basis. Any salaries paid would be considered an
integral component of such activities. A is incorrect because financing
activities relate to raising new capital (an increase in borrowing and/or
issuance of shares) and paying dividends, repaying debt, or
repurchasing of shares. B is incorrect because investing activities
typically relate to purchases or sales of long-term assets, such as
equipment or buildings.
23. C is correct. When a company issues long-term debt, it is a cash inflow
from financing activities. A is incorrect because the payment for
inventory is a cash outflow for an operating activity related to the
company’s recurring profit-making activities. B is incorrect because the
purchase of a machine is a cash outflow related to investing activities.
24. B is correct. The proceeds of a sale by a manufacturing company of a
building are classified as a cash inflow from investing activities.
Investing activities typically relate to purchases or sales of long-term
assets, such as equipment or buildings.
25. A is correct. Ratio analysis is used to compare companies of different
sizes. When companies are different sizes, it is critical to standardise
the financial information. B is incorrect because the cash flow statement
is used to identify the sources and uses of cash over a period of time. C
is incorrect because the income statement is used to identify the profit or
loss associated with operations over a period of time.
26. A is correct. The quick ratio is a liquidity ratio used to assess a
company’s ability to pay its outstanding obligations in the short term. B
is incorrect because the asset turnover ratio measures asset utilisation,
which indicates the volume of revenues being generated by the assets
used in the business. C is incorrect because the debt-to-equity ratio, a
leverage ratio, measures how much debt is used in the financing of the
business.
27. C is correct. Ratio analysis can provide an analyst with information
about the past financial performance of a company, including its relative
position of assets, liabilities, liquidity, and profitability using such
ratios as the quick ratio, return on assets, and financial leverage.
Additionally, an analyst can use the historical information provided by
the financial statements combined with market price of a company’s
shares to compare companies and their relative valuation in the market
by using such ratios as price-to-earnings and price-to-book. A and B are
incorrect because ratio analysis can be used by analysts to evaluate both
historical financial performance and relative market valuation.
28. A is correct. The return on equity is higher for the company than for the
industry, indicating that the company is performing better. An analyst
should conduct further analysis to identify the source(s) of this
apparently superior performance.
29. B is correct. Ratios used in determining how a company is financing its
assets often look at the amount of debt that is used by the company.
Ratios that can help provide this information include the debt-to-equity
ratio and financial leverage (or the equity multiplier) ratios. A is
incorrect because the current ratio is used to assess liquidity. C is
incorrect because return on assets is used to evaluate a company’s
profitability.
30. C is correct. The quick ratio, a liquidity ratio, measures a company’s
ability to meet its short-term obligations. When analysing a liquidity
ratio, the higher the number, the higher the company’s liquidity. Thus,
1.50 represents the best liquidity ratio. A and B are incorrect because
both values are lower than 1.50 and when analysing liquidity, a higher
ratio is preferable.
31. C is correct. The basic ratio for return on equity (ROE) is calculated as
Net income/Equity. Analysts often break this down into component parts
to determine what is affecting the return on equity. ROE can be
calculated as follows:
ROE = (Net income/Revenues) × (Revenues/Total assets) ×
(Revenues/Equity)
or, put another way,
ROE = Net profit margin × Asset turnover × Financial leverage.
A and B are incorrect because liquidity is not used in the calculation of
ROE.
NOTES
1Note that operating income and EBIT may be different. For example, profit (or losses) that are not
related to the company’s operations are excluded from operating income but included in EBIT. The
difference is usually small, so these two terms are often used interchangeably.
2The differences between 32.62%, 32.53%, and 32.55% are due to rounding.
Chapter 8
Quantitative Concepts
by Michael J. Buckle, PhD, James Seaton, PhD, and
Stephen Thomas, PhD
© 2014 CFA Institute. All rights reserved.
LEARNING OUTCOMES
After completing this chapter, you should be able to do the following:
a. Define the concept of interest;
b. Compare simple and compound interest;
c. Define present value, future value, and discount rate;
d. Describe how time and discount rate affect present and future values;
e. Explain the relevance of net present value in valuing financial
investments;
f. Describe applications of time value of money;
g. Explain uses of mean, median, and mode, which are measures of
frequency or central tendency;
h. Explain uses of range, percentile, standard deviation, and variance,
which are measures of dispersion;
i. Describe and interpret the characteristics of a normal distribution;
j. Describe and interpret correlation.
1. INTRODUCTION
Knowledge of quantitative (mathematically based) concepts is extremely
important to understanding the world of finance and investing. Quantitative
concepts play a role in financial decisions, such as saving and borrowing,
and also form the foundation for valuing investment opportunities and
assessing their risks. The time value of money and descriptive statistics are
two important quantitative concepts. They are not directly related to each
other, but we combine them in this chapter because they are key quantitative
concepts used in finance and investment.
The time value of money is useful in many walks of life: it helps savers to
know how long it will take them to afford a certain item and how much they
will have to put aside each week or month, it helps investors to assess
whether an investment should provide a satisfactory return, and it helps
companies to determine whether the profit from investing will exceed the
cost.
Statistics are also used in a wide range of business and personal contexts. As
you attempt to assess the large amount of personal and work-related data that
are part of our everyday lives, you will probably realise that an efficient
summary and description of data is helpful to make sense of it. Most people,
for instance, look at summaries of weather information to make decisions
about how to dress and whether to carry an umbrella or bring rain gear.
Summary statistics help you understand and use information in making
decisions, including financial decisions. For example, summary information
about a company’s or market’s performance can help in investment decisions.
In short, quantitative concepts are fundamental to the investment industry. For
anyone working in the industry, familiarity with the concepts described in
this chapter is critical. As always, you are not responsible for calculations,
but the presentation of formulae and illustrative calculations may
enhance your understanding.
2. TIME VALUE OF MONEY
Valuing cash flows, which occur over different periods, is an important issue
in finance. You may be concerned with how much money you will have in the
future (the future value) as a result of saving or investing over time. You may
want to know how much you should save in a certain amount of time to
accumulate a specified amount in the future. You may want to know what
your expected return is on an investment with specified cash flows at
different points in time. These types of problems occur every day in
investments (e.g., in buying a bond), personal finance (e.g., in arranging an
automobile loan or a mortgage), and corporate finance (e.g., in evaluating
whether to build a factory). These problems are known as “time value of
money” problems because their solutions reflect the principle that the timing
of a cash flow affects the cash flow’s value.
2.1. Interest
Borrowing and lending are transactions with cash flow consequences.
Someone who needs money borrows it from someone who does not need it in
the present (a saver) and is willing to lend it. In the present, the borrower has
money and the lender has given up money. In the future, the borrower will
give up money to pay back the lender; the lender will receive money as
repayment from the borrower in the form of interest, as shown below. The
lender will also receive back the money lent to the borrower. The money
originally borrowed, which interest is calculated on, is called the principal.
Interest can be defined as payment for the use of borrowed money.
Interest is all about timing: someone needs money now while someone else is
willing and able to give up money now, but at a price. The borrower pays a
price for not being able to wait to have money and to compensate the lender
for giving up potential current consumption or other investment opportunities;
that price is interest. Interest is paid by a borrower and earned by the lender
to compensate the lender for opportunity cost and risk. Opportunity cost,
in general, is the value of alternative opportunities that have been given up by
the lender, including lending to others, investing elsewhere, or simply
spending the money. Opportunity cost can also be seen as compensation for
deferring consumption. Lending delays consumption by the term of the loan
(the time over which the loan is repaid). The longer the consumption is
deferred, the more compensation (higher interest) the lender will demand.
The lender also bears risks, such as the risk of not getting the money back if
the borrower defaults (fails to make a promised payment). The riskier the
borrower or the less certain the borrower’s ability to repay the loan, the
higher the level of interest demanded by the lender. Another risk is that as a
result of inflation (an increase in prices of goods and services), the money
received may not be worth as much as expected. In other words, a lender’s
purchasing power may decline even if the money is repaid as promised. The
greater the expected inflation, the higher the level of interest demanded by the
lender.
From the borrower’s perspective, interest is the cost of having access to
money that they would not otherwise have. An interest rate is determined by
two factors: opportunity cost and risk. Even if a loan is viewed as riskless
(zero likelihood of default), there still has to be compensation for the
lender’s opportunity cost and for expected inflation. Exhibit 1 shows
examples of borrowers and lenders.
Exhibit 1.
Examples of Borrowers and Lenders
2.1.1. Simple Interest
A simple interest rate is the cost to the borrower or the rate of return to
the lender, per period, on the original principal (the amount borrowed).
Conventionally, interest rates are stated as annual rates, so the period is
assumed to be one year unless stated otherwise. The cost or return is stated
as a percentage rate of the original principal so the rates can then be
compared, regardless of the amount of principal they apply to. For example,
a loan with a 5% interest rate is more expensive to the borrower than a loan
with a 3% interest rate. Similarly, a loan with a 5% interest rate provides a
higher promised return to the lender than a loan with a 3% interest rate.
The actual amount of interest earned or paid depends on the simple interest
rate, the amount of principal lent or borrowed, and the number of periods
over which it is lent or borrowed. We can show this mathematically as
follows:
Simple interest = Simple interest rate × Principal × Number of periods
If you put money in a bank account and the bank offers a simple interest rate
of 10% per annum (or annually), then for every £100 you put in, you (as a
lender to the bank) will receive £10 in the course of the year (assume at year
end to simplify calculations):
Interest = 0.10 × £100 × 1 = £10
If your money is left in the bank for two years, the interest paid will be £20:
Interest = 0.10 × £100 × 2 = £20
Simple interest is not reinvested and is applied only to the original principal,
as shown in Exhibit 2.
Exhibit 2.
Simple Interest of 10% on £100 Original Principal
If the interest earned is added to the original principal, the relationship
between the original principal and its future value with simple interest can be
described as follows:
Future value = Original principal × [1 + (Simple interest rate
× Number of periods)]
To extend our deposit example: £100 × [1 + (0.10 × 2)] = £100 × (1.20) =
£120. The value at the end of two years is £120.
2.1.2. Compound Interest
Interest compounds when it is added to the original principal. Compound
interest is often referred to as “interest on interest”. As opposed to simple
interest, interest is assumed to be reinvested so future interest is earned on
principal and reinvested interest, not just on the original principal.
If a deposit of £100 is made and earns 10% and the money is reinvested
(remains on deposit), then additional interest is earned in the course of the
second year on the £10 of interest earned in the first year. The interest is
being compounded. Total interest after two years will now be £21; £10 (=
£100 × 0.10) for the first year, plus £11 (= £110 × 0.10) for the second year.
The second year’s interest is calculated on the original £100 principal plus
the first year’s interest of £10. As shown in Exhibit 3, the total interest after
two years is £21 rather than £20 as in the case of simple interest shown in
Exhibit 2.
Exhibit 3.
Principal
Compound Interest of 10% on £100 Original
The relationship between the original principal and its future value when
interest is compounded can be described as follows:
Future value = Original principal × (1 + Simple interest rate)Number of
periods
In the deposit example, £100 × (1 + 0.10)2 = £100 × (1.10)2 = £121. With
compounding, the value at the end of two years is £121.
2.1.3. Comparing Simple Interest and Compound
Interest
Compound interest is extremely powerful for savers; reinvesting the interest
earned on investments is a way of growing savings. Somebody who invests
£100 at 10% for two years will end up with £1 more by reinvesting the
interest (£121) than with simple interest (£120). This amount may not look
very impressive, but over a longer time period, say 20 years, £100 invested
at 10% for 20 years becomes £300 with simple interest {£100 × [1 + (0.10 ×
20)] = £100 × 3 = £300} but £673 with compound interest [£100 × (1 +
0.10)20 = £100 × (1.10)20 = £673]. This concept is illustrated in Exhibit 4.
Exhibit 4.
Interest
Effects on Savings of Simple and Compound
2.1.4. Annual Percentage Rate and Effective Annual
Rate
Unless stated otherwise, interest rates are stated as annual rates. The rate
quoted is often the annual percentage rate (APR), which is a simple
interest rate that does not involve compounding. Another widely used rate is
the effective annual rate (EAR). This rate involves annualising, through
compounding, a rate that is paid more than once a year—usually monthly,
quarterly, or semi-annually. The following equation shows how to determine
the EAR given the APR.
Example 1 shows a few types of financial products and their simple interest
rates (APRs) and their compound rates (EARs).
EXAMPLE 1.
SIMPLE AND COMPOUND INTEREST RATES
A credit card charges interest at an APR of 15.24%, compounded daily.
A bank pays 0.2% monthly on the average amount on deposit over the
month. A loan is made with a 6.0% annual rate, compounded quarterly.
The following table shows what the expected annual rate is for each of
these situations. The rate is higher than the APR because of
compounding.
Simple Interest Rate
or APR
Credit card
Bank deposit
Loan
Compound Interest Rate
or EAR
15.24%
2.4% (= 0.2% × 12)
6.0%
As can be seen in Example 1, in general, whenever an interest rate
compounds more often than annually, the EAR is greater than the APR. In
other words, more frequent compounding leads to a higher EAR.
2.2. Present Value and Future Value
Two basic time value of money problems are finding the value of a set of
cash flows now (present value) and the value as of a point of time in the
future (future value).
2.2.1. Present Value and Future Value
If you are offered £1 today or £1 in a year’s time, which would you choose?
Most people say £1 today because it gives them the choice of whether to
spend or invest the money today and avoid the risk of never getting it at all.
The £1 to be received in the future is worth less than £1 received today. The
£1 to be received in the future is today worth £1 minus the opportunity cost
and the risk of being without it for one year. The present value is obtained by
discounting the future cash flow by the interest rate. The rate of interest in
this context can be called the discount rate.
Time affects the value of money because delay creates opportunity costs and
risk. If you earn a return of r% for waiting one year, £1 × (1 + r%) is the
future value after one year of £1 invested today. Put another way, £1 is the
present value of £1 × (1 + r%) received in a year’s time.
A saver may want to know how much money is needed today to produce a
certain sum in the future given the rate of interest, r. In the example in Exhibit
3, today’s value is £100 and the interest rate is 10%, so the future value after
two years is £100 × (1 + 0.10)2 = £121. The present value—the equivalent
value today—of £121 in two years, given that the annual interest rate is 10%,
is £100.
Before you can calculate present or future values, you must know the
appropriate interest or discount rates to use. The rate will usually depend on
the overall level of interest rates in the economy, the opportunity cost, and the
riskiness of the investments under consideration. The following equations
generalise the calculation of future and present values:
Future value = Present value × (1 + Interest rate)Number of periods
Present value =
Note that the interest and discount rates are the same percentage rates, but the
terminology varies based on context. Calculating present values allows
investors and analysts to translate cash flows of different amounts and at
different points in the future into sums in the present that can be compared
with each other. Likewise, the cash flows can be translated into the values
they would be equivalent to at a common future point.
Example 2 compares two investments with the same initial outflow
(investment) but with different future cash inflows at different points in time.
EXAMPLE 2.
COMPARING INVESTMENTS
1. You are choosing between two investments of equal risk. You
believe that given the risk, the appropriate discount rate to use is
9%. Your initial investment (outflow) for each is £500. One
investment is expected to pay out £1,000 three years from now; the
other investment is expected to pay out £1,350 five years from
now. To choose between the two investments, you must compare
the value of each investment at the same point in time.
Present value of £1,000 in three years discounted at 9% =
Present value of £1,350 in five years discounted at 9% =
As you can see, the investment with a payout of £1,350 five years
from now is worth more in present value terms, so it is the better
investment.
2. You are choosing between the same two investments but you have
reassessed their risks. You now consider the five-year investment
to be more risky than the first and estimate that a 15% return is
required to justify making this investment.
Present value of £1,350 in five years discounted at 15% =
The investment paying £1,000 in three years (discounted at 9%) is,
in this case, preferable to the investment paying £1,350 in five
years (discounted at 15%) in present value terms. Its present value
of £771.18 is higher than the present value of £671.19 on the fiveyear investment.
Example 2 shows three elements that must be considered when comparing
investments:
the cash flows each investment will generate in the future,
the timing of these cash flows, and
the risk associated with each investment, which is reflected in the
discount rate.
Present value considers the joint effect of these three elements and provides
an effective way of comparing investments with different risks that have
different future cash flows at different points in time.
2.2.2. Net Present Value
Present value is appropriate for comparing investments when the initial
outflow for each investment is the same, as in Example 2. But investments
may not have the same initial cash outflow, and outflows may occur at times
other than time zero (the time of the initial outflow). The net present
value (NPV) of an investment is the present value of future cash flows or
returns minus the present value of the cost of the investment (which often, but
not always, occurs only in the initial period). Using NPV rather than present
value to evaluate investments is especially important when the investments
have different initial costs. Example 3 below illustrates this.
EXAMPLE 3. COMPARING INVESTMENTS USING NET
PRESENT VALUE
The NPV of the investment in Example 2 that is paying £1,350 in five
years (discounted at 15%) if it initially cost £500 is:
£671.19 – £500.00 = £171.19
The NPV of the investment paying £1,000 in three years discounted at
9% if it initially cost £700 is:
£772.18 – £700 = £72.18.
This amount is less than £171.19, making the investment paying £1,350
in five years discounted at 15% worth more in present value terms. This
conclusion differs from that reached when present value only was used.
If costs were to occur at times different from time zero, then they would also
be discounted back to time zero for the purposes of comparison and
calculation of the NPV. If the NPV is zero or greater, the investment is
earning at least the discount rate. An NPV of less than zero indicates that the
investment should not be made.
Calculating the NPV allows an investor to compare different investments
using their projected cash flows and costs. The concepts of present value and
net present value have widespread applications in the valuation of financial
assets and products. For example, equities may pay dividends and/or be sold
in the future, bonds may pay interest and principal in the future, and insurance
may lead to future payouts.
Estimating values by using cash flows is also important to companies
considering a range of investment opportunities. For example, should the
sales team be supplied with tablets or laptops, or should the company open a
new office in Asia or carry on visiting from the company’s European
headquarters? In order to choose, decision makers estimate the expected
future cash flows of the alternatives available. The decision makers then
discount the estimated cash flows by an appropriate discount rate that
reflects the riskiness of these cash flows. They work out the discounted cash
flows for each opportunity to estimate the value of the cash flows at the
current time (the present value) and to arrive at the net present value. They
then compare the net present values of all the opportunities and choose the
opportunity or combination of opportunities with the largest positive net
present value.
2.2.3. Application of the Time Value of Money
The time value of money concept can help to solve many common financial
problems. If you save in a deposit account, it can tell you by how much your
money will grow over a given number of years. Time value of money
problems can involve both positive cash flows (inflows or savings) and
negative cash flows (outflows or withdrawals). Example 4 illustrates, with
two different sets of facts, how cash inflows and outflows affect future value.
EXAMPLE 4.
FUTURE VALUE
1. You place £1,000 on deposit at an annual interest rate of 10% and
make regular contributions of £250 at the end of each of the next
two years. How much do you have in your account at the end of
two years?
The initial £1,000 becomes £1,000 × (1 + 0.10)2
The first annual £250 payment becomes £250 ×
(1+ 0.10)
The second annual payment is received at the end
and earns no interest
= £1,210
The total future value
= £1,735
=
£275
=
£250
2. You place £1,000 on deposit and withdraw £250 at the end of the
first year. The balance on deposit at the beginning of the year earns
an annual interest rate of 10%. How much do you have in your
account at the end of two years?
At the end of the first year, you have £1,000 × (1 +
0.10)
You withdraw £250 and begin the second year
with an amount
At the end of the second year, you have £850 × (1
+ 0.10)
= £1,100
=
£850
=
£935
Time value of money can also help determine the value of a financial
instrument. It can help you work out the value of an annuity or how long it
will take to pay off the mortgage on your home.
2.2.3.1. Present Value and the Valuation of Financial Instruments
People invest in financial products and instruments because they expect to get
future benefits in the form of future cash flows. These cash flows can be in
the form of income, such as dividends and interest, from the repayment of an
amount lent, or from selling the financial product or instrument to someone
else. An investor is exchanging a sum of money today for future cash flows,
and some of these cash flows are more uncertain than others. The value
(amount exchanged) today of a financial product should equal the value of its
expected future cash flows. This concept is shown in Example 5.
EXAMPLE 5.
VALUE OF A LOAN
Consider the example of a simple loan that was made three years ago.
Two years from today, the loan will mature and the borrower should
repay the principal value of the loan, which is £100. The investor who
buys (or owns) this loan should also receive from the borrower two
annual interest payments at the originally promised interest rate of 8%.
The interest payments will be £8 (= 8% × £100), with the first interest
payment received a year from now and the second two years from now.
How much would an investor pay today to secure these two years of
cash flow if the appropriate discount rate is 10% (i.e. r = 0.10)? Note
that the rate used for discounting the future cash flows should reflect the
risk of the investment and interest rates in the market. In practice, it is
unlikely that the discount rate will be equal to the loan’s originally
promised interest rate because the risk of the investment and interest
rates in the market may change over time.
The first year’s interest payment is worth
The second year’s interest payment is worth
The repayment of the loan’s principal value in two years is worth
So today, the cash flows returned by the loan are worth £7.27 + £6.61 +
£82.64 = £96.52. So this loan is worth £96.52 to the investor. In other
words, if the original lender wanted to sell this loan, an investor would
pay £96.52.
Through the understanding of present value and knowing how to calculate it,
investors can assess whether the price of a financial instrument trading in the
marketplace is priced cheaply, priced fairly, or overpriced.
2.2.3.2. Time Value of Money and Regular Payments
Many kinds of financial arrangements involve regular payments over time.
For example, most consumer loans, including mortgages, involve regular
periodic payments to pay off the loan. Each period, some of the payment
covers the interest on the loan and the rest of the payment pays off some of
the principal (the loaned amount). A pension savings scheme or pension plan
may also involve regular contributions.
Most consumer loans result in a final balance of money equal to zero. That is,
the loan is paid off. Two time value of money applications that require the
final balance of money to be zero are annuities and mortgages.
An annuity involves the initial payment of an amount, usually to an
insurance company, in exchange for a fixed number of future payments of a
certain amount. Each period, the insurance company makes payments to the
annuity holder; these payments are equivalent to the annuity holder making
withdrawals. These withdrawals can be viewed as negative cash flows
because they reduce the annuity balance. The initial payment to the insurer is
called the value of the annuity and the final value is equal to zero.
A repayment or amortising mortgage involves a loan and a series of fixed
payments. The initial amount of the loan is referred to as the principal.
Although the payment amounts are fixed, the portion of each payment that is
interest is based on the remaining principal at the beginning of each period.
As some of the principal is repaid each period, the amount of interest
decreases over time, and thus the amount of principal repaid increases with
each successive payment until the value of the principal is reduced to zero.
At this point, the loan is said to mature.
Example 6 illustrates the reduction of an annuity to zero over time and the
reduction of a mortgage to zero over time. To simplify the examples, the
assumption is that the annuity and the mortgage each mature in five years and
entail a single withdrawal or payment each of the five years.
EXAMPLE 6.
ANNUITY AND MORTGAGE
1. A retired French man pays an insurance company €10,000 in
exchange for a promise by the insurance company to pay him
€2,375 at the end of each of the next four years and €2,370 at the
end of the fifth year. The insurance company is in effect paying him
6.0% interest on the annuity balance.
Annuity
Balance
at
Beginning
Year
of Year
1
€10,000
Balance at
End of Year
before
Withdrawal
€10,600 (=
10,000 ×
1.06)
Withdrawal (Payment by
Insurance Company)
€2,375
Annuity
Balance
at
Beginning
Year
of Year
2
€8,225
3
€6,344
4
€4,350
5
€2,236
6
€0
Balance at
End of Year
before
Withdrawal
€8,719 (=
8,225 × 1.06)
€6,725 (=
6,344 × 1.06)
€4,611 (=
4,350 × 1.06)
€2,370 (=
2,236 × 1.06)
Withdrawal (Payment by
Insurance Company)
€2,375
€2,375
€2,375
€2,370
2. You borrow £60,000 to buy a small cottage in the country. The
interest rate on the mortgage is 4.60%. Your payment at the end of
each year will be £13,706.
Mortgage
Outstanding at
Beginning of
Year
Total
Mortgage
Payment
1
£60,000
£13,706
2
£49,054
£13,706
3
£37,605
£13,706
Year
Interest
Paid
Principal
Reduced
£2,760 (=
60,000 ×
0.046)
£2,257 (=
49,054 ×
0.046)
£1,730 (=
37,605 ×
0.046)
£10,946
£11,449
£11,976
Mortgage
Outstanding at
Beginning of
Year
Total
Mortgage
Payment
4
£25,630
£13,706
5
£13,103
£13,706
6
£0
Year
Interest
Paid
Principal
Reduced
£1,179 (=
25,630 ×
0.046)
£603 (=
13,103 ×
0.046)
£12,527
£13,103
As you can see in Example 6, both the annuity and mortgage balances
decline to zero over time.
3. DESCRIPTIVE STATISTICS
As the name suggests, descriptive statistics are used to describe data. Often,
you are confronted by data that you need to organise in order to understand it.
For example, you get the feeling that the drive home from work is getting
slower and you are thinking of changing your route. How could you assess
whether the journey really is getting slower? Suppose you calculated and
compared the average daily commute time each month over a year. The first
question you need to address is, what is meant by average? There are a
number of different ways to calculate averages that are described in Section
3.1, each of which has advantages and disadvantages.
In general, descriptive statistics are numbers that summarise essential
features of a data set. A data set relates to a particular variable—the time it
takes to drive home from work in our example. The data set includes several
observations—that is, observed values for the variable. For example, if you
keep track of your daily commute time for a year, you will end up with
approximately 250 observations. The distribution of a variable is the
values a variable can take and the number of observations associated with
each of these values.
We will discuss two types of descriptive statistics: those that describe the
central tendency of a data set (e.g., the average or mean) and those that
describe the dispersion or spread of the data (e.g., the standard deviation). In
addition to knowing whether the drive to work is getting slower (by
comparing monthly averages), you might also want to find a way to measure
how much variation there is between journey times from one day to another
(by using standard deviation).
Similar needs to summarise data arise in business. For example, when
comparing the time taken to process two types of trades, a sample of the
times required to process each trade would need to be collected. The
average time it takes to process each type of trade could be calculated and
the average times could then be compared. Descriptive statistics efficiently
summarise the information from large quantities of data for the purpose of
making comparisons. Descriptive statistics may also help in predicting future
values and understanding risk. For example, if there was little variation in
the times taken to process a trade, then presumably you would be confident
that you had a good idea of the average time it takes to process a trade and
comfortable with that as an estimate of how long it will take to process future
trades. But if the time taken to process trades was highly variable, you would
have less confidence in how long it would take on average to process future
trades.
3.1. Measures of Frequency and Average
The purpose of measuring the frequency of outcomes or “central tendency” is
to describe a group of individual data scores with a single measurement. The
value used to describe the group will be the single value considered to be
most representative of all the individual scores.
Measures of central tendency are useful for making comparisons between
groups of individuals or between sets of figures. Such measures reduce a
large number of measurements to a single figure. For instance, the mean or
average temperature in country X in July from 1961 to 2011 is calculated to
be 16.1°C. Over the same period in September, the average temperature is
13.6°C. Because it is a long time series, you can reasonably conclude that it
is usually warmer in July than September in country X.
Common measures of central tendency are
arithmetic mean,
geometric mean,
median, and
mode.
The appropriate measure for a given data set depends on the features of the
data and the purpose of your calculation. These measures are examined in the
following sections.
3.1.1. Arithmetic Mean
The arithmetic mean is the most commonly used measure of central
tendency and is familiar to most people. It is usually shortened to just “mean”
or “average”. To calculate the mean, you add all the numbers in the data set
together and divide by the number of observations (items in the data set). The
arithmetic mean assumes that each observation is equally probable (likely to
occur). If each observation is not equally probable, you can get a weighted
mean by multiplying the value of each observation by its probability and then
summing these values. The sum of the probabilities always equals 1.
Exhibit 5 shows the annual returns earned on an investment over a 10-year
period. The information contained in Exhibit 5 will be used in examples
throughout this section.
Exhibit 5.
Ten Years of Annual Returns
Example 7 shows the calculation of the arithmetic mean.
EXAMPLE 7.
ARITHMETIC MEAN
An investment earns the returns shown in Exhibit 5 over a 10-year
period.
The arithmetic mean return or average annual return over the 10-year
period is 6.3%. The weighted mean return (shown in the following
equation) is the same as the arithmetic return because the probability
assigned to each return is the same: 10% or 0.1.
Weighted mean annual return
= (0.1 × 1.3) + (0.1 × 2.4) + (0.1 × 0.8) + (0.1 × 3.7) + (0.1 × 8.0)
+ (0.1 × 3.7) + (0.1 × 7.2) + (0.1 × 26.4) + (0.1 × 4.2) + (0.1 × 5.2)
= 6.3%
The arithmetic mean annual return is 6.3%.
The mean has one main disadvantage: it is particularly susceptible to the
influence of outliers. These are values that are unusual compared with the
rest of the data set by being especially small or large in numerical value. The
arithmetic mean is not very representative of the whole set of observations
when there are outliers. Example 8 shows the effect of excluding an outlier
from the calculation of the arithmetic mean.
EXAMPLE 8.
EFFECT OF OUTLIER ON ARITHMETIC MEAN
In the case of the annual returns in Exhibit 5, there is one value—26.4%
—that is much larger than the others. If this value is included, the mean
is 6.3%, but excluding this value reduces the mean to 4.1%.
The arithmetic mean excluding the outlier is 4.1%.
Including the outlier, the mean is dragged in the direction of the outlier. When
there are one or more outliers in a set of data in one direction, the data are
said to be skewed in that direction. In Example 7, ordering data so larger
numbers are to the right of smaller numbers, 26.4% lies to the right of the
other data. Thus, the data are said to be right skewed (or positively skewed).
Other measures of central tendency may better accommodate outliers.
3.1.2. Geometric Mean
An alternative average to the arithmetic mean is the geometric average or
geometric mean. Applied to investment returns, the geometric mean return
is the average return assuming that returns are compounding. To illustrate
how the geometric mean is calculated, let us start with the example of a
three-year investment that returns 8% the first year, 3% the second year, and
7% the third year.
The first step to calculate the geometric mean return is to multiply 1 plus
each annual return and add them together, which gives you the amount you
would have accumulated at the end of the three years per currency unit of
investment: [(1 + 8%) × (1 + 3%) × (1 + 7%) ≈ 1.1903]. This value of
1.1903 reflects three years of investment, but the geometric mean return
should capture an average rate of return for each of the three years. So, the
second step requires moving from three years to one by raising the
accumulation to the power of “one over the number of periods held,” three in
this particular case; this calculation can also be described as taking “the
number of periods held” root of the value (1.19031/3 ≈ 1.060). This value of
1.060 includes both the original investment and the average yearly return on
the investment each year (1 plus the geometric mean return). The last step is,
therefore, to subtract 1 from this value to arrive at the return that would have
to be earned on average each year to get to the total accumulation over the
three years (1.060 – 1 ≈ 0.060 or 6.0%). The geometric mean return is 6.0%,
which in this case is the same as the arithmetic mean return. Geometric mean
is frequently the preferred measure for the investment industry.
The following formula is used to arrive at the geometric mean return:
Geometric mean return =
where
ri = the return in period i expressed using decimals
t = the number of periods
Example 9 shows the calculation of the geometric mean return for the
investment of Exhibit 5.
EXAMPLE 9.
GEOMETRIC MEAN RETURN
If 1 currency unit was invested, you would have 1.8 currency units at the
end of the 10 years.
Total accumulation after 10 years
= [(1 + 1.3%) × (1 + 2.4%) × (1 + 0.8%) × (1 + 3.7%) × (1 + 8.0%)
× (1 + 3.7%) × (1 + 7.2%) × (1 + 26.4%) × (1 + 4.2%) × (1 +
5.2%)]
= [(1.013) × (1.024) × (1.008) × (1.037) × (1.08) × (1.037) ×
(1.072) × (1.264) × (1.042) × (1.052)]
= 1.8
Average accumulation per year = 10th root of 1.8 = (1.8)1/10 = 1.061
Geometric mean annual return = 1.061 – 1 = 0.061 = 6.1%
This can also be done as one calculation:
Geometric mean annual return
= {[(1 + 1.3%) × (1 + 2.4%) × (1 + 0.8%) × (1 + 3.7%) × (1 +
8.0%) × (1 + 3.7%) × (1 + 7.2%) × (1 + 26.4%) × (1 + 4.2%) × (1 +
5.2%)](1/10)} – 1
= 6.1%
The geometric mean annual return is 6.1%. One currency unit invested
for 10 years and earning 6.1% per year would accumulate to
approximately 1.8 units.
An important aspect to notice is that the geometric mean is lower than the
arithmetic mean even though the annual returns over the 10-year holding
period are identical. This result is because the returns are compounded when
calculating the geometric mean return. Recall that compounding will result in
a higher value over time, so a lower rate of return is required to reach the
same amount. In fact, if the same set of numbers is used to calculate both
means, the geometric mean return is never greater than the arithmetic mean
return and is normally lower.
3.1.3. Median
If you put data in ascending order of size from the smallest to the largest, the
median is the middle value. If there is an even number of items in a data set,
then you average the two middle observations. Hence, in many cases (i.e.,
when the sample size is odd or when the two middle-ranked items of an
even-numbered data set are the same) the median will be a number that
actually occurs in the data set. Example 10 shows the calculation of the
median for the investment of Exhibit 5.
EXAMPLE 10.
MEDIAN
When the returns are ordered from low to high, the median value is the
arithmetic mean of the fifth and sixth ordered observations.
The median investment return over the 10-year period is 4.0%.
An advantage of the median over the mean is that it is not sensitive to
outliers. In the case of the annual returns shown in Exhibit 5, the median of
close to 4.0% is more representative of the data’s central tendency. This
4.0% median return is close to the 4.1% arithmetic mean return when the
outlier is excluded. The median is usually a better measure of central
tendency than the mean when the data are skewed.
3.1.4. Mode
The mode is the most frequently occurring value in a data set. Example 11
shows how the mode is determined for the investment of Exhibit 5.
EXAMPLE 11.
MODE
Looking at Exhibit 5, we see that one value occurs twice, 3.7%. This
value is the mode of the data.
The mode can be used as a measure of central tendency for data that have
been sorted into categories or groups. For example, if all the employees in a
company were asked what form of transportation they used to get to work
each day, it would be possible to group the answers into categories, such as
car, bus, train, bicycle, and walking. The category with the highest number
would be the mode.
A problem with the mode is that it is often not unique, in which case there is
no mode. If there are two or more values that share the same frequency of
occurrence, there is no agreed method to choose the representative value.
The mode may also be difficult to compute if the data are continuous.
Continuous data are data that can take on an infinite number of values
between whole numbers—for example, weights of people. One person may
weigh 62.435 kilos and another 62.346 kilos. By contrast, discrete data
show observations only as distinct values—for example, the number of
people employed at different companies. The number of people employed
will be a whole number. For continuous data, it is less likely that any
observation will occur more frequently than once, so the mode is generally
not used for identifying central tendency for continuous data.
Another problem with the mode is that the most frequently occurring
observation may be far away from the rest of the observations and does not
meaningfully represent them.
3.2. Measures of Dispersion
Whereas measures of central tendency are used to estimate representative or
central values of a set of data, measures of dispersion are important for
describing the spread of the data or its variation around a central value. Two
data sets may have the same mean or median but completely different levels
of variability, or vice versa. A description of a data set should include both a
measure of central tendency, such as the mean, and a measure of dispersion.
Suppose two companies both have an average annual salary of $50,000, but
in one company most salaries are clustered close to the average, whereas in
the second they are spread out with many people earning very little and some
earning a lot. It would be useful to have a measure of dispersion that can help
identify such differences between data sets.
Another reason why measures of dispersion are important in finance is that
investment risk is often measured using some measure of variability. When
investors are considering investing in a security, they are interested in the
likely (expected) return on that investment as well as in the risk that the
return could differ from the expected return (its variability). A risk-averse
investor considering two investments that have similar expected returns but
very different measures of variability (risk) around those expected returns,
typically prefers the security with the lower variability.
Two common measures of dispersion of a data set are the range and the
standard deviation.
3.2.1. Range
The range is the difference between the highest and lowest values in a data
set. It is the easiest measure of dispersion to calculate and understand, but it
is very sensitive to outliers. Example 12 explains the calculation of the
range of returns for the investment of Exhibit 5.
EXAMPLE 12.
RANGE
In Exhibit 5 we see that the highest annual return is 26.4% and the
lowest annual return is 0.8%.
If the extreme value at the upper end of the range is excluded, the next
highest value, 8.0%, is used to estimate the range, and the range is
reduced significantly.
Clearly, the range is affected by extreme values and, if there are outliers, it
says little about the distribution of the data between those extremes.
If there are a large number of observations ranked in order of size, the range
can be divided into 100 equal-sized intervals. The dividing points are termed
percentiles. The 50th percentile is the median and divides the observations
so that 50% are higher and 50% are lower than the median. The 20th
percentile is the value below which 20% of observations in the series fall.
So, the dispersion of the observations can be described in terms of
percentiles. Observations can be divided into other equal-sized intervals.
Commonly used intervals are quartiles (the observations are divided into
four equal-sized intervals) and deciles (the observations are divided into 10
equal-sized intervals)
3.2.2. Standard Deviation
A commonly used measure of dispersion is the standard deviation. It
measures the variability or volatility of a data set around the average value
(the arithmetic mean) of that data set. Although, as mentioned before, you are
not responsible for any calculations, you may find it helpful to look at the
formula for how standard deviation is calculated.
Standard deviation =
where
Xi = observation i (one of n possible outcomes for X)
n = number of observations of X
E(X) = the mean (average) value of X or the expected value of X
[Xi – E(X)] = difference between value of observation Xi and the mean
value of X
The differences between the observed values of X and the mean value of X
capture the variability of X. These differences are squared and summed. Note
that because the differences are squared, what matters is the size of the
difference not the sign of the difference. The sum is then divided by the
number of observations. Finally, the square root of this value is taken to get
the standard deviation.
The value before the square root is taken is known as the variance, which is
another measure of dispersion. The standard deviation is the square root of
the variance. The standard deviation and the variance capture the same thing
—how far away from the mean the observations are. The advantage of the
standard deviation is that it is expressed in the same unit as the mean. For
example, if the mean is expressed as minutes of journey time, the standard
deviation will also be expressed as minutes, whereas the variance will be
expressed as minutes squared, making the standard deviation an easier
measure to use and compare with the mean.
To illustrate the calculation of the standard deviation, let us return to the
example of a three-year investment that returns 8% or 0.08 the first year, 3%
or 0.03 the second year, and 7% or 0.07 the third year. The arithmetic mean
return is 6% or 0.06. The standard deviation is approximately 2.16%.
Standard deviation =
=
=
=
= 0.0216 = 2.16%
Example 13 shows the calculation of the standard deviation for the
investment in Exhibit 5.
EXAMPLE 13.
STANDARD DEVIATION
The arithmetic mean annual return, as calculated in Example 7, is
6.3%.
Standard deviation
= square root of {[(0.013 – 0.063)2 + (0.024 – 0.063)2 + (0.008 –
0.063)2 + (0.037 – 0.063)2 + (0.08 – 0.063)2 + (0.037 – 0.063)2 +
(0.072 – 0.063)2 + (0.264 – 0.063)2 + (0.042 – 0.063)2 + (0.052 –
0.063)2] ÷ 10}
= square root of [(0.0025 + 0.0015 + 0.0030 + 0.0007 + 0.0003 +
0.0007 + 0.0001 + .0404 + 0.0004 + 0.0001) ÷ 10]
= square root of 0.00497
= 0.0705, rounded to the nearest 10th percent = 7.1% (this value is
used in Example 14).
The standard deviation is 7.1%.
Larger values of standard deviation relative to the mean indicate greater
variation in a data set. Also, by using standard deviation, you can determine
how likely it is that any given observation will occur based on its distance
from the mean. Example 14 compares the returns of the investment shown in
Exhibit 5 and the returns on another investment over the same period using
mean and standard deviation.
EXAMPLE 14.
COMPARISON OF INVESTMENTS
An investment earns the returns shown in Exhibit 5 over a 10-year
period:
Number of observations = 10
Mean = 6.3%
Standard deviation = 7.1%
Another investment over the same time period has the following
characteristics:
Number of observations = 10
Mean = 6.5%
Standard deviation = 2.6%
Based on mean and standard deviation, the second investment is better
than the first investment. It has a higher mean return and less variability,
which implies less risk, in its returns.
3.2.3. Normal Distribution
The arithmetic mean and standard deviation are two powerful ways of
describing many distributions of data. A distribution is simply the set of
values that a variable can take, showing their observed or theoretical
frequency of occurrence. For example, consider the distribution of salaries
earned by employees in two companies as shown in Exhibit 6. The
observations in these distributions are grouped into different salary ranges.
Exhibit 6.
Number of Employees in Various Salary Ranges
Salary ($)
15,000–20,000
20,001–25,000
25,001–30,000
30,001–35,000
35,001–40,000
40,001–45,000
45,001–50,000
50,001–55,000
55,001–60,000
Number of Employees
Company X Company Y
5
8
20
30
22
12
6
2
1
1
1
3
8
10
15
20
9
7
Sometimes it is helpful to look at a picture of the distribution to understand it.
The shape of the distribution has a bearing on how you interpret the summary
measures of the distribution. This data can be shown pictorially using a
histogram—a bar chart with bars that are proportional to the frequency of
occurrence of each group of observations—as shown in Exhibits 7A and 7B.
Exhibit 7A.
Salaries of Employees at Company X
Exhibit 7B.
Salaries of Employees at Company Y
Note that the two distributions are not symmetrical. A symmetrical
distribution would have observations falling off fairly evenly on either side
of the centre of the range of salaries ($35,001–$40,000). Instead, in each of
these distributions, the bulk of the observations are stacked towards one end
of the range and tail off gradually towards the other end. The two
distributions are different in that each is stacked towards a different end.
Such distributions are considered skewed; the distribution for Company X is
positively skewed (i.e., the majority of the observations are on the left and
the skew or tail is on the right), whereas the distribution for Company Y is
negatively skewed (left skewed).
Although the range of the observations is the same in each case, the mean for
each is very different. Company X’s mean is approximately $35,000,
whereas Company Y’s mean is approximately $44,000.
For a perfectly symmetrical distribution, such as a normal distribution (see
Exhibit 8), the mean, median, and mode will be identical. If the distribution
is skewed, these three measures of central tendency will differ. Looking
again at Company X’s salary data, for instance, we do not have enough
detailed information to identify a mode. The mean is larger than the median
because the mean is more affected by extreme values than the median. The
distribution is skewed to the right, so the mean is dragged towards the
extreme positive values. The reverse is true for distributions that are
negatively skewed, such as in Company Y’s salary data. In this case, the
mean is smaller than the median because the mean is pulled left in the
direction of the skew.
A normal distribution is represented in a graph by a bell curve; an
example of a bell-shaped curve is shown in Exhibit 8. The shape of the curve
is symmetrical with a single central peak at the mean of the data and the
graph falling off evenly on either side of the mean; 50% of the distribution
lies to the left of the mean, and 50% lies to the right of the mean. The shape
of a normal distribution depends on the mean and the standard deviation. The
mean of the distribution determines the location of the centre of the curve,
and the standard deviation determines the height and width of the curve.
When the standard deviation is large, the curve is short and wide; when the
standard deviation is small, the curve is tall and narrow.
A normal distribution has special importance in statistics because many
variables have the approximate shape of a normal distribution—for example,
height, blood pressure, and lengths of objects produced by machines. This
distribution is often useful as a description of data when there are a large
number of observations.
A normal distribution is a distribution of a continuous random variable (i.e.,
a variable that can take on an infinite number of values). The vertical axis for
the normal distribution is the probability or likelihood of occurrence. By
contrast, on the histogram shown earlier, the vertical axis was frequency of
occurrence. The mean (and median) is the centre of the distribution and has
the highest probability of occurrence. Half of the observations lie on one side
of the mean and half on the other. Approximately two-thirds of the
observations are within one standard deviation of the mean, and 95% of
observations are within two standard deviations of the mean. Exhibit 8
shows a normal distribution.
Exhibit 8.
Standard Deviation (SD) and Normal Distribution
The total area under the curve or bell is 100% of the distribution. The area
under the curve that is within one standard deviation of the mean is about
68% of all the observations. In other words, given a mean of 0 and a
standard deviation of 1, about 68% of the observations fall between –1 and
+1, and 32% of the observations are more than one standard deviation from
the mean. The area under the curve that is within 2 standard deviations of the
mean is about 95% of the observations. Given a mean of 0 and a standard
deviation of 1, about 95% of the observations fall between –2 and +2, and
5% of the observations are more than two standard deviations from the mean.
The area under the curve that is within three standard deviations of the mean
represents about 99% of the observations. Given a mean of 0 and a standard
deviation of 1, about 99% of the observations fall between –3 and +3, and
less than 1% of the observations occur more than three standard deviations
away from the mean.
The observations that are more than a specified number of standard
deviations from the mean can be described as lying in the tails of the
distribution. Assuming that returns on a portfolio of stocks are normally
distributed, the chance of extreme losses (a return more than three standard
deviations lower than the mean return) is relatively small. The chance of the
return being in the left tail more than two standard deviations from the mean
(which would be an extreme loss under typical circumstances) is just 2.5%.
In other words, out of 200 days, 5 days are expected to have observations
that are more than two standard deviations from the mean. But during the
financial crisis of 2008, the losses that were incurred by some banks over
several days in a row were 25 standard deviations below the mean.
To put this in perspective, if returns are normally distributed, a return that is
7.26 standard deviations below the mean would be expected to occur once
every 13.7 billion years. That is approximately the age of the universe. The
frequency of extreme events during the financial crisis of 2008 was,
therefore, much higher than predicted by the normal distribution. This
inconsistency is often referred to as the distribution having “fat tails”,
meaning that the probability of observing extreme outcomes is higher than
that predicted by a normal distribution.
Exhibit 9 gives examples of different types of bell-shaped distributions.
How would you describe each curve? What does each tell you about the
likelihood of extreme outcomes?
Exhibit 9.
Bell-Shaped Distributions with Fat and Thin Tails
In Exhibit 9, the curve with the solid line represents the normal distribution.
The curve with the dotted line is an example of distribution with thinner tails
than the normal distribution, indicating a reduced probability of extreme
outcomes. By contrast, the curve with the dashed line is an example of a
distribution with fatter tails than the normal distribution, indicating increased
likelihood of extreme outcomes.
3.3. Correlation
Another way of using and understanding data is identifying connections
between data sets. The strength of a relationship between two variables, such
as growth in gross domestic product (GDP) and stock market returns, can be
measured by using correlation. Essentially, two variables are correlated
when a change in one variable helps predict change in another variable.
When both variables change in the same direction, the variables are
positively correlated. If we take the example of traders at an investment
bank, salary and age are positively correlated if salaries increase as age
increases. If the variables move in the opposite direction, then they are
negatively correlated. For example, the size of a transaction and the fees
expressed as a percentage of the transaction are negatively correlated if the
larger the transaction, the smaller the associated fees. When there is no clear
tendency for one variable to move in a particular direction (up or down)
relative to changes in the other variable, then the variables are close to being
uncorrelated. In practice, it is difficult to find two variables that have
absolutely no relationship, even if just by chance.
Correlation is measured by the correlation coefficient, which has a scale
of –1 to +1. When two variables move exactly in step with each other in the
same direction—if one goes up, the other goes up in the same proportion—
the variables are said to be perfectly positively correlated. In that case, the
correlation coefficient is at its maximum of +1. When the two variables move
exactly in step in opposite directions, they are perfectly negatively correlated
and the correlation coefficient is –1. Variables with no relationship to each
other will have a correlation coefficient close to 0.
Correlation measures both the direction of the relationship between two
variables (negative or positive) and the strength of that relationship (the
closer to +1 or –1, the stronger the relationship). In practice, it is unusual to
find variables that are perfectly positively or perfectly negatively correlated.
The stronger the relationship between two variables—the higher the degree
of correlation—the more confidently one variable can be predicted given the
other variable. For example, there may be a high correlation between stock
market index returns and expected economic growth. In that case, if economic
growth in the future is expected to be high then returns on the stock market
index are likely to be high too.
It is important, however, to realise that correlation does not imply causation.
For example, historically in the United States, stock market returns and
snowfall are both higher in January, and from that you may assume a
correlation. But obviously snowfall does not cause an increase in stock
market returns, and an increase in stock market returns clearly does not cause
snowfall. There may be situations in which a correlation implies some causal
relationship. For example, a high correlation has been found between power
production and job growth. It may follow that the more workers there are, the
more power is consumed, but it does not necessarily follow that an increase
in power generation will create jobs.
Correlation is important in investing because the rise or fall in value of a
variable may help predict the rise or fall in value of another variable. It is
also important because when two or more securities that are not perfectly
correlated are combined together in a portfolio, there is normally a reduction
in risk (measured by the portfolio’s standard deviation of returns). As long as
the returns on the securities do not have a correlation of +1 (that is, they are
less than perfectly correlated), then the risk of the portfolio will be less than
the weighted average of the risks of the securities in the portfolio because it
is not likely that all the securities will perform poorly at the same time.
The practice of combining securities in a portfolio to reduce risk is known as
diversification. An extreme example of an undiversified portfolio is one
holding only one security. This approach is risky because it is not unusual for
a single security to go down in value by a large amount in one year. It is much
less common for a diversified portfolio of 20 different securities to go down
by a large amount, even if they are selected at random. If the securities are
selected from a variety of sectors, industries, company sizes, asset classes,
and markets, it is even less likely. One caveat is that the benefits of
diversification are much reduced in periods of financial crisis. In such
periods, the correlation between returns on different securities (and different
asset classes) tends to increase towards +1.
SUMMARY
The better your understanding of quantitative concepts, the easier it will be
for you to make sense of the financial world. Knowledge of quantitative
concepts, such as time value of money and descriptive statistics, is important
to the understanding of many of the key products in the financial industry.
Understanding the time value of money allows you to interpret cash flows
and thus value them. Meanwhile, knowledge of statistical concepts will help
in identifying the important information in a large amount of data, as well as
in understanding what statistical measures reported by others mean. It is easy
to misinterpret or be misled by statistics, such as mean and correlation, so an
understanding of their uses and limitations is crucial.
Interest is return earned by a lender that compensates for opportunity
cost and risk. For the borrower, it is the cost of borrowing.
The simple interest rate is the cost to the borrower or the rate of return
to the lender, per period, on the original principal borrowed. A
commonly quoted simple interest rate is the annual percentage rate
(APR).
Compound interest is the return to the lender or the cost to the borrower
when interest is reinvested and added to the original principal.
The effective annual rate (EAR) of interest is calculated by annualising
a rate that is compounded more than once a year. The EAR is equal to or
greater than the annual percentage rate.
The present value of a future sum of money is found by discounting the
future sum by an appropriate discount rate. (The present value of
multiple cash flows is the sum of the present value of each cash flow.)
Three elements must be considered when comparing investments: the
cash flows each investment will generate in the future, the timing of
these cash flows, and the risk associated with each investment. The
discount rate reflects the riskiness of the cash flows.
All else being equal (in other words, only one of the three elements
differs):
the higher the cash flows, the higher the present and future values.
the earlier the cash flows, the higher the present and future values.
the lower the discount rate, the higher the present value.
the higher the interest rate, the higher the future value.
The net present value is the present value of future cash flows net of the
investment required to obtain them. It is useful when comparing
alternatives that require different initial investments.
Financial instruments can be valued as the present value of their
expected future cash flows.
An annuity involves an initial payment (outflow) in exchange for a fixed
number of future receipts (inflows), each of an equal amount. Mortgages
are amortising loans; the periodic payment is fixed, and in each period
some of the payment covers the interest on the loan and the rest of the
payment pays off some of the principal. Over time, the portion of the
payment that reduces the principal increases.
The role of descriptive statistics is to summarise the information given
in large quantities of data for the purpose of making comparisons,
predicting future values, and better understanding the data.
The purpose of measures of frequency or central tendency is to describe
a group of individual data scores with a single measurement. This
measure is intended to be representative of the individual scores.
Measures of central tendency include arithmetic mean, geometric mean,
median, and mode. Different measures are appropriate for different
types of data.
The arithmetic mean is the most commonly used measure. It represents
the sum of all the observations divided by the number of observations. It
is an easy measure to understand but may not be a good representative
measure when there are outliers.
The geometric mean return is the average compounded return for each
period—that is, the average return for each period assuming that returns
are compounding. It is frequently the preferred measure of central
tendency for returns in the investment industry.
When observations are ranked in order of size, the median is the middle
value. It is not sensitive to outliers and may be a more representative
measure than the mean when data are skewed.
The mode is the most frequently occurring value in a data set. A data set
may have no identifiable unique mode. It may not be a meaningful
representative measure of central tendency.
Measures of dispersion are important for describing the spread of the
data, or its variation around a central value. Two common measures of
dispersion are range and standard deviation.
Range is the difference between the highest and lowest values in a data
set. It is easy to measure, but it is sensitive to outliers.
Standard deviation measures the variability of a data set around the
mean of the data set. It is in the same unit of measurement as the mean.
A distribution is simply the values that a variable can take, showing its
observed or theoretical frequency of occurrence.
For a perfectly symmetrical distribution, the mean, median, and mode
will be identical.
A common symmetrical distribution is the normal distribution, a bellshaped curve that is represented by its mean and standard deviation. In a
normal distribution, 68% of all the observations lie within one standard
deviation of the mean and about 95% of the observations are within two
standard deviations.
The strength of a relationship between two variables can be measured
by using correlation.
Correlation is measured by the correlation coefficient on a scale from –
1 to +1. When two variables move exactly in tandem with each other,
the variables are said to be perfectly positively correlated and the
correlation coefficient is +1. When two variables move exactly in
opposite directions, they are perfectly negatively correlated and the
correlation coefficient is –1. Variables with no relationship to each
other will have a correlation coefficient close to 0.
It is important to realise that correlation does not imply causation.
CHAPTER REVIEW QUESTIONS
© 2014 CFA Institute. All rights reserved.
1. Interest is paid by the borrower to compensate the lender:
A. for opportunity cost and risk.
B. for forgoing future consumption.
C. for increases in future purchasing power.
2. A company obtains a loan from a local bank for $50 million. From the
company’s perspective, interest is best defined as the:
A. risk of default.
B. cost of borrowing.
C. value of the next best alternative.
3. The greater the risk associated with a borrower’s ability to repay a
loan, the greater the:
A. opportunity cost for the borrower.
B. interest rate demanded by the lender.
C. risk of purchasing power increasing over the life of the loan.
4. To maintain purchasing power, lenders demand an interest rate that
reflects the:
A. likelihood of default.
B. current rate of inflation.
C. expected rate of inflation.
5. If interest is paid and compounded annually, the compound interest rate
is most likely to be:
A. higher than the simple interest rate.
B. the same as the simple interest rate.
C. lower than the simple interest rate.
6. Compared with compound interest, simple interest assumes that interest
is:
A. paid annually.
B. calculated using only the original amount invested.
C. reinvested and added to the original amount invested.
7. Which of the following is associated with the concept of interest on
interest?
A. Simple interest
B. Compound interest
C. Annual percentage rate
8. If $1,000 is deposited to an account with an annual interest rate of 3%
and is left on deposit for three years, the amount of money in the account
at the end of three years will be:
A. lower using simple interest compared with using compound
interest.
B. the same using either simple interest or compound interest.
C. greater using simple interest compared with using compound
interest.
9. The interest rate used to determine the present value of future cash
flows is called the:
A. discount rate.
B. effective annual rate.
C. annual percentage rate.
10. The most effective way to compare investments with the same initial
outflow that have different cash flows at different points in time is to
determine each investment’s:
A. discount rate.
B. present value.
C. future cash flows.
11. The present value of €100 that will be received two years from today
is:
A. less than €100.
B. equal to €100.
C. more than €100.
12. All else being equal, given a choice of when to pay for a purchase, an
individual would most likely prefer to pay £100:
A. today.
B. one year from today.
C. two years from today.
13. Assuming a discount rate of 10%, which of the following projects will
have the highest present value?
A. A €10,000 lump-sum payment received today
B. A €10,000 lump-sum payment received in one year
C. A €5,000 payment received today plus €5,000 to be received in
one year
14. Given an interest rate of 10% and assuming that interest is reinvested,
which of the following will have the highest future value?
A. €10,000 invested today for 5 years.
B. €10,000 invested today for 10 years.
C. €10,000 invested today for 15 years.
15. When evaluating an investment, if the discount rate increases while
holding all other factors constant, the present value will:
A. increase.
B. decrease.
C. remain unchanged.
16. When choosing among investments that have different initial costs and
future cash flows, the best choice is the investment with the highest:
A. discount rate.
B. net present value.
C. present value of future cash flows.
17. Which of the following investments is unacceptable? An investment
with a net present value of:
A. negative $5.
B. $0.
C. positive $5.
18. If an individual makes an initial payment to an insurance company in
exchange for a fixed number of future payments of a certain amount from
the insurance company, the individual has:
A. received a loan.
B. obtained a mortgage.
C. purchased an annuity.
19. In a mortgage transaction, the amount of each fixed payment made by the
borrower that represents interest:
A. decreases over time.
B. remains the same over time.
C. increases over time.
20. Which of the following is a measure of central tendency?
A. Mean
B. Range
C. Standard deviation
21. If the data in a set are continuous and skewed, which of the following
gives the best measure of central tendency?
A. Mean
B. Mode
C. Median
22. The preferred measure of central tendency for investment returns is the:
A. mode.
B. arithmetic mean.
C. geometric mean.
23. An analyst is comparing the returns of two investment portfolios. The
two portfolios have the same mean return. The portfolio with the higher
standard deviation most likely:
A. is less risky.
B. is more risky.
C. has a smaller range.
24. Which of the following is a measure of dispersion?
A. Mode
B. Range
C. Median
25. Which of the following is a measure of dispersion used to assess the
risk of an investment?
A. Arithmetic mean
B. Geometric mean
C. Standard deviation
26. Which of the following characteristics most likely represents a normal
distribution?
A. The values of the mean and median are identical.
B. There are more observations to the right of the mean than to the
left.
C. There are more observations to the left of the mean than to the
right.
27. A characteristic of a normal distribution is that the distribution of data
is:
A. symmetrical.
B. positively skewed.
C. negatively skewed.
28. For a normal distribution, the height and width of the distribution is
determined by the distribution’s:
A. mean.
B. median.
C. standard deviation.
29. If there is no relationship between two variables, the correlation
coefficient is closest to:
A. +1.
B. 0.
C. –1.
30. Assume the correlation between the unemployment rate and the inflation
rate is close to –1. Based on this information, if the unemployment rate
is expected to increase, then the inflation rate will most likely:
A. increase.
B. decrease.
C. remain unchanged.
ANSWERS
1. A is correct. Interest is a payment paid by the borrower and earned by
the lender that compensates for opportunity cost and risk. B is incorrect
because the lender is forgoing current, not future, consumption. C is
incorrect because interest is paid by the borrower to compensate the
lender for potential decreases in future purchasing power.
2. B is correct. From the company’s perspective, interest is defined as
payment for the use of borrowed money or the cost of borrowing. A and
C are incorrect because from the lender’s perspective, interest is earned
to compensate for opportunity cost (value of the next best alternative)
and risk, including default.
3. B is correct. The lower the certainty a borrower will make the
promised payments on the loan in a timely manner, the higher the level
of interest required by the lender to compensate for the increased risk of
default. A is incorrect because the opportunity cost for the lender, not
the borrower, is unrelated to the risk of the borrower. C is incorrect
because the lender bears the risk that purchasing power will decrease
not increase.
4. C is correct. To maintain purchasing power, lenders demand an interest
rate that takes into account expected inflation. As a result of inflation,
the money received from a loan may not be worth as much as expected
even if the loan is repaid as promised. To compensate for the risk of
inflation and a decline in purchasing power, the interest rate demanded
by the lender includes expected inflation over the life of the loan. The
higher the expected inflation, the higher the interest rate demanded. A is
incorrect because even if the loan is repaid as promised, purchasing
power will decline if inflation is greater than expected over the life of
the loan. B is incorrect because the expected rate of inflation is
reflected in the interest rate, not in the current rate of inflation.
5. B is correct because the number of compounding periods is one.
Therefore, the simple and compound interest rates are the same. More
frequent compounding leads to a higher compound interest rate than the
simple interest rate.
6. B is correct. Simple interest assumes that interest is not reinvested;
consequently, simple interest is only calculated on the original principal
amount, or the original amount invested. C is incorrect because
compound interest (not simple interest) assumes that, over time, interest
is earned on the original amount invested as well as on the interest
earned. A is incorrect because both simple and compound interest may
be paid annually or more frequently.
7. B is correct. Compound interest is based on the assumption that interest
earned is added to the original amount invested. Over time, interest is
earned on the original amount invested as well as on the interest earned.
As a result, compound interest is often referred to as interest on interest.
A is incorrect because simple interest assumes that interest is always
calculated based on the original amount invested. C is incorrect because
the annual percentage rate is a simple interest rate and does not involve
compounding.
8. A is correct. The amount of money in the account at the end of three
years will be lower using simple interest compared with compound
interest. Compound interest will result in interest being earned on the
original deposit as well as interest on interest.
9. A is correct. The present value of future cash flows is obtained by
discounting the future cash flows by the interest rate. The interest rate in
this context is called the discount rate. C is incorrect because the annual
percentage rate is a quoted simple interest rate. B is incorrect because
the effective annual rate is used to annualise a rate that is paid more than
once a year.
10. B is correct. Present value considers the three elements that should be
used when comparing investments; the amount of the future cash flows,
the timing of the future cash flows, and the risk associated with each
investment as reflected by the discount rate. A and C are incorrect
because they are elements needed to determine present value.
11. A is correct. The present value of any amount is less than the same
amount received in the future. How much less depends on the discount
rate used to determine the present value. B and C are incorrect because
any amount received in the future is worth less than the same amount
received today.
12. C is correct. For any given amount of money, most individuals would
prefer to pay the amount later compared with paying the same amount of
money today because money has a time value. The present value of the
payment of £100 is lower the further in the future that amount is paid. A
and B are incorrect because if the individual postpones payment, the
£100 could be invested for two years rather than for one year or not at
all.
13. A is correct. A lump-sum payment received today has a higher present
value than the same amount received in the future or in instalments.
14. C is correct. The longer the compounding period, the greater the future
value.
15. B is correct. The higher the discount rate, the lower the present value.
16. B is correct. Net present value is the difference between the present
value of future cash inflows and the cost of that investment. The
investment with the highest positive net present value is the best choice
if only one investment will be chosen. A is incorrect because the
investment with the largest discount rate is the one with the most risk. It
may or may not have the highest net present value, depending on
expected cash flows and their timing and initial cost. C is incorrect
because the present value of future cash flows must be compared with
the cost before a choice can be made.
17. A is correct. A net present value of negative $5 means that the cost of
the investment is $5 more than the present value of the future cash flows
from the investment and the investment should not be made. B and C are
incorrect because a net present value of zero or greater means that the
investment is earning at least the discount rate and is acceptable.
18. C is correct. The time value of money application described is an
annuity. After the initial payment, the insurance company will make
payments to the individual which can also be considered withdrawals
by the individual. These withdrawals reduce the balance of the annuity
over time. A is incorrect because a simple loan requires interest
payments and the repayment of the loan amount when the loan matures.
B is incorrect because the individual obtaining the mortgage must make
the fixed payments of a certain amount to the lender.
19. A is correct. Although the payment amount is fixed, the portion of each
payment that is interest is based on the remaining principal at the
beginning of each period. As the principal declines, so does the amount
of the fixed payment that constitutes interest. B is incorrect because the
payment remains fixed, but the portion allocated to interest decreases
over time while the portion allocated to principal increases over time.
C is incorrect because the portion of the fixed payment allocated to
principal increases over time.
20. A is correct. Mean is a measure of central tendency. B and C are
incorrect because both the range and standard deviation are measures of
dispersion.
21. C is correct. The median is the middle value in a data set when the
items in that data set are ordered from smallest to largest. Thus, the
median is not affected by outliers (extremely high or low value items in
the data set). A is incorrect because the mean is affected by outliers. B
is incorrect because with continuous data, it is less likely that any
observation will appear more than once; thus, the mode may not be
identifiable.
22. C is correct. The investment industry prefers the geometric mean
because the geometric mean is the average return earned each year to
get the total accumulation assuming that returns are compounding. A is
incorrect because investment returns are continuous data; the mode is
not a useful measure of central tendency when data are continuous. B is
incorrect because the arithmetic mean does not assume compounding.
23. B is correct. Higher standard deviation indicates higher variability and
risk. A and C are incorrect because the portfolio with the higher
standard deviation is more dispersed, has a larger range, and is more
risky.
24. B is correct. Measures of dispersion are used to measure the spread
associated with a dataset or its variation around a central value. The
range is a measure of dispersion that is calculated by taking the
difference between the highest and lowest values of the dataset. A and C
are incorrect because the mode and the median are measures of central
tendency.
25. C is correct. The standard deviation is a measure of dispersion in a
dataset. The higher the standard deviation, the greater the risk
associated with an investment. A and B are incorrect because they are
measures of central tendency.
26. A is correct. The mean and median are identical in a normal
distribution. B and C are incorrect because in a normal distribution, like
any symmetrical distribution, there are the same number of observations
to the left and to the right of the mean.
27. A is correct. A normal distribution is a distribution in which 50% of the
distribution lies to the left of the mean and 50% of the distribution lies
to the right of the mean; the shape of the distribution is symmetrical. B
and C are incorrect because if the distribution is skewed, more than
50% of the distribution lies to either the left (negatively skewed) or
right (positively skewed) of the mean.
28. C is correct. The height and width of a normal distribution is
determined by the standard deviation. If the standard deviation is large,
the curve is short and wide; if the standard deviation is small, the curve
is tall and narrow. A and B are incorrect because the mean and median
are the same in a normal distribution; they determine the centre of the
curve in a normal distribution.
29. B is correct. Correlation measures the strength of a relationship
between two variables. A correlation close to 0 indicates that there is
no relationship between the variables. A is incorrect because a
correlation of +1 indicates that the two variables are perfectly
positively correlated. C is incorrect because a correlation of –1
indicates that the two variables are perfectly negatively correlated.
30. B is correct. Because the unemployment rate and the inflation rate are
negatively correlated, if unemployment is expected to increase, then the
inflation rate is likely to decrease
Module 4
Investment Instruments
© 2014 CFA Institute. All rights reserved.
CONSIDER THIS
Think about your financial goals. Are you saving money to buy a
car or a house? Are you building a fund for your children’s
education? Do you have plans for retirement? No matter what your
financial goals are, how you invest your savings is very important.
The investment industry provides many choices to help you reach
your financial goals. Some of these choices offer high expected
returns but may be risky. Others are safer, but the expected returns
may not be high enough to help you buy that house or retire when
you want to. Knowing the types of investments that are available
and how to combine them are central to making the best investment
decisions.
When we invest, we need to think about and understand the risks we are
taking with our money as well as the level of return we need or expect. This
understanding may help us personally in achieving our own financial goals,
but it also has professional relevance. Many of you work for companies that
create or distribute investment instruments or that offer investment
management or trading services that require an understanding of investment
instruments.
Main types of investment instruments are equity securities (stocks), debt
securities (bonds), alternative investments, and derivatives. As an investment
industry participant (or future participant), you should know what these
instruments are.
These investment instruments exist because they respond to the needs of users
of capital as well as to investors’ needs. Users of capital include
individuals, companies, and governments that need to raise capital for a
variety of reasons. Individuals, for instance, might need to borrow to finance
a house purchase or their child’s education. Companies require capital to
fund and grow their operations, and governments borrow when their tax
receipts are insufficient to finance their spending plans.
Investors use many types of investment instruments, but stocks, bonds,
alternative investments, and derivatives are the instruments that compose the
majority of investors’ portfolios. Each instrument has different
characteristics that affect the risks to investors and the returns they can
achieve:
Equity and debt securities are the building blocks of many investors’
portfolios. Investing in stocks and bonds, either directly or indirectly, is
how most investors participate in financial markets.
Alternative investments can help investors enhance returns and reduce
risk in a portfolio of investments. Real estate, commodities, and private
equity are examples of alternative investments.
Derivatives exist to help both investors and borrowers manage future
risks, such as changes in stock or commodity prices, interest rates,
exchange rates, or non-financial factors, such as weather.
The four chapters in this module are: Debt Securities, Chapter 9; Equity
Securities, Chapter 10; Derivatives, Chapter 11; and Alternative Investments,
Chapter 12.
Chapter 9
Debt Securities
by Lee M. Dunham, PhD, CFA, and Vijay Singal, PhD,
CFA
© 2014 CFA Institute. All rights reserved.
LEARNING OUTCOMES
After completing this chapter, you should be able to do the following:
a. Identify issuers of debt securities;
b. Describe features of debt securities;
c. Describe seniority ranking of debt securities when default occurs;
d. Describe types of bonds;
e. Describe bonds with embedded provisions;
f. Describe securitisation and asset-backed securities;
g. Define current yield;
h. Describe the discounted cash flow approach to valuing debt securities;
i. Describe a bond’s yield to maturity;
j. Explain the relationship between a bond’s price and its yield to
maturity;
k. Define yield curve;
l. Explain risks of investing in debt securities;
m. Define a credit spread.
1. INTRODUCTION
The Canadian entrepreneur in the Investment Industry: A Top-Down View
chapter initially financed her company with her own money and that of family
and friends. But over time, the company needed more money to continue to
grow. The company could get a loan from a bank or it could turn to investors,
other than family and friends, to provide additional money.
Companies and governments raise external capital to finance their
operations. Both companies and governments may raise capital by borrowing
funds. As the following illustration shows, in exchange for the use of the
borrowed money, the borrowing company or government promises to pay
interest and to repay the borrowed money in the future.
The illustration has been simplified to show a company borrowing from
individuals. In reality, the borrower may be a company or a government, and
the investors may be individuals, companies, or governments. Companies
may also raise capital by issuing (selling) equity securities, as discussed in
the Equity Securities chapter.
As discussed in the Quantitative Concepts chapter, from the borrower’s
perspective, paying interest is the cost of having access to money that the
borrower would not otherwise have. For the lender, receiving interest is
compensation for opportunity cost and risk. The lender’s opportunity cost is
the cost of not having the loaned cash to invest, spend, or hold—that is, the
cost of giving up other opportunities to use the cash. The various risks
associated with lending affect the interest rates demanded by lenders.
2. FEATURES OF DEBT SECURITIES
When a large company or government borrows money, it usually does so
through financial markets. The company or government issues securities that
are generically called debt securities, or bonds. Debt securities represent a
contractual obligation of the issuer to the holder of the debt security.
Companies and governments may have more than one issue of debt securities
(bonds). Each of these bond issues has different features attached to it, which
affect the bond’s expected return, risk, and value.
A bond is governed by a legal contract between the bond issuer and the
bondholders. The legal contract is sometimes referred to as the bond
indenture or offering circular. In the event that the issuer does not meet the
contractual obligations and make the promised payments, the bondholders
typically have legal recourse. The legal contract describes the key features of
the bond.
A typical bond includes the following three features: par value (also called
principal value or face value), coupon rate, and maturity date. These
features define the promised cash flows of the bond and the timing of these
flows.
Par value.
The par (principal) value is the amount that will be paid by the issuer to the
bondholders at maturity to retire the bonds.
Coupon rate.
The coupon rate is the promised interest rate on the bond.
The term “coupon rate” is used because, historically, bonds were
printed with coupons attached. There was one coupon for each date an
interest payment was owed, and each coupon indicated the amount
owed (coupon payment). Bondholders cut (clipped) the coupons off the
bond and submitted them to the issuer for payment. The use of the term
“coupon rate” helps prevent confusion between the interest rate
promised by the bond issuer and interest rates in the market.
Coupon payments are linked to the bond’s par value and the bond’s coupon
rate. The annual interest owed to bondholders is calculated by multiplying
the bond’s coupon rate by its par value. For example, if a bond’s coupon rate
is 6% and its par value is £100, the coupon payment will be £6. Many bonds,
such as government bonds issued by the US or UK governments, make
coupon payments on a semiannual basis. Therefore, the amount of annual
interest is halved and paid as two coupon payments, payable every six
months. Taking the previous example, bondholders would receive two
coupon payments of £3. Coupon payments may also be paid annually,
quarterly, or monthly. The bond contract will specify the frequency and
timing of payments.
Maturity date.
Debt securities are issued over a wide range of maturities, from as short as
one day to as long as 100 years or more. In fact, some bonds are perpetual,
with no pre-specified maturity date at all. But it is rare for new bond issues
to have a maturity of longer than 30 years. The life of the bond ends on its
maturity date, assuming that all promised payments have been made.
Example 1 describes the interaction of the three main features of a bond and
shows the payments that the bond issuer will make to a bondholder over the
life of the bond.
EXAMPLE 1.
MAIN FEATURES OF A BOND
A bond has a par value of £100, a coupon rate of 6% (paid annually),
and a maturity date of three years. These characteristics mean the
investor receives a coupon payment of £6 for each of the three years it
is held. At the end of the three years, the investor receives back the
£100 par value of the bond.
Other features.
Other features may be included in the bond contract to make it more
attractive to bondholders. For instance, to protect bondholders’ interests, it is
common for the bond contract to contain covenants, which are legal
agreements that describe actions the issuer must perform or is prohibited
from performing. A bond may also give the bondholder the right, but not the
obligation, to take certain actions.
Bonds may also contain features that make them more attractive to the issuer.
These include giving the issuer the right, but not the obligation, to take certain
actions. Rights of bondholders and issuers are discussed further in the Bonds
with Embedded Provisions section.
3. SENIORITY RANKING
The bond contract gives bondholders the right to take legal action if the
issuer fails to make the promised payments or fails to satisfy other terms
specified in the contract. If the bond issuer fails to make the promised
payments, which is referred to as default, the debtholders typically have
legal recourse to recover the promised payments. In the event that the
company is liquidated, assets are distributed following a priority of claims,
or seniority ranking. This priority of claims can affect the amount that an
investor receives upon liquidation.
The par value (principal) of a bond plus missed interest payments represents
the maximum amount a bondholder is entitled to receive upon liquidation of a
company, assuming there are sufficient assets to cover the claim. Because
debt represents a contractual liability of the company, debtholders have a
higher claim on a company’s assets than equity holders. But not all
debtholders have the same priority of claim: borrowers often issue debt
securities that differ with respect to seniority ranking. In general, bonds may
be issued in the form of secured or unsecured debt securities.
Secured.
When a borrower issues secured debt securities, it pledges certain specific
assets as collateral to the bondholders. Collateral is generally a tangible
asset, such as property, plant, or equipment, that the borrower pledges to the
bondholders to secure the loan. In the event of default, the bondholders are
legally entitled to take possession of the pledged assets. In essence, the
collateral reduces the risk that bondholders will lose money in the event of
default because the pledged assets can be sold to recover some or all of the
bondholders’ claim (missed coupon payments and par value).
Unsecured.
Unsecured debt securities are not backed by collateral. Consequently,
bondholders will typically demand a higher coupon rate on unsecured debt
securities than on secured debt securities. A bond contract may also specify
that an unsecured bond has a lower priority in the event of default than other
unsecured bonds. A lower priority unsecured bond is called subordinated
debt. Subordinated debtholders receive payment only after higher-priority
debt claims are paid in full. Subordinated debt may also be ranked according
to priority, from senior to junior.
Exhibit 1 shows an example of the seniority ranking of debt securities.
Exhibit 1.
Seniority Ranking of Debt Securities
4. TYPES OF BONDS
Bonds, in general, can be classified by issuer type, by type of market they
trade in, and by type of coupon rate.
Although the term “bond” may be used to describe any debt security,
irrespective of its maturity, debt securities can also be referred to by
different names based on time to maturity at issuance. Debt securities
with maturities of one year or less may be referred to as bills. Debt
securities with maturities from 1 to 10 years may be referred to as
notes. Debt securities with maturities longer than 10 years are referred
to as bonds.
Issuer.
Bonds issued by companies are referred to as corporate bonds and bonds
issued by central governments are sovereign or government bonds. Local and
regional government bodies may also issue bonds.
In some cases, bonds issued by certain central governments carry
particular names in the market. For example, bonds issued by the US
government are referred to as Treasury securities or Treasuries, by the
New Zealand government as Kiwi Bonds, by the UK government as
gilts, by the German government as Bunds, and by the French
government as OATs (obligations assimilables du Trésor).
Market.
At issuance, investors buy bonds directly from an issuer in the primary
market. The primary market is the market in which new securities are issued
and sold to investors. The bondholders may later sell their bonds to other
investors in the secondary market. In the secondary market, investors trade
with other investors. When investors buy bonds in the secondary market, they
are entitled to receive the bonds’ remaining promised payments, including
coupon payments until maturity and principal at maturity.
Coupon rates.
Bonds are often categorised by their coupon rates: fixed-rate bonds, floatingrate bonds, and zero-coupon bonds. These categories of bonds are described
further in the following sections.
4.1. Fixed-Rate Bonds
Fixed-rate bonds are the main type of debt securities issued by companies
and governments. Because debt securities were historically issued with fixed
coupon rates and paid fixed coupon payments, they may be referred to as
fixed-income securities. A fixed-rate bond has a finite life that ends on the
bond’s maturity date, offers a coupon rate that does not change over the life
of the bond, and has a par value that does not change. If interest rates in the
market change or the issuer’s creditworthiness changes over the life of the
bond, the coupon the issuer is required to pay does not change. Fixed-rate
bonds pay fixed periodic coupon payments during the life of the bond and a
final par value payment at maturity.
Example 2 describes how Walt Disney Corporation raised capital in August
2011 by using three different fixed-rate bond issues. Notice how the bond
issues with longer times to maturity have higher coupon rates.
EXAMPLE 2.
FIXED-RATE BOND
On 16 August 2011, the Walt Disney Corporation, a US company, raised
$1.85 billion in capital with three debt issues. It issued $750 million in
5-year fixed-rate bonds offering a coupon rate of 1.35%, $750 million
in 10-year fixed-rate bonds offering a coupon rate of 2.75%, and $350
million in 30-year fixed-rate bonds offering a coupon rate of 4.375%.
Coupon payments are due semiannually (twice per year) on 16 February
and 16 August. The following table summarises features of these issues.
On the maturity date, each bondholder will receive $1,000 per bond
plus the final semiannual coupon payment.
Total par value (millions)
Number of bonds issued
5-year,
1.35%
Bonds
10-year,
2.75%
Bonds
30-year,
4.375%
Bonds
$750
750,000
$750
750,000
$350
350,000
Par value of one bond
Coupon rate (annual)
Semiannual coupon
payment per bond
Maturity date
5-year,
1.35%
Bonds
10-year,
2.75%
Bonds
30-year,
4.375%
Bonds
$1,000
1.35%
$6.75
$1,000
2.75%
$13.75
$1,000
4.375%
$21.875
16 August
2016
16 August
2021
16 August
2041
4.2. Floating-Rate Bonds
Floating-rate bonds, sometimes referred to as variable-rate bonds or
floaters, are essentially identical to fixed-rate bonds except that the coupon
rate on floating-rate bonds changes over time. The coupon rate of a floatingrate bond is usually linked to a reference rate. The London Interbank
Offered Rate (Libor) is a widely used reference rate.
The calculation of the floating rate reflects the reference rate and the
riskiness (or creditworthiness) of the issuer at the time of issue. The floating
rate is equal to the reference rate plus a percentage that depends on the
borrower’s (issuer’s) creditworthiness and the bond’s features. The
percentage paid above the reference rate is called the spread and usually
remains constant over the life of the bond. In other words, for an existing
issue, the spread used to calculate the coupon payment does not change to
reflect any change in creditworthiness that occurs after issue. But the
reference rate does change over time with changes in the level of interest
rates in the economy.
In bond markets, the practice is to refer to percentages in terms of basis
points. One hundred basis points (or bps, pronounced bips) equal 1.0%, and
one basis point is equal to 0.01%, or 0.0001. Therefore, rather than stating
a floating rate as Libor plus 0.75%, the floating rate would be stated as Libor
plus 75 bps. A floating-rate bond’s coupon rate will change, or reset, at each
payment date, typically every quarter. Floating-rate coupon payments are
paid in arrears—that is, at the end of the period on the basis of the level of
the reference rate set at the beginning of the period. On a payment date, the
coupon rate is set for the next period to reflect the current level of the
reference rate plus the stated spread. This new coupon rate will determine
the amount of the payment at the next payment date. Example 3 is a
hypothetical example illustrating the effect of changes in a reference rate on
coupon rates and coupon payments.
EXAMPLE 3.
FLOATING-RATE BOND
On 31 March, a UK company raises £2 million by issuing floating-rate
notes with a maturity of nine months. The coupon rate is three-month
Libor plus 140 bps (1.40%). Note that even though it is called threemonth Libor, the rate quoted is an annual rate. It is standard practice to
quote interest rates as an annual rate. Therefore, the total rate (Libor +
1.40%) must be divided by four to calculate the quarterly coupon
payment. The coupon rate is reset every quarter. The following table
shows the Libor rate at the beginning of each quarter and the total
coupon payment made each quarter by the company.
4.2.1. Inflation-Linked Bonds
An inflation-linked bond is a particular type of floating-rate bond. Inflationlinked bonds contain a provision that adjusts the bond’s par value for
inflation and thus protects the investor from inflation. Recall from the
Macroeconomics chapter that inflation will typically reduce an investor’s
purchasing power from bond cash flows. Changes to the par value reduce the
effect of inflation on the investor’s purchasing power from bond cash flows.
For most inflation-linked bonds, the par value—not the coupon rate—of
the bond is adjusted at each payment date to reflect changes in inflation
(which is usually measured via a consumer price index). The bond’s coupon
payments are adjusted for inflation because the fixed coupon rate is
multiplied by the inflation-adjusted par value. Examples of inflation-linked
bonds are Treasury Inflation-Protected Securities (TIPS) in the United States,
index-linked gilts in the United Kingdom, and iBonds in Hong Kong SAR.
Because of the inflation protection offered by inflation-linked bonds, the
coupon rate on an inflation-linked bond is lower than the coupon rate on a
similar fixed-rate bond.
4.3. Zero-Coupon Bonds
As with fixed-rate and floating-rate bonds, zero-coupon bonds have a finite
life that ends on the bond’s maturity date. Zero-coupon bonds do not,
however, offer periodic interest payments during the life of the bond. The
only cash flow offered by a zero-coupon bond is a single payment equal to
the bond’s par value that is paid on the bond’s maturity date.
Zero-coupon bonds are issued at a discount to the bond’s par value—that is,
at an issue price that is lower than the par value.1 The difference between the
issue price and the par value received at maturity represents the investment
return earned by the bondholder over the life of the zero-coupon bond, and
this return is received at maturity.
Many debt securities issued with maturities of one year or less are issued as
zero-coupon debt securities. For example, Treasury bills issued by the US
government are issued as zero-coupon securities. Companies and
governments sometimes issue zero-coupon bonds that have maturities of
longer than one year. Because of the risk involved when the only payment is
the payment at maturity, investors are reluctant to buy zero-coupon bonds
with long terms to maturity. If they are willing to do so, the expected return
has to be relatively high compared to the interest rate on coupon-paying
bonds, and many issuers are reluctant to pay such a high cost for borrowing.
Also, if the buyer of a zero-coupon bond decides to sell it prior to maturity,
its price could be very different because of changes in interest rates in the
market and/or changes in the issuer’s creditworthiness.
Example 4 describes the issue of zero-coupon notes by Vodafone on 1
December 2008. Although this issue has a 20-year term to maturity, it is
termed a notes issue.
EXAMPLE 4.
ZERO-COUPON BOND
On 1 December 2008, Vodafone Group, a UK company, issued zerocoupon notes with a par value of €186.35 million to mature on 1
December 2028. The notes were issued (sold) for 26.83% of par value.
In other words, for every €1,000 of par value, investors paid €268.31.
1. If an investor bought the note on 1 December 2008, holds it to
maturity, and receives €1,000, the annual return over the life of the
bond to the investor is 6.80%. The investor will receive no cash
flows before 1 December 2028 unless he or she sells the note. The
annual return of 6.80% represents the investor’s required rate of
return.
2. To illustrate the sensitivity of zero-coupon bonds to changes in
required rate of return, assume that an original buyer decides to
sell the Vodafone note one year after issue. Furthermore, assume
that at that time, given market conditions and the creditworthiness
of Vodafone, the required rate of return on the note is 8.0%. Under
these circumstances, the original buyer would receive €231.71 for
every €1,000 of par value.
5. BONDS WITH EMBEDDED
PROVISIONS
Many bonds include features referred to as embedded provisions. Embedded
provisions give the issuer or the bondholder the right, but not the obligation,
to take certain actions. Common embedded provisions include call, put, and
conversion provisions.
Call, put, and conversion provisions are options, a type of derivative
instrument discussed in the Derivatives chapter. The following sections
describe call, put, and conversion provisions and callable, putable, and
convertible bonds.
5.1. Callable Bonds
A call provision gives the issuer the right to buy back the bond issue prior to
the maturity date. Bonds that contain a call provision are referred to as
callable bonds.
A callable bond gives the issuer the right to buy back (retire or call) the
bond from bondholders prior to the maturity date at a pre-specified price,
referred to as the call price. The call price typically represents the par value
of the bond plus an amount referred to as the call premium. In general, bond
issuers choose to include a call provision so that if interest rates fall after a
bond has been issued, they can call the bond and issue new bonds at a lower
interest rate. In this case, the bond issuer has the ability to retire the existing
bonds with a higher coupon rate and issue bonds with a lower coupon rate.
For example, consider a company that issues 10-year fixed-rate bonds that
are callable starting 3 years after issuance. Suppose that three years after the
bonds are issued, interest rates are much lower. The inclusion of the call
provision allows the company to buy back the bonds, presumably using
proceeds from the issuance of new bonds at a lower interest rate.
It is important to note that the call provision is a benefit to the issuer and is
an adverse provision from the perspective of bondholders. In other words,
the call provision is an advantage to the issuer and a disadvantage to the
bondholder. Consequently, the coupon rate on a callable bond will generally
be higher than a comparable bond without an embedded call provision to
compensate the bondholder for the risk that the bond may be retired early.
This risk is referred to as call risk.
A bond issuer is likely to exercise the call provision when interest rates fall.
From the perspective of bondholders, this outcome is unfavourable because
the bonds available for the bondholder to purchase with the proceeds from
the original bonds will have lower coupon rates. For most callable bonds,
the bond issuer cannot exercise the call provision until a few years after
issuance. The pre-specified call price at which bonds can be bought back
early may be fixed regardless of the call date, but in some cases the call
price may change over time. Under a typical call schedule, the call price
tends to decline and move toward the par value over time.
5.2. Putable Bonds
A put provision gives the bondholder the right to sell the bond back to the
issuer prior to the maturity date. Bonds that contain a put provision are called
putable bonds.
A putable bond gives bondholders the right to sell (put back) their bonds
to the issuer prior to the maturity date at a pre-specified price referred to as
the put price. Bondholders might want to exercise this right if market interest
rates rise and they can earn a higher rate by buying another bond that reflects
the interest rate increase.
It is important to note that, in contrast to call provisions, put provisions are a
right of the bondholder and not the issuer. The inclusion of a put provision is
an advantage to the bondholder and a disadvantage to the issuer.
Consequently, the coupon rate on a putable bond will generally be lower than
the coupon rate on a comparable bond without an embedded put provision.
Bondholders are willing to accept a relatively lower coupon rate on a bond
with a put provision because of the downside price protection provided by
the put provision. The put provision protects bondholders from the loss in
value because they can sell their bonds to the issuing company at the put
price.
Putable bonds typically do not start providing bondholders with put
protection until a few years after issuance. When a bondholder exercises the
put provision, the pre-specified put price at which bonds are sold back to the
issuer is typically the bond’s par value.
5.3. Convertible Bonds
A conversion provision gives the bondholder the right to exchange the bond
for shares of the issuing company’s stock prior to the bond’s maturity date.
Bonds that contain a conversion provision are referred to as convertible
bonds.
A convertible bond is a hybrid security. A hybrid security has
characteristics of and relationships with both equity and debt securities. A
convertible bond is a bond issued by a company that offers the bondholder
the right to convert the bond into a pre-specified number of common shares
of the issuing company at some point prior to the bond’s maturity date.
Convertible bonds are debt securities prior to conversion, but the fact that
they can be converted to common shares makes their value somewhat
dependant on the price of the common shares. Because the conversion feature
is a benefit to bondholders, convertible bonds typically offer a coupon rate
that is lower than the coupon rate on a similar bond without a conversion
feature. Convertible bonds are discussed further in the Equity Securities
chapter.
6. ASSET-BACKED SECURITIES
Securitisation refers to the creation and issuance of new debt securities,
called asset-backed securities, that are backed by a pool of other debt
securities. The most common type of asset-backed security is backed by a
pool of mortgages. In some parts of the world, these asset-backed securities
may be referred to as mortgage-backed securities.
Mortgage-backed securities are based on a pool of underlying residential
mortgage loans (home loans) or on a pool of underlying commercial
mortgage loans. Mortgage loans are loans to homeowners or owners of other
real estate who repay the loans through monthly payments. To create
mortgage-backed securities, a financial intermediary bundles a pool of
mortgage loans from lenders and then issues debt securities against the pool
of mortgages.
Mortgage-backed securities have the advantage that default losses and early
repayments are much more predictable for a diversified portfolio of
mortgages than for individual mortgages. This feature makes them less risky
than individual mortgages. Mortgage-backed securities, a diversified
portfolio of mortgages, may be attractive to investors who cannot service
mortgages efficiently or evaluate the creditworthiness of individual
mortgages. By securitising mortgage pools, mortgage banks allow investors
who are not wealthy enough to buy hundreds of mortgages to gain the benefits
of diversification, economies of scale in loan servicing, and professional
credit screening. Other asset-backed securities are created similarly to
mortgage-backed securities except that the types of underlying assets differ.
For instance, the underlying assets can include credit card receivables, auto
loans, and corporate bonds.
Securitisation improves liquidity in the underlying asset markets because it
allows investors to indirectly buy assets that they otherwise would not or
could not buy directly. Because the financial risks associated with security
pools are more predictable than the risks of the individual assets, assetbacked securities are easier to price and, therefore, easier to sell when
investors need to raise cash. These characteristics make the markets for
asset-backed securities more liquid than the markets for the underlying
assets. Because investors value liquidity, they may pay more for securitised
assets than for the individual underlying assets.
Investors who buy asset-backed securities receive a portion of the pooled
monthly loan payments. Unlike typical debt securities that offer coupon
payments on a quarterly, semiannual, or annual basis and a single principal
payment paid at the maturity date, most asset-backed securities offer monthly
payments that include both an interest component and a principal component.
7. VALUATION OF DEBT SECURITIES
Valuing debt securities is relatively straightforward compared with, say,
valuing equity securities (see the Equity Securities chapter) because bonds
typically have a finite life and predictable cash flows. The value of a debt
security is usually estimated by using a discounted cash flow (DCF)
approach. The DCF valuation approach is a valuation approach that takes
into account the time value of money. Recall from the discussion of the time
value of money in the Quantitative Concepts chapter that the timing of a cash
flow affects the cash flow’s value. The DCF valuation approach estimates
the value of a security as the present value of all future cash flows that the
investor expects to receive from the security.
The cash flows for a debt security are typically the future coupon payments
and the final principal payment. The value of a bond is the present value of
the future coupon payments and the final principal payment expected from the
bond. This valuation approach relies on an analysis of the investment
fundamentals and characteristics of the issuer. The analysis includes an
estimate of the probability of receiving the promised cash flows and an
establishment of the appropriate discount rate. Once an estimate of the value
of a bond is calculated, it can be compared with the current price of the bond
to determine whether the bond is overvalued, undervalued, or fairly valued.
7.1. Current Yield
A bond’s current yield is calculated as the annual coupon payment divided
by the current market price. This measure is simple to calculate and is often
quoted. A bond’s current yield provides bondholders with an estimate of the
annualised return from coupon income only, without concern for the effect of
any capital gain or loss resulting from changes in the bond’s value over time.
The current yield should not be confused with the discount rate used to
calculate the value of the bond.
7.2. Valuation of Fixed-Rate and Zero-Coupon
Bonds
For fixed-rate bonds and zero-coupon bonds, the timing and promised amount
of the interest payments and final principal payment are known. Thus, the
value of a fixed-rate bond or zero-coupon bond can be expressed as
where V0 is the current value of the bond, CFt is the bond’s cash flow
(coupon payments and/or par value) at time t, r is the discount rate, and n is
the number of periods until the maturity date. The bond’s cash flows and the
timing of the cash flows are defined in the bond contract, but the discount rate
reflects market conditions as well as the riskiness of the borrower. As
always, you are not responsible for calculations, but the presentation of
formulas and illustrative calculations may enhance your understanding.
It is important to note that the expected payments may not occur if the issuer
defaults. Therefore, when estimating the value of a debt security using the
DCF approach, an analyst or investor must estimate and use an appropriate
discount rate (r) that reflects the riskiness of the bond’s cash flows. This
discount rate represents the investor’s required rate of return on the bond
given its riskiness. The expected cash flows of bonds with higher credit risk
should be discounted at relatively higher discount rates, which results in
lower estimates of value.
Although you are not responsible for calculating a bond’s value, Example 5
illustrates how to do so and the effect of using different discount rates. This
example also serves to illustrate the effect of a change in discount rates on a
bond. A change in discount rates may be the result of a change in interest
rates in the market or a change in credit risk of the bond issuer.
EXAMPLE 5. BOND VALUATION USING DIFFERENT
DISCOUNT RATES
Consider a three-year fixed-rate bond with a par value of $1,000 and a
coupon rate of 6%, with coupon payments made semiannually. The bond
will make six coupon payments of $30 (one coupon payment every six
months over the life of the bond) and a final principal payment of
$1,000 on the maturity date. The value of the bond can be estimated by
discounting the bond’s promised payments using an appropriate discount
rate that reflects the riskiness of the cash flows. If an investor
determines that a discount rate of 7% per year, or 3.5% semiannually, is
appropriate for this bond given its risk, the value of the bond is
$973.36, calculated as
For the same bond, if an investor determines that a discount rate of 8%
per year, or 4.0% semiannually, is appropriate for this bond given its
risk, the value of the bond is $947.58, calculated as
For the same bond, if an investor determines that a discount rate of 6%
per year, or 3.0% semiannually, is appropriate for this bond given its
risk, the value of the bond is $1,000.00, calculated as
For the same bond, if an investor determines that a discount rate of 5%
per year, or 2.5% semiannually, is appropriate for this bond given its
risk, the value of the bond is $1,027.54, calculated as
Example 5 also illustrates how the relationship between the coupon rate and
the discount rate (required rate of return) affects the bond’s value relative to
the par value. To explain this relationship further,
if the bond’s coupon rate and the required rate of return are the same,
the bond’s value is its par value. Thus, the bond should trade at par
value.
if the bond’s coupon rate is lower than the required rate of return, the
bond’s value is less than its par value. Thus, the bond should trade at a
discount (trade at less than par value).
if the bond’s coupon rate is higher than the required rate of return, the
bond’s value is greater than its par value. Thus, the bond should trade at
a premium (trade at more than par value).
In the case of a zero-coupon bond, the only promised payment is the par
value on the maturity date. To estimate the value of a zero-coupon bond, the
single promised payment equal to the bond’s par value is discounted to its
present value by using an appropriate discount rate that reflects the riskiness
of the bond.
7.3. Yield to Maturity
Investors can also use the DCF approach to estimate the discount rate
implied by a bond’s market price. The discount rate that equates the present
value of a bond’s promised cash flows to its market price is the bond’s yield
to maturity, or yield. An investor can compare this yield to maturity with
the required rate of return on the bond given its riskiness to decide whether
to purchase it.
A bond’s yield to maturity can be expressed as
where P0 represents the current market price of the bond, and rytm represents
the bond’s yield to maturity.
Many investors use a bond’s yield to maturity to approximate the annualised
return from buying the bond at the current market price and holding it until
maturity, assuming that all promised payments are made on time and in full.
When a bond’s payments are known, as in the case of fixed-rate bonds and
zero-coupon bonds, the yield to maturity can be inferred by using the current
market price. Example 6 shows the calculation of yield to maturity. Again,
you are not responsible for knowing how to do the calculation.
EXAMPLE 6.
YIELD TO MATURITY
Consider a fixed-rate bond with exactly five years remaining until
maturity, a par value of $1,000 per unit, and a coupon rate of 4% with
semiannual payments. The bond is currently trading at a price of
$914.70. With this information, the bond’s yield to maturity can be
found by solving for rytm:
The bond’s yield to maturity is the discount rate that makes the present
value of the bond’s promised cash flows equal to its market price. The
bond’s future cash flows consist of 10 semiannual coupon payments of
$20 occurring every 6 months and a final principal payment of $1,000
on the maturity date in 5 years, or 10 semiannual periods. In this case,
rytm is 3% on a semiannual basis, or 6% annualised. Thus, at a price of
$914.70, the bond’s yield to maturity is 6%.
The current yield is calculated as $40/$914.70 = 4.37%. You can see
that the current yield and the yield to maturity differ.
It is important to understand that bond prices and bond yields to maturity are
inversely related. That is, as bond prices fall, their yields to maturity
increase, and as bond prices rise, their yields to maturity decrease.
7.4. Yield Curve
When investors try to determine the appropriate discount rate (yield to
maturity or required rate of return) for a particular bond, they often begin by
looking at the yields to maturity offered by government bonds. The term
structure of interest rates, often referred to simply as the term structure,
shows how interest rates on government bonds vary with maturity. The term
structure is often presented in graphical form, referred to as the yield curve.
The yield curve graphs the yield to maturity of government bonds (y-axis)
against the maturity of these bonds (x-axis). It is important when developing
a yield curve to ensure that bonds have identical features other than their
maturity, such as identical coupon rates. In other words, the bonds
considered should only differ in maturity.
A yield curve applied by investors to US debt securities is the US Treasury
yield curve, which graphs yields on US government bonds by maturity.
Exhibit 2 illustrates the US Treasury yield curve as of 22 April 2014. In this
case, the yield curve is upward sloping, indicating that longer-maturity bonds
offer higher yields to maturity than shorter-maturity bonds. For example, the
yield to maturity on a 30-year Treasury bond is 3.50%, but the yield to
maturity on a 1-year Treasury bill is only 0.11%.
Exhibit 2.
US Treasury Yield Curve, 22 April 2014
Source: Based on data from the US Department of the Treasury (www.treasury.gov).
Although an upward-sloping curve is typical, there are times when the yield
curve may be flat, meaning that the yield to maturity of US Treasury bonds is
the same no matter what the maturity date is. There are also times when the
yield curve is downward sloping, or inverted, which can happen if interest
rates are expected to decline in the future.
The term structure for government bonds, such as Treasury bonds, provides
investors with a base yield to maturity, which serves as a reference to
compare yields to maturity offered by riskier bonds. Relative to Treasury
bonds, riskier bonds should offer higher yields to maturity to compensate
investors for the higher credit or default risk.
8. RISKS OF INVESTING IN DEBT
SECURITIES
Investing in debt securities is generally considered less risky than investing
in equity securities, but bondholders still face a number of risks. These risks
include credit risk, interest rate risk, inflation risk, liquidity risk,
reinvestment risk, and call risk. A change in a bond’s risk will affect its
required rate of return and its price. The required rate of return can be
thought of as the yield to maturity required by an investor. Riskier bonds
typically have higher yields to maturity, reflecting the higher required rate of
return.
8.1. Credit Risk
Credit risk, sometimes referred to as default risk, is the risk of loss if the
borrower, or bond issuer, fails to make full and timely payments of interest
and/or principal. Debt securities represent legal obligations, but the issuer
may face financial hardship and consequently not have the money available
to make the promised interest and/or principal payments. In this case,
bondholders may lose a substantial amount of their invested capital.
It is important to note that credit risk can affect bondholders even when the
company does not actually default on its payments. For example, if market
participants suspect that a particular bond issuer will not be able to make its
promised bond payments because of adverse business or general economic
conditions, the probability of future default will increase and the bond price
will likely fall in the market. Consequently, investors holding that particular
bond will be exposed to a price decline and a potential loss of money if they
want to sell the bond.
8.1.1. Credit Rating
Investors may be able to assess the credit risk of a bond by reviewing its
credit rating. Independent credit rating agencies assess the credit quality of
particular bonds and assign them ratings based on the creditworthiness of the
issuer. Exhibit 3 presents the credit ratings systems of Standard & Poor’s,
Moody’s Investors Service, and Fitch Ratings.
Bonds are classified based on credit risk as investment-grade bonds
(those in the shaded area of Exhibit 3) or non-investment-grade bonds
(those in the non-shaded area of Exhibit 3). The term investment-grade bonds
comes from the fact that regulators often specify that certain investors, such
as insurance companies and pension funds, must restrict their investments to
or largely hold bonds with a high degree of creditworthiness (low risk of
default).
Non-investment-grade bonds are commonly referred to as high-yield
bonds or junk bonds. They are called junk bonds because they are less
creditworthy and have a greater probability of default. Investors in these
bonds prefer the term high-yield bonds, which acknowledges the higher
yields (expected returns) on these bonds because of the higher level of risk.
Recall that the riskier the borrower—or the less certain the borrower’s
apparent ability to repay the loan—the higher the level of interest demanded
by the lender.
Although both individual and institutional investors tend to own investmentgrade bonds, investors with a willingness to take on greater risk in exchange
for higher expected returns dominate the high-yield bond market.
Exhibit 3.
Agencies
Rating Systems Used by Major Credit Rating
Credit rating agencies assign a bond rating at the time of issue, but they also
review the rating and may change a bond’s credit rating over time depending
on the issuer’s perceived creditworthiness. An improvement in credit rating
is referred to as an upgrade, and a reduction in credit rating is referred to as
a downgrade. A high credit rating gives a bond issuer two major benefits: the
ability to issue debt securities at a lower interest rate and the ability to
access a larger pool of investors. The larger pool of investors will include
institutional investors that must hold significant portions of their investment
assets in investment-grade bonds.
8.1.2. Credit Spreads
US Treasuries and government bonds of some developed and emerging
countries are considered very safe securities that carry minimal default risk.
Consequently, relative to these government bonds, yields on other bonds are
typically higher. Investors commonly refer to the difference between a risky
bond’s yield to maturity and the yield to maturity on a government bond with
the same maturity as the risky bond’s credit spread. The credit spread tells
the investor how much extra yield is being offered for investing in a bond that
has a higher probability of default. Example 7 shows the credit spread for a
bond issue by Caterpillar Inc.
EXAMPLE 7.
CREDIT SPREADS
Caterpillar, a US company, has a bond outstanding with a maturity date
of 27 May 2041. The bond’s coupon rate is 5.2%. On 13 April 2012,
the bond was trading at a price of $1,185.32, representing a yield to
maturity of 4.10%. The bond has approximately 29 years remaining until
maturity as of 13 April 2012. On that same date, 30-year Treasury
bonds are yielding 3.22%.
The bond’s credit spread over a 30-year Treasury is 4.10% – 3.22% =
0.88%, or 88 bps. The extra yield, or credit spread, being offered by the
Caterpillar bond serves as compensation to the investor for taking a
higher risk relative to the Treasury bond.
Higher-risk bonds, such as junk bonds, trade at wider credit spreads because
of their higher default risk. Similarly, lower-risk bonds trade at narrower
credit spreads relative to high-risk bonds. Credit spreads enable investors to
compare yield differences across bonds of different credit quality. If a bond
is perceived to have become more risky, its price will fall and its yield will
rise, which will likely result in a widening of the bond’s credit spread
relative to a government bond with the same maturity. Similarly, a bond
perceived to have experienced an improvement in credit quality will see its
price rise and its yield fall, likely resulting in a narrower credit spread
relative to a comparable government bond.
8.2. Interest Rate Risk
Interest rate risk is the risk that interest rates will change. Interest rate
risk usually refers to the risk associated with decreases in bond prices
resulting from increases in interest rates. This risk is particularly relevant to
fixed-rate bonds and zero-coupon bonds. Bond prices and interest rates are
inversely related; that is, bond prices increase as interest rates decrease and
bond prices decrease as interest rates increase. Example 4, in the zerocoupon bond section, illustrates the effect of an interest rate change on a
zero-coupon bond.
Prices of zero-coupon and fixed-rate bonds can decline significantly in an
environment of rising interest rates. However, because coupon rates on
floating-rate bonds are reset to current market interest rates at each payment
date, floating-rate bonds exhibit less interest rate risk with respect to rising
interest rates. But a floating-rate bond may exhibit interest rate risk in an
environment of declining interest rates because bondholders receive less
coupon income when the bond’s coupon rate is reset to a lower rate.
8.3. Inflation Risk
Nearly all debt securities expose investors to inflation risk because the
promised interest payments and final principal payment from most debt
securities are nominal amounts—that is, the amounts do not change with
inflation. Unfortunately, as inflation makes products and services more
expensive over time, the purchasing power of the coupon payments and the
final principal payment on most bonds declines. Floating-rate bonds partially
protect against inflation because the coupon rate adjusts. They provide no
protection, however, against the loss of purchasing power of the principal
payment. Investors who are concerned about inflation and want protection
against it may prefer to invest in inflation-linked bonds, which adjust the
principal (par) value for inflation. Because the coupon payment is based on
the par value, the coupon payment also changes with inflation.
8.4. Other Risks
In addition to credit risk, interest rate risk, and inflation risk, investors in
debt securities also face a number of other risks, including liquidity risk,
reinvestment risk, and call risk.
Liquidity risk refers to the risk of being unable to sell a bond prior to the
maturity date without having to accept a significant discount to market value.
Bonds that do not trade very frequently exhibit high liquidity risk. Investors
who want to sell their relatively illiquid bonds face higher liquidity risk than
investors in bonds that trade more frequently.
Reinvestment risk refers to the fact that in a period of falling interest
rates, the coupon payments received during the life of a bond and/or the
principal payment received from a bond that is called early must be
reinvested at a lower interest rate than the bond’s original coupon rate. If
market interest rates fall after a bond is issued, bondholders will most likely
have to reinvest the income received on the bond (the coupon payment) at the
current lower interest rates.
Call risk, sometimes referred to as prepayment risk, refers to the risk that
the issuer will buy back (redeem or call) the bond issue prior to maturity
through the exercise of a call provision. If interest rates fall, issuers may
exercise the call provision, so bondholders will have to reinvest the
proceeds in bonds offering lower coupon rates. Callable bonds, and most
mortgage-backed securities based on loans that allow the borrowers to make
loan prepayments in advance of their maturity date, are subject to prepayment
risk.
How do the risks of a bond affect its price in the market? The yield to
maturity on a bond is a function of its maturity and risk. In general, two bonds
with the same maturity and risk should trade at prices that offer
approximately the same yield to maturity. For example, two five-year bonds
with the same liquidity and a BBB rating will trade at approximately equal
yields to maturity.
Low-risk bonds, such as many government bonds, trade at relatively lower
yields to maturity, which imply relatively higher prices. Similarly, high-risk
bonds, such as junk bonds, trade at relatively higher yields to maturity, which
imply relatively lower prices. Relative to secured debt, subordinated debt
securities offer higher yields to maturity, which reflect their higher default
risk.
SUMMARY
As the Canadian entrepreneur found out, debt securities are an alternative to
bank loans for raising capital and financing growth. But debt securities
generally have more features than bank loans and must be understood before
they are used. Both issuers and investors need to fully understand the key
features and risks of financing with debt securities. The financial
consequences of not doing so can be substantial.
The following points recap what you have learned in this chapter about debt
securities:
Debt security or bond issuers are typically companies and governments.
A typical debt security is characterised by three features: par value,
coupon rate, and maturity date.
Coupon and principal payments must be made on scheduled dates. If the
issuer fails to make the promised payments, it is in default and
bondholders may be able to take legal action to attempt to recover their
investment.
Debt securities are classified as either secured debt securities (secured
by collateral) or unsecured debt securities (not secured by collateral).
Debtholders have a higher priority claim than equityholders if a
company liquidates, but priority of claims or seniority ranking can vary
among debtholders.
Bonds may pay fixed-rate, floating-rate, or zero coupon payments.
Fixed-rate bonds are the most common bonds. They offer fixed coupon
payments based on an interest (or coupon) rate that does not change
over time. These coupon payments are typically paid semiannually.
Floating-rate bonds typically offer coupon payments based on a
reference rate that changes over time plus a fixed spread; the reference
interest rate is reset on each coupon payment date to reflect current
market rates.
The only cash flow offered by a zero-coupon bond is a single payment
equal to the bond’s par value to be paid on the bond’s maturity date.
Many bonds come with embedded provisions that provide the issuer or
the bondholder with particular rights, such as to call, put, or convert the
bond.
Securitisation is a process that creates new debt securities backed by a
pool of other debt securities. These new debt securities are called
asset-backed securities. Most asset-backed securities generate monthly
payments that include both interest and principal components.
A bond’s current yield is calculated as the annual coupon payments
divided by the current market price. It provides an estimate of return
from coupon income only.
The value of a typical debt security is usually estimated by using a
discounted cash flow approach, which estimates the value of a debt
security as the present value of all future cash flows (interest and
principal payments) that are expected from the debt security. The
discount rate used to estimate present value represents the required rate
of return on the debt security based on market conditions and riskiness.
The discount rate that equates the present value of a bond’s promised
cash flows to its market price is called the yield to maturity, or yield.
Investors use a bond’s yield to approximate the annualised return from
buying the bond at the current market price and holding the bond until
maturity.
The term structure of interest rates depicts the relationship between
government bond yields and maturities and is often presented in
graphical form as the yield curve.
The primary risks of investing in debt securities are credit or default
risk, interest rate risk, inflation risk, liquidity risk, reinvestment risk,
and call risk.
The credit spread is the difference in the yields of two bonds with the
same maturity but different credit quality. Investors commonly assess the
credit spread of risky corporate bonds relative to government bonds,
such as US Treasury bonds.
CHAPTER REVIEW QUESTIONS
© 2014 CFA Institute. All rights reserved.
1. Sovereign bonds are issued by:
A. companies.
B. central governments.
C. all levels of government.
2. Which of the following entities raises external capital to finance their
operations by issuing a combination of equity and debt securities?
A. Companies
B. Governments
C. Both companies and governments
3. Which of the following classifications of debt securities is backed by
collateral?
A. Secured debt
B. Subordinated debt
C. Senior unsecured debt
4. Which of the following classes of debt securities has the highest ranking
in the priority of claims?
A. Secured debt
B. Subordinated debt
C. Senior unsecured debt
5. Which debt security promises its investors only one payment over the
life of the bond?
A. Fixed-rate bond
B. Zero-coupon bond
C. Floating-rate bond
6. Which of the following characteristics most likely remains unchanged
during the life of an inflation-linked bond?
A. Par value
B. Coupon rate
C. Coupon payments
7. Bonds with coupon rates linked to a reference rate are best described
as:
A. fixed-rate bonds.
B. floating-rate bonds.
C. zero-coupon bonds.
8. Zero-coupon bonds are typically issued at:
A. par value.
B. a discount to par value.
C. a premium to par value.
9. Which of the following provisions in a debt security is a right of the
issuer?
A. Put
B. Call
C. Conversion
10. The risk of loss as a result of the bond issuer failing to make timely
payments of interest and/or principal is referred to as:
A. call risk.
B. credit risk.
C. interest rate risk.
11. Ratings assigned to debt securities by credit rating agencies help
investors assess:
A. default risk.
B. inflation risk.
C. interest rate risk.
12. The risk of being unable to sell a bond prior to the maturity date without
having to accept a significant discount to market value best describes:
A. credit risk.
B. liquidity risk.
C. interest rate risk.
13. When valuing debt securities by using the discounted cash flow
approach, the expected cash flows of bonds with:
A. lower credit risk should be discounted by using higher discount
rates.
B. higher credit risk should be discounted by using lower discount
rates.
C. higher credit risk should be discounted by using higher discount
rates.
14. When valuing a fixed-rate bond by using the discounted cash flow
approach, the discount rate used in the valuation is typically the:
A. bond’s coupon rate.
B. London Interbank Offered Rate (Libor).
C. investor’s required rate of return for the bond.
15. The rate that equates the present value of a bond’s promised cash flows
to its market price is a bond’s:
A. coupon rate.
B. current yield.
C. yield to maturity.
16. ABC Company issued a 10-year bond at a price of $1,000. A month
after issuance, the market price of the bond had dropped to $980. Over
the month, the yield to maturity on the bond:
A. increased.
B. decreased.
C. stayed the same.
17. If the discount rate increases, the value of a zero-coupon bond will:
A. increase.
B. decrease.
C. remain unchanged.
18. A bond’s current yield is calculated as the annual coupon payment
divided by its:
A. par value.
B. yield to maturity.
C. current market price.
19. The term structure of interest rates on government bonds presented in
graphical form is referred to as the:
A. yield curve.
B. current yield.
C. credit spread.
20. Compared with its underlying securities, an asset-backed security
provides:
A. less diversification, but more liquidity.
B. less liquidity, but more diversification.
C. more diversification and more liquidity.
21. If a corporate bond’s default risk increases, its credit spread will most
likely:
A. decrease.
B. remain unchanged.
C. increase.
ANSWERS
1. B is correct. Bonds issued by central governments are called sovereign
bonds. A is incorrect because bonds issued by companies are called
corporate bonds. C is incorrect because bonds issued by different levels
of government take different names; there is no standard name that
covers bonds issued by all levels of government.
2. A is correct. Companies raise external capital to finance their
operations by issuing a combination of debt and equity securities. B and
C are incorrect because governments raise external capital by issuing
debt securities but they do not issue equity securities.
3. A is correct. Secured debt securities are backed by collateral.
Collateral is generally a tangible asset, such as property, plant, or
equipment, that the borrower pledges to the lender to secure the loan. B
and C are incorrect because subordinated debt and senior unsecured
debt are not backed by collateral.
4. A is correct. The priority of claims, from highest to lowest of the
choices given, is secured debt, senior unsecured debt, subordinated
debt.
5. B is correct. A zero-coupon bond does not pay periodic interest
payments (coupon payments) to its investors during its life. The only
payment received by an investor in a zero-coupon bond is a single
payment of the par value at the maturity date. A and C are incorrect
because fixed-rate and floating-rate bonds promise periodic coupon
payments over the life of the bond in addition to a final payment of the
par value at maturity. The periodic coupon payment does not change
during the life of a fixed-rate bond, but changes over time for a floatingrate bond.
6. B is correct. The coupon rate usually remains unchanged. The par value
of the bond, not the coupon rate, is adjusted at each payment date to
reflect changes in inflation, usually measured by a consumer price
index. A is incorrect because the par value is adjusted to reflect changes
in inflation. C is incorrect because the bond’s coupon payments are
adjusted for inflation and the fixed coupon rate is multiplied by the
inflation-adjusted par value.
7. B is correct. The coupon rate of a floating-rate bond is usually linked to
a reference rate. The floating rate is equal to the reference rate plus a
spread that depends on the borrower’s creditworthiness and the bond’s
features. A is incorrect because the coupon rate of a fixed-rate bond
does not change during the life of the bond. C is incorrect because the
only payment offered by a zero-coupon bond is a single payment equal
to the bond’s par value that is paid on the bond’s maturity date.
8. B is correct. Zero-coupon bonds are typically issued at a discount to the
bond’s par value. The difference between the issue price and the par
value received at maturity represents the investment return earned by the
bondholder over the life of the bond.
9. B is correct. The call provision provides bond issuers with the right to
buy back the bonds prior to maturity at a prespecified price. A is
incorrect because a put provision provides bondholders with the right to
sell their bonds to the issuer prior to maturity at a pre-specified price. C
is incorrect because a conversion provision provides bondholders with
the right to convert the bonds into a pre-specified number of common
shares of the issuing company.
10. B is correct. Credit risk, or default risk, is the risk of loss as a result of
the bond issuer failing to make full and timely payments of interest
and/or principal. A is incorrect because call risk describes the risk to
the bondholder that the issuer will buy back (call) a bond prior to
maturity through the exercise of a call provision. C is incorrect because
interest rate risk is the risk that interest rates will increase, resulting in a
decrease in the price of a bond.
11. A is correct. Credit rating agencies assess the credit quality of
particular bonds and issue credit ratings, which help bond investors to
assess the bond’s default risk (or credit risk). B and C are incorrect
because although rating agencies assess inflation and interest rate risk
when they analyse the credit quality of a particular bond, their ratings
help investors assess the default risk of the debt issue.
12. B is correct. Liquidity risk refers to the risk of being unable to sell a
bond prior to the maturity date without having to accept a significant
discount to market value. A is incorrect because credit risk is the risk of
loss as a result of the borrower (the bond issuer) failing to make full
and timely payments of interest and/or principal. C is incorrect because
interest rate risk refers to the risk associated with decreases in bond
prices as a result of increases in interest rates.
13. C is correct. When estimating the value of a debt security using the
discounted cash flow approach, an analyst or investor must estimate and
use an appropriate discount rate that reflects the riskiness of the bond’s
cash flows. The expected cash flows of bonds with higher credit risk
should be discounted at relatively higher discount rates. This approach
will result in lower estimates of value. A is incorrect because the
expected cash flows of bonds with lower credit risk should be
discounted at relatively lower discount rates. B is incorrect because the
credit risk associated with the expected cash flows of bonds and the
discount rate have a positive, as opposed to inverse, relationship. Thus,
the expected cash flows of bonds with higher credit risk should be
discounted at relatively higher, not lower, discount rates.
14. C is correct. The discount rate used in the valuation is the investor’s
required rate of return on the bond given its riskiness. The expected
cash flows of bonds with higher credit risk should be discounted at
relatively higher discount rates, which results in lower estimates of
value. A is incorrect because the coupon rate is used in determining the
bond’s future cash flows. B is incorrect because Libor is a widely used
reference rate to determine the coupon rate for floating-rate bonds.
Libor is not necessarily the discount rate used to value a fixed-rate
bond.
15. C is correct. The yield to maturity for a bond is the discount rate that
equates the present value of a bond’s promised cash flows with its
market price. Many investors use a bond’s yield to maturity to
approximate the annualised return from buying a bond at the market
price and holding it until maturity. A is incorrect because the coupon
rate determines the periodic coupon payments but does not measure the
overall return from or reflect the risk of investing in a bond. B is
incorrect because the current yield measures the current year return
calculated as the total annual coupon payment divided by the current
market price of the bond.
16. A is correct. Bond prices and bond yields to maturity are inversely
related. As the price of a bond falls, its yield to maturity increases.
17. B is correct. A bond’s price and the discount rate are inversely related.
If the discount rate increases, the bond’s value, represented by the
present value of the bond’s expected cash flows, will decrease.
18. C is correct. A bond’s current yield is calculated as the annual coupon
payment divided by its current market price. A is incorrect because a
bond’s coupon rate is calculated as the annual coupon payment divided
by its par value. B is incorrect because the discount rate that equates the
present value of a bond’s promised cash flows with its market price is
the bond’s yield to maturity.
19. A is correct. The term structure of interest rates shows how interest
rates on government bonds vary with maturity. The term structure
presented in graphical form is referred to as the yield curve. B is
incorrect because the bond’s current yield is calculated as the bond’s
annual coupon payment divided by its current market price. C is
incorrect because the credit spread is the difference between a risky
bond’s yield to maturity and the yield to maturity on a government bond
with the same maturity.
20. C is correct. An asset-backed security pools a large number of related
underlying securities, such as mortgages, which creates both more
diversification and more liquidity relative to the underlying securities.
A and B are incorrect because asset-backed securities provide both
more diversification and more liquidity that their underlying securities.
21. C is correct. The difference between a risky bond’s yield to maturity
and the yield to maturity on a government bond with the same maturity is
the risky bond’s credit spread. If the corporate bond’s default risk
increases, its credit spread will also increase to compensate investors
for the increased risk of default.
NOTES
1In the exceptional circumstance of negative interest rates, zero coupon bonds may not be issued at a
price below par.
Chapter 10
Equity Securities
by Lee M. Dunham, PhD, CFA, and Vijay Singal, PhD,
CFA
© 2014 CFA Institute. All rights reserved.
LEARNING OUTCOMES
After completing this chapter, you should be able to do the following:
a. Describe features of equity securities;
b. Describe types of equity securities;
c. Compare risk and return of equity and debt securities;
d. Describe approaches to valuing common shares;
e. Describe company actions that affect the company’s shares outstanding.
1. INTRODUCTION
At some point in their lives, many people participate in the stock market
either directly, such as by buying shares, or indirectly, perhaps by
contributing to a retirement plan or by investing through a mutual fund.1
Whether or not they participate in the stock market, most people tend to be
aware of shares and stock markets because stock market information, such as
stock market indices, is widely reported. As discussed in the
Macroeconomics chapter, stock market indices, which represent the
performance of a group of shares, are useful indicators of the state of the
economy.
In addition to borrowing funds, companies may raise external capital to
finance their operations by issuing (selling) equity securities. Issuing shares
(also called stock and shares of stock) is a company’s main way of raising
equity capital and shares are the primary equity securities discussed in this
chapter.2
This chapter also describes other basic types of equity securities available in
the market and features of these securities. There is some discussion of debt
securities in order to make some basic comparisons between debt securities
and equity securities.
Given the importance of equity securities in the investment industry, an
understanding of what they are and how they are valued is likely to help you
in your role. Some approaches that investment professionals use to value
common shares are discussed. Some company actions that affect a company’s
number of shares are also described. Examples intended to enhance your
understanding are included. Some of these examples include calculations but,
as always, you are not responsible for calculations.
2. FEATURES OF EQUITY SECURITIES
Companies may issue different types of equity securities. The types of equity
securities, or equity-like securities, that companies typically issue are
common stock (or common shares), preferred stock (or preferred shares),
convertible bonds, and warrants. Each of these types is discussed more
extensively in the next section. Each type of equity security has different
features attached to it. These features affect a security’s expected return, risk,
and value.
There are four features that characterise and vary among equity securities:
Life
Par value
Voting rights
Cash flow rights
Life.
Many equity securities are issued with an infinite life. In other words, they
are issued without maturity dates. Some equity securities are issued with a
maturity date.
Par Value.
Equity securities may or may not be issued with a par value. The par value
of a share is the stated value, or face value, of the equity security. In some
jurisdictions, issuing companies are required to assign a par value when
issuing shares.
Voting Rights.
Some shares give their holders the right to vote on certain matters.
Shareholders do not typically participate in the day-to-day business
decisions of large companies. Instead, shareholders with voting rights
collectively elect a group of people, called the board of directors, whose
job it is to monitor the company’s business activities on behalf of its
shareholders. The board of directors is responsible for appointing the
company’s senior management (e.g., chief executive officer and chief
operating officer), who manage the company’s day-to-day business
operations. But decisions of high importance, such as the decision to acquire
another company, usually require the approval of shareholders with voting
rights.
Cash Flow Rights.
Cash flow rights are the rights of shareholders to distributions, such as
dividends, made by the company. In the event of the company being
liquidated, assets are distributed following a priority of claims, or seniority
ranking. This priority of claims can affect the amount that an investor will
receive upon liquidation.
3. TYPES OF EQUITY SECURITIES
Companies may issue different types and classes of equity securities. The
two main types of equity securities are common shares (also called common
stock or ordinary shares) and preferred shares (also known as preferred
stock or preference shares). In addition, companies may issue convertible
bonds and warrants. Depositary receipts are not issued by a company, but
they give the holder an equity interest in the company.
3.1. Common Stock
Common stock (also known as common shares, ordinary shares, or voting
shares) is the main type of equity security issued by companies. A common
share represents an ownership interest in a company. Common shares have an
infinite life; in other words, they are issued without maturity dates. Common
stock may or may not be issued with a par value. When common shares are
issued with par values, companies typically set their par value extremely
low, such as 1 cent per share in the United States. It is important to note that
the par value of a common share may have no connection to its market value,
even at the time of issue. For instance, a common share with a par value of 1
cent may be issued to a shareholder for $50.
Common shares represent the largest proportion of equity securities by
market value. Large companies often have many common shareholders, each
of whom owns a portion of the company’s total shares. Investors may own
common stock of public or private companies. Shares of public companies
typically trade on stock exchanges that facilitate trading of shares between
buyers and sellers. Private companies are typically much smaller than public
companies, and their shares do not trade on stock exchanges. The ability to
sell common shares of public companies on stock exchanges offers potential
shareholders the ability to trade when they want to trade and at a fair price.
Common stock typically provides its owners with voting rights and cash
flow rights in proportion to the size of their ownership stake. Common
shareholders usually have the right to vote on certain matters. Companies
often pay out a portion of their profits each year to their shareholders as
dividends; the rights to such distributions are the shareholders’ cash flow
rights. Dividends are typically declared by the board of directors and vary
according to the company’s performance, its reinvestment needs, and the
management’s view on paying dividends. As owners of the underlying
company, common shareholders participate in the performance of the
company and have a residual claim on the company’s liquidated assets after
all liabilities (debts) and other claims with higher seniority have been paid.
Many companies have a single class of common stock and follow the rule of
“one share, one vote”. But some companies may issue different classes of
common stock that provide different cash flow and voting rights. In general,
an arrangement in which a company offers two classes of common stock
(e.g., Class A and Class B) typically provides one class of shareholders with
superior voting and/or cash flow rights.
Example 1 describes the two classes of common stock of Berkshire
Hathaway and their cash flow and voting rights.
EXAMPLE 1.
DIFFERENT SHARE CLASSES
As of May 2012, Berkshire Hathaway, a US company, has two classes
of common stock: Class A (NYSE: BRK.A)3 and Class B (NYSE:
BRK.B). In terms of cash flow rights, one Class A share is equivalent to
1,500 Class B shares. But the ratio of the voting rights of Class A shares
to the voting rights of Class B shares is not 1,500:1. Voting rights for 1
Class A share are equivalent to the voting rights of 10,000 Class B
shares.
BRK.A
Cash flow rights
Voting rights
1
1
BRK.B
=
=
1,500
10,000
The reason for having multiple share classes is usually that the company’s
original owner wants to maintain control, as measured by voting power,
while still offering cash flow rights to attract shareholders. In general, for
large public companies in which nearly all shareholders hold small
ownership positions, the difference in voting rights may not be important to
shareholders.
3.2. Preferred Stock
Companies may also issue preferred stock (also known as preferred
shares or preference shares). These shares are called preferred because
owners of preferred stock will receive dividends before common
shareholders. They also have a higher claim on the company’s assets
compared with common shareholders if the company ceases operations. In
other words, preferred shareholders receive preferential treatment in some
respects. Generally, preferred shareholders are not entitled to voting rights
and have no ownership or residual claim on the company.
Preferred shares are typically issued with an assigned par value. Along with
a stated dividend rate, this par value defines the amount of the annual
dividend promised to preferred shareholders. Preferred share terms may
provide the issuing company with the right to buy back the preferred stock
from shareholders at a pre-specified price, referred to as the redemption
price. In general, the pre-specified redemption price equals the par value for
a preferred share. The par value of a preferred share also typically
represents the amount the shareholder would be entitled to receive in a
liquidation, as long as there are sufficient assets to cover the claim.
Preferred shareholders usually receive a fixed dividend, although it is not a
legal obligation of the company. The preferred dividend will not increase if
the company does well. If the company is performing poorly, the board of
directors is often reluctant to reduce preferred dividends.
Preferred shares differ with respect to the policy on missed dividends,
depending on whether the preferred stock is cumulative or non-cumulative.
Cumulative preferred stock requires that the company pay in full any missed
dividends (dividends promised, but not paid) before paying dividends to
common shareholders. In comparison, non-cumulative preferred stock does
not require that missed dividends be paid before dividends are paid to
common shareholders. In a liquidation, preferred shareholder may have a
claim for any unpaid dividends before distributions are made to common
shareholders.
Example 2 provides a variety of the features that can characterise a
preferred share issue. It shows the features of two different issues of
Canadian preferred stock.
EXAMPLE 2.
Issue
PREFERRED STOCK
Cumulative/NonCumulative
Par Value
(Canadian
dollars)
Annual
Dividend
Rate
Redeemab
Royal
Issue
Bank of
Canada,
Series B
Canadian
Utilities
Limited,
Series
AA
Cumulative/NonNon-cumulative
Cumulative
Cumulative
Par Value
Annual
(Canadian Dividend
C$25.00 6.25%,
dollars)
Rate
reset after
five years
and every
five years
thereafter to
3.50% over
the fiveyear
Government
of Canada
bond yield
C$25.00 4.90%
Yes,
Redeemab
redeemabl
on or after
24 Februar
2014 at pa
Yes,
redeemabl
after 1
September
2017,
redemption
price begin
at C$26.00
and declin
over time t
C$25.00
Some companies have more than a single issue of preferred stock. Multiple
preferred stock issues (or rounds) are referred to by series. Each preferred
stock issue by a company usually carries its own dividend, based on stated
par value and dividend rate, and may differ with respect to other features as
well.
3.3. Convertible Bonds
To raise capital, companies may issue convertible bonds. A convertible
bond is a bond issued by a company that offers the bondholder the right to
convert the bond into a pre-specified number of common shares. Although a
convertible bond is actually a debt security prior to conversion, the fact that
it can be converted to common shares makes its value somewhat dependant
on the price of common shares. Thus, convertible bonds are known as hybrid
securities. Hybrid securities have features of and relationships with both
equity and debt securities.
The number of common shares that the bondholder will receive from
converting the bond is known as the conversion ratio. The conversion ratio
may be constant for the security’s life, or it may change over time. The
conversion value (or parity value) of a convertible bond is the value of the
bond if it is converted to common shares. The conversion value is equal to
the conversion ratio times the share price. At conversion, the bonds are
retired (cease to exist) and common shares are issued.
Because the conversion feature is a benefit to the bondholder, a convertible
bond typically offers the bondholder a lower fixed annual coupon rate than
that of a comparable bond without a conversion feature (a straight bond).
Convertible bonds have a maturity date. If the bonds are not converted to
common stock prior to maturity, they will be paid off like any other bond and
retired at the maturity date.
When a convertible bond is issued, the conversion ratio is set so that its
value as a straight bond (i.e., the value of the bond if it were not convertible)
is higher than its conversion value. If the share price of the company
significantly increases, the conversion value of the bond will rise and may
become greater than the value of the convertible bond as a straight bond. If
this happens, converting the bond becomes attractive. In general, if the
conversion value is low relative to the straight bond value, the convertible
bond will trade at a price close to its straight bond value. But if the
conversion value is greater than the straight bond value, the convertible bond
will trade at a value closer to its conversion value.
Because a convertible bond should not trade below its conversion value,
bondholders may choose not to convert into common shares even if the
conversion value is higher than the par (principal) value of the bond. Often, a
convertible bond includes a redemption (buyback) option. The redemption
(buyback) option gives the issuing company the right to buy back (redeem)
the convertible bonds, usually at a pre-specified redemption price and only
after a certain amount of time. Convertible bond issues typically include
redemption options so that the issuing company can force conversion into
common shares.
Example 3 describes a convertible bond issue of Navistar International
Corp. The Navistar bond issue illustrates the typical features of a convertible
bond.
EXAMPLE 3.
CONVERTIBLE BONDS
On 22 October 2009, Navistar, a US company, issued convertible
bonds. The bond issue pays interest semiannually (twice a year) at a
rate of 3.0% per year and has a maturity date of 15 October 2014.
Owners of this convertible bond issue may convert each $1,000 bond
into 19.891 common shares. The owners may unconditionally convert at
any time on or after 15 April 2014 up to the maturity date and may
convert the bond prior to that date under certain conditions. No
redemption right is included as part of the bond issue. On 9 October
2012, the company’s common shares closed at $22.26 and, therefore,
each $1,000 bond’s conversion value was $442.77 (= $22.26 ×
19.891). The bond price in the market was $912. In this case, the bond
is trading at close to its straight bond value, rather than at its conversion
value.
Similar to convertible bonds, some preferred shares include a convertible
feature. The convertible feature provides the shareholder with the option to
convert the preferred share into a specified number of common shares. With
this option, a preferred shareholder may be able to participate in the
performance of the company. That is, if the company is doing well, it may be
to a preferred shareholder’s advantage to convert the preferred share into the
specified number of common shares. Also, similar to convertible bonds,
convertible preferred shares typically include a redemption option.
3.4. Warrants
A warrant is an equity-like security that entitles the holder to buy a prespecified amount of common stock of the issuing company at a pre-specified
per share price (called the exercise price or strike price) prior to a prespecified expiration date. A company may issue warrants to investors to
raise capital or to employees as a form of compensation. The holders of
warrants may choose to exercise the rights prior to the expiration date. A
warrant holder will exercise the right only when the exercise price is equal
to or lower than the price of a common share. Otherwise, it would be
cheaper to buy the stock in the market. When a warrant holder exercises the
right, the company issues the pre-specified number of new shares and sells
them to the warrant holder at the exercise price.
Warrants typically have expiration dates several years into the future. In
some cases, companies may attach warrants to a bond issue or a preferred
stock issue in an effort to make the bond or preferred stock more attractive.
When issued in this manner, warrants are known as sweeteners because the
inclusion of the warrants typically allows the issuer to offer a lower coupon
rate (interest rate) on a bond issue or a lower annual fixed dividend on a
preferred stock issue.
Companies may also issue warrants to employees as a form of compensation,
in which case they are referred to as employee stock options. When warrants
are used as employee compensation, the goal is to align the objectives of the
employees with those of the shareholders. Many companies compensate their
senior management with salaries and some form of equity-based
compensation, which may include employee stock options.
Example 4 describes the use of warrants to make a deal more attractive to
an investor.
EXAMPLE 4.
WARRANTS
On 25 August 2011, Bank of America, a US company, announced it had
reached an agreement with Berkshire Hathaway, another US company;
Berkshire Hathaway would invest $5 billion in Bank of America in
exchange for preferred stock and warrants. Berkshire Hathaway
received $5 billion in preferred stock, offering a fixed dividend of 6%
per year, redeemable by Bank of America at any time at a 5% premium
to the $5 billion par value. In addition to the preferred stock, Berkshire
Hathaway received warrants to purchase 700 million shares of Bank of
America common stock at an exercise price of $7.142857 per share.
The warrants can be exercised at any time during the 10 years following
the closing date of the transaction. In this example, the warrants served
as a sweetener to the preferred stock issue. It is likely that the annual
dividend of 6% on the preferred stock would have been higher in the
absence of the warrants.
3.5. Depositary Receipts
A depositary receipt is a security representing an economic interest in a
foreign company that trades like a common share on a domestic stock
exchange. For investors buying shares of foreign companies, the transaction
costs associated with purchasing depositary receipts are significantly lower
than the costs of directly purchasing the stock on a foreign country’s stock
exchange.
Depositary receipts are not issued by the company and do not raise capital
for the company, but rather, they are issued by financial institutions.
Depositary receipts facilitate trading of a company’s stock in countries other
than the country where the company is located. Depositary receipts are often
referred to as global depositary receipts (GDRs), but may be called by
different names in different countries. In the United States, GDRs are known
as American Depositary Receipts (ADRs) or American depositary shares.
Depositary receipts are generally similar globally but may vary slightly
because of different laws.
Now we will consider how depositary receipts are created and work, using
the example of Sony and Mexican investors. Mexican investors may want to
invest in the stock of Sony, a Japanese company, but Sony’s stock is not listed
on the Mexican Stock Exchange. Buying Sony stock on the Tokyo Stock
Exchange is expensive and inconvenient for Mexican investors. To make this
process easier, a financial institution in Mexico, such as a bank, can buy
Sony’s stock on the Tokyo Stock Exchange and make it available to Mexican
investors. Rather than making the shares directly available for trading on the
Mexican Stock Exchange, the bank holds the shares in custody and issues
GDRs against the shares held. The Sony GDRs issued by the custodian bank
are listed on the Mexican Stock Exchange for trading. In essence, the Sony
GDRs trade like the stock of a domestic company on the Mexican Stock
Exchange in the local currency (Mexican peso).
Depositary receipts, like the shares they are based on, have no maturity date
(i.e., they have an infinite life). Depositary receipts typically do not offer
their owners any voting rights even though they essentially represent common
stock ownership; the custodian financial institution usually retains the voting
rights associated with the stock.
Example 5 describes the depositary receipt of Vodafone Group in the United
States.
EXAMPLE 5.
DEPOSITARY RECEIPTS
The ordinary shares (common stock) of Vodafone, a UK company, trade
on the London Stock Exchange. The company’s stock trades on the
NASDAQ exchange in the United States in the form of an American
Depositary Receipt (ADR). The Bank of New York Mellon (BNY
Mellon) is the financial institution that holds the ordinary shares in
custody and issues ADRs of Vodafone against the ordinary shares of
Vodafone held in custody. The ADRs of Vodafone are available for US
and international investors. The ADRs are quoted in US dollars, and
each one is equivalent to 10 ordinary shares. Unusually, BNY Mellon
does not retain the voting rights associated with the shares, and ADR
shareholders can instruct BNY Mellon on the exercise of voting rights
relative to the number of ordinary shares represented by their holding of
ADRs.
4. RISK AND RETURN OF EQUITY AND
DEBT SECURITIES
There are significant risk and return differences between debt and equity
securities because of differences in cash flow, voting rights, and priority of
claims.
Exhibit 1 shows the three main types of securities and their typical cash flow
and voting rights.
Exhibit 1.
Cash Flow and Voting Rights by Security Type
Type of
Security
Cash Flow Rights
Voting
Rights
Common
stock
Right to dividends if declared by the
board of directors
Proportional
to
ownership
Type of
Security
Preferred
stock
Debt
security
Cash Flow Rights
Right to promised dividends if
declared by the board of directors;
board does not have a legal
obligation to declare the dividends
Legal right to promised cash flows
Voting
Rights
None
None
The return potential for both debt securities and preferred stock is limited
because the cash flows (interest, dividends, and repayment of par value) do
not increase if the company performs well. The return potential to common
shareholders is higher because the share price rises if the company performs
well. Relative to holders of debt securities and preferred stock, common
shareholders expect a higher return but must accept greater risk. The voting
rights of common shareholders may give them some influence over the
company’s business decisions and thereby somewhat reduce risk.
Debt securities are the least risky because the cash flows are contractually
obligated. Preferred stock is less risky than common stock because it ranks
higher than common stock with respect to the payment of dividends. The risk
of preferred stock is also reduced to some degree by the expectation of a
dividend each year. Although the dividend is not a contractual obligation,
companies are reluctant to omit dividends on preferred shares. Common
stock is considered the riskiest of the three because it ranks last with respect
to the payment of dividends and distribution of net assets if the company is
liquidated.
In the event of the company being liquidated, assets are distributed following
a priority of claims, or seniority ranking. This priority of claims can
affect the amount that an investor will receive upon liquidation. Exhibit 2
illustrates the priority of claims.
Exhibit 2.
Priority of Claims
Debt capital is borrowed money and represents a contractual liability of the
company. Debt investors thus have a higher claim on the company’s assets
than equity investors.4 After the claims of debt investors have been satisfied,
preferred stock investors are next in line to receive what they are due.
Common shareholders are last in line and known as the residual claimants
in a company. Common shareholders share proportionately in the remaining
assets after all other claims have been satisfied. If funds are insufficient to
pay off all claims, equity investors will likely receive only a fraction of their
investment back or may even lose their entire investment. Accordingly,
investing in equity securities is riskier than investing in corporate debt
securities.
Equity investors are at least protected by limited liability, which means that
higher claimants, particularly debt investors, cannot recover money from
other assets belonging to the shareholders if the company’s assets are
insufficient to fully cover their claims.5 Because a company is a legal entity
separate from its shareholders, it is responsible, at the corporate level, for
all company liabilities. By legally separating the shareholders from the
company, an individual shareholder’s liability is limited to the amount he or
she invested. So, shareholders cannot lose more money than they have
invested in the company.
It is important to note that limited liability of shareholders can actually
increase the losses of debt investors as the company approaches bankruptcy.
As a company moves closer to a bankruptcy filing, shareholders do not have
any incentive to maintain or upgrade the assets of the company because doing
so might require additional capital, which they might be unwilling to invest.
The consequent deterioration in asset quality hurts debt investors because the
liquidation value of the company decreases. Debt investors are thus
motivated to closely monitor the company’s actions to ensure that the
company operates in accordance with the debt contract.
Given the fact that equity securities are riskier than debt securities,
shareholders expect to earn higher returns on equity securities over the long
term. Because equity is riskier than debt, risk-averse investors may prefer
debt securities to equity securities. However, although debt is safer than
equity for a given entity, debt securities are not risk-free; they are subject to
many risk factors, which are discussed in the Debt Securities chapter.
Exhibit 3 shows annualised historical return and risk data on various equity
and debt indices for the 1980–2010 period. Recall from the Quantitative
Concepts chapter that the standard deviation of returns is often used as a
measure of risk. The shaded rows in Exhibit 3 present return and risk data
(based on standard deviation of returns) for six equity indices. The nonshaded rows present return and risk data for three bond indices.
Exhibit 3. Historical Annual Returns on Equity and Debt
Securities, 1980–2010
Source: Frank K. Reilly and Keith C. Brown, Investment Analysis and Portfolio
Management, 10th ed. (Mason, OH: South-Western Cengage Learning, 2012).
The data are generally consistent with the expectation that riskier investments
should generate higher returns over the long term. For the United States and
Europe, annual equity returns (first three shaded indices) were higher than
annual bond returns (non-shaded indices). Annual equity returns exhibited
higher risk than annual debt returns. Note that for the three indices that
include emerging economies (the last three shaded indices), however, annual
equity returns were marginally lower than annual bond returns but more
risky.
Exhibit 4 presents annual real returns (returns adjusted for inflation) on
equity securities and government long-term bonds for 19 countries, Europe,
the world, and the world excluding the United States (ex-US) for 1900–2010.
Equity returns over the period are higher than government bond returns
within every country and region. The real return (return adjusted for
inflation) of equity securities ranged from approximately 2% to 7%. The real
returns of government bonds ranged from approximately –2% (that is, they
failed to cover inflation) to +3%. On average, government bonds have beaten
inflation, earning a modest positive real return per year. But in some
countries, the return to bondholders was not sufficient to cover inflation, so
bondholders lost purchasing power.
Exhibit 4. Real Annualised Returns on Equities vs. Bonds
Internationally, 1900–2010
Source: E. Dimson, P. Marsh, and M. Staunton, Credit Suisse Global Investment
Returns Sourcebook 2011 (Zurich: Credit Suisse Research Institute, 2011).
5. VALUATION OF COMMON SHARES
Valuing common shares is a complex process because of their infinite life
and the difficulty of estimating future company performance. There are three
basic approaches to valuing common shares:
Discounted cash flow valuation
Relative valuation
Asset-based valuation
Analysts frequently use more than one approach to estimate the value of a
common share. Once an estimate of value has been determined, it can be
compared with the current price of the share, assuming that the share is
publicly traded, to determine whether the share is overvalued, undervalued,
or fairly valued.
5.1. Discounted Cash Flow Valuation
The discounted cash flow (DCF) valuation approach takes into account the
time value of money. This approach estimates the value of a security as the
present value of all future cash flows that the investor expects to receive
from the security. This valuation approach applied to common shares relies
on an analysis of the characteristics of the company issuing the shares, such
as the company’s ability to generate earnings, the expected growth rate of
earnings, and the level of risk associated with the company’s business
environment.
Common shareholders expect to receive two types of cash flows from
investing in equity securities: dividends and the proceeds from selling their
shares. Example 6 illustrates the application of the DCF approach, using
estimates of dividends and selling price, for a common share of Volkswagen.
EXAMPLE 6.
DISCOUNTED CASH FLOW APPROACH
On 1 January 2012, an investor expects Volkswagen, a German
company, to generate dividends of €4.00 per share at the end of 2012,
€4.20 per share at the end of 2013, and €4.50 per share at the end of
2014. Furthermore, the investor estimates that the stock price of
Volkswagen will trade at €150.00 per share at the end of 2014. Note
that, under the DCF valuation approach, the expected price of
Volkswagen stock at the end of 2014 (€150.00 per share) represents the
present value of cash flows to investors expected to be generated by the
company beyond 2014. The investor considers all risks and concludes
that a discount rate of 14% is appropriate. In other words, the investor
wants to earn at least an annual rate of return of 14% by investing in
Volkswagen.
The estimated value of a Volkswagen share using the DCF valuation
approach is equal to the present value of the cash flows the investor
expects to receive from the equity investment. The investor computes
the present value of the expected cash flows as follows:
= €111.02
So, the investor’s estimated value of Volkswagen on a per share basis is
€111.02. If shares of Volkswagen are priced at less than €111.02 on 1
January 2012, the investor may conclude that the stock is undervalued
and decide to buy it. Alternatively, if the stock is priced at more than
€111.02, the investor may conclude that the stock is overvalued and
decide not to buy.
The DCF valuation approach can also be used to value preferred shares.
Valuing preferred shares is typically easier than for common shares because
the expected dividends are specified and do not change over time. The value
of a preferred share, with a fixed dividend and no maturity date, is the
discounted value of the future dividends, which is equal to the dividend
divided by the discount rate.
5.2. Relative Valuation
The relative valuation approach estimates the value of a common share as the
multiple of some measure, such as earnings per share (EPS) or revenue per
share. The multiple is determined based on price and the relevant measure
for publicly traded, comparable equity securities. The key assumption of the
relative valuation approach is that common shares of companies with similar
risk and return characteristics should have similar values. Relative valuation
relies on the use of price multiples of comparable, publicly traded
companies or an industry average.
One multiple commonly used in relative valuation is the price-to-earnings
ratio (P/E), which is the ratio of a company’s stock price to its EPS. For
instance, a publicly traded company that generates annual earnings per share
of $1.00 and is trading at $12 per share has a P/E (or price-to-earnings
multiple) of 12. Example 7 illustrates two applications of the relative
valuation approach.
EXAMPLE 7.
RELATIVE VALUATION
1. An investor is estimating the value of an airline’s common stock on
a per share basis. The airline in question generates annual EPS of
€2.00. The investor finds that the average price-to-earnings
multiple or P/E for the industry is 9. Using relative valuation, the
investor estimates that the value of the airline’s stock, on a per
share basis, is €18.00 (= €2.00 × 9).
2. An investor is estimating the value of the common stock of Ford
Motor Company, a US automobile manufacturing company, on a
per share basis. Analysts estimate that Ford will generate EPS of
$1.60 next year. The investor gathers information, shown in the
second and third columns of the following table, on three
competing automobile makers: General Motors, Toyota, and
Honda. The investor calculates the P/E (shown in the fourth
column) for each of the three companies. The investor then
calculates the average P/E for the three companies as 9 [= (8 + 10
+ 9)/3].
Current
Stock
Price
Next Year’s
Estimated EPS
General
Motors
Toyota
$40.00
$5.00
$85.00
$8.50
Honda
$36.00
$4.00
Company
Average
P/E
$40.00/$5.00
=8
$85.00/$8.50
= 10
$36.00/$4.00
=9
(8 + 10 +
9)/3 = 9
The investor estimates the value of Ford common stock, on a per share
basis, is $14.40 (= $1.60 × 9). It is important to note that even though
the P/E is 9 in both examples, this does not mean that 9 is a typical P/E.
One issue with the use of the relative valuation approach is that price
multiples change with investor sentiment. Companies trade at higher
multiples and as a result of higher market prices when investors are
optimistic and at lower multiples and prices when investors are pessimistic.
5.3. Asset-Based Valuation
The asset-based valuation approach estimates the value of common stock by
calculating the difference between the value of a company’s total assets and
its outstanding liabilities. In other words, the asset-based valuation approach
estimates the value of common equity by calculating a company’s net asset
value. The asset-based valuation approach implicitly assumes that the
company is liquidated, sells all its assets, and then pays off all its liabilities.
The residual value after paying off all liabilities is the value to the
shareholders.
The difference between total assets and total liabilities on a company’s
balance sheet represents shareholders’ equity, or the book value of equity.
But the values of some assets on the balance sheet are based on historical
cost (the cost when they were purchased), and the actual market value of
these assets may be very different. For instance, the value of land on a
company’s balance sheet, typically carried at historical cost, may be quite
different from its current market value. As a result, estimating the value of the
equity of a company using asset values taken directly from the balance sheet
may provide a misleading estimate. To improve the accuracy of the value
estimate, current market values can be estimated instead.
Also, some assets may not be included on the balance sheet because of
financial reporting rules. For instance, some internally developed intangible
assets, such as a brand or reputation, are not listed in the financial reports. It
is important that analysts using asset-based valuation estimate reasonable
values for all of a company’s assets, which can be very challenging to do.
5.4. Implicit Assumptions of Valuation
Approaches
The DCF valuation approach relies solely on estimates of a company’s future
cash flows and implicitly assumes that the company will continue to operate
forever. In contrast, the asset-based valuation approach implicitly assumes
that the company will stop operating and essentially provides a liquidation
value.
The relative valuation approach does not estimate future cash flows but
instead uses price multiples of other comparable, publicly traded companies
to arrive at an estimate of equity value. These price multiples rely on
performance measures, such as EPS or revenue per share, to estimate value.
The relative valuation approach implicitly assumes that common shares of
companies with similar risk and return characteristics should have similar
price multiples.
6. COMPANY ACTIONS THAT AFFECT
EQUITY OUTSTANDING
Companies undertake major changes as they grow, evolve, mature, or merge
with another company. Some of these changes result in changes to the number
of common shares outstanding—the number of common shares currently held
by shareholders. Various corporate actions can affect equity outstanding:
Selling shares to the public for the first time (when a private company
becomes a public company), referred to as an initial public offering
(IPO)
Selling shares to the public in an offering subsequent to the initial public
offering, referred to as a seasoned equity offering or secondary
equity offering
Buying back existing shares from shareholders, referred to as a share
repurchase or share buyback
Issuing a stock dividend or conducting a stock split
Issuing new stock after the exercise of warrants
Issuing new stock to finance an acquisition
Creating a new company from a subsidiary in a process referred to as a
spinoff
Each of these actions and their effects are discussed in the following
sections.
6.1. Initial Public Offering
The main difference between a private company and a publicly traded
company is that the shares of a private company are available only to select
investors and are not traded on a public market. A private company becomes
a publicly traded company through an IPO, which is the first time that it sells
new shares to investors in a public market.
Private companies become publicly traded companies for a number of
reasons. First, it gives the company more visibility, which makes it easier to
raise capital to fund growth opportunities. It also helps attract talented staff,
raise brand awareness, and gain credibility with trading partners. In addition,
it provides greater liquidity for shareholders who want to sell their shares or
buy additional shares. At or after the IPO, some of the original shareholders
may choose to sell some of their shares. The fact that the shares now trade in
a public market makes the shares more liquid and thus easier to sell.
A disadvantage to becoming a public company is increased regulatory and
disclosure requirements. IPOs are also expensive; their cost can be as much
as 10% of the proceeds. Example 8 gives an example of how costly an IPO
can be.
EXAMPLE 8.
INITIAL PUBLIC OFFERING
Glencore International, a Swiss company founded in 1974, announced in
April 2011 its intention to become a publicly traded company. The
shares were to trade on both the London Stock Exchange (LSE) and the
Hong Kong Stock Exchange (HKSE). The company raised $7,896
million, but had to pay transaction costs of $566 million (about 7% of
the entire proceeds of the IPO).
6.2. Seasoned Equity Offering
After an IPO, publicly traded companies may sell additional shares to raise
more capital. The selling of new shares by a publicly traded company after
an IPO is referred to as a seasoned or secondary equity offering. A seasoned
equity offering typically has far lower costs associated with it compared
with an IPO.
A typical seasoned equity offering increases the number of shares outstanding
by 5%–20%. For an existing investor who does not buy additional shares in
the seasoned equity offering, the increase in shares outstanding dilutes the
investor’s ownership percentage.
Example 9 gives an example of a seasoned equity offering and the
associated costs.
EXAMPLE 9.
SEASONED EQUITY OFFERING
On 1 October 2008, General Electric, a US company that has traded
publicly since 1896, announced it would sell additional shares to the
public in a seasoned equity offering. According to the 2008 annual
report, 547.8 million shares were issued at $22.25 share (= $12,189
million = 547.8 million × $22.25). The net proceeds were $12,006
million, which implies issuance costs of $183 million (= $12,189
million – $12,006 million, less than 2% of the proceeds). The issuance
costs for this seasoned offering are much lower than the costs of the IPO
in Example 8.
6.3. Share Repurchases
Companies may choose to return cash to shareholders by repurchasing shares
rather than paying dividends. Assuming that the company’s net income is
unaffected by the repurchase, the share repurchase will increase the
company’s earnings per share because net income will be divided by a
smaller number of shares. Repurchased shares are either cancelled or kept
and reported as treasury stock in the shareholders’ equity account on the
company’s balance sheet. Treasury shares are not included in the number of
shares outstanding.
To buy back shares, a company can buy shares on the open market just like
other investors or it can make a formal offer for repurchase directly to
shareholders. Shareholders may choose to sell their shares or to remain
invested in the company. For an existing investor who does not sell shares,
the decrease in the number of shares outstanding effectively increases that
investor’s ownership percentage.
Example 10 compares a share repurchase and a dividend distribution.
EXAMPLE 10.
SHARE REPURCHASE
A company with 2 million common shares outstanding and a current
stock price of $50 wants to distribute $1 million to its shareholders.
The company could pay a dividend of 50 cents per share ($1 million/2
million shares) or buy back 20,000 shares from shareholders willing to
sell their shares (20,000 shares × $50 = $1,000,000), assuming that the
company can buy the shares at their current market value. After the
repurchase, the number of shares outstanding would decrease to 1.98
million (2 million – 20,000).
6.4. Stock Splits and Stock Dividends
Companies may, on occasion, conduct stock splits or issue stock dividends.
A stock split is when a company replaces one existing common share with a
specified number of common shares. A stock dividend is a dividend in which
a company distributes additional shares to its common shareholders. Stock
splits and stock dividends both increase the number of shares outstanding,
but they do not change any single shareholder’s proportion of ownership.
When a company splits its stock or issues a stock dividend, the number of
shares outstanding increases and additional shares are issued proportionally
to existing shareholders based on their current ownership percentages. The
overall value of the company should not change, so the price of each share
should decrease. But the value of any single shareholder’s total shares should
not change in value. Example 11 illustrates the effects of a stock split and a
stock dividend on the stock price, number of shares, and total shareholder
value.
EXAMPLE 11.
DIVIDEND
EFFECTS OF A STOCK SPLIT AND A STOCK
A company has 24,000 shares outstanding and each share trades at
€75.00. An investor owns 900 shares.
Stock Split
The company announces a three-for-two stock split. This means for
every two shares the investor currently owns, she will receive three
shares in replacement. So, she will have 1,350 shares after the stock
split.
(900/2) × 3 = 1,350 shares
Stock Dividend
The company declares a 50% stock dividend—that is, for every share
the investor currently owns, she will receive an additional 0.5 shares. In
other words, she will have 1,350 shares.
900 × 1.5 = 1,350 shares
The effects of the stock split and stock dividend are shown in the
following table.
As Example 11 illustrates, a stock split or stock dividend does not change
each shareholder’s proportional ownership of the company. Shareholders do
not invest any additional money for the increased number of shares, and the
stock split or stock dividend does not have any effect on the company’s
operations. The total value of the company’s shares and an investor’s shares
are unchanged by the stock split or stock dividend.
Given that stock splits and stock dividends do not have any effect on
company operations or value, why do you think companies take these
actions? One explanation is that as a company does well and its assets and
profits increase, the stock price is likely to increase. At some point, the stock
price may get so high that shares become unaffordable to some investors and
liquidity decreases. A stock split or stock dividend will have the effect of
lowering a company’s stock price, making the stock more affordable to
investors, and thereby improving liquidity.
It is important to note that the affordability of a company’s stock is different
from whether the stock is undervalued or overvalued. That is, a company
with a stock price of $500 per share may be unaffordable to some investors,
but may still be considered undervalued when the price per share is
compared with the estimated value per share. Similarly, a company with a
stock price of $5 per share may be affordable to most investors yet still be
overvalued.
Companies with very low stock prices may conduct a reverse stock split to
increase their stock price. In this case, the company reduces the number of
shares outstanding. The primary reason for a reverse stock split is that a
company may face the risk of having its shares delisted from a public
exchange if its stock price falls below a minimum level dictated by the
exchange. After the reverse stock split, shareholders will still own the same
proportion of the shares they originally owned. In other words, a reverse
stock split reduces the number of shares outstanding but does not affect a
shareholder’s proportional ownership of the company. After a reverse stock
split, the stock price should increase by the same multiple as the reverse
stock split. Example 12 describes a 1-for-10 reverse stock split by
Citigroup.
EXAMPLE 12.
REVERSE STOCK SPLIT
On 21 March 2011, Citigroup, a US company, announced a 1-for-10
reverse stock split effective after the close of trading on 6 May 2011.
Before the split, Citigroup had approximately 29 billion shares
outstanding. The closing stock price of Citigroup on 6 May was $4.52.
After the reverse split, the number of shares outstanding decreased to
approximately 2.9 billion. On the next trading day after the reverse
stock split took effect, which was 9 May, the opening stock price was
$44.89; this price is about ten times the pre-split price of $4.52.
6.5. Exercise of Warrants
Companies that issue warrants as a form of additional or bonus compensation
to employees may have to increase shares outstanding if the warrants are
exercised. If an investor exercises warrants, the issuing company’s number of
shares outstanding increases and all other existing shareholders of the
company’s stock will see their ownership percentage decrease. Given that
there may be numerous employees who exercise warrants on a recurring
basis, companies that issue warrants to employees as a form of compensation
will typically experience an increase in shares outstanding every year. To
mitigate the dilution effect on existing shareholders, these companies may
repurchase a small amount of shares each year to offset the additional shares
issued when warrants are exercised.
6.6. Acquisitions
One company may acquire another by agreeing to buy all of its shares
outstanding. All of the outstanding shares of the acquired company are
redeemed for cash, for stock in the acquiring company, or for a combination
of cash and stock of the acquiring company. Shareholders of the acquiring
company and the target company (the company to be acquired) are typically
asked to vote on a proposed acquisition. If the company being acquired is
small and the acquirer has sufficient cash, there is no need to issue new
shares.
For larger acquisitions, the acquiring company may pay for the purchase by
issuing new shares. The amount of new shares issued depends on the
purchase price and the ratio of the two companies’ stock prices. An
acquisition in which the company uses its stock to finance the transaction
results in an increase in the acquiring company’s shares outstanding. For
existing shareholders in the acquiring company, the increased shares
outstanding effectively dilutes their ownership percentage.
6.7. Spinoffs
A company may create a new company from an existing subsidiary in a
process referred to as a spinoff. Shares of the new entity are distributed to
the parent company’s existing shareholders. After the spinoff, the value of the
shares of the parent company initially declines as the assets of the parent
company are reduced by the amount allocated to the new company. But
shareholders receive the shares of the newly formed company to compensate
them for the decrease in value.
A company’s management may conduct a spinoff in an effort to create value
for its shareholders by splitting the company into two separate businesses.
The rationale behind a spinoff is that the market may assign a higher
valuation to two separate but more specialised companies compared with the
value assigned to these entities when they were part of the parent company.
SUMMARY
Equity securities are an important way for companies to raise financing to
fund their activities. They are also popular assets among investors, who are
attracted by their potential returns. However, equities are riskier than debt
securities and must be analysed with care and skill.
The following points recap what you have learned in this chapter about
equity securities:
Companies often issue different types or classes of equity securities.
The types of equity securities, or equity-like securities, that companies
may issue include common shares, preferred shares, convertible bonds,
and warrants.
Equity securities are typically characterised by four main features:
specified life (infinite or with a maturity date), par value, voting rights,
and cash flow rights.
Debt securities include contractual obligations to pay a return to the
debt providers. Equity securities, however, contain no such contractual
obligations. A company does not have to repay the amounts contributed
by the shareholders or pay a dividend.
The board of directors, elected by the common shareholders, plays an
important role in monitoring the company’s business activities and
management on behalf of its shareholders. The board is also responsible
for declaring dividends on shares of the company.
Common stock is the main type of equity security issued by a company.
Common shares have an infinite life and may or may not have a par
value. A common share represents an ownership interest in a company.
Common shareholders have a residual claim on the net assets of the
company and typically have voting rights.
Preferred shares typically offer fixed dividends, based on stated par
values and dividend rates. Generally, preferred shareholders have no
voting rights or ownership claim on the company.
A convertible bond is a bond issued by a company that offers the
bondholder the right to convert the bond into a specified number of
common shares. It has features of and relationships with both equity and
debt securities.
A warrant is an equity-like security that entitles the holder to buy a
specified amount of common stock of the issuing company at a specified
price per share prior to the warrant’s expiration date.
A depositary receipt is a security representing an interest in a foreign
company that trades like a common share on a domestic stock exchange.
It is not issued by the foreign company.
In the event of liquidation, priority of claims states that debt investors
rank higher than preferred shareholders and preferred shareholders rank
higher than common shareholders.
Relative to preferred stock, common stocks offer the potential for a
higher return but with greater investment risk.
Equity securities are riskier than debt securities, and empirical data
suggest that equity securities earn higher returns than debt securities,
thereby compensating investors for the higher risk.
Common approaches used to value common shares include discounted
cash flow valuation, relative valuation, and asset-based valuation
approaches.
The discounted cash flow approach estimates the value of a security as
the present value of its expected future cash flows to its holder.
The relative valuation approach estimates the value of a common share
as the multiple of some measure, such as earnings per share. This
approach implicitly assumes that common shares of companies with
similar risk and return characteristics should have similar price
multiples.
The asset-backed valuation approach estimates the value of common
stock of a company as the difference between the value of its total assets
and liabilities, in other words, as its net asset value.
Some corporate actions result in changes to the number of common
shares outstanding. Such actions include initial public offerings,
seasoned equity offerings, share repurchases, stock splits, stock
dividends, acquisitions, and spinoffs.
CHAPTER REVIEW QUESTIONS
© 2014 CFA Institute. All rights reserved.
1. Which of the following securities most likely provides voting rights to
investors?
A. Common shares
B. Preferred shares
C. Depositary receipts
2. The right to elect members of the board of directors of a company
belongs to that company’s:
A. senior management.
B. common shareholders.
C. preferred shareholders.
3. Which of the following is most likely an advantage of owning common
stock?
A. Low risk
B. Finite life
C. Limited liability
4. The key difference between cumulative preferred stock and noncumulative preferred stock relates to:
A. voting rights.
B. the treatment of missed dividends.
C. the company’s ability to buy back the preferred shares.
5. Compared with a preferred shareholder, a common shareholder most
likely has:
A. voting rights.
B. limited liability.
C. cash flow rights.
6. All else being equal, the fixed coupon rate on a convertible bond
compared with a straight bond is most likely:
A. lower.
B. the same.
C. higher.
7. Compared with preferred shareholders, the ranking of common
shareholders in the priority of claims on the company’s net assets upon
liquidation is:
A. equal.
B. lower.
C. higher.
8. A security representing an economic interest in a foreign company that
trades like a common stock on a local stock exchange is most likely a:
A. warrant.
B. convertible bond.
C. depositary receipt.
9. Depositary receipts are issued by:
A. governments.
B. financial institutions.
C. the company whose shares are represented by the depositary
receipts.
10. If the price of a company’s common shares increases significantly, the
conversion value of a convertible bond issued by that company most
likely:
A. increases.
B. decreases.
C. remains unchanged.
11. Stock options issued by a company to its employees as a form of
compensation are an example of:
A. warrants.
B. convertible bonds.
C. depositary receipts.
12. Compared with common shares, an investment in preferred shares is
most likely to be:
A. less risky.
B. more risky.
C. equally risky.
13. Compared with the expected return on an investment in preferred
shares, the expected return on an investment in common shares is most
likely to be:
A. equal.
B. lower.
C. higher.
14. The discounted cash flow approach to valuation of a company’s
common shares most likely considers the:
A. expected dividends on the shares.
B. current value of the company’s assets.
C. price-to-earnings ratios of comparable companies.
15. The approach to valuing common shares that uses price multiples of
other comparable, publicly traded companies best describes:
A. relative valuation.
B. asset-based valuation.
C. discounted cash flow valuation.
16. A company that needs to raise capital in a public market for the first
time would most likely:
A. repurchase shares.
B. conduct an initial public offering.
C. conduct a seasoned equity offering.
17. The process of a publicly traded company raising additional capital by
selling new shares to the public best describes a:
A. stock dividend.
B. share repurchase.
C. seasoned equity offering.
18. Which of the following corporate actions would decrease a company’s
number of outstanding shares?
A. Share repurchase
B. Exercise of warrants
C. Seasoned equity offering
19. After a company conducts a stock split, a common shareholder’s
proportional ownership will most likely:
A. increase.
B. decrease.
C. remain unchanged.
20. The process of a company creating a new company from an existing
subsidiary best describes a:
A. spinoff.
B. stock split.
C. reverse stock split.
21. The corporate action most likely taken to mitigate the effects of
exercised warrants is:
A. a stock dividend.
B. an issuance of new shares.
C. a share repurchase program.
ANSWERS
1. A is correct. Common shareholders usually have the right to vote on
certain matters. B is incorrect because preferred shareholders are not
generally entitled to voting rights. C is incorrect because depositary
receipts are securities that represent an economic interest in a foreign
company, are issued by a custodian financial institution, and trade like
common stock on a local stock exchange. Although they essentially
represent common stock ownership, they typically do not offer their
owners any voting rights because the custodian financial institution
usually retains the voting rights associated with the stock.
2. B is correct. Common shareholders collectively elect members of the
board of directors, whose job it is to monitor the company’s business
activities on behalf of its shareholders. A is incorrect because senior
management is appointed/hired by the board of directors, not the other
way around. C is incorrect because preferred shareholders are usually
not entitled to voting rights.
3. C is correct. By legally separating the shareholders from the company,
an individual shareholder’s liability is limited to the amount he or she
invested. A is incorrect because investing in common stock carries
relatively high risk. B is incorrect because common stock is issued
without maturity dates. Thus, it has an infinite life.
4. B is correct. Cumulative preferred stock requires that the company pay
in full any missed dividends (dividends promised but not paid in prior
years) before paying dividends to common shareholders. By
comparison, non-cumulative (or straight) preferred stock does not
require that missed dividends from prior years be paid before dividends
are paid to common shareholders. A is incorrect because preferred
shareholders are usually not entitled to voting rights, irrespective of
whether the preferred stock is cumulative or non-cumulative. C is
incorrect because the redemption feature (that is, the company’s ability
to buy back the preferred shares) is unrelated to the distinction between
cumulative and non-cumulative preferred stock.
5. A is correct. Except in rare circumstances, preferred shareholders do
not possess voting rights. By contrast, common shareholders receive
voting rights. B and C are incorrect because both preferred and common
shareholders have limited liability and possess cash flow rights to
declared dividends and in liquidation.
6. A is correct. Because the conversion feature represents a benefit to the
bondholder, a convertible bond typically offers the bondholder a lower
fixed annual coupon rate than that of a comparable bond without a
conversion feature (a straight bond).
7. B is correct. Common shareholders are last in line if the company is
liquidated; they are the residual claimants in a company. Thus, common
shareholders have a lower claim on the company’s net assets (that is,
the difference between a company’s total assets and its outstanding
liabilities) upon liquidation than preferred shareholders.
8. C is correct. A depositary receipt is a security representing an
economic interest in a foreign company that trades like a common stock
on a local stock exchange. A is incorrect because a warrant is an equitylike security that entitles the holder to buy a pre-specified amount of
common stock of the issuing company at a pre-specified share price
prior to a pre-specified expiration date. B is incorrect because a
convertible bond is a type of debt security issued by a company that
offers the holder the right to convert the bond into a pre-specified
number of common shares.
9. B is correct. Depositary receipts are securities representing an
economic interest in a foreign company that trade like common stock on
a local stock exchange. They are issued by a custodian financial
institution that is located in the domestic country. The financial
institution buys the shares in the foreign country, holds them in custody,
issues depositary receipts against the shares held, and sells the
depositary receipts to domestic investors who can trade them on the
local stock exchange. A and C are incorrect because governments and
the company whose shares are represented by the depositary receipts do
not issue depositary receipts.
10. A is correct. If the price of a company’s common shares increases
significantly, the conversion value of a convertible bond issued by that
company increases.
11. A is correct. Stock options issued by a company to its employees as a
form of compensation are an example of warrants. A warrant is an
equity-like security that entitles the holder to buy a pre-specified amount
of common stock of the issuing company at a pre-specified share price
prior to a pre-specified expiration date. By issuing stock options to its
employees, the company’s goal is to align the objectives of the
employees (such as senior management) with those of the shareholders.
B is incorrect because a convertible bond is a bond issued by a
company that offers the bondholder the right to convert the bond into a
pre-specified number of common shares. C is incorrect because a
global depository receipt is a security representing an economic interest
in a foreign company that trades like a common share on a local stock
exchange.
12. A is correct. Preferred shares are less risky than common shares
because they rank higher than common shares with respect to the
payment of dividends and distribution of net assets upon liquidation.
The risk of preferred shares is also reduced to some degree by the
expectation of a fixed dividend each year.
13. C is correct. Common shares are considered riskier than preferred
shares, but they offer a higher expected return. If a company does very
well, common shareholders stand to benefit greatly whereas preferred
shareholders only receive the fixed dividend.
14. A is correct. The discounted cash flow approach to valuation estimates
the value of a security as the present value of all future cash flows that
the investor expects to receive from the security. Common shareholders
expect to receive two types of cash flows: dividends and the proceeds
from selling their shares. Thus, the expected dividends on the shares are
an important component of the discounted cash flow valuation approach.
B is incorrect because the valuation approach that considers the current
value of the company’s assets is the asset-based valuation approach. C
is incorrect because the valuation approach that considers the price-toearnings ratios of comparable companies is the relative valuation
approach. In such a valuation approach, the value of a common share is
estimated by using multiples based on market prices and some other
measure for comparable, publicly traded companies.
15. A is correct. The relative valuation approach estimates the value of a
common share by using multiples based on prices and some other
measure for comparable, publicly traded companies. One multiple
commonly used is the price-to-earnings ratio, which is the ratio of a
company’s share price to its earnings per share. B is incorrect because
the asset-based valuation approach estimates the value of common
shares by calculating the company’s net asset value—that is, the
difference between a company’s total assets and its outstanding
liabilities. C is incorrect because the discounted cash flow valuation
approach estimates the value of a common share as the present value of
all future cash flows that the investor expects to receive from the
common share.
16. B is correct. An initial public offering (IPO) is a way for a company to
raise capital in a public market for the first time. In the process, the
company becomes a publicly traded company. A is incorrect because
share repurchases require the company to use capital to buy back (or
repurchase) shares from existing shareholders. C is incorrect because
publicly traded companies may raise additional capital by selling
additional shares in a seasoned (or secondary) equity offering
subsequent to the IPO.
17. C is correct. The selling of new shares to the public by a publicly
traded company to raise additional capital is referred to as a seasoned
(or secondary) equity offering. A and B are incorrect because stock
dividends and share repurchases do not raise additional capital for the
company. In a stock dividend, the company distributes new shares at no
cost to existing shareholders. In a share repurchase, the company buys
back (or repurchases) shares from existing shareholders.
18. A is correct. In a share repurchase, the company buys back (or
repurchases) shares from existing shareholders, which decreases the
number of shares outstanding. B and C are incorrect because the
exercise of warrants and seasoned equity offerings increase the number
of shares outstanding.
19. C is correct. A stock split replaces one existing common share with a
specified number of common shares. It increases the number of shares
outstanding but does not change any single shareholder’s proportion of
ownership.
20. A is correct. The process of a company creating a new company from an
existing subsidiary is called a spinoff. Shares of the new entity are
distributed to the parent company’s existing shareholders. B is incorrect
because a stock split simply replaces one existing common share with a
specified number of common shares, which increases the number of
shares outstanding. C is incorrect because a reverse stock split reduces
the number of shares outstanding. Stock splits and reverse stock splits
do not change any single shareholder’s proportion of ownership.
21. C is correct. Whenever warrants are exercised, there is an increase in
the total number of shares outstanding of a company. To mitigate the
dilution effect on existing shareholders, companies typically buy back
or repurchase shares in the open market to offset the shares issued when
warrants are exercised. A is incorrect because issuing a stock dividend
increases the number of shares outstanding but does not change any
single shareholder’s proportional ownership. A stock dividend does
nothing to mitigate the dilution effect created by the exercise of
warrants. B is incorrect because issuing new shares compounds the
effect of the exercised warrants, increasing the dilution effect on
existing shareholders.
NOTES
1Recall from the Investment Industry: A Top-Down View chapter that a mutual fund is a professionally
managed investment vehicle that has investments in a variety of securities. Mutual funds are discussed
further in the Investment Vehicles chapter.
2Security market indices are discussed further in the Investment Vehicles chapter.
3These are ticker symbols, which are used to identify a particular stock, share class, or issue on a
particular stock exchange.
4The priority of claims of debtholders is discussed in the Debt Securities chapter.
5An exception is cases of fraud and wilful negligence; in such situations, management and the board of
directors may be held personally liable.
Chapter 11
Derivatives
by Vijay Singal, PhD, CFA
© 2014 CFA Institute. All rights reserved.
LEARNING OUTCOMES
After completing this chapter, you should be able to do the following:
a. Define a derivative contract;
b. Describe uses of derivative contracts;
c. Describe key terms of derivative contracts;
d. Describe forwards and futures;
e. Distinguish between forwards and futures;
f. Describe options and their uses;
g. Define swaps and their uses.
1. INTRODUCTION
When you plan a vacation, you do not usually wait until you get to your
planned destination to book a room. Booking a hotel room in advance
provides assurance that a room will be available and locks in the price. Your
action reduces uncertainty (risk) for you. It also reduces uncertainty for the
hotel. Now imagine that you are a wheat farmer and want to reduce some of
the risk of farming. You might presell some of your crop at a fixed price. In
fact, contracts to reduce the uncertainty of agricultural products have been
traced back to the 16th century. These contracts on agricultural products may
be the oldest form of what are known as derivatives contracts or, simply,
derivatives.
Derivatives are contracts that derive their value from the performance of an
underlying asset, event, or outcome—hence their name. Since the
development of derivatives contracts to help reduce risk for farmers, the uses
and types of derivatives contracts and the size of the derivatives market have
increased significantly. Derivatives are no longer just about reducing risk,
but form part of the investment strategies of many fund managers.
The size of the global derivatives market is now around $800 trillion. To put
this figure in context, the combined value of every exchange-listed company
in the United States is around $23 trillion.1 Given their sheer volume,
derivatives are very important to financial markets and the work of
investment professionals.
2. USES OF DERIVATIVES
CONTRACTS
Derivatives can be created on any asset, event, or outcome, which is called
the underlying. The underlying can be a real asset, such as wheat or gold,
or a financial asset, such as the share of a company. The underlying can also
be a broad market index, such as the S&P 500 Index or the FTSE 100 Index.
The underlying can be an outcome, such as a day with temperatures under or
over a specified temperature (also known as heating and cooling days), or an
event, such as bankruptcy. Derivatives can be used to manage risks
associated with the underlying, but they may also result in increased risk
exposure for the other party to the contract.
Let us continue the story of the wheat farmer. The farmer anticipates having at
least 50,000 bushels of wheat available for sale in mid-September, six
months from now. Wheat is currently trading in the market at $9.00 per
bushel, which is the spot price. The farmer has no way of knowing what the
market price of wheat will be in six months. The farmer finds a cereal
producer that needs wheat and is willing to contract to buy 50,000 bushels of
wheat at a price of $8.50 per bushel in six months. The contract provides a
hedge for both the farmer and the cereal producer. A hedge is an action that
reduces uncertainty or risk.
But what if the farmer cannot find someone who actually needs the wheat?
The farmer might still find a counterparty that is willing to enter into a
contract to buy the wheat in the future at an agreed on price. This
counterparty may anticipate being able to sell the wheat at a higher price in
the market than the price agreed on with the farmer. This counterparty may be
called a speculator. This counterparty is not hedging risk but is instead taking
on risk in anticipation of earning a return. But there is no guarantee of a
return. Even if the price in the market is lower than the price agreed on with
the farmer, the counterparty has to buy the wheat at the agreed on price and
then may have to sell it at a loss.
Derivatives allow companies and investors to manage future risks related to
raw material prices, product prices, interest rates, exchange rates, and even
uncontrollable factors, such as weather. They also allow investors to gain
exposure to underlying assets while committing much less capital and
incurring lower transaction costs than if they had invested directly in the
assets.
3. KEY TERMS OF DERIVATIVES
CONTRACTS
There are four main types of derivatives contracts: forward contracts
(forwards), futures contracts (futures), option contracts (options), and swap
contracts (swaps). Each of these will be discussed in the following sections.
All derivatives contracts specify four key terms: the (1) underlying, (2) size
and price, (3) expiration date, and (4) settlement.
3.1. Underlying
Derivatives are constructed based on an underlying, which is specified in the
contract. Originally, all derivatives were based only on tangible assets, but
now some contracts are based on outcomes. Examples of underlyings include
the following:
Agricultural products (such as wheat, rice, soybeans, cotton, butter, and
milk)
Livestock (such as hogs and cattle)
Currencies
Interest rates
Individual shares and equity indices
Bond indices
Economic factors (such as the inflation rate)
Natural resources (such as crude oil, natural gas, gold, silver, and
timber)
Weather-related outcomes (such as heating or cooling days)
Other products (such as electricity or fertilisers)
A derivative’s underlying must be clearly defined because quality can vary.
For example, crude oil is classified by specific attributes, such as its
American Petroleum Institute (API) gravity, specific gravity, and sulphur
content; Brent crude oil, light sweet crude oil, and crude oil are different
underlyings. Similarly, there is a difference between Black Sea Wheat, Soft
Red Winter Wheat No. 1 and No.2, and KC Hard Red Winter Wheat No. 1
and No. 2.
3.2. Size and Price
The contract must also specify size and price. The size is the amount of the
underlying to be exchanged. The price is what the underlying will be
purchased or sold for under the terms of the contract. The price specified in
the contract may be called the exercise price or the strike price. Note
that the price specified in the contract is not the current or spot price for the
underlying but a price that is good for future delivery.
3.3. Expiration Date
All derivatives have a finite life; each contract specifies a date on which the
contract ends, called the expiration date.
3.4. Settlement
Settlement describes how a contract is satisfied at expiration. Some contracts
require settlement by physical delivery of the underlying and other contracts
allow for or even require cash settlement. If physical delivery to settle is
possible, the contract will specify delivery location(s). Contracts with
underlying outcomes, such as heating or cooling days, cannot be settled
through physical delivery and must be settled in cash. In practice, most
derivatives contracts are settled in cash.
4. FORWARDS AND FUTURES
Forwards and futures involve obligations in the future on the part of both
parties to the contract. Forward and futures contracts are sometimes termed
forward commitments or bilateral contracts because both parties have a
commitment in the future. Bilateral contracts expose each party to the risk
that the other party will not fulfil the contractual agreement.
4.1. Forwards
A forward contract is an agreement between two parties in which one
party agrees to buy from the seller an underlying at a later date for a price
established at the start of the contract. The future date can be in one month, in
one year, in five years, or at any other specified date. Investors primarily use
forward contracts to lock in the price of an underlying and to gain certainty
about future financial outcomes. Example 1 continues the story of the farmer
and describes a forward contract between the farmer and a cereal producer.
EXAMPLE 1. FORWARD CONTRACT BETWEEN FARMER
AND CEREAL PRODUCER
The contract between the farmer and cereal producer for 50,000 bushels
of wheat in mid-September, six months from now, at $8.50 per bushel is
a forward contract. The underlying is wheat, the size is 50,000 bushels,
the exercise price is $8.50 per bushel, the expiration date is midSeptember, and settlement will be with physical delivery. In September,
the farmer will deliver the wheat to the cereal producer and receive
$8.50 per bushel.
By entering into the forward contract, the farmer knows the wheat will
sell and has eliminated uncertainty about how much money will be
received for the wheat. The cereal producer knows that wheat will be
available and has eliminated uncertainty about how much the wheat will
cost.
Forward contracts transact in the over-the-counter market—that is, the
agreement is made directly between two parties, a buyer and a seller—
although a dealer may help arrange the agreement.2 The risk that the other
party to the contract will not fulfil its contractual obligations is called
counterparty risk. To reduce counterparty risk, the parties to a forward
contract evaluate the default risk of the other party before entering into a
contract. If the risk of default is significant, the parties may not agree to a
forward contract. Or one or both parties may require a performance
bond. A performance bond is a guarantee, usually provided by a third party,
such as an insurance company, to ensure payment in case a party fails to fulfil
its contractual obligations (defaults). As an alternative to a performance
bond, collateral may be requested. Collateral refers to pledged assets. That
is, if one party cannot fulfil its contractual obligations, the other party can
keep the collateral as compensation.
No payment on the contract is required by either party prior to delivery. At
expiration, forward contracts usually settle with physical delivery. At
settlement, one party will lose and the other party will gain relative to the
spot price at the expiration date—this price variance also serves to increase
counterparty risk. Example 2 uses the forward contract between the farmer
and the cereal producer to illustrate how one party’s gains on a forward
contract are the other party’s losses.
EXAMPLE 2.
CONTRACT
GAINS AND LOSSES ON A FORWARD
If at expiration of the forward contract, the price in the market for a
bushel of wheat is $8.50 per bushel, neither the farmer nor the cereal
producer would be better off transacting in the spot market, but neither
lost anything.
But if at expiration of the forward contract, the price in the market for a
bushel of wheat is $9.00 per bushel, the farmer loses $0.50 per bushel
relative to the spot price. In other words, the farmer could have sold the
wheat for $9.00 per bushel rather than the $8.50 per bushel agreed on in
the forward contract. The cereal producer gains $0.50 per bushel
relative to the spot price because the producer only pays $8.50 per
bushel rather than the $9.00 spot price.
Similarly, if at expiration of the forward contract the price in the market
for a bushel of wheat is $8.00 per bushel, the farmer gains and the
cereal producer loses $0.50 per bushel relative to the spot price.
Given the possibility of losing money relative to the future spot price,
why do the farmer and cereal producer enter into the forward contract?
Because each is more concerned about eliminating the uncertainty
related to the sale price and purchase price of wheat in six months,
which is valuable in making investment and production decisions. This
certainty is more important to them than winning or losing relative to the
future spot price.
4.2. Futures
What if the farmer could not identify a party that wanted to be on the other
side of the contract? Futures markets may provide the solution. A futures
contract is similar to a forward contract in that it is an agreement that
obligates the seller, at a specified future date, to deliver to the buyer a
specified underlying in exchange for the specified futures price. The buyer of
the contract is obligated to take delivery of the underlying, and the seller of
the contract is obligated to deliver the underlying, although settlement may be
with cash. The main difference is that futures contracts are standardised
contracts that trade on exchanges. The buyers and sellers do not necessarily
know who is on the other side of the contract. Because the contracts are
traded on exchanges, they are liquid and it is possible for a buyer or seller to
close out a position by taking the opposite side. In other words, the buyer of
a contract can sell the same contract and the seller of a contract can buy the
same contract.
The presence of an exchange as an intermediary between buyers and sellers
helps reduce counterparty risk. Counterparty risk cannot be eliminated
completely, however, because there is always a remote chance that the
exchange fails to fulfil its own contractual obligations. To protect itself
against one of the parties defaulting, the exchange typically requires that
parties to the contract deposit funds as collateral. The depositing of funds as
collateral is called posting margin.
The amount deposited on the day that the transaction occurs is called the
initial margin. The initial margin should be sufficient to protect the
exchange against movements in the underlying’s price. The exchange sets the
margin amount depending on the underlying’s price volatility—the greater the
underlying’s price volatility, the higher the margin.
Another way of reducing the counterparty risk for futures contracts is by
marking to market daily. Marking to market means that profits or losses
on futures contracts are settled at the end of every business day, which has
the effect of resetting the contract price and cash flows to buyers and sellers.
At the end of each day, the exchange establishes a settlement price based on
the closing trades and determines the difference between the current
settlement price and the previous day’s settlement price. The buyer’s and
seller’s margin accounts are adjusted to reflect the change in settlement price
and whether it was to their advantage or disadvantage. Marking to market
continues until the contract expires.
If at any time the balance in an account falls below a pre-specified amount,
the exchange will ask the customer to submit additional funds. If the customer
does not do so, the futures position is closed. Daily marking to market
reduces counterparty risk and administrative overhead for the exchange. The
result is enhanced trading, increased liquidity, and reduced transaction costs
on futures contracts.
Standardised terms of futures contracts include the underlying; size, price,
and expiration date of the contract; and settlement. A number of different
standardised contracts may trade for an underlying on an exchange, but
standardisation of futures contracts reduces the number of contract types
available for the same underlying. Typically, each of the contracts is the same
with respect not only to the underlying but also to size and settlement.
Exercise price and expiration date may vary among contracts.
Specifying the underlying in a futures contract includes defining the quality of
the asset so that the buyer and seller have little room for confusion regarding
pricing and physical delivery. Certain deviations from the default quality
standards are permitted with adjustments in price. In addition, the contract
specifies the delivery locations and the period within which delivery must be
made. The size of a futures contract is set by the exchange to ensure a
tradable quantity of adequate value.
The other terms may vary across the different contracts. Futures typically
expire every quarter, usually on the third Wednesday of March, June,
September, and December. In addition, many end-of-month futures are
available. Standardised contracts may exist that only differ on the specified
price. A contract’s net initial value to each party should be zero; cash may be
paid by one of the parties to enter into the contract depending on how the
exercise price compares with the current settlement price.
Example 3 describes futures contracts on wheat along with actions of and
cash flows for the farmer and cereal producer. The cash flows include those
in the marking-to-market process. For simplicity, the price of wheat changes
only twice over the life of the contract and at expiration. In reality, the price
is likely to change daily, with resulting changes to the accounts of the farmer
and cereal producer.
EXAMPLE 3.
FUTURES CONTRACTS ON WHEAT
Futures contracts trade on a number of exchanges globally, including the
Chicago Mercantile Exchange. The standard terms of a futures contract
on wheat on the Chicago Mercantile Exchange include the following:
Underlying: #2 Soft Red Winter at contract price, #1 Soft Red
Winter at a 3 cent premium, other deliverable grades listed in Rule
14104.
Size: 5,000 bushels (approximately 136 metric tons)
Settlement: cash settlement
Pricing unit: cents per unit
Expiration: March (H), May (K), July (N), September (U), and
December (Z)
The farmer and the cereal producer find contracts that expire in
September with exercise prices ranging from 550.0 cents to 1100.00
cents. The farmer decides to sell 10 contracts with an exercise price of
850.0 cents. This means the farmer has a contract for the delivery of
50,000 bushels of wheat or their cash settlement equivalent. The cereal
producer decides to buy 10 contracts with an exercise price of 850.0
cents.
The farmer and the cereal producer do not transact directly with each
other, but through an exchange. The current spot price of wheat is 900.0
cents per bushel. Because a contract’s net initial value to each party
should be zero, the farmer has to give the exchange 50.0 cents per
bushel and the exchange puts 50.0 cents into the cereal producer’s
account. The effective receipt to the farmer and cost to the cereal
producer is 850.0 cents per bushel if the contract expires today. In
addition, each is required to deposit an additional amount as collateral
with the exchange to protect the exchange, which takes on the
counterparty risk to the contract.
The price of wheat remains unchanged for two months and then changes
to 875.0 cents per bushel, a decrease of 25.0 cents from the initial spot
price of 900.0 cents. The farmer’s account is increased by 25.0 cents
per bushel and the cereal producer’s account is reduced by 25.0 cents
per bushel. After another two months, the price per bushel increases to
925.0 cents per bushel, an increase of 50.0 cents from the previous spot
price of 875.0 cents. So, the farmer’s account is reduced by 50.0 cents
per bushel and the cereal producer’s account is increased by 50.0 cents
per bushel.
At expiration, the price per bushel is 910.0 cents per bushel, a decrease
in price of 15.0 cents from the previous spot price of 925.0 cents. The
farmer’s account is increased by 15.0 cents per bushel and the cereal
producer’s account is reduced by 15.0 cents per bushel. The farmer has
settled over time by paying in net 60 cents (= –50.0 + 25.0 – 50.0 +
15.0). The cereal producer has received over time net 60 cents. Each
will receive back the additional amount deposited to protect the
exchange.
The farmer and the cereal producer are each in the same position as they
would have been under the forward contract. The farmer can sell the
wheat in the spot market for 910.0 cents per bushel and paid 60 cents
per bushel to settle the futures contract. The farmer has a net receipt of
850.0 cents per bushel. Similarly, the cereal producer can buy the wheat
in the spot market for 910.0 cents per bushel and received 60 cents per
bushel to settle the futures contract. So, the cereal producer has a net
cost of 850.0 cents per bushel.
4.3. Distinctions between Forwards and
Futures
Forwards and futures differ in how they trade, the flexibility of key terms in
the contract, liquidity, counterparty risk, transaction costs, timing of cash
flows, and settlement.
Trading and Flexibility of Terms.
Forward contracts transact in the over-the-counter market and terms are
customised according to the contracting parties’ needs. Futures contracts
trade on exchanges. Each exchange typically sets the terms of the contracts
that trade on it. Futures contracts are standardised regardless of buyers’ and
sellers’ specific needs. As a result, the expiration date or contract size may
not match that desired by the buyer or seller of the futures contract.
For hedgers that are trying to reduce or eliminate risk, standardisation makes
it difficult to precisely hedge a position. For non-hedging investors who are
entering into contracts expecting compensation for taking the opposite side of
a hedge or who are taking a position based on expectations about future
performance of an underlying, standardisation of the contracts is not
problematic.
Liquidity.
Forward contracts trade in the over-the-counter market and are illiquid.
Futures contracts are relatively liquid; they trade on exchanges and can be
bought and sold at times other than initiation. An investor can close out
(cancel) a position using futures contracts relatively easily.
Counterparty Risk.
Counterparty risk is potentially very high in forward contracts. That is, the
risk that one party may be unwilling or unable to fulfil its contractual
obligations. Futures contracts have lower counterparty risk. The presence of
an exchange or a clearing house as the intermediary for all buyers and all
sellers helps reduce counterparty risk. Counterparty risk cannot be
eliminated completely, however, because there is always a remote chance
that the exchange fails to fulfil its own contractual obligations.
Transaction Costs.
There can be significant costs to arrange a forward contract. Transaction
costs usually are embedded in forward contracts and are not easily visible to
the customer. Futures contracts, however, are traded on exchanges through
brokerage firms or brokers (agents authorised to trade directly with the
exchange), and the transaction costs are visible. So, there is more
transparency in the futures markets. A broker typically earns the difference
between the bid and ask prices as a commission to arrange the trade.3
Because futures contracts are standardised, transaction costs are relatively
low.
Timing of Cash Flows.
Forward contracts have no cash flows except at maturity. Futures contracts
are marked to market daily. It is important to note that if forward and futures
contracts with identical terms are held to maturity, the final outcome is the
same. For a forward contract, the entire effect of changing prices is taken into
account at maturity, whereas for a futures contract, the effect of changing
prices is taken into account on an ongoing basis.
Settlement.
Forward contracts may settle with physical delivery or cash settlement.
Futures contracts are typically settled with cash.
Exhibit 1 provides a comparison of forward and futures contracts.
Exhibit 1.
Comparison of Forward and Futures Contracts
Similarities
Both types of
contracts exist on
a wide range of
underlyings,
including shares,
bonds,
agricultural
products, and
precious and
industrial metals,
among others.
For both types of
contracts, both the
buyer and seller
have obligations.
Both types of
contracts allow
locking in a price
today for a
transaction that
will occur in the
future.
Differences
Forwards are customised
contracts that trade in private
over-the-counter markets,
whereas futures are standardised
contracts that trade on exchanges.
Counterparty risk is high with
forward contracts, but limited
with futures contracts.
Requirements imposed by
exchanges, such as initial and
maintenance margins and daily
marking to market, reduce the
counterparty risk associated with
futures contracts.
It is easier to exit a position prior
to the settlement date with a
futures contract than with a
forward contract. A position in a
futures contract can be settled
(closed) by taking an opposite
position in the same contract.
5. OPTION CONTRACTS
What if the farmer does not want to lock in the price because the farmer
thinks the price of wheat is going to increase? But the farmer does want to
make sure that at least a certain amount is received for the wheat. Similarly,
the cereal producer thinks that the price of wheat is going to decrease, but
wants to make sure that no more than a certain amount is paid. Option
markets may provide the solution for both parties.
Options give one party (the buyer) to the contract the right to demand an
action from the other party (the seller) in the future. In an option contract,
the buyer of the option has the right, but not the obligation, to buy or sell the
underlying. Options are termed unilateral contracts because only one party to
the contract (the seller) has a future commitment that, if broken, represents a
breach of contract. Unilateral contracts expose only the buyer to the risk that
the seller will not fulfil the contractual agreement.
The buyer of the contract will exercise the right or option if conditions are
favourable or if specified conditions are met. For this reason, options are
also known as contingent claims—that is, claims are dependant on future
conditions. If the buyer decides to use (exercise) the option, the seller is
obligated to satisfy the option buyer’s claim. If the buyer decides not to
exercise the option, it expires without any action by the seller.
Options may trade in the over-the-counter market, but they trade
predominantly on exchanges. In this chapter, we focus on options traded on
exchanges. Options in the over-the-counter market are similar, except that
they are customisable.
An option contract specifies the underlying, the size, the price to trade the
underlying in the future (called the exercise price or strike price), and
the expiration date. Option contracts typically expire in March, June,
September, or December, but options are available for other months as well.
A buyer chooses whether to exercise an option based on the underlying’s
price compared with the exercise price. A buyer will exercise the option
only when doing so is advantageous compared with trading in the market,
which puts the seller at a disadvantage. Because of the unilateral future
obligation (only the seller has an obligation), options have positive value for
the buyer at the inception of the contract. The option buyer pays this value, or
option premium, to the option seller at the time of the initial contract. The
premium paid by the option buyer compensates the option seller for the risk
taken; the option seller is the only party with a future obligation. The
maximum benefit to the option seller is the premium. The option seller hopes
the option will not be exercised.
5.1. Call Options and Put Options
There are two basic types of options: options to buy the underlying, known as
call options, and options to sell the underlying, known as put options.
An investor who buys a call option has the right (but not the
obligation) to buy or call the underlying from the option seller at the
exercise price until the option expires.
An investor who buys a put option has the right (but not the
obligation) to sell or put the underlying to the option seller at the
exercise price until expiration.
The cereal producer may buy a call option to secure the right, but not the
obligation, to buy wheat at the exercise price. The farmer may buy a put
option to secure the right, but not the obligation, to sell wheat at the exercise
price. Note that the cereal producer and farmer enter into totally different
option contracts to manage their risks.
Example 4 describes how a call option works in practice.
EXAMPLE 4.
ILLUSTRATION OF A CALL OPTION
Consider a call option in which the underlying is 1,000 shares of
hypothetical Company A trading on the London Stock Exchange (LSE).4
The call option’s exercise price is £6.00 per share, which means that
the call option buyer can buy 1,000 shares of Company A at £6.00 per
share until expiration, regardless of Company A’s share price in the
market. Note that the buyer will exercise this option only if Company
A’s price on the LSE is more than £6.00 per share. If Company A’s
share price at expiration is £7.00 per share, the buyer exercises the
option, pays £6,000, and receives 1,000 shares of Company A. The call
option buyer can then sell those shares in the market for a profit of
£1,000 (ignoring transaction costs, such as the premium paid for the call
option and trading costs). The seller of the call option is obligated to
sell the shares at £6.00 per share to the call option buyer, even though
the market price is £7.00 per share, incurring a loss of £1,000 (ignoring
the premium received for the call option).
If Company A’s share price is less than £6.00 per share, the call option
buyer has no incentive to exercise the option; it would not make sense to
voluntarily pay more than the market price. In this case, the buyer will
let the option expire. Because an option buyer is not forced to exercise
an option, an option’s value cannot be negative.
Example 4 illustrates that, ignoring the premium paid, an option buyer’s
payoff is never negative. Option buyers pay premiums to option sellers to
compensate option sellers for their risk. But if an option seller
underestimates the risk associated with the option, the premiums paid may be
far less than the losses they incur on exercise.
Call options protect the buyer by establishing a maximum price the option
buyer will have to pay to buy the underlying; the maximum price is the
exercise price.
A call option is said to be “in the money” if the market price is greater
than the exercise price. In this case, the option would be exercised.
A call option is “out of the money” if the market price is less than the
exercise price. In this case, the option would not be exercised.
A call option is “at the money” if the market price and exercise price
are the same. In this case, the option may be exercised.
Put options protect the buyer by establishing a minimum price the option
buyer will receive when selling the underlying; the minimum price is the
exercise price.
A put option is said to be “in the money” if the market price is less than
the exercise price. In this case, the option would be exercised.
A put option is “out of the money” if the market price is greater than the
exercise price. In this case, the option would not be exercised.
A put option is “at the money” if the market price and exercise price are
the same. In this case, the option may be exercised.
An option’s in- or out-of-the-money designation, also known as
“moneyness”, reflects whether it would be profitable for the buyer to
exercise the option at the current time.
5.2. Factors that Affect Option Premiums
Option premiums are expected to compensate option sellers for their risk.
The option premium represents the maximum profit that the option seller can
make. If an option seller underestimates the risk associated with the option,
the premiums may be far less than the losses incurred if the option is
exercised.
The lower the exercise price for a call option relative to the current spot
price, the higher the premium because the likelihood that it will be exercised
is greater. The higher the exercise price for a put option relative to the
current spot price, the higher the premium because the likelihood that it will
be exercised is greater.
The longer the time to expiration of an option, the higher the option premium
because the likelihood is greater that the underlying will change in favour of
the option buyer and that it will be exercised. Similarly, the greater the
volatility of the underlying, the higher the option premium because the
likelihood is greater that the underlying will change in favour of the option
buyer and that it will be exercised.
In summary, an option’s premium depends on the current spot price of the
underlying, exercise price, time to expiration, and volatility of the
underlying. Exhibit 2 shows the effects on an option’s premium for a call
option and a put option of an increase in each factor.
Exhibit 2. Effects on Premiums for a Call Option and a Put
Option of an Increase in a Factor
Factor Increasing
Call Option
Premium
Put Option
Premium
Underlying’s price
Exercise price
Time to expiration
Underlying’s
volatility
Increases
Decreases
Increases
Increases
Decreases
Increases
Increases
Increases
6. SWAP CONTRACTS
Swaps are typically derivatives in which two parties exchange (swap) cash
flows or other financial instruments over multiple periods (months or years)
for mutual benefit, usually to manage risk.
Swaps of this type involve obligations in the future on the part of both parties
to the contract. These swaps, like forwards and futures, are forward
commitments or bilateral contracts because both parties have a commitment
in the future. Similar to forwards and futures, a contract’s net initial value to
each party should be zero and as one side of the swap contract gains the other
side loses by the same amount.
Swaps in which two parties exchange cash flows include interest rate and
currency swaps. An interest rate swap, the most common type, allows
companies to swap their interest rate obligations (usually a fixed rate for a
floating rate) to manage interest rate risk, to better match their streams of
cash inflows and outflows, or to lower their borrowing costs. A currency
swap enables borrowers to exchange debt service obligations denominated
in one currency for equivalent debt service obligations denominated in
another currency. By swapping future cash flow obligations, the two parties
can manage currency risk.
As an example of a currency swap, Company C, a US firm, wants to do
business in Europe. At the same time, Company D, a European firm, wants to
do business in the United States. The US firm needs euros and the European
firm needs dollars, so the companies enter into a five-year currency swap for
$50 million. Assume that the exchange rate is $1.25 per euro. On this basis,
Company C pays Company D $50 million, and Company D pays €40 million
to Company C. Now each company has funds denominated in the other
currency (which is the reason for the swap). The two companies then
exchange monthly, quarterly, or annual interest payments. Finally, at the end
of the five-year swap, the parties re-exchange the original principal amounts
and the contract ends.
Credit default swaps (CDS) are not truly swaps. Like options, credit
default swaps are contingent claims and unilateral contracts. One party buys
a CDS to protect itself against a loss of value in a debt security or index of
debt securities; the loss of value is primarily the result of a change in credit
risk. The seller is providing protection to the buyer against declines in value
of the underlying. The seller does this in exchange for a premium payment
from the buyer; the premium compensates the seller for the risk of the
contract. The contract will specify under what conditions the seller has to
make payment to the buyer of the CDS. Similar to sellers of options, sellers
of CDS may misjudge the risk associated with the contracts and incur losses
far in excess of payments received to enter into the contracts.
The use of swaps has grown because they allow investors to manage many
kinds of risks, including interest rate risk, currency risk, and credit default
risk. In addition, investors can use swaps to reduce borrowing and
transaction costs, overcome currency exchange barriers, and manage
exposure to underlying assets.
SUMMARY
Derivatives have grown remarkably since their introduction because they
help to provide innovative investment products and to manage risk at a
considerably lower cost. For example, by using options, investors can gain
exposure to stock or bond markets with a fraction of the capital needed to
invest directly in stocks or bonds. Also, the transaction costs of trading
derivatives are considerably smaller compared with direct investments.
Derivatives thus can effectively substitute for direct investments in
underlying assets.
Derivatives also provide ways to manage future risk. For example, an airline
company cannot hedge the risk of volatile jet fuel prices in a cost-effective
manner except through derivatives. Theoretically, it is possible to buy and
store millions of gallons of jet fuel for next year’s operations. But the capital
investment and storage costs required for such an undertaking would be
formidable. In addition to hedging the risk of movements in raw material
prices, derivatives can be used to hedge other kinds of risk, including
currency risk, product price risk, and economic risk.
Finally, exchange-traded derivatives improve financial market efficiency.
They help market prices become better indicators of value, which improves
resource allocation, an important benefit provided by the financial services
industry and discussed in The Investment Industry: A Top-Down View
chapter. For example, if a particular share is undervalued in the stock market
relative to the futures market, an investor can buy it in the stock market and
sell the related futures contract. Futures and spot market prices will adjust
and become better indicators of value.
The following points recap what you have learned in this chapter about
derivatives:
Derivatives are contracts (agreements to do something in the future) that
derive their value from the performance of an underlying asset, event, or
outcome.
Derivatives are used to manage risks of various types, to earn
compensation for taking the opposite side of a hedge, and to potentially
benefit an investor based on expectations about the future performance
of an underlying.
There are four main types of derivatives contracts: forwards, futures,
options, and swaps.
Derivatives are characterised by certain common features, including the
(1) underlying, (2) maturity, (3) size and price, and (4) settlement.
Forwards, futures, and most swaps involve obligations in the future on
the part of both parties to the contract. These contracts are sometimes
termed forward commitments or bilateral contracts because both parties
have a commitment in the future.
Options and credit default swaps are unilateral contracts and provide
contingent claims. They give one party to the contract the right to extract
an action from the other party under specified conditions.
Forwards and futures are similar; both represent an agreement to buy or
sell a specified underlying at a specified date in the future for a
specified price.
Forwards are customised and trade in the over-the-counter market,
whereas futures are standardised and trade on exchanges. Futures are
more liquid and have less counterparty risk.
Options give the option buyer the right, but not the obligation, to buy (in
the case of a call option) or sell (in the case of a put option) a specified
amount of the underlying at a prespecified price (exercise price) until
the option expires.
A call option ensures that the option buyer will pay, ignoring transaction
costs, no more than the exercise price. A put option ensures that the
option buyer will receive, ignoring transaction costs, no less than the
exercise price.
The option seller is paid a premium for providing the option. The
premium is the maximum benefit to the option seller. An option’s
premium depends on spot and exercise prices for the underlying, the
time to expiration, and volatility of the underlying. The effect of an
increase in each on an option premium is shown in the following table.
Factor Increasing
Call Option
Premium
Put Option
Premium
Underlying’s price
Exercise price
Time to expiration
Underlying’s
volatility
Increases
Decreases
Increases
Increases
Decreases
Increases
Increases
Increases
Swaps are typically derivatives in which two parties exchange (swap)
cash flows or other financial instruments over multiple periods (months
or years) for mutual benefit, usually to manage risk.
Interest rate swaps, the most common type, allow companies to swap
their interest rate obligations to manage interest rate risk, to better match
their streams of cash inflows and outflows, or to lower their borrowing
costs.
A currency swap enables borrowers to exchange debt service
obligations denominated in one currency for equivalent debt service
obligations denominated in another currency. By swapping future cash
flow obligations, the two parties can manage currency risk.
A credit default swap (CDS) is a contingent claim and unilateral
contract. One party buys a CDS to protect itself against the loss of value
in a debt security or index of debt securities. The contract will specify
under what conditions the other party has to make payment to the buyer
of the credit default swap.
CHAPTER REVIEW QUESTIONS
© 2014 CFA Institute. All rights reserved.
1. The value of a derivatives contract is most likely to be directly affected
by the:
A. price of the underlying.
B. supply of the underlying.
C. demand for the underlying.
2. Counterparty risk is most likely lowest for:
A. swap contracts.
B. futures contracts.
C. forward contracts.
3. A farmer will harvest his corn crop in six months but wants to lock in a
price today. The farmer will most likely:
A. buy a corn futures contract.
B. sell a corn futures contract.
C. buy a corn forward contract.
4. Forward contracts and futures contracts, with otherwise identical terms,
are similar with respect to:
A. counterparty risk.
B. payoffs at maturity.
C. customisation of contracts.
5. Relative to a futures contract, an advantage of a forward contract is:
A. greater liquidity.
B. lower counterparty risk.
C. the ability to customise the contract.
6. Which of the following parties to an option contract on a company’s
shares has the right to buy shares at the exercise price?
A. Put seller
B. Call seller
C. Call buyer
7. Which of the following parties to an option contract on a company’s
shares is obligated to buy shares at the option strike price if the option
is exercised?
A. Put seller
B. Put buyer
C. Call seller
8. Which of the following options would be described as being in the
money?
A. A put option in which the underlying’s price is lower than the
exercise price.
B. A call option in which the underlying’s price is lower than the
exercise price.
C. A put option in which the underlying’s price is higher than the
exercise price.
9. A call option contract on shares of Company A has an exercise price of
€50. The option is in the money when the share price of Company A is:
A. €45.
B. €50.
C. €55.
10. A put option on shares of Company B has an exercise price of £40. The
option is out of the money when the share price of Company B is:
A. £35.
B. £40.
C. £45.
11. Swap contracts:
A. are mostly traded on exchanges.
B. have an initial net value of zero.
C. are not susceptible to counterparty risk.
ANSWERS
1. A is correct. Derivatives are contracts that derive their value from the
performance, such as price, of an underlying. B and C are incorrect
because although the supply of and demand for the underlying will affect
the price of the underlying, they will indirectly rather than directly affect
the value of the derivatives.
2. B is correct. Futures contracts are exchange traded. Margin
requirements and daily marking to market reduce counterparty risk for
investors in futures contracts. A and C are incorrect because forward
contracts and swap contracts are traded in private, over-the-counter
markets. Consequently, counterparty risk is higher in forward contracts
and swap contracts than in futures contracts.
3. B is correct. The seller of a forward or futures contract is obligated to
make delivery of the underlying. By selling a corn futures contract, the
farmer is agreeing to sell corn in six months at the contract price locked
in today. A and C are incorrect because buying (taking a long position
in) a corn futures contract or a corn forward contract, respectively,
would require the farmer to buy, not sell, corn in the future, which is not
the farmer’s objective.
4. B is correct. If a forward contract and a futures contract with identical
terms are held to maturity, the final outcome is the same. For a forward
contract, the entire effect of changing prices is taken into account at
maturity, whereas for a futures contract, the effect of changing prices is
taken into account on an ongoing basis. A is incorrect because
counterparty risk is much higher for investors in forward contracts. C is
incorrect because forward contracts are customised contracts, whereas
futures contracts are standardised contracts.
5. C is correct. An advantage of forward contracts is the ability of the
investor to create customised contracts that meet his or her needs.
Futures contracts are standardised contracts with contract terms
established by the exchange and are not customisable. A is incorrect
because futures contracts have greater liquidity. It is easier to exit a
position prior to the settlement date with futures than with forwards. B
is incorrect because futures contracts have lower counterparty risk.
6. C is correct. The buyer of a call option has the right to buy shares at the
exercise price. A is incorrect because the seller of a put option has an
obligation to buy shares at the exercise price. B is incorrect because
the seller of a call option has an obligation to sell shares at the exercise
price if the call buyer exercises the option.
7. A is correct. The seller of a put option has an obligation to buy shares
at the strike or exercise price if the put buyer exercises the option. B is
incorrect because a put buyer has the right to sell shares at the exercise
price. C is incorrect because a call seller has an obligation to sell
shares at the exercise price if the call buyer exercises the option.
8. A is correct. A put option is in the money when the underlying’s price is
lower than the exercise price. The put buyer has the right to sell the
underlying at the exercise price, which is higher than the current market
price of the underlying. B is incorrect because a call option in which the
underlying’s price is lower than the exercise price is out of the money.
C is incorrect because a put option in which the underlying’s price is
higher than the exercise price is out of the money.
9. C is correct. A call option is in the money when the underlying’s price
exceeds the exercise price. A is incorrect because the call option is out
of the money when the underlying’s price is less than the exercise price.
B is incorrect because the call option is at the money when the
underlying’s price equals the exercise price.
10. C is correct. A put option contract is out of the money when the
underlying’s price is higher than the exercise price. A is incorrect
because the put option contract is in the money when the underlying’s
price is less than the exercise price. B is incorrect because the put
option contract is at the money when the underlying’s price equals the
exercise price.
11. B is correct. The initial net value of a swap contract is zero. Over time,
the swap changes in value as the underlying changes in value. One side
of the swap contract loses while the other side gains. A and C are
incorrect because swap contracts mostly trade in private, over-the-
counter (OTC) markets and not on exchanges; consequently, the parties
to swap contracts are susceptible to counterparty risk.
NOTES
1Information from “Centrally Cleared Derivatives: Clear and Present Danger”, Economist (4 April
2012).
2Over-the-counter markets are also called quote-driven markets and dealer markets. They are called
over-the-counter markets because in the past, securities literally traded over a counter in a dealer’s
office. Traders call them quote-driven and dealer markets because customers trade at the prices quoted
by dealers. More information about dealer markets, quote-driven markets, and dealers is provided in The
Functioning of Financial Markets chapter.
3Recall from the Economics of International Trade chapter that the bid price is the price at which a
dealer is prepared to buy, and the ask (or offer) price is the price at which a dealer is prepared to sell.
4The number of shares associated with an option varies with the exchange.
Chapter 12
Alternative Investments
by Sean W. Gill, CFA
© 2014 CFA Institute. All rights reserved.
LEARNING OUTCOMES
After completing this chapter, you should be able to do the following:
a. Describe advantages and limitations of alternative investments;
b. Describe private equity investments;
c. Describe real estate investments;
d. Describe commodity investments.
1. INTRODUCTION
If a public company needs funds to invest in a project, perhaps to build a new
production facility or to expand its operations abroad, it may turn to the
financial markets and issue the types of debt and equity securities discussed
in the Debt Securities and Equity Securities chapters. But what if an
entrepreneur needs money to start a promising new business? Or what if a
young company needs funds to grow, but it is not established well enough to
seek an initial public offering? The entrepreneur and the young company are
not established well enough to issue debt or equity securities to the public. In
addition, although they may seek loans from banks, the amount of money they
can borrow is often limited. Banks often do not finance new and young
companies because the risk of not getting the money back is too high. So,
entrepreneurs or young companies may turn to the venture capital sector to
obtain the money they need. Venture capitalists specialise in financing new
and young companies. They provide entrepreneurs and young companies with
both the capital and the expertise to launch and grow their businesses.
Venture capital is a form of private equity, which is itself a type of
alternative investment. From an investor’s point of view, alternative
investments are diverse and typically include the following:
Private equity: investments in private companies—that is, companies
that are not listed on a stock exchange
Real estate: direct or indirect investments in land and buildings
Commodities: investments in physical products, such as precious and
base metals (e.g., gold, copper), energy products (e.g., oil), and
agricultural products that are typically consumed (e.g., corn, cattle,
wheat) or used in the manufacture of goods (e.g., lumber, cotton, sugar)
Private equity, real estate, and commodities are all considered alternative
because they represent an alternative to investing exclusively in “traditional”
asset classes, such as debt and equity securities. Although alternative
investments have gained prominence in the 21st century, they are not new; in
fact, real estate and commodities are among the oldest types of investments.
As will be discussed in the next section, alternative investments are an
opportunity to potentially enhance returns and obtain diversification benefits
—recall from the Quantitative Concepts chapter that diversification is the
practice of combining different types of assets or securities in a portfolio to
reduce risk. The search for higher returns and lower risk explains why
alternative investments are now an integral part of the portfolios of many
investors who view private equity, real estate, and/or commodities as
opportunities to deliver both.
2. WHY INVEST IN ALTERNATIVES?
The different types of alternative investments often look completely unrelated
to each other. But they have potential common advantages: they may help
enhance returns and reduce risk by providing diversification benefits. They
also share similar limitations: typically, they are less regulated, transparent,
liquid, and easier to value than debt and equity investments. Advantages and
disadvantages of alternative investments are discussed further in Sections 2.1
and 2.2.
Exhibit 1 shows the results of a global survey of institutional investors
regarding their holdings of different assets. As of March 2012, almost 100%
of respondents invest in equity and debt. But 94% of them also hold some
type of alternative investments. On average, 22.4% of the respondents’
portfolios are invested in alternative investments, with the most popular
types being private equity and private real estate.
Exhibit 1.
Global Survey of Institutional Investors’ Holdings
Source: Based on data from Russell Research, “Russell Investment’s 2012 Global Survey
on Alternative Investing”, (19 June 2012):
http://www.russell.com/Public/pdfs/publication/communique_october_2012/global
_survey_on_alternative_investing.pdf.
2.1. Advantages of Alternative Investments
Investors add alternative investments to their portfolios for two main
reasons:
to enhance returns and
to reduce risk by obtaining diversification benefits.
Enhancing Returns.
Exhibit 2 shows historical returns for various asset classes between 1990
and 2009. It indicates that over the 20-year period, investments in private
equity and real estate have outperformed investments in equity and debt
securities. However, you should not conclude from this exhibit that
alternative investments always offer higher returns than other asset classes.
During the global financial crisis that started in 2008, many investors
suffered losses on their private equity and real estate investments and some
of these losses were worse than those on traditional investments, such as
publicly traded equity.
Exhibit 2. Historical Returns for Various Asset Classes
between 1990 and 2009
Source: T. Duhon, G. Spentzos, and S. Stewart, “Introduction to Alternative Investments”,
in CFA Program, Level 1, Volume 6 (CFA Institute, 2012):177.
Reducing Risk.
Investors rarely allocate all their money to one type of asset or security.
Instead, they diversify their portfolios by investing in assets and securities
that behave differently from each other. How investments behave relative to
each other takes us back to the concept of correlation discussed in the
Quantitative Concepts chapter. If two assets or securities do not have a
correlation of +1 (that is, if they are less than perfectly positively
correlated), then combining these two assets or securities in a portfolio
provides diversification benefits and thus reduces the risk in the portfolio. In
other words, the risk to the portfolio of including these two assets or
securities is lower than the weighted sum of the risks of the two assets or
securities. Because there is a relatively low correlation between different
types of alternative investments and also between alternative investments and
other asset classes, adding private equity, real estate, and commodities to
portfolios helps investors reduce risk. As noted in the Quantitative Concepts
chapter, during periods of financial crisis, returns on different investments
may become more correlated and the benefits of diversification may be
reduced.
2.2. Limitations of Alternative Investments
Although alternative investments have the potential to enhance returns and
reduce risk, they also have limitations. Typically, alternative investments are
less regulated and less transparent than traditional investments,
illiquid, and
difficult to value.
Because alternative investments are less regulated and less transparent than
traditional investments, such as equity and debt securities, individual
investors are less likely to invest in them. Institutional investors may view
this as an opportunity to take advantage of market inefficiencies. This is
discussed further in the Investment Management chapter.
In addition, most alternative investments are illiquid—that is, they are
difficult to sell quickly without accepting a lower price. For example, it is
much easier to sell shares of a public company listed on a stock exchange
than shares in a private company, a piece of land, or a building. Some
institutional investors, depending on their cash flow needs, may be willing
and able to hold investments for long periods, so liquidity may be less
important for them than for individuals or institutional investors that have
liquidity constraints.
Alternative investments are also difficult to value because data availability
to assess how much they are worth is limited. Purchases and sales of start-up
companies, land, or buildings are infrequent, so valuation is challenging and
is often based on an appraisal. An appraisal is an assessment or estimation
of the value of an asset and is subject to certain assumptions, which may not
always be realistic. For example, a property may be estimated to be worth
£100,000 based on its location, its square footage, and the price per square
foot paid in similar transactions. But if the property market slows down, the
assumption about the price per square foot may prove overly optimistic and
the value of the property could be worth less than estimated.
3. PRIVATE EQUITY
Let us revisit the example of the Canadian entrepreneur we first encountered
in The Investment Industry: A Top-Down View chapter. When the
entrepreneur set up her new business, she turned to her friends and
neighbours for the money she needed. Five years later, her company was
successful. To raise the additional capital the company required to support
its growth plans, it could issue shares to the public via an initial public
offering (IPO). But in between, the company probably needed more money to
grow than the entrepreneur, her friends, neighbours, and banks were able or
willing to provide, and it was not yet ready to go public. Who could have
potentially financed such a young and not well-established company? As
mentioned in the introduction, the answer is venture capitalists. The
entrepreneur could have sold some of her company’s shares to a private
equity firm to get the additional capital necessary to grow her business.
Private equity firms invest in private companies that are not publicly
traded on a stock exchange. Although people commonly refer to private
“equity”, investments include both equity and debt securities. Debt
investments, however, are less common than equity investments.
3.1. Private Equity Strategies
Private equity encompasses several strategies that may help provide money
to companies at different stages of their development. The most widely used
strategies are venture capital, growth equity, buyouts, and distressed. Another
private equity investment strategy, which is unrelated to the stage of a
company’s development, is called secondaries.
3.1.1. Venture Capital
As mentioned in the example provided in the introduction, venture capital
is a private equity investment strategy that consists of financing the early
stage of companies that have an innovative business idea. Venture capitalists
frequently invest in “start-up” companies that exist merely as an idea or a
business plan. The company may have only a few employees, have little or
no revenue, and still be developing its product or business model.
Entrepreneurs are often looking not only for capital to start their business but
also for advice and expertise about how to establish and run their company.
Venture capital is considered the riskiest type of private equity investment
strategy because many more companies fail than succeed. It can take many
years before a company becomes successful, and most venture capital–
funded companies have years of unprofitable activity before they reach the
point of making money. So, venture capital investing requires patience.
However, those companies that do succeed tend to greatly reward their
investors.
3.1.2. Growth Equity
Growth equity is a private equity investment strategy that usually focuses
on financing companies with proven business models, good customer bases,
and positive cash flows or profits. These companies often have opportunities
to grow by adding new production facilities or by making acquisitions, but
they do not generate sufficient cash flows from their operations to support
their growth plans. By providing additional money in return for equity of the
company, growth equity investors help these companies expand and become
more established.
Some growth equity investors specialise in helping companies prepare for an
initial public offering. These investors provide additional money at a later
stage of a company’s development than venture capitalists or early-stage
growth equity investors. As discussed in the Equity Securities chapter,
additional equity dilutes existing shareholders’ ownership because there are
more investors sharing the company’s cash flows. However, because the
later-stage growth equity investors typically have expertise in organising
initial public offerings, they may bring benefits that outweigh the
disadvantages of dilution. An initial public offering, such as those of
Microsoft, Google, and Facebook, is an opportunity for founders and existing
shareholders to convert some or all of their investment in the company into
cash. So, the late addition of equity investors that have successful track
records in organising initial public offerings may be valuable for founders
and existing shareholders.
3.1.3. Buyouts
Buyouts are a private equity investment strategy that consists of financing
established companies that require money to restructure and facilitate a
change of ownership. Buyout transactions sometimes involve making a
publicly traded company private. For example, such companies as UK-based
Alliance Boots or US-based Hertz and Hilton Hotels were once public
companies, but they underwent buyouts and are now privately owned
companies.
Buyouts for which the financing of the transaction involves a high proportion
of debt are often called leveraged buyouts (LBOs)—recall from the Debt
Securities chapter that financial leverage refers to the proportion of debt
relative to equity in a company’s capital structure. Because the high level of
debt implies high interest payments and principal repayments, companies that
undergo an LBO must be able to generate strong and sustainable cash flows.
So, they are often well-established companies with good competitive
positioning in their industry. Buyout investors often target companies that
have recently underperformed but that offer opportunities to grow revenues
and margins.
3.1.4. Distressed
When companies encounter financial troubles, they may be at risk of not
being able to make full and timely payments of interest and/or principal. This
risk, which is known as credit or default risk, was discussed in the Debt
Securities chapter. Distressed investing focuses on purchasing the debt of
troubled companies that may have defaulted or are on the brink of defaulting.
Frequently, investments are made at a significant discount to par value—that
is, the amount owed to the lenders at maturity. For example, an investor who
purchases the debt of a troubled company may only offer the existing lenders
20% or 30% of the amount they are owed. If the company can survive and
prosper, the value of its debt will increase and the investor will realise
significant value. Distressed investing does not typically involve a cash flow
to the company.
3.1.5. Secondaries
Another strategy that does not involve a cash flow to the company is
secondaries. Secondaries are not based on a company’s stage of
development. This strategy involves buying or selling existing private equity
investments. As discussed more thoroughly in the next section, private equity
investments are usually organised in funds managed by partnerships. The life
of a private equity fund is typically about 10 years, but it can be longer. It
includes three or four years of investing followed by five to seven years of
developing the investments and returning capital to those who invested in the
private equity fund. Some private equity partnerships may not be able or
willing to hold on to all of their investments, which could be venture capital,
growth equity, buyouts, or distressed. So, a partnership may want to sell one
or several of its investments to another private equity partnership in what is
known as the secondary market. The purchases and sales between private
equity partnerships are secondary transactions.
3.2. Structure and Mechanics of Private
Equity Partnerships
As mentioned in the previous section, private equity investments are usually
organised in funds managed by partnerships. A private equity
partnership usually includes two types of partners:
The general partner is typically a private equity firm that sets up the
partnership. It is responsible for raising capital, finding suitable
investments, and making decisions. General partners have unlimited
personal liability for all the debts of the partnership—that is, general
partners could lose more than their investment in the partnership
because if necessary, their personal assets could be used to pay the
partnership’s debts.
Limited partners are investors who contribute capital to the
partnership. They are not involved in the selection and management of
the investments. Limited partners have limited personal liability—that
is, limited partners cannot lose more than the amount of capital they
contributed to the partnership.
A private equity firm may create different private equity funds for different
types of investments. The investments are usually not managed by the general
partner itself, but by professional fund managers who are hired by the general
partner. Each private equity fund may have its own fund manager who is
responsible for the day-to-day management of the investments in the funds.
The private equity firm makes money through two mechanisms:
management fees, which are the fees that limited partners must pay
general partners to compensate them for managing the private equity
investments. Management fees are typically set as a percentage of the
amount the limited partners have committed rather than the amount that
has been invested. Additionally, limited partners must pay management
fees even if an investment is underperforming and must continue paying
management fees even if an investment has failed.
carried interest, which is a share of the profit on a private equity
investment. It is a form of incentive fee that general partners deduct
before distributing to the limited partners the profit made on
investments. Carried interest is designed to ensure that general partners’
interests are aligned with limited partners’ interests.
Investments in private equity partnerships tend to be illiquid. That is, once
the limited partners have committed capital to the partnership, it is difficult,
if not impossible, for them to exit the investment before the end of the
commitment term.
Example 1 illustrates the structure and mechanics of a private equity
partnership.
EXAMPLE 1. STRUCTURE AND MECHANICS OF A PRIVATE
EQUITY PARTNERSHIP
Assume that a private equity firm has created a $4 million private equity
fund to invest in start-up companies. As discussed in Section 3.1.1, this
private equity investment strategy is called venture capital. The private
equity firm is the general partner and its first task is to raise capital
from investors. Suppose that it identifies four investors who are willing
and able to contribute $1 million each. These investors are the limited
partners—A, B, C, and D in the figure. The limited partners do not
transfer $1 million each to the general private equity firm immediately;
initially, they only agree to invest $1 million each over the commitment
term of the private equity fund’s life, say 10 years.
When the private equity firm has secured the $4 million, it can start
investing. Assume that it finds a suitable investment in Company W for
$400,000. The private equity firm contacts the limited partners and
makes a capital call of $100,000 per limited partner—capital calls
often happen on short notice. Limited partners A, B, C, and D transfer
$100,000 each to the private equity firm, which invests the $400,000 in
Company W. A few months later, the private equity firm identifies
another suitable investment in Company X for $600,000. It makes
another capital call, this time of $150,000 per limited partner. This
process may continue for several years until the private equity firm has
invested the $4 million.
As shown in the figure, the private equity firm makes investments in four
companies. These investments are typically managed by a professional
fund manager who charges the private equity firm fees for his or her
services, usually a combination of a fixed fee plus an incentive fee. In
turn, the private equity firm charges the limited partners management
fees to cover the fund manager fees and other administrative fees. For
example, assume that the annual management fee is 1.5% of the
committed capital. So, each limited partner who committed $1 million
must pay the private equity firm an annual management fee of $15,000
regardless of how much capital the private equity firm has already
invested. Thus, in the early years of the private equity fund’s life, the
limited partners may be paying management fees on amounts that have
not actually been invested.
After several years, assume that the private equity firm sells its
investment in Company W for $1 million. It can now distribute capital
plus profit to the limited partners. Before it does so, it deducts a share
of the profit, which is carried interest. Recall that carried interest is a
form of incentive fee that ensures that the private equity firm and the
fund manager make the best possible decisions on behalf of the limited
partners. Suppose that carried interest is 15%. The profit on the
investment in Company W is $600,000—that is, the difference between
the selling price of $1,000,000 and the initial investment of $400,000.
So the private equity firm and the fund manager can keep $90,000 (15%
of $600,000) in carried interest, which means that the amount of profit
to be split between the limited partners is $510,000 ($600,000 –
$90,000). Thus, each limited partner receives a cash distribution of
$227,500—that is, $100,000 of capital plus $127,500 of profit, which
represents a return on investment of 128% [($227,500 –
$100,000)/$100,000], ignoring management fees.
This return on investment is high, but remember that venture capital is
risky. Assume that Company X encounters financial trouble and that the
private equity firm wants to sell its ownership interest in Company X.
Another private equity firm is willing to buy this ownership interest but
for only $100,000; recall from Section 3.1.5 that such a transaction is
called a secondary transaction. The investment in Company X turns out
to be a loss of $500,000 (the selling price of $100,000 minus the initial
investment of $600,000) so there is no carried interest. Each limited
partner receives a cash distribution of $25,000, which represents a
return on investment of –83% [($25,000 – $150,000)/$150,000],
ignoring management fees. As mentioned earlier, limited partners are
not exempt from paying management fees on their total commitment,
including the $150,000 contribution to Company X, even if the
investment is underperforming or fails.
As illustrated in Example 1, each limited partner’s capital of $1 million is
drawn down gradually over the commitment term of the private equity fund’s
life. In the early years of the fund, the limited partners face negative cash
flows because they receive several capital calls to fund investments and they
must pay management fees on the committed capital. Later on, when
investments pay dividends or are sold, the private equity firm makes cash
distributions to the limited partners. When cash distributions net of carried
interest exceed capital calls and management fees, the limited partners
experience positive cash flows.
A typical pattern of cash flows for a limited partner is illustrated in Exhibit
3. This illustration reflects a hypothetical investment of $1 million in a
private equity fund with a life of 10 years. It is assumed that the private
equity firm makes investments in 10 companies between Year 1 and Year 6,
these investments start paying dividends in Year 4, and they get sold between
Year 6 and Year 10. The blue bars show the sum of the capital calls and
management fees, which are assumed to be 1.5% of the committed capital.
The green bars reflect the cash distributions, ignoring carried interest. The
line is the cumulative net cash flow to the limited partner—that is, the sum of
the cash distributions minus the sum of the capital calls and management fees.
This line is known as a J curve because its shape resembles the letter J.
Exhibit 3.
The J Curve
4. REAL ESTATE
Real estate investments take different forms. For many people, it is the
purchase of their home, which may be a significant portion of their net worth.
Houses, apartments, and other residential properties that are owner occupied
are indeed the foundation of many individuals’ financial plans. However,
although considered part of their financial plan, most residential real estate is
not included in individuals’ investment portfolios.
Generally, residential real estate transactions involve owner-occupiers (that
is, people who live in the home they own), and are made for personal
reasons as opposed to purely investment-related reasons. Individuals or
groups of individuals may invest in residential real estate for investmentrelated purposes, such as renting out holiday homes.
Many investors focus their real estate investments on what is commonly
referred to as commercial real estate—that is, income-generating real
estate. As illustrated in Exhibit 4, the majority of commercial real estate in
terms of value is concentrated in a small number of countries.
Exhibit 4.
Country Share of Commercial Real Estate
Country
United States
Japan
China
Germany
United Kingdom
France
Italy
Brazil
Canada
Spain
Australia
Russia
South Korea
Netherlands
Country Share
25.4%
10.1
7.0
6.1
5.2
4.7
3.7
3.3
2.9
2.6
2.5
2.3
1.8
1.4
Country
Mexico
India
Switzerland
Remaining Countries
Country Share
1.4
1.3
1.1
17.2
Source: Prudential Real Estate Investors, “A Bird’s Eye View of Global Real Estate
Markets: 2012 Update”, (2012): www.prei.prudential.com/view/page/pimcenter/6815.
4.1. Commercial Real Estate Segments
Commercial real estate is made up of many segments, which all have their
own characteristics, advantages, and limitations. The major segments are
land, offices, multifamily residential dwellings, retail and industrial
properties, and hotels. The following sections describe each in turn.
4.1.1. Land
Undeveloped, or raw, land can be highly speculative because there are no
cash inflows from tenants or occupants, only cash outflows in the form of
real estate taxes and other costs of holding the land. As improvements are
made, such as obtaining building permits and installing roads, utilities, and
other services, the land becomes more developed and its value rises based
on a projected stream of future cash flows. Investing in undeveloped land is
risky because values can decrease rapidly when housing demand falls. As an
example, CalPERS, one of the largest US pension plans representing public
employees in California, had a $970 million investment in 15,000 acres of
undeveloped land outside Los Angeles lose more than 90% of its value in the
aftermath of the 2008 global financial crisis.1
4.1.2. Offices
Offices represent one of the largest segments of commercial real estate. They
are usually owned by real estate investment companies that lease space to
tenants in varying terms, from short-term monthly leases to longer multiyear
leases. Because tenants are responsible for paying their leases whether they
occupy the space or not, the income associated with office rents is relatively
predictable over the life of the lease. In addition, office rents typically adjust
for inflation, which makes offices an attractive investment for those seeking
to protect their real estate income against inflation.
4.1.3. Multifamily Residential Dwellings
Also known as apartments or flats, multifamily residential dwellings
represent a significant portion of the investable commercial real estate
market. They are commercial properties that contain multiple units within a
single property or development. These units are rented to individuals or
families. Most leases tend to be for periods of one year or less, so the
multifamily residential dwellings segment is sensitive to supply and demand
dynamics in the local marketplace.
4.1.4. Retail Properties
The retail segment includes such assets as shopping malls, commercial
shopping centres, and other buildings designated for retail purposes. The
owner, or investor, leases the space to a retailer with lease terms varying
from weeks to years.
4.1.5. Industrial Properties
The industrial segment includes such properties as manufacturing facilities,
research and development space, and warehouse/distribution space. Again,
lease terms vary in length.
4.1.6. Hotels
Hotels include branded short-term stay facilities and longer-stay facilities
catering to contract workers in remote locations, as well as boutique and
independent facilities.
4.1.7. Other Segments
Depending on the country, there may be other commercial real estate
segments. For example, in many developed markets, senior housing designed
for people aged 55+ and student housing for post-secondary education have
both received considerable investments.
4.2. How To Invest in Real Estate?
Investors who have sufficient funds can buy real estate directly. Otherwise,
they can gain exposure to real estate through either the private or public
market.
4.2.1. Private Market Investments
In the private market, the primary way of investing in real estate is through
real estate limited partnerships and real estate equity funds.
Real estate limited partnerships are partnerships that specialise in real
estate investments. Their structure and mechanics are similar to those of the
private equity partnerships discussed in Section 3.2. The partnership is often
set by a real estate development firm that becomes the general partner. The
general partner then raises capital from investors, who become the real estate
limited partnership’s limited partners. The capital raised is invested in real
estate projects. Real estate projects take different forms, such as the
construction of an office block or an apartment complex. If the general
partner is a real estate development firm, it may also manage the real estate
projects. As with private equity partnerships, the limited partners in a real
estate limited partnership must pay the general partner management fees on
the committed capital and carried interest on the profit made on the real
estate assets.
Similar to investments in private equity partnerships, investments in real
estate limited partnerships are illiquid. In addition, the limited partners may
face years of negative cash flows because the general partner may not make
cash distributions until the real estate assets—the office block or the
apartment complex—are sold.
Real estate equity funds typically hold investments in hundreds of
commercial properties. These properties are diversified by geography,
property type, and vintage year (that is, the year the purchase was made).
Real estate equity funds are often open-end funds, meaning that they issue or
redeem shares when investors want to buy or sell—open-end mutual funds
are discussed in the Investment Vehicles chapter. Redemptions either take
place at regular intervals, such as quarterly, or on demand. They are made
out of the real estate equity funds’ cash flows, such as the income received
from rents and the sale of properties. So, real estate equity funds are, in
theory, more liquid than real estate limited partnerships. However, there is
no guarantee that the cash flows will be sufficient to meet investors’
redemption requests.
4.2.2. Public Market Investments
In contrast to real estate limited partnerships and real estate equity funds that
are private investments, real estate investment trusts (REITs) are
investments through public markets. Like other equity securities, the shares of
REITs are traded on exchanges, which makes them more liquid than real
estate limited partnerships and real estate equity funds. REITs are companies
that mainly own, and in most cases operate, income-producing real estate.
Most REITs are involved at all stages of the real estate process, from the
development of land to the construction of buildings and the management of
the properties.
5. COMMODITIES
Commodities, such as precious and base metals, energy products, and
agricultural products, tend to rise in price with inflation. So, they can
provide inflation protection in a portfolio.
There are several ways for investors to gain exposure to commodities. They
can buy
the physical commodity,
shares of natural resources or commodity-related companies, or
commodity derivatives.
Purchase of the physical commodity.
Theoretically, an investor could buy a barrel of oil or a head of cattle or a
bushel of wheat. But the transportation and storage difficulties associated
with purchasing a physical commodity means that it is rare for investors to
gain access to commodities this way.
Purchase of shares of natural resources or commodity-related
companies.
Investors can buy shares of companies that have a major portion of their
operations in the exploration, recovery, production, and processing of
commodities. For example, an investor who wants exposure to oil may buy
shares in a major oil company, such as BP, Eni, ExxonMobil, Petrobras,
PetroChina, Statoil, or Total.
Purchase of commodity derivatives.
As mentioned in the Derivatives chapter, investors can buy derivatives in
which the underlying asset is a commodity or a commodity index. Typical
commodity derivatives are forwards, futures, options, and swaps. Recall that
futures and some types of options are traded on exchanges, whereas
forwards, swaps, and other types of options are privately negotiated
agreements.
SUMMARY
Many investors allocate a portion of their portfolios to alternative
investments, such as private equity, real estate, and commodities, in order to
potentially enhance returns and reduce risk by taking advantage of the
diversification benefits.
The following points recap what you have learned in this chapter about
alternative investments:
Alternative investments are an alternative to traditional investments,
such as debt and equity securities.
Alternative investments are diverse and include private equity, real
estate, and commodities.
Investors add alternative investments to their portfolios to potentially
help enhance returns and reduce risk by obtaining diversification
benefits. Diversification benefits occur because there is a relatively low
correlation between different types of alternative investments and also
between alternative investments and other asset classes. The benefits of
diversification may be reduced in periods of financial crisis when
returns on different investments may become more correlated.
Alternative investments have limitations. Typically, they are less
regulated, transparent, liquid, and easy to value than traditional
investments.
Private equity is often categorised according to the stage of
development of the companies it invests in. Categories include venture
capital, growth equity, buyouts, and distressed investing. Another
category, which is unrelated to the stage of a company’s development, is
called secondaries.
Private equity investments are usually organised in funds managed by
partnerships. Limited partners commit capital and the general partner,
usually a private equity firm, makes investment decisions. Limited
partners pay the general partners annual management fees based on the
amount they have committed. The general partner also charges limited
partners carried interest, a form of incentive fee equal to a share of the
profit made on the private equity fund’s investments.
Real estate includes both residential and commercial properties, the
latter representing a larger portion of the investable universe.
Commercial real estate segments include land, offices, multifamily
residential dwellings, retail and industrial properties, and hotels.
Investors can buy real estate directly or gain exposure to real estate
through the private market via real estate limited partnerships and real
estate equity funds, or through the public market via real estate
investment trusts.
To gain exposure to commodities, investors can buy the physical
commodity, shares of natural resources or commodity-related
companies, or commodity derivatives.
CHAPTER REVIEW QUESTIONS
© 2014 CFA Institute. All rights reserved.
1. Alternative investments most likely:
A. are highly liquid.
B. exhibit low correlations with equity and debt securities.
C. offer greater transparency than investments in equity and debt
securities.
2. Which type of private equity strategy is most likely used to finance a
start-up company?
A. Buyout
B. Growth equity
C. Venture capital
3. A private equity fund is most likely:
A. funded by investors who are limited partners.
B. operated by a fund manager who is a limited partner.
C. set up by a private equity firm who is a limited partner.
4. The private equity firm receives management fees:
A. based on committed capital.
B. only if the private equity fund is profitable.
C. based on profits generated by the private equity fund’s investments.
5. Which of the following real estate segments represents the most
speculative investment?
A. Offices
B. Undeveloped land
C. Land with utilities and building permits
6. A private market investment vehicle holding hundreds of commercial
properties that are diversified by geography, property type, and vintage
year is best described as a real estate:
A. equity fund.
B. investment trust.
C. limited partnership.
7. Which of the following alternative investments is the least liquid?:
A. An investment in a private equity fund
B. An investment in a real estate investment trust
C. An investment in a commodity futures contract
ANSWERS
1. B is correct. There is a relatively low correlation between alternative
investments and equity and debt securities. Thus, alternative investments
provide diversification benefits. A is incorrect because most alternative
investments are illiquid—that is, it is difficult to sell them quickly
without accepting a lower price. C is incorrect because many
alternative investments are less transparent than investments in equity
and debt securities.
2. C is correct. The venture capital strategy invests in start-up companies
that exist merely as an idea or a business plan. The company may have
only a few employees, have little to no revenue, and may still be
developing its product or business model. A is incorrect because
buyouts are investments in established companies that require money to
restructure and facilitate a change of ownership. B is incorrect because
the growth equity strategy usually invests in existing companies with
proven business models, good customer bases, and positive cash flow
or profits.
3. A is correct. A private equity fund is typically funded by investors who
are limited partners; these investors face limited liability, which means
that they cannot lose more than the amount of capital they contributed to
the private equity fund. B is incorrect because a private equity fund is
typically operated by a fund manager but the fund manager is not a
limited partner. C is incorrect because a private equity fund is set up by
a private equity firm but the private equity firm is a general rather than
limited partner.
4. A is correct. The private equity firm receives management fees based
on the amount of committed capital. B is incorrect because the private
equity firm receives management fees even if the private equity fund is
not profitable. C is incorrect because carried interest is the fee that the
private equity firm receives based on profits generated by the private
equity fund’s investments.
5. B is correct. Undeveloped (raw) land can be highly speculative. It has
no cash flow streams from tenants or occupants and instead has only
cash outflows in the form of real estate taxes and other costs of holding
the land. The success of the investment depends on developing the land
at a profit or on the land appreciating in value. A is incorrect because
offices are less speculative than land. Offices are typically leased, and
office rents provide a stream of future cash flows. C is incorrect
because land with utilities and building permits approaches something
having a commercial value based on a projected stream of future cash
flows.
6. A is correct. A real estate equity fund is a private market investment
vehicle that holds hundreds of commercial properties that are
diversified by geography, property type, and vintage year (year the
purchase was made). B is incorrect because a real estate investment
trust (REIT) is an investment through public rather than private markets.
A REIT is a company that mainly owns, and in most cases operates,
income-producing real estate. C is incorrect because a real estate
limited partnership is a private market investment vehicle that typically
focuses on a smaller number of commercial properties, such as the
construction of a housing subdivision or an apartment complex.
7. A is correct. Investments in private equity funds are private market
investments. Thus, they are illiquid investments. B and C are incorrect
because real estate investment trusts and commodity futures contracts
are both traded on public exchanges. Thus, they are more liquid
investments.
NOTES
1Michael Corkery, “Calpers Confronts Huge Housing Losses”, Wall Street Journal (13 November
2008).
Module 5
Industry Structure
© 2014 CFA Institute. All rights reserved.
CONSIDER THIS
If you had $10,000 to invest toward retirement, would you rather
seek the advice of a seasoned financial professional or a highly
experienced firefighter? You would choose the financial
professional, of course! Why? Although both have a lot of
experience in their fields, the financial professional understands
the investment industry and has the information you need to make
the best possible decisions. Think about your area of expertise—
how will learning more about the financial industry build your
credibility and inspire trust?
It is particularly important for those who work in the investment industry to
have knowledge of how it works. Why? Because the industry is more
complex to understand than many other industries and it is constantly
evolving. Everyone in the investment industry must make it a priority to
achieve knowledge of the industry as a whole in order to establish and
maintain trust with clients. To achieve this knowledge, you must be familiar
with how the investment industry is structured, how it works, and how it
serves its clients. This familiarity includes being aware of the role of
organisations in the investment industry, the different products and services
that investment managers provide to their clients, and how these products and
services are packaged and sold.
To help you achieve the level of knowledge required to fulfil your role most
effectively, this module focuses on
the structure of the investment industry,
investment vehicles, and
the functioning of financial markets.
Structure of the investment industry.
Clients range from individual small investors to large institutional investors.
Companies within the investment industry also vary. Some companies sell
directly to investors, whereas others act as intermediaries. Some
organisations trade in the markets, whereas others provide investment advice
and support services. Each company in the investment industry plays a role
that, if performed well, creates value.
Investment vehicles.
The investment industry creates value by providing products and services
intended to meet the needs of diverse investors. These products and services
include direct investments in shares and bonds, and indirect investments,
through shared or “pooled” investment vehicles, which combine the assets of
a large number of investors. Understanding these products and services and
how they benefit clients will help you support investment professionals and
contribute to the value-creation process.
Functioning of financial markets.
You will learn how securities are issued and how these securities are traded.
We all benefit from markets that produce informative prices and allow
investors to trade at low cost. When investment markets work well, investors
allocate their capital to the people and businesses with the best ideas about
how to use the funds and the economy as a whole can prosper.
Armed with knowledge and understanding of the investment industry, you
will be better able to appreciate how your own work enhances value for the
individuals and institutions that the industry serves.
The three chapters in this module are: Structure of the Investment Industry,
Chapter 13; Investment Vehicles, Chapter 14; and The Functioning of
Financial Markets, Chapter 15.
Chapter 13
Structure of the Investment
Industry
by Larry Harris, PhD, CFA
© 2014 CFA Institute. All rights reserved.
LEARNING OUTCOMES
After completing this chapter, you should be able to do the following:
a. Describe needs served by the investment industry;
b. Describe financial planning services;
c. Describe investment management services;
d. Describe investment information services;
e. Describe trading services;
f. Compare the roles of brokers and dealers;
g. Distinguish between buy-side and sell-side firms in the investment
industry;
h. Distinguish between front-, middle-, and back-office functions in the
investment industry;
i. Identify positions and responsibilities within firms in the investment
industry.
1. INTRODUCTION
The investment industry helps individuals, companies, and governments save
and invest money for the future. Individuals save to ensure that money will be
available to cover unforeseen circumstances, to buy a house, to cover their
living expenses during retirement, to pay for college or university tuition, to
fund such discretionary spending as travel and charitable gifts, and to pass
wealth on to the next generation. Companies save to invest in future projects
and to pay future salaries, taxes, and other expenses. Governments save when
they collect tax revenues in advance or in excess of spending requirements or
receive the money from bond sales before this money is spent.
The investment industry provides many services to facilitate successful
saving and investing. This chapter discusses how investment professionals
organise their efforts to help their clients meet their financial goals. It also
describes how these efforts help ensure that only the individuals, companies,
and governments with the best value-enhancing plans for using capital
receive funding.
2. HOW THE INVESTMENT INDUSTRY
PROMOTES SUCCESSFUL INVESTING
The investment industry provides services to those who have money to invest
—individual and institutional investors who become providers of capital.
Investing involves many activities that most individual and institutional
investors cannot do themselves. Investors must
determine their financial goals—in particular, how much money they
will need to invest for future uses and how much money they can
withdraw over time.
identify potential investments.
evaluate the risk and return prospects of potential investments.
trade securities and assets.
hold, manage, and account for securities and assets during the periods of
the investments.
evaluate the performance of their investments.
These activities generally require information, expertise, and systems that
few individual and institutional investors have. Investors obtain assistance
with these activities from investment professionals, either directly by hiring
investment professionals or indirectly by investing in investment vehicles
that the investment industry creates and oversees.
Some investment firms and professionals working in the investment industry
specialise in providing a single service. Others provide a broad spectrum of
investment services. For the sake of clarity, this discussion considers each
service separately, even though most investment firms and professionals
provide multiple services.
3. FINANCIAL PLANNING SERVICES
Investment clients often need advice to set their financial goals and determine
how much money they should save for future expenses. Some clients also
need advice about how much money they can spend on current expenses
while still preserving their capital. Financial planners help their clients
understand their current and future financial needs, the risks they face when
investing, their ability to tolerate investment risks, and their preferences for
capital preservation versus capital growth. This process is described further
in the Investors and Their Needs chapter.
Financial planners create savings and investment plans appropriate for their
clients’ needs. The plans often require complex analyses that depend on
expected rates of return and risks for various securities and assets, the
client’s capacity and tolerance for bearing risk, tax considerations, and
projections of future expenses. Future expenses are often particularly
difficult to forecast. They may depend on inflation and, in the case of
retirement expenses, uncertain longevity and uncertain future health care
expenses. Analyses related to pensions and health care are typically done by
actuaries—professionals who specialise in assessing insurance risks using
statistical models.
Many pension funds employ financial planners to help pension beneficiaries
make better savings decisions. Some employers also contract with financial
planning consultants to make financial planning services available to their
employees and retirees. Increasingly, financial planners provide financial
planning advice over the internet to retail investors.1
Various organisations require financial planning services to help them meet
their investment objectives. For example, foundations and endowment funds
—which are not-for-profit institutions with long-term investment objectives
—sometimes hire financial planners to help them create their payout
policies. Payout policies specify how much money can be taken from
long-term funds to use for current spending. The payout policies depend on
the assumptions the financial planners make about future expected investment
returns. Assuming high future expected returns allows for higher current
spending. But if these assumptions prove to be overly optimistic, payouts
will exceed the returns generated by the investments and the spending of the
foundation or endowment fund will have to decrease over time.
4. INVESTMENT MANAGEMENT
SERVICES
Once they have determined their financial goals, individual and institutional
investors need to implement their savings and investment plans to be able to
achieve these goals. They often require investment management services to
do so. Investment management activities include asset allocation, investment
analysis, and portfolio construction. Investment management is described
further in the Investment Management chapter. The types of services investors
have access to for help with investment management activities depend on the
amount of investable assets they have.
4.1. Services for High-Net-Worth and
Institutional Clients
Some high-net-worth and institutional clients rely on investment
professionals to take care of the entire investment process, from identifying
potential investments to implementing the investments and evaluating their
performance; others use the services of investment professionals selectively.
Many investment professionals receive authority from their clients to trade
securities and assets on their behalf. Those who have such discretionary
authority are often called investment managers or asset managers.
Depending on the context, these terms may refer to the individuals who make
investment decisions or to the investment firms for which they work.
4.1.1. Investment Management Activities
Investment managers perform various activities for their clients. The
following are the three major activities:
asset allocation
investment analysis
portfolio construction
Asset allocation indicates the proportion of a portfolio that should be
invested in various asset classes to help meet financial goals. Asset classes
typically include cash, equity and debt securities, and alternative investments
(such as private equity, real estate, and commodities). Equity and debt
securities may be further divided, such as into foreign and domestic. To
determine the appropriate allocation to each of the various asset classes,
investment managers must assess the risk and return characteristics of many
potential investments.
Investment analysis involves estimating the fundamental value of potential
investments and identifying attractive securities and assets. An investment’s
fundamental value, also called intrinsic value, indicates the price that
investors would pay for the investment if they had a complete understanding
of the investment’s characteristics. A widely used approach to estimating the
fundamental value of an investment is to estimate the present value of all the
cash flows that the investment will generate in the future. Recall from the
Equity Securities chapter that the value of a common share can be estimated
as the present value of all the cash flows, such as dividends, that the investor
expects to receive from the common share in the future. Provided that it fits
the client’s needs, a potential investment is appealing when its current price
is below its estimated fundamental value.
Portfolio construction is the activity that brings everything together. It
requires investment managers to invest in the attractive securities and assets
they identified through their investment analysis, taking into account the
client’s requirements and appropriate asset allocation. To do so, investment
managers must trade securities and assets; hold, manage, and account for
these securities and assets during the periods of investment; and evaluate the
performance of these investments.
The investment managers who provide assistance to high-net-worth and
institutional investors typically work for investment firms. Clients pay
management fees to their investment managers for their services. The size of
these fees typically depends on the total assets under management. Clients
may also pay performance fees that depend on the investment performance of
the portfolio.
4.1.2. Passive and Active Investment Management
Investment managers may suggest passive or active investment management,
or both. Passive investment managers seek to match the return and risk
of an appropriate benchmark. Benchmarks include broad market indices that
cover an entire asset class, indices for a specific industry, and benchmarks
that are customised to the needs of a specific client.
Passive investment strategies are the least costly strategies to implement
because they involve buying and holding securities based only on their
characteristics rather than on analyses of their future return prospects. Index
investing is a widely used passive investment strategy and is discussed
further in the Investment Vehicles chapter.
In contrast, active investment managers try to predict which securities
and assets will outperform or underperform comparable securities and
assets. The managers then act on their opinions by buying the securities and
assets that they expect to outperform and selling (or simply not buying) the
securities and assets that they expect to underperform. Active investment
strategies are more expensive than passive investment strategies because they
require greater resources, so investment clients hire active investment
managers only when they believe that these managers have the skill to
outperform the market after taking into consideration all fees and
commissions.
Active investment managers collect and analyse as much relevant information
and data as they can reasonably obtain to predict which securities and assets
will outperform or underperform their peers in the future. They often need the
help of investment information service providers to gather the required
information and data.
4.2. Services for Retail Clients
Retail investors do not typically have access to the same level of service as
high-net-worth and institutional investors. Many retail clients obtain
assistance and advice on investment management activities, including asset
allocation, investment analysis, and portfolio construction from investment
professionals who work for financial institutions or brokers; more
information about brokers is provided in Section 6.1.
Some investment professionals receive commissions from the firms that sell
mutual funds and life insurance policies for the trades and contracts they
recommend. Others are fee-only professionals who accept payments only
from their clients. Unlike brokers and agents, who are paid commissions on
the trades and contracts they recommend, fee-only professionals do not have
incentives to generate commissions by recommending specific products or
excessive trades. Retail clients may implement their investment plans by
passive investing in pooled investment vehicles, such as mutual funds, that
are professionally managed. Types and characteristics of pooled investment
vehicles are discussed in the Investment Vehicles chapter. Retail investors
may also need investment information to implement their investment plans.
5. INVESTMENT INFORMATION
SERVICES
Many investors and investment managers obtain investment research,
financial data, and consultancy services from firms that specialise in
providing these services. These companies include investment research
providers, credit rating agencies, financial news services, financial data
vendors, and investment consultants. This section introduces these types of
firms and discusses the various business models that they use to generate
revenue.
5.1. Investment Research Providers
Many investors use research reports when making investment decisions.
These reports often help them gain deeper insight into the risk and return
prospects of potential investments.
Firms that provide research reports assemble information and opinions that
most investors cannot easily produce themselves. To produce the reports,
these firms employ data collectors, financial reporters, and expert analysts.
Research reports can be particularly valuable when they are written by
industry experts who understand the financial implications of new industrial
technologies—for example, the fracking technologies that oil and gas drillers
now increasingly use to extract hydrocarbons.
Most research reports are largely based on publicly available information.
These reports summarise information from lengthy disclosures, saving
investors considerable time. Many reports also present financial analyses
that estimate the fundamental value of securities.
Investors often get research reports from their brokers, who purchase them or
produce them internally in their research departments. Brokers give research
to their clients to better serve them, to attract new clients, and to encourage
their clients to trade. Investors may also purchase reports directly from
independent research firms, or they may obtain reports from research firms
that issuers pay to produce reports about their securities.
5.2. Credit Rating Agencies
Credit rating agencies specialise in providing opinions about the credit
quality of bonds and of their issuers. A high bond credit rating (or rating)
indicates that the credit rating agency believes that the issuer—for example, a
company—has a high probability of making all future payments of principal
and interest when due.
Most credit rating agencies do not charge investors for their ratings, although
they may charge them for the detailed reports on which the ratings are based.
Instead, companies pay credit rating agencies to rate their securities; they are
willing to do so because having a rating generally makes a security more
marketable. An obvious conflict of interest thus arises because companies
are likely to direct their business to those credit rating agencies that will
provide higher ratings. Equally, the credit ratings agencies may give
companies high ratings to secure future business. If they lose their
independence, credit rating agencies run the risk that investors may no longer
respect their ratings. Such a situation would have a negative effect not only
on credit rating agencies but also on the economy in general and the
investment industry in particular because flows of capital would be reduced.
5.3. Data Vendors
To invest and trade successfully, most investors need current and accurate
data about companies and market conditions. Many data vendors provide
such data, including historical data and real-time data.
Exhibit 1 shows examples of historical data that may be of interest to
investors and how investors may use these data to make decisions.
Exhibit 1.
Examples and Potential Uses of Historical Data
Type of Data
Examples
Potential Uses
Type of Data
Examples
Potential Uses
Macroeconomic
data
Information about
economic activity
and international
trade.
Accounting data
Information about
a company’s
financial
statements,
including the
balance sheet,
income statement,
and cash flow
statement.
Information about
past market
prices and
trading volumes.
Investment professionals
use macroeconomic data
to better understand the
environment in which
companies operate and
compete.
Investment professionals
use accounting data to
assess a company’s
financial performance
and to estimate the
fundamental value of its
securities, such as
common shares.
Historical
market data
Investment professionals
use historical market
data to evaluate the
performance of their
investments and to help
them identify securities
that may outperform in
the future.
The following are important real-time data resources used by investment
professionals:
Newsfeeds, which provide real-time news about companies and
markets that investors need to know because such news may affect the
value of the companies’ securities.
Market data feeds, which provide real-time information about market
quotes and orders, as well as recent trades, that is helpful for investors
who want to trade.
Access to investment data was once very expensive and thus restricted to
investment firms and institutional investors. The growth of information
technologies, particularly those involving the internet, has substantially
reduced the cost of accessing data, so more investment data are now
available to the general public. In many countries, some data, such as
regulatory disclosures by issuers, can be freely accessed via the internet.
Other data are only available on a subscription basis from data vendors.
The widespread availability of investment data has greatly changed the
investment industry landscape; whereas access to data used to be a key
driver of investment profits, now investment profits increasingly depend on
the ability to analyse data.
6. TRADING SERVICES
Brokers, dealers, clearing houses, settlement agents, custodians, and
depositories provide various services that facilitate investment by helping
buyers and sellers of securities and investment assets arrange trades with
each other and by holding assets for clients.
6.1. Brokers
Brokerage services are provided to clients who want to buy and sell
securities; they include not only execution services (that is, processing orders
on behalf of clients) but also investment advice and research.
Brokerage services are provided by brokerage firms or brokers. Brokers
are agents who arrange trades for their clients. They do not trade with their
clients. Instead, they search for traders who are willing to take the other side
of their clients’ orders. Brokers help their clients by reducing the cost of
finding counterparties for their clients’ trades.
Brokers provide many different trading services. First and foremost, brokers
find sellers for their clients who want to buy and buyers for their clients who
want to sell. For highly liquid securities, the search usually involves only
routing (directing) a client’s order to an exchange or to a dealer. Exchanges
arrange trades by matching buy and sell orders and are discussed in The
Functioning of Financial Markets chapter; dealers are discussed in the next
section. For less liquid securities and assets, brokers may spend substantial
resources looking for suitable counterparties.
For complex trades, such as real estate transactions, for which effective
negotiation is essential to successful investment, brokers often serve as
professional negotiators. In such transactions, skilled negotiators can
increase the probability of arranging trades with favourable financial terms.
Clients pay commissions to their brokers for arranging their trades. The
commissions vary widely but typically depend on the value or quantity
traded. It is worth noting that commissions have decreased over the past 30
years, primarily because of deregulation, technological progress, and
increased competition among brokers.
Brokers often also ensure that their clients settle their trades. Such
assurances are essential when exchanges arrange trades between strangers
who do not have credit arrangements with each other. For such trades,
brokers guarantee the settlement of their clients’ trades.
Individual brokers may work for large brokerage firms or the brokerage arms
of investment banks or at exchanges. Some brokers match clients personally.
Others use specialised computer systems to identify potential trades and help
their clients fill their orders. Many simply route their clients’ orders to
exchanges or to dealers.
Block brokers help investors who want to trade large blocks of securities.
Large block trades are hard to arrange because finding a counterparty willing
to buy or sell a large number of securities is often quite difficult. Investors
who want to trade a large block often have to offer price concessions to
encourage other investors to trade with them. Often, buying a large number of
securities requires paying a premium on the current market price, and selling
a large number of shares requires offering a discount on the current market
price.
Prime brokerage refers to a bundle of services that brokers provide to
some of their clients, usually investment professionals engaged in trading. In
addition to the typical brokerage services mentioned, a prime broker helps
these professionals finance their positions. Although the trades may be
arranged by other brokers, prime brokers clear and settle them. Thus, prime
brokerage allows the netting of collateral requirements across all their trades
and the lowering of costs of financing to the trader.
6.2. Dealers
Dealers make it possible for their clients to trade without having to wait to
find a counterparty; they are ready to buy from clients who want to sell and to
sell to clients who want to buy. Dealers thus participate in their clients’
trades, in contrast to brokers who do not trade with their clients but only
arrange trades on behalf of their clients.
Dealers profit when they can buy securities for less than they sell them—that
is, when the price at which they buy securities (called the bid price) is lower
than the price at which they sell them (called the ask price or offer price). If
dealers can arrange trades simultaneously with buyers and sellers, they will
make risk-free profits. Dealers risk losses if prices fall after they purchase
but before they can sell or if prices rise after they sell but before they can
repurchase.
Dealers provide liquidity to their clients by allowing them to buy and sell
when they want to trade. In effect, dealers match buyers and sellers who want
to trade the same instrument at different times and are thus unable to trade
directly with each other. In contrast, brokers must bring a buyer and a seller
together to trade at the same time and place. Dealers are often called market
makers because they are willing to make a market (that is, trade on demand)
in specified securities at their bid and ask prices.
Dealers may organise their operations within investment banks, hedge funds,
or sole proprietorships. Almost all investment banks have dealing operations
ready to buy and sell currencies, bonds, stocks, and derivatives if no other
counterparty can be found. Some dealers rely on individuals to make trading
decisions; others primarily use computers.
Many dealers also broker orders, and many brokers also deal with their
clients in a process called internalisation. Internalisation is when brokers fill
their clients’ orders by acting as proprietary traders rather than as agents
—that is, by trading directly with their clients rather than by arranging trades
with others on behalf of their clients. Because the distinction between broker
and dealer is not always clear, many practitioners often use the term
broker/dealer to refer to them jointly.
Broker/dealers face a conflict of interest with respect to how they fill their
clients’ orders. When acting as brokers, they must seek the best price for
their clients’ orders. When acting as dealers, however, they profit most when
they sell to their clients at high prices or buy from their clients at low prices.
This trading conflict of interest is most serious when clients allow their
brokers to decide whether to trade their orders with other traders or to fill
them internally. Consequently, when trading with broker/dealers, some
clients may specify that they do not want their orders to be internalised. Or
they may choose to trade only via brokers who do not also act as dealers.
Primary dealers are dealers with which central banks trade when
conducting monetary policy. Recall from the Macroeconomics chapter that
monetary policy refers to central bank activities that aim to influence the
money supply, interest rates, and credit availability in an economy. Central
banks sell bonds to primary dealers to decrease the money supply. The
primary dealers then sell the bonds to their clients. Central banks buy bonds
from primary dealers to increase the money supply, the primary dealers buy
bonds from their clients and sell them back to the central banks.
6.3. Clearing Houses and Settlement Agents
Clearing houses and settlement agents settle trades after they have been
arranged. Clearing refers to all activities that occur from the arrangement of
the trade to its settlement. Settlement consists of the final exchange of cash
for securities.
Clearing houses arrange for the final settlement of trades. The members of
a clearing house are the only traders for whom the clearing house will settle
trades. Thus, brokers and dealers who are not members of the clearing house
must arrange to have a clearing member settle their trades at the clearing
house.
Reliable settlement of all trades promotes liquidity because it reassures
investors that their trades will be settled and thus allows strangers to
confidently contract with each other without worrying much about
settlement risk, which is the risk that counterparties will not settle their
trades. A secure clearing system thus greatly increases the number of
counterparties with whom a trader can safely arrange a trade.
6.4. Custodians and Depositories
Custodians are typically banks and brokerage firms that hold money and
securities for safekeeping on behalf of their clients. Thus, they play an
important role in reducing the risk that securities may be lost or stolen.
Security ownership records were once commonly held as actual paper
certificates in secure vaults. Now, securities are almost exclusively held in
book-entry form as secure computer records. The conversion of evidence of
security ownership from physical certificates (called immobilisation) and
electronic corporate ownership records (called dematerialisation) into
standardised book-entry records greatly reduces the costs of clearing and
settling trades.
Custodians may also offer other services for their clients, including trade
settlement and collection of interest and dividends. The fees they charge their
clients often depend on the type of services they provide to them.
Depositories act not only as custodians but also as monitors. They are
often regulated and their role is to help
prevent the loss of securities and payments through fraud, deficient
oversight, or natural disaster.
ensure that securities cannot be pledged more than once by the same
borrower as collateral for loans.
ensure that securities said to be purchased are actually purchased.
Having reputable third-party custodians and depositories hold all assets
managed by an investment manager helps prevent investment fraud, such as
Ponzi schemes, which use money contributed by new investors to pay
purported returns to existing investors rather than to purchase additional
securities.
Most individual and many smaller institutional investors hold securities in
brokerage accounts that provide them with custodial services. Their brokers,
in turn, hold the securities with custodians and depositories for safekeeping.
6.5. Comparison of Providers of Trading
Services
Brokers
Act as agents
Find sellers for clients who want to buy and buyers
for clients who want to sell
Serve as professional negotiators
Ensure clients will settle their trades
Dealers
Participate in their clients’ trades
Allow clients to trade when they want by being ready
to buy when their clients want to sell and to sell when
their clients want to buy
Provide liquidity because they are willing to trade on
demand
Often are proprietary traders
Clearing
houses
Arrange for final settlement of trades
Settlement
agents
Arrange final exchange of cash for securities
Custodians
Hold money and securities for safekeeping on behalf
of clients
Promote liquidity by reassuring investors that their
trades will be settled
May offer other services for clients, such as trade
settlement and collection of interest and dividends
Depositories
Act not only as custodians but also as monitors to
prevent the loss of securities and fraud
Often are regulated
7. ORGANISATION OF FIRMS IN THE
INVESTMENT INDUSTRY
In this chapter so far, we have discussed how firms in the investment industry
serve their clients and facilitate trading. What gives the investment industry
recognisable structure is how participants are grouped and how some of the
firms organise their activities. In practice, a distinction is often made
between buy-side and sell-side firms. When structuring their activities, many
sell-side firms distinguish between the front, middle, and back office.
7.1. Buy-Side and Sell-Side Firms
Practitioners classify many firms in the investment industry by whether they
are on the sell side or the buy side. Sell-side firms primarily provide
investment products and services; they are typically investment banks,
brokers, and dealers. Buy-side participants purchase these investment
products and services from sell-side firms. For example, such institutional
investors as pension plans, endowment funds, foundations, and sovereign
wealth funds, as well as insurance companies, are all considered buy-side
participants. Buy-side firms include firms that manage portfolios for
clients and/or themselves. Practitioners also sometimes use the term buy side
to refer to consultants who provide services only to buy-side firms. For
example, many buy-side consultants help buy-side institutional investors
evaluate investment performance.
However, the buy-side/sell-side classification does not apply to all firms in
the investment industry. For example, it is not relevant for the investment
information services presented in Section 5. In addition, the buy-side/sellside classification is somewhat arbitrary and not easily applied to many
large, integrated firms. For example, many investment banks have divisions
or wholly owned subsidiaries that provide investment management services,
which are buy side. These functions are on the buy side, even though
investment banks are sell-side firms.
7.2. Front, Middle, and Back Offices
Most sell-side firms organise their activities along similar lines. Activities
are classified by whether they are in the front office, the middle office, or the
back office.
The front office consists of client-facing activities that provide direct
revenue generation. The sales, marketing, and customer service departments
are the most important front-office activities. Some practitioners consider the
trading department to be a front-office activity, especially if the traders
regularly interact with clients. Some consider research to be a front-office
activity because it generates revenue from clients.
The middle office includes the core activities of the firm. Risk
management, information technology (IT), corporate finance, portfolio
management, and research are generally considered middle-office activities,
especially if these departments do not interact directly with clients. IT
activities are particularly important because most firms in the investment
industry need to process and retrieve vast quantities of data efficiently and
accurately. Risk management activities are also critical because they help
ensure that the firm and its clients are not intentionally, inadvertently, or
fraudulently exposed to excessive risk.
The back office houses the administrative and support functions necessary
to run the firm. These functions include accounting, human resources, payroll,
and operations. For brokerage firms and banks that provide custodial
services, the accounting department is especially important because it is
responsible for clearing and settling trades and for keeping track of who
owns what.
Some activities are not easily classified as front, middle, or back office. For
example, compliance activities are relevant to the entire organisation. A
firm’s compliance department ensures that the firm and its clients comply
with the many laws and regulations that govern the investment industry.
The terms front office, middle office, and back office are generally not used
when describing buy-side firms. However, the main departments of buy-side
investment management firms are similar to those of sell-side firms. These
departments include sales and client relations, investment research and
portfolio management, trading, compliance, accounting, and administration.
7.3. Leadership Titles and Responsibilities
Exhibit 2 provides an example of major leadership titles and responsibilities
in the investment industry. Titles used by different firms may vary.
Exhibit 2.
Leadership Titles and Responsibilities
Title
Responsibility
Chief
executive
officer
(CEO)
Chief
financial
officer
(CFO)
Chief
operating
officer
(COO)
Chief
investment
officer (CIO)
Manages the firm.
Head trader
Chief
accountant
(also known
as finance
controller)
Treasurer
Chief risk
officer
Responsible for financing the firm and for
financial reporting.
Responsible for the day-to-day management of
the firm.
Responsible for any investment advice that the
firm provides to its clients and for the
investment decisions that the firm makes for
itself and on behalf of its clients.
Responsible for all trading operations. At firms
that engage in proprietary trading, the head
trader is responsible for all positions, risks, and
profits.
Responsible for the accounting and financial
systems.
Responsible for cash management, including the
investment of receipts and payment of invoices.
Responsible for identifying and managing the
risks to which the firm and its clients are
exposed.
Title
Chief
compliance
officer
Chief audit
executive
General
counsel
Responsibility
Responsible for ensuring that the firm complies
with all constraints placed on it by laws,
regulations, and clients.
Leads the internal audit department, which is
responsible for providing independent
assessments of the firm’s operational systems as
well as suggestions for improvement.
Leads the legal department, which reviews and
helps write contracts, responds to or initiates
lawsuits, and interprets regulations, among many
other activities.
At many firms, especially smaller ones, some people hold multiple titles and
responsibilities. For example, the chief investment officer of a smaller
investment management firm may also be the chief executive officer.
7.4. Investment Staff
Firms in the investment industry employ many types of investment
professionals. Examples include the following:
Portfolio managers at buy-side firms make investment decisions for one
or more portfolios.
Buy-side, sell-side, and independent research analysts produce the
investment research that portfolio managers use to make decisions.
Research assistants assist research analysts with the collection and
analysis of investment information.
Buy-side traders interact with sell-side firms to trade orders created by
their portfolio managers.
Sales traders at sell-side firms help arrange trades for their buy-side
clients.
Sales managers manage sales for regions, products, or customer types.
Salespeople identify potential clients and sell them the firm’s products
and services.
Sales assistants provide administrative support to the salespeople.
Client service agents and their assistants answer client questions and
help clients open, close, and manage their accounts.
Investment professionals who interact with clients may also be known as
account executives and account managers at many firms.
Research assistant is often the entry-level position for investment
professionals interested in becoming portfolio managers. Assistants who
acquire strong expertise in a particular area and who can write well may be
promoted to research analysts. Those analysts who demonstrate excellent
investment judgment often become portfolio managers. Likewise, sales
assistants and account services assistants are entry-level positions for
investment professionals interested in sales or account services.
Companies that provide investment management services also employ many
other types of professionals besides investment professionals. These include
professionals working in accounting, information services, marketing, and
legal services.
SUMMARY
You should now have a good idea of who the main participants are in the
investment industry and what roles they fulfil. Ways in which the various
participants interact have also been described, and you should be able to
visualise the basic structure of the industry based on the description of these
interactions. Some important points to remember include the following:
The investment industry provides many services to facilitate successful
saving and investing.
Investing involves many activities that most individual and institutional
investors cannot do themselves. Investors obtain assistance with these
activities either directly or indirectly.
Financial planning helps investors set their financial goals and
determine how much money they should save for future expenses and/or
how much money they can spend on current expenses while still
preserving their capital.
Investment management assists retail, institutional, and high-net-worth
investors in implementing their savings and investment plans to be able
to achieve their financial goals. The three major investment management
activities are asset allocation, investment analysis, and portfolio
construction.
Many investors and their investment managers rely on investment
information services to obtain investment research, financial data, and
consultancy services that help them make decisions.
Brokers act as agents, arrange trades for their clients, and ensure that
clients settle their trades. For complex trades, they often serve as
professional negotiators.
Dealers participate on the opposite side of their clients’ trades and are
willing to trade on demand, thus providing liquidity.
After a trade has been agreed on, clearing houses arrange for final
settlement of the trade, and then settlement agents organise the final
exchange of cash for securities.
Custodians and depositories hold money and securities for safekeeping
on behalf of their clients and help prevent loss from securities
investment fraud.
Sell-side firms are typically investment banks, brokers, and dealers that
provide investment products and services. Buy-side participants are
typically investors and investment managers that purchase investment
products and services.
The front office of a sell-side firm consists of client-facing activities
that provide direct revenue generation. The middle office includes the
core activities of the firm, such as risk management, information
technology, corporate finance, portfolio management, and research. The
back office houses the administrative and support functions necessary to
run the firm, such as accounting, human resources, payroll, and
operations.
Firms in the investment industry employ many types of investment
professionals. Leadership titles and responsibilities vary among firms.
At many firms, especially smaller ones, some people hold multiple
titles and responsibilities.
CHAPTER REVIEW QUESTIONS
© 2014 CFA Institute. All rights reserved.
1. Investment professionals who create savings and investment plans
appropriate for their clients’ needs are most likely:
A. dealers.
B. financial planners.
C. investment research providers.
2. Investment managers that determine the proportion of a client’s money
that should be invested in cash, equities, and fixed income are
performing which of the following activities?
A. Asset allocation
B. Investment analysis
C. Portfolio construction
3. When investment managers identify attractive securities based on
fundamental values, the investment managers are performing which of
the following activities?
A. Asset allocation
B. Investment analysis
C. Portfolio construction
4. Passive managers will most likely:
A. sell securities that are expected to outperform.
B. sell securities that are expected to underperform.
C. match the return and risk of a broad market index.
5. Credit rating agencies are best described as providing:
A. custodial services.
B. financial planning services.
C. investment information services.
6. Real-time data about companies and market conditions are usually
supplied by:
A. data vendors.
B. credit rating agencies.
C. investment research providers.
7. Credit rating agencies provide:
A. historical accounting data.
B. opinions about an issuer’s credit quality.
C. real-time news about companies and markets.
8. Which of the following statements is most accurate? Brokers trade:
A. with clients by buying and selling the traded securities.
B. on behalf of clients in exchange for a commission that typically
depends on the value or quantity traded.
C. on behalf of clients in exchange for a fee that is usually based on
assets under management.
9. Which of the following parties most likely arranges trades on behalf of
clients who want to trade large blocks of securities?
A. Block brokers
B. Prime brokers
C. Primary dealers
10. Which of the following services is most likely provided by brokers?
A. Finding counterparties for their clients’ trades
B. Collecting interest and dividends for clients’ securities
C. Eliminating settlement risk by acting as a settlement intermediary
11. Which of the following parties most likely acts as a custodian and as a
monitor?
A. Depositories
B. Clearing houses
C. Primary dealers
12. Which of the following statements is most accurate? Dealers:
A. match buyers and sellers.
B. serve as trade negotiators.
C. provide liquidity in securities markets.
13. Sell-side firms are best described as firms that:
A. sell insurance products to retail clients.
B. sell investment data, research, and consulting services.
C. provide investment products and services.
14. Practitioners most likely use the term buy side to refer to:
A. dealers who provide investment products and services.
B. investors who purchase investment products and services from the
sell side.
C. firms that only provide investment data, research, and consulting
services.
15. An example of a middle office activity is:
A. sales.
B. accounting.
C. risk management.
16. Front office activities within a sell-side firm most likely include:
A. core activities of the firm.
B. administrative and support activities.
C. client-facing, revenue-producing activities.
17. Which of the following titles best describes the person responsible for
leading the legal department and interpreting regulations?
A. Chief risk officer
B. General counsel
C. Chief compliance officer
18. Which of the following titles best describes the person in a firm
responsible for providing independent assessments of the firm’s
operational systems?
A. Chief risk officer
B. Chief audit executive
C. Chief operating officer
ANSWERS
1. B is correct. Financial planners are investment professionals who
create savings and investment plans appropriate for their clients’ needs.
In particular, they help their clients set their financial goals and
determine how much money they should save for future expenses and/or
how much money they can spend on current expenses while still
preserving their capital. A is incorrect because dealers are agents who
provide trading services for their clients by participating directly in
each trade. C is incorrect because investment research providers
research and compile data about industries, companies, and
technologies and document the results in investment reports. They
provide information services and do not interact with clients regarding
their investment planning needs.
2. A is correct. Investment managers are performing asset allocation when
they determine the proportion of a client’s money to invest in various
asset classes, such as cash, equity securities, and debt securities. B is
incorrect because investment analysis is when investment managers
determine the value of potential investments and identify attractive
securities. C is incorrect because portfolio construction is the process
of trading, holding, and managing the assets according to the client’s
asset allocation requirements.
3. B is correct. When investment managers identify attractive securities
based on fundamental values, they are performing investment analysis.
A is incorrect because asset allocation is the process of determining the
proportion of a portfolio to invest in various asset classes. C is
incorrect because portfolio construction is the process of trading,
holding, and managing the assets according to the asset allocation
requirements.
4. C is correct. Passive managers seek to match the return and risk of an
appropriate benchmark, such as a broad market index. A and B are
incorrect because it is active, not passive, managers who trade
securities to beat the benchmark. Note that active managers will buy
securities that are expected to outperform and sell securities that are
expected to underperform.
5. C is correct. Credit rating agencies are investment information services
providers that specialise in providing opinions about the credit quality
of bonds and of their issuers. A is incorrect because custodians, not
credit rating agencies, are firms that hold money and securities on
behalf of their clients for safekeeping. B is incorrect because credit
rating agencies do not provide financial planning services.
6. A is correct. Real-time data about companies and market conditions are
usually supplied by data vendors. B and C are incorrect because credit
rating agencies and investment research providers do not supply realtime data about companies and market conditions. Credit rating agencies
supply opinions about the credit quality of bonds and their issuers.
Investment research providers supply research reports about companies.
7. B is correct. Credit rating agencies provide opinions about an issuer’s
credit quality. A and C are incorrect because data vendors, not credit
rating agencies, provide historical accounting data and real-time news
about companies and markets.
8. B is correct. Brokerage services primarily include placing trade orders
for securities on behalf of clients, otherwise described as acting as an
agent to execute trade orders. Clients pay commissions to brokers for
finding buyers or sellers for their securities, and these commissions
typically depends on the value or quantity traded. A is incorrect because
trading with a client by buying and selling the traded security, also
described as “making a market” in a security, describes the function of
an investment dealer, not a broker. C is incorrect because neither
brokers nor dealers are usually compensated by collecting a fee based
on assets under management, which would describe how investment (or
asset) managers are typically compensated.
9. A is correct. Brokers who help arrange trades of large blocks of
securities for clients by finding counterparties willing to buy or sell a
large number of securities are referred to as block brokers. B is
incorrect because prime brokers usually offer brokerage services to
investment professionals, as well as a bundle of other services,
including financing clients’ investment positions. C is incorrect because
primary dealers do not typically trade for clients on a brokerage basis.
Their role is to facilitate monetary policy transactions that are initiated
by central banks.
10. A is correct. Brokers are agents who arrange trades for their clients by
finding counterparties to take the other side of their clients’ trades. B is
incorrect because collecting interest and dividends for clients’
securities is a function most likely provided by custodians. C is
incorrect because eliminating settlement risk by acting as a settlement
intermediary is a role that is performed by a clearing house, not a
broker.
11. A is correct. Depositories usually act as a custodian and a monitor.
They tend to be regulated and monitor counterparties to prevent fraud,
monitor securities pledges, and monitor security settlement, among other
activities. B and C are incorrect because clearing houses and primary
dealers do not monitor counterparties or take custody of assets. Clearing
houses arrange for the final settlement of trades. Primary dealers trade
with clients and facilitate monetary policy transactions that are initiated
by central banks.
12. C is correct. Dealers provide liquidity in securities markets by trading
on demand; they buy when their clients want to sell and sell when their
clients want to buy. A and B are incorrect because matching buyers and
sellers and serving as trade negotiators are services provided by
brokers, not by dealers.
13. C is correct. Sell-side firms provide investment products and services.
Brokers, dealers, and investment banks are considered sell-side firms.
A is incorrect because insurance companies typically sell insurance
products and buy investment products and services. B is incorrect
because firms that provide only investment data, research, and
consulting services are neither buy- or sell-side firms. These firms are
investment information services providers.
14. B is correct. Practitioners typically use the term buy side to refer to
investors who purchase investment products and services from the sell
side. A is incorrect because it is sell-side, not buy-side, firms that
provide investment products and services. C is incorrect because the
classifications of buy side and sell side are not usually applied to
independent firms, such as the ones that provide investment data,
research, and consulting services.
15. C is correct. Risk management is classified as a middle office activity.
A is incorrect because sales is classified as a front office activity. B is
incorrect because accounting is classified as a back office activity.
16. C is correct. Front office activities in a sell-side firm include activities
that directly produce revenue and typically have direct client contact.
Examples include sales and customer services. A is incorrect because
core activities of the firm are performed by the middle office. B is
incorrect because the back office of a firm is responsible for support
and administrative functions.
17. B is correct. A firm’s general counsel is usually the head of the legal
department, which is responsible for arranging contracts, interpreting
regulations, and handling lawsuits. A is incorrect because the chief risk
officer is responsible for identifying and managing potential risks to
clients and the firm. C is incorrect because the chief compliance officer
is usually the person responsible for ensuring that the firm follows
internal policies and regulations or constraints placed on the firm by
laws, regulations, and clients.
18. B is correct. The firm’s chief auditor, or chief audit executive, is
responsible for leading the firm’s auditing department, assessing the
firm’s operational systems, and suggesting ways for the firm to improve
them. A is incorrect because the chief risk officer is responsible for
identifying and managing potential risks to clients and the firm. C is
incorrect because the firm’s chief operating officer is responsible for
the day-to-day management of the firm.
NOTES
1Recall from the Investment Industry: A Top-Down View chapter that retail investors are individual
investors with a low amount of investable assets.
Chapter 14
Investment Vehicles
by Larry Harris, PhD, CFA
© 2014 CFA Institute. All rights reserved.
LEARNING OUTCOMES
After completing this chapter, you should be able to do the following:
a. Compare direct and indirect investing in securities and assets;
b. Distinguish between pooled investments, including open-end mutual
funds, closed-end funds, and exchange-traded funds;
c. Describe security market indices including their construction and
valuation, and identify types of indices;
d. Describe index funds, including their purposes and construction;
e. Describe hedge funds;
f. Describe funds of funds;
g. Describe managed accounts;
h. Describe tax-advantaged accounts and describe the use of taxable
accounts to manage tax liabilities.
1. INTRODUCTION
Investment professionals offer a great number of financial services, which
were discussed in the previous chapter, and products to help their clients
address their investment and risk management requirements. The large
variety of services and products reflects the many different needs and
challenges their clients face. Understanding the products and how they are
structured is necessary to appreciate how the investment industry creates
value for its clients.
Investment vehicles are assets offered by the investment industry to help
investors move money from the present to the future, with the hope of
increasing the value of their money. These assets include securities, such as
shares, bonds, and warrants; real assets, such as gold; and real estate. Many
investment vehicles are entities that own other investment vehicles. For
example, an equity mutual fund is an investment vehicle that owns shares.
This chapter introduces the most important investment vehicles and explains
how they are structured and how those structures serve investors.
Understanding these products and how they benefit clients will help you
support investment professionals and contribute to the value creation
process.
2. DIRECT AND INDIRECT
INVESTMENTS
Investors make direct investments when they buy securities issued by
companies and governments and when they buy real assets, such as precious
metals, art, or timber.
But a common way to invest is through indirect investment vehicles. That is,
investors give their money to investment firms, which then invest the money
in a variety of securities and assets on their behalf. Thus, investors make
indirect investments when they buy the securities of companies, trusts,
and partnerships that make direct investments. The following are examples of
indirect investment vehicles:
Shares in mutual funds and exchange-traded funds
Limited partnership interests in hedge funds
Asset-backed securities, such as mortgage-backed securities
Interests in pension funds
Most indirect investment vehicles are pooled investments (also known as
collective investment schemes) in which investors pool their money together
to gain the advantages of being part of a large group. The resulting economies
of scale can significantly improve investment returns.
2.1. Comparison of Direct and Indirect
Investments
Indirect investment vehicles provide many advantages to investors in
comparison with direct investments.
Indirect investments are professionally managed. Professional
management is particularly important when direct investments are hard
to find and must be managed.
Indirect investments allow small investors to use the services of
professional managers, whom they otherwise could not afford to hire.
Indirect investments allow investors to share in the purchase and
ownership of large assets, such as skyscrapers. This advantage is
especially important to small investors who cannot afford to buy large
assets themselves.
Indirect investments allow investors to own diversified pools of risks
and thereby obtain more stable, although not necessarily better,
investment returns. Many indirect investment vehicles represent
ownership in many different assets, each of which typically is subject to
specific risks not shared by the others. For example, a risk of investing
in home mortgages is that the homeowners may default on their
mortgages. Defaults on individual mortgages are highly unpredictable,
which makes holding an individual mortgage quite risky. In contrast, the
average default rate among a large set of mortgages is much more
predictable. Investing an amount in shares of a large mortgage pool is
much less risky than investing that same amount in a single mortgage.
Indirect investments are often substantially less expensive to trade than
the underlying assets. This cost advantage is especially significant for
publicly traded investment vehicles that own highly illiquid assets;
recall from the Alternative Investments chapter that liquidity is one of
the benefits of real estate investment trusts compared with real estate
limited partnerships or real estate equity funds. Although the assets in
which traded investment vehicles invest may be difficult to buy and sell,
ownership shares in these vehicles can trade in liquid markets.
Direct investments also present some advantages to investors compared with
indirect investments.
Investors exercise more control over direct investments than over
indirect investments. Investors who hold indirect investments generally
must accept all decisions made by the investment managers, and they
can rarely provide input into those decisions.
Investors choose when to buy or sell their direct investments to
minimise their tax liabilities. In contrast, although the managers of
indirect investments often try to minimise the collective tax liabilities of
their investors, they cannot simultaneously best serve all investors when
those investors have diverse tax circumstances.
Investors can choose not to invest directly in certain securities—for
example, in securities of companies that sell tobacco or alcohol. In
contrast, indirect investors concerned about such issues must seek
investments with investment policies that include these restrictions.
Investors who are wealthy can often obtain high-quality investment
advice at a lower cost when investing directly rather than indirectly.
So, is direct or indirect investment more advantageous for investors? The
answer is: it depends. Each investor and each investment firm must decide on
the best approach given their specific needs and circumstances.
2.2. Investment Control Problems
Although the majority of investment managers work faithfully to serve their
clients, some are not always careful, conscientious, or honest, which can
lead to investment losses from poor research, missed opportunities, selfserving advice, or outright fraud. Consider the following examples of
potential investment management problems:
Investment managers who do not conduct sufficient research and due
diligence may suggest inappropriate investments. Take the example of a
manager who buys a stock for a client portfolio simply based on the
recommendation of a friend. It would be inappropriate for the manager
to buy the stock without first conducting thorough research and due
diligence on the company.
Investment managers who receive commissions on trades that they
recommend may execute too many trades. Some managers have been
known to sell and replace their entire portfolios once or more over the
course of a year. Practitioners commonly call this practice churning.
Investment managers may favour themselves or their preferred clients
over other clients when allocating trades that have been, or are expected
to be, profitable. For instance, a manager might offer shares in an initial
public offering that is expected to do well only to preferred clients.
To successfully use the services of professional investment managers,
investors must control potential investment management problems. Investors
who cannot easily deal with these problems often prefer indirect investment
vehicles, such as public mutual funds, for which a board of directors (or
trustees) has primary responsibility for monitoring the performance of the
managers. Unfortunately, although board members generally work
conscientiously on behalf of their shareholders, some may be more loyal to
the managers that they monitor than to the shareholders that they represent.
Regardless, the managers of public mutual funds generally work hard for
their investors because they usually are paid in proportion to their total
assets under management. Because good performance tends to attract
additional investments, mutual fund managers generally work to produce
investment returns that attract new investments and thus increase their fees.
In contrast, large institutional investors are often direct investors who hire
and oversee investment managers. These institutional investors can often
devote substantial resources to monitoring and evaluating their managers.
3. POOLED INVESTMENTS
Most retail investors choose to save through pooled investment vehicles
managed by investment firms. The sole purpose of these investment vehicles
is to own securities and other assets. The investment vehicles, in turn, are
owned by their investors, who share in the profits and losses in proportion to
their ownership. It is important to note that investors in an investment vehicle
do not share ownership of the investment securities and assets held by the
investment vehicle. Instead, they share in the ownership of the investment
vehicle itself. That is, they are the beneficial owners of the investment
vehicle’s securities and assets, but not their legal owners.
3.1. How Pooled Investment Vehicles Work
Banks, insurance companies, and investment management firms organise most
pooled investment vehicles. The organiser is often called the sponsor.
Sponsors can organise investment vehicles as business trusts, limited
partnerships, or limited liability companies. Depending on the form of the
organisation, ownership shares are known as shares, units, or partnership
interests. Large sponsors can organise hundreds of investment vehicles.
Pooled investment vehicles are overseen by a board of directors, a board of
trustees, a general partner, or a single trustee; the governance structure
depends on the form of legal organisation. In some countries, directors must
be independent of the sponsor—that is, they are not allowed to work for the
banks, insurance companies, or investment companies that organise the
investment vehicle. In other countries, employees or directors of the sponsor
may also serve as directors of its associated investment vehicles.
The directors appoint a professional investment management firm, which is
almost always an affiliate of the sponsor. The investment manager works on a
contractual basis in exchange for a management fee paid by the investment
vehicle from its assets. The investment manager chooses the securities and
other assets held by the investment vehicle.
All pooled investment vehicles disclose their investment policies, deposit
and redemption procedures, fees and expenses, and past performance
statistics in an official offering document called a prospectus. Investors
use this information to evaluate potential investments. Investment vehicles
may disclose additional information through other mandated regulatory
filings, on their websites, or in marketing materials.
The three main types of pooled investment vehicles are open-end mutual
funds, closed-end funds, and exchange-traded funds. An important distinction
between pooled investment vehicles is whether they are exchange-traded or
not. Many closed-end funds and exchange-traded funds trade in organised
secondary markets just like common stocks. In contrast, open-end mutual
funds are not exchange traded.
Another important distinction between pooled investment vehicles is whether
their managers use passive or active investment strategies. The distinction
between passive and active investment strategies was introduced in the
Structure of the Investment Industry chapter. Recall that passive managers
seek to match the return and risk of a benchmark, and active managers try to
outperform (beat) the benchmark. Almost all closed-end funds use active
management strategies. Open-end mutual funds may use active or passive
investment strategies, depending on the fund. Most exchange-traded funds use
passive indexing strategies, but some are actively managed.
Sections 3.2 to 3.4 discuss more thoroughly the characteristics of open-end
mutual funds, closed-end funds, and exchange-traded funds. Section 3.5
compares the three types of pooled investment vehicles and concludes with a
summary table.
3.2. Open-End Mutual Funds
Open-end mutual funds are pooled investment vehicles used by many
individual and institutional investors. These pooled investment vehicles are
called open-end because they have the ability to issue or redeem
(repurchase) shares on demand. When investors want to invest in a mutual
fund, the fund issues new shares in exchange for cash that the investors
deposit. When existing investors want to withdraw money, the fund redeems
the investors’ shares and pays them cash. So from the fund’s point of view,
investor purchases and sales are deposits and redemptions, respectively.
The manager of an open-end mutual fund determines the prices at which
deposits and redemptions occur. No-load funds, which do not charge deposit
or redemption fees, set the same price for deposits and redemptions on any
given day. This price is the net asset value of the fund. The net asset value
(NAV) of a fund is calculated by dividing the total net value of the fund (the
value of all assets minus the value of all liabilities) by the fund’s current total
number of shares outstanding. Managers compute the fund’s NAV each day
following the normal close of exchange market trading. They use last
reported trade prices to value their portfolio securities and usually publish
the NAVs a few hours after the market closes.
Investors may have to pay sales loads to the fund distributor, who markets the
fund, at the time of purchase, at the time of redemption, or over time. Frontend sales loads are fees that investors may have to pay when they buy shares
in a fund. Back-end sales loads are fees that investors may have to pay when
they sell shares in a fund that they have not held for more than some prespecified period, typically a year or more. Sales loads are calculated as a
percentage of the sales price. The percentage is usually around 3%, but can
be as high as 9%. Typically, the fund distributor receives the fee and pays
part of it to the investment manager and part of it to anybody who helped
arrange the sale, except where legally restricted from doing so.
Some funds also charge purchase or redemption fees. Investors pay these
fees to the fund as opposed to paying them to the distributor as in a front-end
or back-end sales load. Purchase and redemption fees help compensate
existing shareholders for costs imposed on the fund when other shareholders
buy and sell their shares. These costs primarily consist of the costs of trading
portfolio securities incurred when buying securities to invest the cash
received from investors or when selling securities to raise cash for
redemptions.
As mentioned earlier, open-end mutual funds may be passively or actively
managed. Passively managed funds typically have much lower fees than
actively managed funds.
Money market funds are a special class of open-end mutual funds that
investors view as uninsured interest-paying bank accounts. Unlike other
open-end mutual funds, regulators permit money market funds to accept
deposits and satisfy redemptions at a constant price per share (typically one
unit of the local currency—for example, a euro per share in the eurozone) if
they meet certain conditions. In particular, they may only hold money market
securities—that is, generally very short-term, low-risk debt securities issued
by entities with very high-quality credit. In that case, regulators allow money
market funds to pay daily income distributions to their shareholders, which
they typically distribute at the end of the month. These arrangements ensure
that money market funds’ NAVs remain very close to their constant
redemption price.
Money market funds are vulnerable to a run on assets. In particular, if
investors expect that the value of their money market funds will decline in the
near future, they may rush to redeem their shares before the NAV falls. These
actions can be destabilising because they force funds to sell portfolio
securities when the market is falling.
3.3. Closed-End Funds
Unlike open-end funds, closed-end funds have a fixed number of shares;
they do not issue or redeem shares on demand. They may issue additional
shares in secondary offerings or through rights offerings or they may
repurchase shares, but these events are uncommon. Accordingly, the total
number of shares outstanding for most closed-end funds rarely changes.
Listed closed-end funds sell shares to the public in initial public offerings
(IPOs), as described in the Equity Securities chapter. They then use the
proceeds from the IPO to purchase securities and other assets. After the IPO,
investors who want to buy or sell a listed closed-end fund do so through
exchanges and dealers. The closed-end fund does not participate in these
transactions aside from registering the resulting ownership changes. Investors
buy and sell the shares at whatever prices they can obtain in the market.
Listed closed-end funds are actively managed and generally trade at prices
different from their NAV. A fund is said to trade at a discount if the trading
price is lower than the fund’s NAV or at a premium if the trading price is
greater than its NAV. Discounts are more common than premiums because
many closed-end fund investment managers have been unable to add more
value to their funds than the funds lose through their various operational
costs. The investment management fee typically is the largest of these costs.
Other costs include portfolio transaction costs and fees for accounting and
other administrative services.
3.4. Exchange-Traded Funds
Exchange-traded funds (ETFs) are pooled investment vehicles that are
typically passively managed to track a particular index or sector, although an
increasing number of ETFs are actively managed. ETFs are generally
managed by investment professionals who provide investment, managerial,
and administrative services. The fees for these services and trading costs are
low, particularly for ETFs that are passively managed.
3.5. Comparison of Pooled Investment
Vehicles
We already mentioned that two important differences between pooled
investment vehicles is whether they are exchange traded and whether they are
passively or actively managed. Other differences involve risks, management
accountability, costs, and taxes.
3.5.1. Risks
All pooled investment vehicles are risky, although the risks associated with
each investment vehicle mainly depend on the securities and other assets that
it holds in its portfolio. These risks vary much more by the investment
approach than by how the investment vehicle is organised. In general,
passively managed funds are less risky than actively managed funds that
invest in the same asset class because investors in actively managed funds
run the risk that their managers will underperform the market for that asset
class.
Closed-end funds generally are riskier than similar open-end mutual funds
because the discounts and occasional premiums at which closed-end funds
trade relative to their NAVs vary over time. Variation of these discounts and
premiums increases the risk of holding closed-end funds. ETFs also
sometimes trade at discounts and premiums to their NAVs, but these
variations tend to be small.
3.5.2. Management Accountability
Investors in indirect investment vehicles cannot choose who will manage
their investments. But they can choose the funds in which they invest and seek
to invest in funds run by managers that they trust and sell funds run by
managers they no longer have confidence in.
Management accountability is only a minor concern for ETFs and for openend mutual funds that use passive investing strategies because their managers
have little influence on portfolio performance.
Investors are more concerned about the accountability of managers of
actively managed open-end mutual funds and ETFs. Investors will withdraw
their money from these funds if they are unhappy with the management, thus
reducing the manager’s assets under management and the fee paid to the
manager.
In contrast, managers of closed-end funds are largely insulated from their
shareholders. Shareholders can sell their shares to new investors, but the
assets under management remain the same.
3.5.3. Costs
The costs incurred by pooled investment vehicles are deducted from their
assets, reducing their investment performance.
The biggest costs are those associated with management, distribution, and
account maintenance. The level of management fees depends primarily on the
style of asset management and the type of assets managed. Investors in
passively managed funds generally pay lower management fees, whereas
management fees for actively managed funds are usually higher.
Another type of cost is associated with trading. Investors can trade most
listed closed-end funds or ETFs at any time they can find a counterparty
willing to take the other side of their trade. In contrast, investors in open-end
mutual funds can trade only at the end of the day. They can place their orders
at any time, but settlement occurs after the markets close when the NAV has
been determined.
Investors who trade listed closed-end funds and exchange-traded funds
generally know the prices at which their trades can take place because
market prices are available. They usually use brokers to arrange their trades
and must pay commissions to them.
3.5.4. Tax Implication of Cash Distributions
Pooled investment vehicles generally distribute the income (typically interest
and dividends) that they receive from holding securities as cash dividends to
their investors. They also distribute any short- and long-term capital gains
realised (gains as a result of selling a security at a higher price than paid for
it) on their portfolio security trades as cash dividends. Distributions (made
on a per-share basis) are the same for all investors, regardless of how long
the shares have been held. Investors may choose, if the investment vehicle
allows it, to reinvest these distributions rather than receive them.
Investors should be aware of the tax implication of these cash dividends.
Section 8 discusses more thoroughly how investors can manage their tax
liabilities.
3.5.5. Summary of Differences Between Pooled
Investment Vehicles
Exhibit 1 offers a summary table of characteristics of open-end mutual funds,
closed-end funds, and ETFs.
Exhibit 1. Comparison of Open-End Mutual Funds, ClosedEnd Funds, and ETFs
Open-End
Mutual
Funds,
including
Money
Market
Funds
Managed
Exchange
traded
Yes,
actively or
passively
No
If exchange
traded, size of
the gap between
the price and the
net asset value
Closed-End
Funds
Yes, primarily
actively
Yes, but not
traded
continuously
Can be large,
usually trade
at a discount
to the NAV
ExchangeTraded
Funds
Yes,
primarily
passively
Yes, traded
continuously
Small,
usually
trade at
close to the
NAV
Redeemable
Risky
Management
accountability
Yes
Yes
No
Yes
Yes
Yes
Few issues,
particularly
if funds are
passively
managed
Few issues,
particularly
if funds are
passively
managed
Management
fees
High if
actively
managed,
low if
passively
managed
Management
not
particularly
responsive to
shareholders’
concerns
High because
actively
managed
Low if
passively
managed
4. INDEX FUNDS
Index funds, which are passively managed, are among the most common types
of pooled investment vehicles and are used widely in most parts of the
world. They are popular because they provide broad exposure to an asset
class and are cheap relative to many other products. In order to understand
index funds, it is necessary to have an understanding of security market
indices.
4.1. Security Market Indices
If you want to assess how a stock market performed this week, you could
look at the performance of every single security listed on the market. But it is
more practical to use a single measure that is representative of the
performance of the entire stock market. If you are located in the United
States, you can look at the S&P 500 Index; if you are in the United Kingdom,
you can look at the FTSE 100 (practitioners commonly pronounce FTSE as
“footsie”); if you are in France, you can look at the CAC 40; or if you are in
South Korea, you can look at the Korea Stock Price Index (KOSPI).
A security market index is a group of securities representing a given
security market, market segment, or asset class. The security market indices
just mentioned are widely published equity market indices. Practitioners
have also created many other indices.
4.1.1. The Index Universe
The investment industry has created indices to measure the values of almost
every existing market, asset class, country, and sector:
Broad market indices cover an entire asset class—for example, stocks
or bonds—generally within a single country or region.
Multi-market indices cover an asset class across many countries or
regions.
Industry indices cover single industries.
Sector indices cover broad economic sectors—sets of industries related
by common products or common customers, such as healthcare, energy,
or transportation.
Style indices provide benchmarks for common styles of investment
management. Examples of equity-style indices include indices of value
and growth stocks; of small-, mid-, and large-capitalisation stocks; and
of combinations of these classifications, such as small-cap growth.
Fixed-income indices cover debt securities and vary by characteristics
of the underlying securities and by characteristics of the issuers. For
example, separate indices are available for securities issued by
governments (sovereign) and companies (corporate); short-, mid(intermediate-), and long-term bonds; investment-grade and high-yield
bonds; inflation-protected and convertible bonds; and asset-backed
securities.
Other indices track the performance of alternative investments, such as
hedge funds, real estate investment trusts (REITs), and commodities. As
discussed in the Alternative Investments chapter, real estate investment
trusts are public companies that mainly own, and in most cases operate,
income-producing real estate.
4.1.2. How to Compute the Value of Indices
The value of an index is computed from the prices of the securities that
compose the index. Two important elements affect the value of an index:
the securities included in the index and
the weight assigned to each security in the index.
Some indices include a small number of securities from one national market
or one particular sector. For example, the Dow Jones Industrial Average
(DJIA) includes only 30 large US company stocks and the Dow Jones
Utilities includes only 15 large US company stocks from the utility sector.
Other indices try to capture a larger share of the securities market and
include hundreds or thousands of securities from around the world. For
example, the Morgan Stanley Capital International (MSCI) World Index
includes more than 6,000 stocks in 24 developed markets. Note that the list
of securities included in an index may change from time to time. The process
of adding and removing securities included in the index is called index
reconstitution.
There are different approaches used to assign weights to the securities
included in an index: price-weighted, capitalisation-weighted, or equalweighted.
A price-weighted index is an index in which the weight assigned to each
security is determined by dividing the price of the security by the sum of all
the prices of the securities. As a consequence, high-priced securities have a
greater weighting and more of an effect on the value of the index than lowpriced stocks. The DJIA in the United States and the Nikkei 225 in Japan are
examples of price-weighted indices.
Many indices are capitalisation-weighted indices (also known as capweighted indices, market-weighted indices, or value-weighted
indices). The weight assigned to each security depends on the security’s
market capitalisation. Market capitalisation is equal to the market price of
the security multiplied by the number of shares outstanding of the security.
For example, as of August 2018, Apple’s stock price was approximately
$220 per share and there were about 4.9 billion shares outstanding. Thus,
Apple’s market capitalisation was about $1.08 trillion. Securities included in
capitalisation-weighted indices are given weights in proportion to their
relative market capitalisations. In other words, securities of bigger
companies get higher weights. The Hang Seng in Hong Kong SAR, the FTSE
100 in the United Kingdom, and the S&P 500 Market Weight Index are
examples of capitalisation-weighted indices.
Equal-weighted indices show what returns would be made if an equal
value were invested in each security included in the index. The prices of
these securities change continuously. Thus, to maintain the equal weights
between securities, regular index rebalancing is necessary. That is, the
weights given to securities whose prices have risen must be decreased, and
the weights given to securities whose prices have fallen must be increased.
The S&P 500 Equal Weight Index is an example of an equal-weighted index.
The fact that different indices include different securities and use different
approaches to assign weights to the securities explains why the changes in
values of indices vary, even when focusing on the same national market or
sector. For example, as of August 2018, Apple is the largest company by
market capitalisation. Apple stock is included in both the S&P 500 Equal
Weight and Market Weight Indices. Because the S&P 500 Equal Weight Index
assigns the same weights to all the stocks it includes, Apple represents only
0.2% (1/500th) of the S&P 500 Equal Weight Index. Because the S&P 500
Market Weight Index assigns to each stock a weight that reflects the
company’s market capitalisation, Apple represents 4.5% of the S&P 500
Market Weight Index. A change in the price of Apple’s stock will have a
small effect on the S&P 500 Equal Weighted Index, but will have a much
larger effect on the S&P 500 Market Weight Index. Knowing which securities
are included in an index and how much weight is assigned to each is
important information for people using the index.
The percentage change in the value of an index over some time interval is the
index return. Analysts focus more on index returns than on index values
because index values are arbitrary. For example, the value of the FTSE 100
was arbitrarily set to a base value of 1,000 on 3 January 1984 when the
Financial Times and the London Stock Exchange created the index.
4.2. Index Funds
The investment industry creates many investment products based on security
market indices, such as index funds. An index fund is a portfolio of
securities structured to track the returns of a specific index called the
benchmark index. An index fund is a passive investment strategy because the
index fund manager aims to replicate the benchmark index.
Index funds are popular among individual and institutional investors because
they produce returns that closely track market returns. Index funds are
generally broadly diversified and highly transparent, with relatively low
management and trading costs. They are tax-efficient because they do not do
a lot of trading that can generate taxable capital gains. The low level of
trading also reduces trading costs. Most individual investors and many
institutional investors invest in index funds by buying open-end mutual funds
that hold index portfolios. Many large institutional investors also hold index
portfolios in their investment accounts; in other words, they create their own
index funds.
Some index fund managers invest in every security in the benchmark index, a
strategy known as full replication. Other index funds find it difficult to buy
and hold all of the securities included in the benchmark index. The securities
may not be easily available or the transaction costs of acquiring and holding
all the securities included in the benchmark index may be high. If full
replication is difficult or too costly, index fund managers might invest in only
a representative sample of the index securities, a strategy called sampling
replication. Managers of small funds, which track indices with many
securities, often use the sampling replication strategy to reduce costs.
Once set up, index funds only trade if the weightings need to be adjusted.
Adjustments are necessary in the case of index reconstitution—that is, when
securities are added or deleted from the list of index securities. All index
funds are affected by index reconstitution, but equal-weighted index funds are
most affected by a need to change weightings. The equal-weighted index fund
has to trade to maintain the equal weighting. The capitalisation-weighted
index fund only needs to rebalance if corporate actions, such as mergers and
acquisitions, affect weightings.
Index funds sometimes buy securities to invest cash when cash inflows are
received. Cash inflows include receipt of dividends and/or interest. They
also include additional net cash inflows from investors—that is, additional
investments from investors that exceed withdrawal (redemption) requests by
investors. Index funds may have to sell securities if withdrawal requests
from investors exceed additional investment from investors.
5. HEDGE FUNDS
Hedge funds are another type of pooled investment vehicle. They are less
widely used by investors than index funds because they tend to be more
complex, less transparent, and less liquid, with higher costs and a high
minimum investment level.
5.1. Characteristics
Hedge funds are private investment pools that investment managers
organise and manage. As a group, they pursue diverse strategies. The term
“hedge” once referred to the practice of buying one asset and selling a
correlated asset to take advantage of the difference in their values without
taking much market risk—thus the use of the term hedge because it refers to a
reduction or elimination of market risk. Although many hedge funds do
engage in some hedging, it is not the distinguishing characteristic of most
hedge funds today.
Hedge funds are distinguished from other pooled investment vehicles
primarily by
their availability to only a limited number of investors,
agreements that lock up the investors’ capital for fixed periods, and
their managers’ performance-based compensation.
They can also be distinguished by their use of strategies beyond the scope of
most traditional closed-end funds and open-end mutual funds that are actively
managed.
5.1.1. Availability
Hedge funds are usually available only to some investors who meet various
wealth, income, and investment knowledge criteria that regulators set. The
criteria are designed to ensure that these investment vehicles are suitable for
their investors. Most money invested in hedge funds comes from large
institutional investors, such as pension funds, university endowment funds,
and sovereign wealth funds, as well as from high-net-worth individuals.
5.1.2. Lock-Up Agreements
Most hedge funds lock up their investors’ capital for various periods, the
length of which depends on how much time the hedge fund managers expect
that they will need to successfully implement their strategies. Funds that
engage in high-frequency strategies generally have shorter lock-up periods
than funds that engage in strategies that may take much more time to realise
the expected returns, such as strategies that involve reforming corporate
governance.
5.1.3. Compensation
Perhaps the most distinguishing characteristic of hedge funds is the
managerial compensation system they use. Hedge fund managers generally
receive an annual management fee plus a performance fee that is often
specified as a percentage of the returns that they produce in excess of a
hurdle rate. For example, a manager who receives “2 and 20”
compensation will receive 2% of the fund assets in management fees every
year plus a performance fee of 20% of the return on the fund assets that
exceeds the hurdle rate.
HURDLE RATE
For example, assume that the assets under management are £1 million,
that the hurdle rate is 5%, and that the return on the fund assets for the
year is 17%. As illustrated in the figure, the excess return—that is, the
return in excess of the hurdle rate—is 12%. Based on a “2 and 20”
compensation, the hedge fund manager will receive an annual
management fee of £20,000 and a performance fee of £24,000 for a total
compensation of £44,000.
The investors’ return net of fees is £126,000 [ = (17% × £1,000,000) –
£44,000] or 12.6%.
Hedge fund managers usually earn the performance fee only if the fund is
above its high-water mark. The high-water mark reflects the highest value,
net of fees, that the fund has reached at any time in the past (Exhibit 2). The
high-water mark provision ensures that investors pay the managers only for
net returns calculated from the initial investment and not for returns that
recoup previous losses. This provision is also called the loss-carryback
provision.
Exhibit 2.
High-Water Mark
Some managers terminate their funds and start over when they have
significant losses because they know they may never achieve their high-water
mark and so cannot collect performance fees. Restarting gives managers a
new high-water mark. But it does not always solve their problem: managers
who have performed poorly often have difficulty raising new funds from
investors.
Investors pay high performance fees in the belief that the fees provide strong
incentives to managers to perform well. These incentives work when the fund
is near its high-water mark but they are less powerful when the fund has
performed poorly.
5.2. Risks
Although many hedge funds are not particularly risky, the high performance
fees might encourage some fund managers to take substantial risks. Hedge
funds sometimes increase their risk exposure through leverage. Increased
leverage can be achieved through the use of borrowed funds or through the
use of derivatives.
On the one hand, if their investments are successful, the performance fee can
make the managers extremely wealthy. On the other hand, if the hedge fund
has poor returns, the investors lose their whole investment but the managers
lose only the opportunity to stay in business. This asymmetry in managers’
compensation can encourage risk taking.
Hedge fund investment managers often also participate as investors in their
hedge funds. Their co-investments help assure their investors that the
managers’ interests are well aligned with theirs. Such assurances help
managers raise funds.
Most hedge funds are open-end investment vehicles that allow new investors
to buy in and existing investors to leave at the NAV. But as mentioned before,
most funds only allow investors to withdraw funds following a lock-up
period and then only on specific dates.
5.3. Legal Structure and Taxes
The legal structure and legal domicile of hedge funds generally depend on
their managers’ and investors’ tax situations. For example, most hedge funds
serving US investors are organised as domestic limited partnerships in which
the manager is the general partner and the investors are the limited partners.
This structure, which is similar to the structure of private equity funds
described in the Alternative Investments chapter, allows for some of the fees
to be treated as capital gains rather than ordinary income.
Some hedge funds are domiciled in offshore financial centres where tax rates
may be lower. The Cayman Islands are a popular domicile for hedge funds
because of favourable laws and regulations for investors and investment
managers and the tax advantages this location offers.
6. FUNDS OF FUNDS
Funds of funds are investment vehicles that invest in other funds. They
can be actively managed or passively managed.
Two main investment strategies characterise most actively managed funds of
funds. Some managers try to identify funds with managers they believe will
outperform the market. They then invest in funds managed by those managers.
Others use various proprietary models to predict which investment strategies
are most likely to be successful in the future and then invest in funds that
implement those strategies. Both types of managers try to hold welldiversified portfolios of funds to reduce the overall risk of their funds.
The costs of investing in an actively managed fund of funds can be high
because investors pay two levels of fees. They pay management and
performance fees directly to the fund of funds manager and they also
indirectly pay fees to the managers of the funds in which the fund of funds
invests.
In the case of a fund of hedge funds, investors may pay particularly high
management fees because of the performance fees paid to the hedge fund
managers. In a well-diversified fund of hedge funds, investment gains in
some funds are often offset by losses in the other funds. The fund of hedge
funds pays performance fees to the winning hedge fund managers and thus
shares its gains in these funds with those managers. But losing hedge fund
managers do not share in the losses of their hedge funds. If the gains and
losses are of equal size, fund-of-hedge-funds investors will not profit
overall, but will still pay substantial performance fees to the winning
managers.
7. MANAGED ACCOUNTS
Many investors contract with investment professionals to help manage their
investments. These investment professionals generally promise to implement
specific strategies in exchange for an advisory fee or for commissions on the
trades that they recommend. Investors are increasingly using fee-based
investment professionals to ensure that these professionals will not profit
from recommending excessive trading.
Institutional investors that do not manage investments in-house use fee-based
investment professionals. Retail investors often obtain the services of feebased investment professionals through wrap accounts. In a wrap account,
the charges for investment services, such as brokerage, investment advice,
financial planning, and investment accounting, are all wrapped into a single
flat fee. The fee typically ranges between 1% and 3% of total assets per year
and is usually paid quarterly or annually.
Investment managers can hold their institutional clients’ investments in
separate accounts or in commingled accounts. In a commingled account,
the capital of two or more investors is pooled together and jointly managed.
In contrast, funds and securities in a separate account are always kept
separate from those of other investors, even if the investment manager uses
identical investment strategies for several such accounts.
8. TAX-ADVANTAGED ACCOUNTS AND
MANAGING TAX LIABILITIES
To promote savings for retirement income, educational expenses, and health
expenses, many countries give tax advantages to certain investment accounts.
8.1. Tax-Advantaged Accounts
In general, tax-advantaged accounts allow investors to avoid paying
taxes on investment income and capital gains as they earn them. In addition,
contributions made to these accounts may have tax advantages. In exchange
for these privileges, investors must accept stringent restrictions on when the
money can be withdrawn from the account and sometimes on how the money
can be used.
Many countries allow contributions to certain tax-advantaged accounts to be
tax deductible, which means that they reduce the income on which taxes are
paid. Tax-deductible contributions are common for retirement accounts. In
most countries, contributions made to pension plans by employers or
employees, as well as contributions made by individuals to specific types of
retirement accounts, are tax deductible up to certain limits. These accounts
are allowed to grow tax free so that any income or capital gains earned by
the account will not be taxed if left in the account. But taxes may be due when
the money is ultimately withdrawn. For most retirement accounts,
distributions are taxed as ordinary income.
Some countries also allow investors to contribute after-tax funds to taxadvantaged accounts. After-tax funds are the amounts that remain after
taxable income and gifts are received and taxed. When placed in taxadvantaged accounts, the funds grow tax free. When withdrawn, taxes, if any,
are collected only on the accumulated investment income and capital gains
earned during the period of the investment. The original investment
(principal), which was taxed once, is not taxed again.
Some countries allow all distributions from certain tax-advantaged accounts
to be tax free if the money is used for higher education or for health care.
Distributions from retirement accounts are generally taxed as ordinary
income.
Governments usually prohibit early withdrawals or withdrawals for
unauthorised purposes from tax-advantaged accounts. When such
withdrawals are permitted, they generally incur penalties and immediate
taxes. In some countries and for some accounts, investors can circumvent
these restrictions by borrowing against the values of their accounts.
Saving in tax-advantaged accounts from which distributions are not taxed is
advantageous for investors if they are certain that they will ultimately use the
money for its authorised purpose. For example, investors saving for
education will always be better off doing so with tax-advantaged accounts if
the withdrawals used to fund educational expenses are not taxable.
Some tax-advantaged accounts allow the deferral of tax. Whether deferral is
advantageous depends on the tax rates at which the principal and investment
income would otherwise be taxed and on the tax rates at which the deferred
income will be taxed. If future tax rates are expected to be lower or the same
as current tax rates, deferral is advantageous.
Deferring taxes may not be beneficial if tax rates are expected to be higher in
the future. Future rates may be higher under a variety of circumstances: tax
rates may change during the period of the investment, the investor may be
wealthier in the future and thus subject to higher tax rates, or the investor may
pay ordinary income tax rates on distributions from a tax-advantaged account
but would have paid lower rates on capital gains and investment income
earned (dividends and interest) on the investment if the money was invested
in a taxable account.
8.2. Managing Tax Liabilities
Investors in taxable accounts can often minimise their tax liabilities through
careful investment management decisions. In particular, most jurisdictions do
not tax capital gains until they are realised. Capital gains and losses
generally are realised on the sale of a previously purchased security or asset.
Investors who have unrealised capital gains because their purchases
increased in value can avoid paying taxes by simply not selling their
appreciated securities or assets.
Most jurisdictions allow taxpayers to offset their realised capital gains with
realised capital losses so that they are taxed only on the net gain.
Accordingly, investors frequently realise losses by selling losing positions
so that they can use them to offset realised capital gains.
Many jurisdictions tax capital gains at lower rates than they tax investment
income, such as interest and dividends. Taxpaying investors in these
jurisdictions can minimise their taxes by using investment vehicles that do
not pay investment income. Alternatively, they could invest in companies that
distribute cash by repurchasing shares on the open market instead of paying
dividends. Share prices of these companies tend to rise over time as the
share repurchases reduce the total number of shares. Investors who retain
their shares thus earn long-term capital gains rather than current investment
income. These companies provide more tax-efficient investments than do
otherwise similar companies that pay dividends. Some countries, such as
Singapore, do not have capital gains taxes.
Whether investors should defer taxable income depends on the tax regime,
their expectations of future tax rates (including estate tax rates, which are
imposed on the transfer of properties from the deceased to his or her heirs),
and the probability that they will need money that they cannot access if
placed in a tax-advantaged account. Some investment professionals can help
investors work through these issues.
SUMMARY
Companies in the investment industry offer many investment vehicles that
help individual and institutional investors meet their investment needs.
Investors use these investment vehicles to reduce the cost of investing,
control their risk exposure, and improve their returns. By pooling their
money in investment vehicles, investors can gain access to skilled
professional investment managers, reduce risk through diversification, and
benefit from economies of scale.
The great diversity in investment vehicles is a result of differences in
investor needs, preferences, and wealth. In their search for profits,
investment firms create a variety of investment vehicles designed to satisfy
investors whose needs are diverse.
This chapter provides an overview of the investment vehicles that investors
commonly use. Some important points to remember include the following:
Investors make direct investments by buying investment securities
issued by companies and governments and real assets. Direct investors
benefit from the ability to choose the securities and assets they invest in,
time their trades to minimise their tax liabilities, and exercise control
over their investments.
Investors who make indirect investments buy investment vehicles from
investment firms. The investment vehicles invest directly in portfolios
of securities and assets. Indirect investors benefit from access to
professional management, the ability to share ownership of large assets,
the ability to diversify their risks, and often, lower trading costs than
direct investments.
The three main types of pooled investments are open-end mutual funds,
closed-end funds, and exchange-traded funds (ETFs). Investors like
them because they allow them to cheaply invest in highly diversified
portfolios in a single low-cost transaction.
Almost all closed-end funds use active management strategies whereas
open-end mutual funds can use active or passive investment strategies.
Most ETFs are passively managed.
Closed-end funds and ETFs are exchange-traded and may trade at
prices other than their net asset values. In contrast, open-end mutual
funds do not trade on an organised secondary market. Open-end funds’
securities are bought and redeemed with the fund at net asset value.
The other main differences between the various types of pooled
investments are related to management accountability, management fees
and trading costs, and the tax implication of cash distributions.
Practitioners have created indices to track markets, asset classes,
industries, and regions. Two important elements that affect the value of
indices are the securities included in the index and the approach used to
assign weights to the securities included in the index: price-weighted,
capitalisation-weighted, or equal-weighted.
The investment industry creates investment products based on indices,
such as index funds. Index funds use passive investment strategies that
are inexpensive to implement, generate minimal management and trading
costs, and thus produce returns that closely track returns of a benchmark
index.
The defining characteristics of hedge funds include their availability to
only a limited number of investors, agreements that lock up the
investors’ capital for fixed periods, and performance-based managerial
compensation contracts. Different hedge funds have different profiles in
terms of risks, legal structure, and taxes.
Funds of funds are investment vehicles that invest in other funds. Fundof-funds managers seek to add value by selecting managers who will
outperform their peers rather than by selecting securities that will
outperform other securities. Fees can be high because investors
implicitly pay two levels of fees.
Separate accounts can be managed for the exclusive benefit of a single
investor, but they can be expensive to manage. In contrast, commingled
accounts provide investors the benefit of economies of scale in asset
management.
Tax-advantaged accounts allow investors to avoid or defer paying taxes
on investment income and capital gains. Investors in taxable accounts
can also often minimise their tax liabilities through timing of investment
decisions and choice of investments.
CHAPTER REVIEW QUESTIONS
© 2014 CFA Institute. All rights reserved.
1. The investment most likely to be purchased by an investor with a
preference for direct investments is a share in:
A. a company.
B. a mutual fund.
C. an exchange-traded fund (ETF).
2. Relative to indirect investments, direct investments:
A. are less expensive to trade.
B. offer more control to investors.
C. allow small investors to share in the purchase of large assets.
3. Direct investments allow retail investors to:
A. own diversified pools of risk.
B. use the services of professional managers.
C. choose when to buy or sell to minimise tax liabilities.
4. Compared with shares of closed-end funds, shares of open-end mutual
funds:
A. are not redeemable.
B. are exchange traded.
C. trade at net asset value.
5. Exchange-traded funds (ETFs) most likely:
A. trade continuously.
B. are actively managed.
C. have relatively high management fees.
6. An index that gives each security’s weight according to the proportion
of its market capitalisation is:
A. a price-weighted index.
B. a value-weighted index.
C. an equal-weighted index.
7. The process of adding and removing securities included in a security
market index is called:
A. churning.
B. rebalancing.
C. reconstitution.
8. Rebalancing is most likely to be associated with an index that is:
A. price weighted.
B. equal weighted.
C. capitalisation weighted.
9. From the perspective of an investor, index funds are popular because
they are generally:
A. broadly diversified.
B. tax-free investments.
C. not subject to management fees.
10. An index fund will sell securities if:
A. the value of the benchmark index falls.
B. withdrawal requests are greater than new receipts from investors.
C. dividends, interest, and investor contributions are greater than
withdrawals.
11. Hedge funds are most likely to:
A. impose capital lock-up periods.
B. raise capital from retail investors.
C. have relatively low management and performance fees.
12. Increasing the hurdle rate for a hedge fund manager will usually lead to
total fees that are:
A. lower.
B. unchanged.
C. higher.
13. An unfavourable feature of hedge funds for most investors is the:
A. hurdle rate.
B. lock-up period.
C. high-water mark.
14. A high-water mark is incorporated in a hedge fund fee structure to
benefit:
A. investors.
B. fund managers.
C. both investors and fund managers.
15. The ability to defer taxes in tax-advantaged accounts will be most
beneficial for investors who expect their tax rates in the future to:
A. increase.
B. decrease.
C. remain unchanged.
ANSWERS
1. A is correct. Buying a share in a company is a direct investment. B and
C are incorrect because an investor buying shares in a mutual fund or in
an ETF is making an indirect investment.
2. B is correct. Investors who hold direct investments can exercise more
control over their investments than investors who hold indirect
investments. Investors who hold indirect investments generally must
accept all the decisions made by the investment managers, and they can
rarely provide input into those decisions. A is incorrect because
indirect investments are often substantially less expensive to trade than
their underlying assets. C is incorrect because indirect investments, not
direct investments, allow investors to share in the purchase and
ownership of large assets. This advantage is especially important to
small investors who cannot afford to buy large assets themselves.
3. C is correct. Direct investments provide an investor with the ability to
choose the securities and assets they invest in, time their trades to
minimise their tax liabilities, and exercise control over their
investments. A and B are incorrect because indirect investments allow
retail investors to own diversified pools of risk and to use the services
of professional managers, which they otherwise might not be able to do.
4. C is correct. The shares of open-end mutual funds are bought and
redeemed at net asset value. Shares of closed-end funds generally trade
at prices different from their net asset value. A is incorrect because it is
the shares of closed-end, not open-end, mutual funds that are not
redeemable. B is incorrect because it is the shares of closed-end, not
open-end, mutual funds that are exchange traded.
5. A is correct. ETFs usually trade continuously. B is incorrect because
ETFs are primarily passively managed. C is incorrect because, as a
result of being primarily passively managed, ETFs do not trade
frequently. Thus, they have relatively low trading costs and management
fees.
6. B is correct. An index that gives each security’s weight according the
proportion of its market capitalisation is a value-weighted index, also
known as a capitalisation-weighted, cap-weighted, or market-weighted
index. The market capitalisation of a security is the market price of the
security multiplied by the number of units outstanding of the security. A
is incorrect because a price-weighted index assigns weights in the
proportion of market price rather than market capitalisation. C is
incorrect because an equal-weighted index gives the same weight to all
the securities included in the index.
7. C is correct. The process of adding and removing securities included in
a security market index is called index reconstitution. A is incorrect
because churning is excessive trading to increase commissions. B is
incorrect because rebalancing is the process of adjusting the weights of
the securities in an index.
8. B is correct. Equal-weighted indices represent returns based on an
equal value invested in each security included in the index. The prices
of these securities change continuously. Thus, to maintain the equal
weights between securities, regular index rebalancing is necessary. A
and C are incorrect because price-weighted and capitalisation-weighted
indices do not require rebalancing.
9. A is correct. Index funds are diversified. They are also transparent and
tax efficient with very low management and trading costs. B is incorrect
because index funds are tax-efficient investments but not tax-free
investments. C is incorrect because index funds represent investments
with very low, but not zero, management fees.
10. B is correct. Index funds may have to sell securities if withdrawal
requests from investors exceed additional investment from investors. A
is incorrect because an index fund uses a passive investment strategy. C
is incorrect because an index fund will purchase securities if net cash
inflows (Dividends + Interest + Investor contributions) are greater than
withdrawal requests.
11. A is correct. Most hedge funds impose capital lock-up periods, the
lengths of which depend on how much time the hedge fund managers
expect that they will need to successfully implement their strategies. B
is incorrect because retail investors are not typically eligible to invest
in hedge funds. C is incorrect because hedge funds have relatively high
management and performance fees.
12. A is correct. Hedge fund managers generally receive an annual
management fee plus a performance fee that is often specified as a
percentage of the returns that they produce in excess of a hurdle rate.
Therefore, if the hurdle rate is increased, the performance fee is
decreased (lower) and total fees are decreased.
13. B is correct. Most hedge funds lock up their investors’ capital for
various periods of time, which will restrict investors’ access to their
invested capital. A and C are incorrect because a hurdle rate and a high-
water mark benefit investors participating in hedge funds and would
thus be viewed as favourable features.
14. A is correct. Hedge fund managers usually earn the performance fee
only if the fund is above its high-water mark. Therefore, the existence of
the high-water mark is a benefit to investors. If the net asset value of the
fund is below the high-water mark, no performance fee is payable.
15. B is correct. Deferral is advantageous if future tax rates are expected to
be lower than current tax rates. In this case, investors will be better off
if they pay taxes at the lower future tax rate rather than at the higher
current tax rate.
Chapter 15
The Functioning of Financial
Markets
by Larry Harris, PhD, CFA
© 2015 CFA Institute. All rights reserved.
LEARNING OUTCOMES
After completing this chapter, you should be able to do the following:
a. Distinguish between primary and secondary markets;
b. Explain the role of investment banks in helping issuers raise capital;
c. Describe primary market transactions, including public offerings,
private placements, and right issues;
d. Explain the roles of trading venues, including exchanges and alternative
trading venues;
e. Identify characteristics of quote-driven, order-driven, and brokered
markets;
f. Compare long, short, and leveraged positions in terms of risk and
potential return;
g. Describe order instructions and types of orders;
h. Describe clearing and settlement of trades;
i. Identify types of transaction costs;
j. Describe market efficiency in terms of operations, information, and
allocation.
1. INTRODUCTION
Have you have ever bought shares, bonds, or invested money in a mutual
fund? If so, you have—whether you realise it or not—been served by
financial markets. Many investors use financial markets to implement their
investment decisions, as reflected by the trillions of financial market
transactions each year.
Investors buy and trade securities that are issued by companies and
governments that need to raise capital. Markets in which companies and
governments sell their securities to investors are known as primary
markets. Each type of security has its own primary market. For example, in
most countries, there is a primary market for shares issued by companies or
bonds issued by the sovereign (national) government.
Investors also trade securities, such as shares and bonds, as well as
contracts, such as futures and options. These trades take place in
secondary markets. When trading securities and contracts in secondary
markets, investors often obtain assistance from trading services providers,
such as brokers and dealers. These specialists perform a variety of tasks,
which were described in the Structure of the Investment Industry chapter.
Well-functioning financial markets are important for economic welfare.
Investment industry participants must understand how financial markets
work; this understanding will help them appreciate how the industry connects
those who need money with those who have savings and are willing to invest
their savings. In this chapter, you will learn how primary and secondary
markets operate, how investors and traders are served by these markets, and
what characterises well-functioning financial markets.
2. PRIMARY SECURITY MARKETS
Secondary markets are the main focus of this chapter because most investors
buy and sell securities via secondary markets. So, most of the investment
industry is focused on secondary markets. But, first, we discuss primary
markets, which are the markets in which issuers sell their securities to
investors. In other words, primary markets are where securities first become
available to all investors. Issuers are typically companies and
governments; selling securities to investors in exchange for cash is a way for
these companies and governments to raise money. The main primary market
transactions are public offerings, private placements, and rights offerings.
2.1. Public Offerings
As discussed in the Equity Securities chapter, a company that sells securities
to the public for the first time makes an initial public offering (IPO),
sometimes also called a placing or placement. Practitioners say that the
company is “going public”. The shares offered consist of new shares issued
by the company and may also include shares that the founders and other early
investors in the company want to sell. The IPO provides founders and other
early investors with a means of converting their investments into cash, a
process known as monetising.
The selling of new shares by a publicly traded company subsequent to its
IPO is referred to as a secondary, or seasoned, equity offering. Both initial
public and seasoned offerings occur in the primary market for a particular
type of securities—for instance, the primary market for corporate bonds.
Later, if investors buy and sell this type of securities from and to each other,
they do so in the secondary market. Note that the issuer only receives
additional capital when it issues new securities in the primary market. It will
not receive any new capital from the trading of its securities in the secondary
market.
Before a public offering, the issuer typically provides detailed information
about its business and inherent risks as well as the proposed uses for the
money it hopes to raise. This information is offered in the form of a
prospectus to potential investors. Most exchanges and their regulators have
detailed rules regarding the format and content of a prospectus.
Companies generally contract with investment banks to help them sell their
securities to the public. Investment banks play an important role in
identifying potential investors and setting the offering price—that is, the
price at which the securities are sold. The role played by investment banks is
different, however, depending on whether it is an underwritten offering or a
best efforts offering.
The most common offering type for initial public and seasoned offerings is an
underwritten offering. In an underwritten offering, the investment bank
acts as an underwriter. In this role, the investment bank buys the securities
from the issuer at a price that is negotiated with the issuer, thus guaranteeing
that the issuer gets the amount of capital it requires. The securities are then
sold at an agreed-on offering price to investors. The objective of the
investment bank is not to become a long-term shareholder of the issuer but to
be an intermediary between the issuer and the investors for a fee. Finding
investors willing to buy the securities is thus an important aspect of an
underwritten offering because it reduces the risk that the investment bank is
unable to resell all the securities it bought from the issuer.
In a process called book building, the investment bank identifies investors
who are willing to buy the securities. These investors are known in the
industry as subscribers. The investment bank tries to build a book of orders
from clients or other interested buyers to whom they can resell the securities.
In the book building process, the right offering price is particularly
important. If there are not enough buyers for all the securities that are for
sale, the offering is said to be undersubscribed. If there is more demand than
securities for sale, the offering is said to be oversubscribed. In the case of
oversubscription, the securities are often allocated by the investment bank to
preferred clients or on a pro rata basis, by which all investors get a set
proportion of the shares they ordered.
In the case of undersubscription, the investment bank will be left with unsold
securities, which not only commits capital for longer than expected but is
also risky. If after the public offering, the price of the securities falls below
the offering price, the investment bank may face a loss. So, investment banks
have a conflict of interest with respect to the offering price in underwritten
offerings. As agents for the issuers, they should price the issue to raise the
most money for the issuer. But as underwriters, they have strong incentives to
choose a lower price because it reduces the risk of the offering being
undersubscribed. Underwriters can also allocate these essentially
“underpriced” securities to benefit their clients, a process that indirectly
benefits the investment bank.
First-time issuers may accept lower offering prices because they are
concerned about the possibility of the issue being undersubscribed. Many
believe that an undersubscribed IPO conveys unfavourable information about
a company’s prospects at a time when the company is most vulnerable to
public opinion about its future. The issuer may fear that an undersubscribed
IPO will reduce the benefits of going public, such as the opportunity to raise
capital in subsequent offerings and the positive publicity associated with a
successful IPO.
In an IPO, the underwriter usually promises to ensure that the secondary
market for the securities will be liquid. If necessary, the underwriter
provides price support for a limited period of time, typically about a month.
During that time, if the price of the securities falls below a certain threshold,
the underwriter will buy securities to stop or limit the price fall. Providing
price support is costly to investment banks, and it is another factor that
motivates them to choose a lower offering price so that the security’s price in
the secondary market rises immediately following the IPO. However, price
support does not guarantee that the security’s price will not fall. For
example, the price of Facebook’s shares declined substantially in the weeks
that followed the company’s IPO in 2012, despite price support from the
underwriters.
Pricing is less challenging in a seasoned offering because the issuer’s
securities already trade in the secondary market. Thus, it is easier to identify
an appropriate price for the offering. The fees charged for a seasoned
offering are lower than for an initial public offering because there is less
risk.
A single investment bank may not have the distribution network, capital, or
risk appetite to organise a large offering, so large offerings are often
organised by a syndicate that includes several investment banks. The
syndicate helps the investment bank that leads the offering (known as the lead
underwriter) to build the book of orders. The issuer pays the investment
banks an underwriting fee for all these services.
In a best efforts offering, the investment bank acts only as a broker and
does not assume the risk associated with buying the securities. If the offering
is undersubscribed, the issuer will sell fewer securities and may not be able
to raise as much capital as it had planned.
Exhibit 1 summarises the roles of those involved in a public offering.
Exhibit 1.
Roles of Those Involved in a Public Offering
Participant
Role
Issuer
Makes new shares or shares held by the founders
and other early investors available for sale to the
public.
Provides detailed information about its business
and inherent risks as well as the proposed uses
for the funds.
Investment
bank
Identifies investors who are willing to buy the
securities and helps sell the securities to the
public.
Underwritten offering
Buys the securities from the issuer at a price that
is negotiated with the issuer and then resells them
to investors at the offering price. This effectively
guarantees that the issuer gets the amount of
capital it expects.
In an initial public offering, it also promises to
ensure that the secondary market for the securities
will be liquid and to provide price support for a
limited period of time.
Best effort offering
Only acts as a broker of the offered securities and
does not assume the risk associated with buying
the securities.
Syndicate
Helps the lead underwriter build the book of
orders.
Companies sometimes sell new issues of seasoned securities directly to the
public over time via shelf registrations. In a shelf registration, the
company provides the same detailed information that it would for a regular
public offering. However, in contrast to a seasoned offering in which all the
shares are sold in a single transaction, a shelf registration allows the
company to sell the shares directly to investors over a longer period of time.
Shelf registrations provide companies with flexibility on the timing of raising
capital, and they can alleviate the downward pricing pressures often
associated with large secondary offerings.
2.2. Private Placements
Companies sometimes issue their securities to select investors via private
placements. In a private placement, companies sell securities directly to a
small group of investors, usually with the assistance of an investment bank
that helps identify potential investors and set the price of the securities.
Investors in private placements are expected to have sufficient knowledge
and experience to recognise the risks that they assume, so most countries
require less disclosure for private placements than for public offerings. Thus,
private placements allow quicker access to capital with less regulatory
oversight and lower cost of regulatory compliance than public offerings.
Issuers can raise money in the primary markets at a lower cost when their
securities can be traded in liquid secondary markets. Investors value
liquidity because they may need to sell their securities quickly to raise cash.
So investors will pay less for securities that are difficult or costly to sell
(illiquid) than for those that are easy to sell (liquid). Because securities
offered in a private placement do not trade in a secondary market like
securities offered in a public offering, investors are willing to pay less for
the former than for the latter. In other words, investors generally require
higher returns for securities issued via private placements than for the same
securities issued via public offerings.
2.3. Rights Offerings
Companies can also raise capital and issue new shares via rights offerings.
In a rights offering, a company allows existing shareholders to buy shares at
a fixed price (called the exercise price) in proportion to their holdings. The
rights that existing shareholders receive are often known as pre-emptive
rights because existing shareholders have the right of first refusal on any new
equity offerings. Without such rights, the issuing company’s management
could dilute (reduce) the ownership interests of existing investors.
Because rights do not need to be exercised, they are options—one of the
types of derivative instruments presented in the Derivatives chapter. The
exercise price of the rights is typically set below the current market price of
the shares so that buying shares by exercising the rights is immediately
profitable—that is, an existing shareholder can pay the exercise price and get
shares that can immediately be sold at a higher market price for a profit.
Accordingly, most rights are exercised.
Existing shareholders who do not want to exercise their rights will be
“diluted”—that is, their proportional ownership will decrease because they
will hold the same number of shares in a company that now has more shares
outstanding. By selling their rights to others who will exercise them, they
receive compensation for the decrease in their proportional ownership.
Shareholders generally dislike rights offerings because they must provide
additional capital to avoid dilution or sell their rights and experience
dilution of ownership.
2.4. Other Primary Market Transactions
The national governments of financially strong countries generally issue their
debt securities in public auctions. These governments may also sell
securities to dealers, who then resell them to their clients. Smaller and less
financially secure national governments often contract with investment banks
to help them sell their securities.
3. TRADING VENUES
So far in this chapter, we have described how primary markets operate; the
rest of the chapter focuses on secondary markets and how they help investors
buy and sell securities. In secondary markets, securities trade among
investors, and there is thus a need for a trading venue—either physical or
electronic—where orders can be placed and trading among investors can
occur. Orders are instructions that investors who want to trade give trading
service providers, such as brokers and dealers, who are discussed in the
Structure of the Investment Industry chapter.
This section discusses exchanges and alternative trading venues and then
compares them.
3.1. Exchanges
Securities exchanges, or exchanges, are where traders can meet to arrange
their trades. Historically, brokers and dealers met on an exchange floor to
negotiate trades. Increasingly, exchanges now arrange trades based on orders
that brokers and dealers submit to them electronically. These exchanges
essentially act as brokers, blurring the distinction between exchanges and
brokers.
The main distinction between exchanges and brokers is their regulatory
operations. Most exchanges regulate their members’ actions when trading on
the exchange and sometimes also away from the exchange. Brokers generally
regulate trading only in their brokerage systems.
Many exchanges also regulate the issuers that list on the exchange, generally
requiring timely financial reporting and disclosure. Financial analysts use
this information to value the securities traded on the exchange. Without such
information, valuing securities would be difficult and market prices might not
reflect the fundamental values of the securities. Recall from the Structure of
the Investment Industry chapter that a security’s fundamental value is the
value that would be placed on it by investors if they had a complete
understanding of the security’s investment characteristics. When market
prices do not reflect fundamental values, well-informed participants can
profit from less-informed participants. To avoid losses, less-informed
participants withdraw from the market, which is detrimental not only to the
investment industry but also to the wider economy.
Exchanges also attempt to ensure that companies are run for the benefit of all
shareholders and not to promote the interests of controlling shareholders who
lack significant economic stakes in the company. For example, some
exchanges prohibit companies from concentrating voting rights in the hands
of a few shareholders who do not own a proportionate share of the
company’s equity.
Exchanges derive their regulatory authority from their national or regional
governments or through voluntary agreements by their members and their
issuers. In most countries, regulators created by the national government
oversee exchanges. Most countries also have regulators that impose financial
disclosure standards on public issuers.
Exchanges charge fees for their services. They may charge the buyer, the
seller, or both parties a transaction fee, which is essentially a commission for
facilitating trades. Transaction fees and other transaction costs are further
discussed in Section 8.
3.2. Alternative Trading Venues
Not all secondary market trading takes place on an exchange. There are a
number of alternative trading venues that are owned and operated by
broker/dealers, exchanges, banks, and private companies. These venues can
take many different forms and be called by many different names. In the
United States, such venues are generally referred to as alternative trading
systems, whereas in Europe, they are commonly called multilateral trading
facilities.
Many alternative trading venues permit only certain traders or types of
traders to use their trading systems, and each of them has its own rules. Most
alternative trading venues allow institutional traders to trade directly with
each other without the intermediation of dealers or brokers, which makes
them lower-cost trading venues.
Some alternative trading venues operate electronic (computerised) trading
systems that are similar to those operated by exchanges. Others operate
innovative trading systems that suggest trades to their clients based on
information that clients share with them or that they obtain through research
into their clients’ preferences.
One type of alternative trading venue is a crossing network, which is an
electronic trading system that matches buyers and sellers who are willing to
trade at prices obtained from exchanges or other alternative trading venues.
Crossing networks are popular with investors who want to trade large blocks
of securities without risking moving the price of those securities by
submitting an order to an exchange.
Some alternative trading venues are known as dark pools because of their
lack of transparency. Dark pools do not display orders from clients to other
market participants. Large institutional investors may transact in dark pools
because market prices often move to their disadvantage when other traders
know about their large orders.
3.3. Comparison of Trading Venues
Most secondary market trading globally is now done via electronic trading
systems. Traders submit orders to the trading venues electronically.
Computers then arrange trades continuously, based on specific trading rules.
Trading rules, which stipulate how to match buyers and sellers, vary
depending on the trading venue.
Electronic trading systems have greatly decreased the costs of arranging
trades. The lower costs of trading have increased trading volumes, and
investors now use many investment strategies that were previously too
expensive to implement.
An important distinction between exchanges and alternative trading venues is
the regulatory authority that exchanges exert over users of their trading
systems. Alternative trading venues only control the conduct of subscribers
who use their trading systems. Another distinction among trading venues is
related to trade transparency. A market is said to be pre-trade transparent if
the trading venue publishes real-time data about quotes and orders. Quotes
are prices at which dealers are prepared to buy and sell securities and are
discussed in Section 6. Markets are said to be post-trade transparent if the
trading venue publishes trade prices and sizes soon after trades occur.
To respond to regulatory requirements, all trading venues offer post-trade
transparency, although the speed at which it happens varies among trading
venues. Exchanges are pre-trade transparent, but many alternative trading
venues are not. Many investors value transparency because it allows them to
better manage their trading, understand market prices, and estimate their
transaction costs. In contrast, dealers often prefer to trade in opaque markets
because, as frequent traders, they have an informational advantage over those
who trade less frequently.
4. TRADING IN SECONDARY
MARKETS
Trading in secondary markets is the successful outcome of searches in which
buyers look for sellers and sellers look for buyers. A critical key to success
is liquidity because when markets are liquid, the costs of finding a suitable
counterparty to trade with are low.
Secondary markets are organised either as call markets or as continuous
trading markets. In a call market, participants can arrange trades only when
the market is called, which is usually once a day. In contrast, in a
continuous trading market, participants can arrange and execute trades
any time the market is open. Most markets, including alternative trading
venues, are continuous.
Buyers can easily find sellers and vice versa in call markets because all
traders interested in trading (or orders representing their interests) are
present at the same time and place. Trading venues that are call markets have
the potential to be very liquid when they are called, but they are completely
illiquid between calls. In contrast, traders can arrange and execute their
trades at any time in continuous trading markets.
There are three main types of market structures for trading: quote-driven,
order-driven, and brokered markets.
4.1. Quote-Driven Markets
Quote-driven markets, also called dealer markets or price-driven
markets, are markets in which investors trade with dealers. These markets
take their name from the fact that investors trade with dealers at the prices
quoted by the dealers. Almost all bonds and currencies, and most spot
commodities (commodities for immediate delivery), trade in quote-driven
markets.
Quote-driven markets are often referred to as over-the-counter (OTC)
markets because securities once literally traded over a counter in the
dealer’s office. Now most trades in OTC markets are conducted
electronically, by telephone, or sometimes via instant messaging systems.
4.2. Order-Driven Markets
In contrast to most bonds, currencies, and spot commodities that trade in
quote-driven markets, many shares, futures contracts, and most standard
options contracts trade on exchanges and alternative trading venues that use
order-driven trading systems. Order-driven markets arrange trades using
rules to match buy orders with sell orders. Orders typically specify the
quantity the traders want to buy or sell. The order may also contain price
specifications, such as the maximum price that the trader will pay when
buying or the minimum price the trader will accept when selling.
Because rules match buyers and sellers, trades are often arranged among
complete strangers. Order-driven markets thus must have settlement systems
to ensure that buyers and sellers settle their security trades and perform on
their contract trades. Otherwise, dishonest traders would not settle their
obligations if a change in market conditions made settlement unprofitable.
4.3. Brokered Markets
Another type of market structure is the brokered market, in which brokers
arrange trades among their clients. Brokers organise markets for assets that
are unique and thus of interest as potential investments to only a limited
number of investors. Examples of such assets include very large blocks of
securities or real estate. Generally, these assets are infrequently traded and
expensive to carry in inventory. Because dealers are often unable or
unwilling to hold a very large block of securities of real estate in inventory,
they will not make markets in them; that is, they will not stand ready to buy or
sell these assets if nobody else does. Thus, organising order-driven markets
for these assets does not make sense because too few traders would submit
orders to them.
Brokers who are organising markets in unique assets try to know everyone
who might now or in the future be willing to trade such assets. These brokers
spend most of their time on the telephone and in meetings building their client
networks.
5. POSITIONS
A position refers to the quantity of an asset or security that a person or
institution owns or owes. An investment portfolio usually consists of many
positions.
Investors are said to have long positions when they own assets or
securities. Examples of long positions include ownership of shares, bonds,
currencies, commodities, or real assets. Long positions increase in value
when prices rise. In contrast, positions that increase in value when prices fall
are called short positions. To take short positions, investors must sell
assets or securities that they do not own, a process that involves borrowing
the assets or securities, selling them, and repurchasing them later to return
them to their owner. Section 5.1 describes this short-selling process more
thoroughly, and Section 5.2 discusses leveraged positions.
5.1. Short Positions
Short sellers construct short positions in securities to take advantage of a fall
in the price of the securities. They must first borrow securities from investors
with long positions. These investors who lend their securities become
security lenders. Short sellers then sell the borrowed securities to other
traders. They close (exit) their positions by repurchasing the securities and
returning them to the security lenders. If the price of the securities falls, the
short sellers profit because they repurchase the securities at lower prices
than the prices at which they sold them. But if the price of securities rises,
short sellers will lose money. When short sellers repurchase the securities,
they are said to cover their positions.
The potential gains in a long position generally are unlimited. For example,
the share prices of successful companies can increase many times over. But
the potential losses in a long position are limited to 100%—a complete loss
of the initial investment—unless the position is financed by borrowings
(debt). We will discuss leveraged positions in the next section.
The potential gains and losses in a short position are mirror images of the
potential losses and gains in a long position. In other words, the potential
gains in a short position are limited to 100%, but the potential losses are
unlimited. The unlimited potential losses make short positions potentially
highly risky.
Although security lenders may believe that they still own the securities they
lend, this is not the case during the period of the loan. Instead, security
lenders own promises made by the short sellers to return the securities.
These promises are recorded in security lending agreements. These
agreements specify that the short sellers will pay the security lenders all
dividends or interest that they otherwise would have received had they not
loaned their securities. These payments are called payments in lieu of
dividends or of interest.
Security lending is subject to the risk that one of the parties to the contract
will fail to honour their obligation, a risk called counterparty risk. To limit
counterparty risk, security lenders require that short sellers leave the
proceeds of the short sale on deposit with them as collateral for the loan.
Collateral refers to assets that a borrower pledges to the lender. Security
lenders run the risk that short sellers will fail to return the securities if their
price rises. Thus, short sellers must provide additional collateral to secure
the loan following an increase in the price of the securities. In contrast, short
sellers run the risk that security lenders will fail to return the collateral if the
price of the securities falls, so security lenders must return some of the
collateral following a decrease in the price of the securities.
5.2. Leveraged Positions
In many markets, investors can buy securities on margin—that is, by
borrowing some of the purchase price. When investors borrow to buy
securities, they are said to leverage (or lever) their positions. A highly
leveraged (or levered) position is one in which the amount of debt is large
relative to the equity that supports it.
Buying securities on margin increases the potential gains or losses for a
given amount of equity in a position because the buyer can buy more
securities using borrowed money. The use of leverage allows buyers to earn
greater profits when prices rise. But, equally, a buyer who has leveraged a
position suffers greater losses when prices fall. Buying securities on margin
thus increases the risk of investing in the securities.
Investors usually borrow the money from their brokers. The borrowed money
is called a margin loan, hence the reference to buying on margin. The
maximum amount an investor can borrow is often set by the government, the
trading venue, or another trading services provider, such as a clearing house.
In practice, though, a broker may only be prepared to lend an investor less
than that maximum amount, particularly if the broker wants to limit its
exposure to a certain investor. The loan does not have a set repayment
schedule and must be repaid on demand. As with any loan, the borrower must
pay interest on the borrowed money.
The leverage ratio is the ratio of a position’s value to the value of the equity
in it. It is a useful measure because it indicates the effect of the return on the
equity investment, as illustrated in Example 1.
EXAMPLE 1
Leverage Ratio of a Position
Assume that an investor bought £250,000 of Toyota’s shares on margin.
She contributed £100,000 of her own money and borrowed £150,000
from her broker. The investor’s equity represents 40% of the value of
the position:
£100,000/£250,000 = 40%.
The leverage ratio is 2.5:
£250,000/£100,000 = 2.5.
A leverage ratio of 2.5 means that if Toyota’s share price rises by 10%,
the investor will experience a 25% return on the equity investment in
her leveraged position:
2.5 × 10% = 25%.
To check this return, the price of the share is now £275,000. The
investor has a £25,000 profit on a £100,000 investment or a 25% return.
But if Toyota’s share price falls by 10%, the return on the equity
investment will be –25%. That is, a loss of 25%, or 2.5 times the loss
on a debt-free position.
This example shows that by buying shares on margin with a leverage
ratio of 2.5, the investor magnifies the return, both positive and
negative, on her equity investment by 2.5. These calculations do not
count interest on the margin loan and commission payments, both of
which lower realised returns.
Some investors, including hedge funds and investment banks, get into trouble
when they use leverage. In an attempt to obtain greater profits by borrowing
to increase their positions, they often underestimate the risks to which they
are exposed. If prices move against their positions, their losses can put them
into financial distress or, in extreme cases, bankruptcy.
6. ORDERS
When investors want to trade a security, they issue an order that will be
directed to a chosen trading venue. All orders specify what security to trade,
whether to buy or sell, and how much should be bought or sold. In addition,
most orders have other instructions attached to them, including order
execution, exposure, and time-in-force instructions, discussed in Sections
6.1, 6.2, and 6.3, respectively.
In quote-driven markets, the prices at which dealers are willing to buy from
investors or other dealers are called bid prices, and the prices at which
they are willing to sell are called ask prices (or offer prices). The ask
prices are invariably higher than the bid prices.
Dealers may also indicate the quantities that they will trade at their bid and
ask prices. These quantities are called bid sizes for bids and ask sizes for
offers. Depending on the trading venue, these quotation sizes may or may not
be exposed to other traders or dealers in that market.
Dealers are said to quote a market when they expose their bids and offers.
They often quote both bid and ask prices, in which case they quote a twosided market. The highest bid in the market is the best bid and the lowest ask
in the market is the best ask. The difference between the best bid and the best
offer is the market bid–ask spread. The market bid–ask spread is
generally smaller than dealers’ bid–ask spreads (it can never be more)
because dealers often quote better prices on one side of the market than on
the other. Accordingly, the bids and asks that are the best bid and best ask in
the market often come from different dealers.
6.1. Order Execution Instructions
Order execution instructions indicate how to fill an order. Market and limit
orders are the most common execution instructions.
A market order instructs the broker or trading venue to obtain the best
price immediately available when filling the order.
A limit order also instructs the broker or trading venue to obtain the
best price immediately available when filling the order, but it also
specifies a limit price—that is, a ceiling price for a buy order and
floor price for a sell order. A trade cannot be arranged at a price higher
than the specified limit price when buying or a price lower than the
specified limit price when selling.
Market orders generally execute immediately if other traders are willing to
take the other side of the trade. The main drawback with market orders is that
a market buy order may fill at a high price and a market sell order may fill at
a low price. The filling of orders at disadvantageous prices is particularly
likely when the order is placed in a market for a thinly traded security or
when the order is large relative to normal trading activity in the market.
Buyers and sellers who are concerned about the possibility of trading at
unacceptable prices add limit prices to their orders. The main problem with
limit orders is that they may not execute. Limit orders do not execute if the
limit price on a buy order is too low or if the limit price on a sell order is
too high. For example, if an investment manager submits a limit order to buy
at €20 and nobody is willing to sell at or below €20, the order will not be
filled.
Whether traders use market orders or limit orders when trying to arrange
trades depends on whether their main concerns are about price, trading
quickly, or failing to trade. On average, limit orders trade at better prices
than market orders when they trade, but they often do not trade.
A stop order is an order for which a trader has specified a stop price—
that is, a price that triggers the conversion of a stop order into a market order.
For a sell order, the trader’s order may not be filled until a trade occurs at or
below the stop price. After that trade, the order becomes a market order. If
the market price subsequently rises above the sell order’s stop price before
the order trades, the order remains valid. For a buy order, the trader’s order
becomes a market order only after a trade occurs at or above the stop price.
Traders who want to protect their long positions often use stop orders that
trigger market sell orders if prices are falling with the hope of stopping
losses on positions that they have established. These stop orders are often
called stop-loss orders.
Some order execution instructions specify conditions on size. For example,
all-or-nothing orders can trade only if their entire sizes can be traded.
Traders can likewise specify minimum fill sizes.
6.2. Order Exposure Instructions
Order exposure instructions indicate whether, how, and sometimes, by whom
an order should be seen. Hidden orders are only seen by the brokers or
trading venues that receive them and cannot be seen by other traders until the
orders can be filled.
Note that there is nothing wrong or unethical about hiding an order. Traders
with large orders use hidden orders when they are afraid that other investors
might trade against them if they knew that a large order was in the market. In
particular, large buyers fear that they will scare sellers away if their orders
are seen. Sellers generally do not want to be the first to trade with large
buyers because large buyers often push prices up.
Large buyers are also concerned that other buyers will be able to trade
before them by buying first to profit from any increase in price necessary to
fill their large orders. This increases the costs of filling large orders by
taking buying opportunities away from the large traders. Large sellers
likewise fear that buyers will shy away from their exposed orders and that
other sellers will trade before them.
6.3. Order Time-in-Force Instructions
Time-in-force instructions indicate when an order can be filled. The most
common time-in-force instructions are
immediate or cancel orders, which can be executed only on immediate
receipt by the broker or trading venue;
day orders, which can be executed only on the day they are submitted
and are cancelled at the end of that day;
good-until-cancelled orders, which can be executed until they are
cancelled; some brokers or trading venues may set a maximum numbers
of days before the order is automatically cancelled.
7. CLEARING AND SETTLEMENT
Brokers and trading venues, especially those that arrange trades among
strangers, generally need intermediaries to help traders clear and settle
orders that have been filled.
7.1. Clearing
The most important clearing activity is confirmation, which is performed
by clearing houses. Before a trade can be settled, the buyer and seller must
confirm that they traded and the exact terms of their trade. Confirmation
generally takes place on the day of the trade and is necessary only for
manually arranged trades. For electronic trades, confirmation is done
automatically.
To ensure that their members settle their trades, clearing houses require that
members have adequate capital and post margins. Margins are cash or
securities that are pledged as collateral. Clearing houses also limit the
aggregate net quantities (that is, buy minus sell) that their members can settle.
In addition, they monitor their members to ensure that these members do not
arrange trades that they cannot settle.
This system generally ensures that traders settle their trades. The brokers and
dealers guarantee settlement of the trades they arrange for their individual
and institutional clients. The clearing members guarantee settlement of the
trades that their clearing clients present to them, and clearing houses
guarantee settlement of all trades presented to them by their clearing
members. If a clearing member fails to settle a trade, the clearing house
settles the trade using its own capital or capital pledged by the other
members of the clearing house.
The ability to settle trades reliably is important because it allows strangers
to confidently contract with each other without worrying about counterparty
risk. A secure clearing system thus greatly increases liquidity because it
vastly expands the number of counterparties with whom a trader can
confidently arrange a trade.
7.2. Settlement
Following confirmation, settlement may occur in real time (instantaneously)
or it may take up to three trading days. The settlement cycle refers to the
timing of the procedures used to settle trades and differs across markets. For
example, in most countries, stocks and bonds settle three trading days after
negotiating a trade. The seller must deliver the security to the clearing house
and the buyer must deliver cash. The settlement agent then makes the
exchange in a process called delivery versus payment. This process
eliminates the losses that would occur if one party settles and the other does
not.
Many markets have reduced the length of their settlement cycles to reduce
what is often referred to as settlement risk, a form of counterparty risk in
which one of the parties fails to honour their obligation between the time a
trade is negotiated and the time the trade is settled—for instance, as a result
of bankruptcy. The fewer unsettled trades outstanding, the less damage occurs
when a trader fails to settle. Also, the shorter the settlement period, the fewer
extreme price changes can occur before final settlement.
Once a trade is settled, the settlement agent reports the trade to the issuing
company’s transfer agent, which maintains a registry of who owns the
company’s securities. Most transfer agents are banks or trust companies, but
sometimes companies keep their own records and act as their own transfer
agents. Companies need to maintain databases about their security holders so
they know who is entitled to any interest and dividend payments, who can
vote in corporate elections, and to whom various corporate communications
should be sent.
Exhibit 2 shows the life of a trade from order to settlement/closure. An order
for a trade is placed by one party. For the trade to execute and settle, another
party has to be willing to take the other side of the trade. Throughout the life
of a trade, various people within the firm receiving the order will be
involved. These include people taking the order, executing the order, and
accounting for the order/trade.
Exhibit 2.
A Trade from Order to Settlement/Closure*
* This assumes the order is one for which the trade is approved. For example, the order’s
magnitude is within approved limits for the trader. Generally, market orders will be
executed. The exceptions occur when there are liquidity issues.
A BASIC TRADE INVOLVING PARTICIPANTS INTRODUCED
IN THE INVESTMENT INDUSTRY: A TOP-DOWN VIEW
CHAPTER
Peter Robinson, an asset manager for Aus Ltd., wants to buy 1 million
shares in a company that is listed on a stock exchange in the Middle
East.
He contacts Amina Al-Subari, a broker at Middle East Corp, which is
based in Dubai. She submits the Aus Ltd. market order to the local stock
exchange.
The order is filled and financial settlement takes place. A record of the
transaction is then sent to James Armistead, who works for Big Bank
Financial Services, a custodian bank. It provides safekeeping of assets,
such as the shares purchased by Aus Ltd. Big Bank Financial Services
keeps a record of the security and the price paid, and this record is
available—usually online—so that Aus Ltd. Can prove it owns the
shares and can include them in its accounts.
8. TRANSACTION COSTS
Trading is expensive. The costs associated with trading are called
transaction costs and include two components: explicit costs and implicit
costs.
8.1. Explicit Trading Costs
Explicit trading costs represent the direct costs associated with trading.
Brokerage commissions are the largest explicit trading cost. Other costs
include fees paid to trading venues and financial transaction taxes, such as
the stamp duty in the United Kingdom, Hong Kong SAR, and Singapore.
Most market participants employ brokers to trade on their behalf. They pay
their brokers commissions for arranging their trades. The commissions are
usually a fixed percentage of the principal value of the transaction or a fixed
price per share, bond, or contract.
The commissions compensate brokers for the resources they use to fill
orders. Brokers must maintain order routing systems, market data systems,
accounting systems, exchange memberships, office space, and personnel to
manage the trading process. These are all fixed costs. Brokers also pay
variable costs, such as exchange, regulatory, and clearing fees, on behalf of
their clients. Traders who do not trade through brokers pay the fixed and
variable costs of trading themselves.
8.2. Implicit Trading Costs
Implicit trading costs are the indirect costs associated with trading. These
costs result from the following:
bid–ask spreads
price impact
opportunity costs
8.2.1. Bid–Ask Spread
Many investors assess a market’s liquidity by looking at the difference
between bid and ask prices, called bid–ask spreads. Recall that bid
prices are the prices at which dealers are willing to buy and ask prices are
the prices at which dealers are willing to sell. So bid–ask spreads represent
the compensation dealers expect for taking the risk of buying and selling
securities. Bid–ask spreads tend to be wider in opaque markets because
finding the best available price is harder for dealers in such markets.
Transparency reduces bid–ask spreads, which benefits investors.
8.2.2. Price Impact
Traders who want to trade quickly tend to purchase at higher prices than the
prices at which they sell. The difference comes from the price concessions
that they offer to encourage other traders to trade with them. For large trades,
impatient buyers generally must raise prices to encourage other traders to
sell to them. Likewise, impatient sellers of large trades must lower prices to
encourage other traders to purchase from them. These price concessions,
called price impact, or market impact, often occur as large-trade buyers push
prices up and large-trade sellers push them down. For large institutional
investors, the price impact of trading large orders generally is the biggest
component of their transaction costs.
8.2.3. Opportunity Costs
Traders who are willing to wait until other traders want to trade with them
generally incur lower transaction costs on their trades. In particular, by using
limit orders instead of market orders, they can buy at the bid price or sell at
the ask price. But these traders risk that they will not trade when the market
is moving away from their orders. They lose the opportunity to profit if their
buy orders fail to execute when prices are rising, and they lose the
opportunity to avoid losses if their sell orders fail to execute when prices are
falling. The costs of not trading are called opportunity costs.
8.3. Minimising Transaction Costs
Traders choose their order submission strategies to minimise their
transaction costs. Efficient traders ultimately are more successful than those
who do not trade well. They buy at lower prices, sell at higher prices, and
less often fail to trade when they want to.
Market participants use various techniques to reduce their transaction costs.
They employ skilful brokers, use electronic algorithms to manage their
trading, or as mentioned before, use hidden orders or dark pools so other
market participants cannot see their orders and exploit them.
Most brokers and large institutional traders conduct transaction cost analyses
of their trades to measure the costs of their trading and to determine which
trading strategies work best for them. In particular, these studies help large
institutional investors better understand how their order submission
strategies affect the trade-off between transaction costs and opportunity
costs.
9. EFFICIENT FINANCIAL MARKETS
As described in the previous section, low transaction costs are an important
characteristic of well-functioning financial markets because they benefit
everyone who needs to trade. Low transaction costs contribute to making
financial markets efficient. Financial market efficiency increases investor
confidence, which ultimately lowers the costs that companies pay to raise
capital.
The following are the three types of efficiency that ultimately contribute to
efficient financial markets:
Operational efficiency. Operationally efficient markets have low
transaction costs and they can absorb large orders without substantial
price impacts. The most operationally efficient markets tend to be those
in which many people are interested in trading the same securities in the
same trading venue.
Informational efficiency. Informationally efficient prices reflect all
available information about fundamental values. They are crucial to an
economy’s welfare because informationally efficient prices help ensure
that the resources available to the economy, such as labour, capital,
materials, and ideas, are used wisely.
Allocational efficiency. Allocationally efficient economies are
economies that put resources to use where they are most valuable.
Economies that misallocate their resources tend to waste resources and
consequently are often relatively poor.
SUMMARY
Financial markets that function efficiently benefit all investors by keeping
transaction costs low and allowing investors to trade financial instruments
easily.
Some important points to remember about financial markets include the
following:
Issuers sell their securities and raise capital in primary markets. The
securities then trade in secondary markets among investors.
Investment banks play an important role in helping issuers raise capital.
In a public offering, they help the issuer identify potential investors and
set the offering price for the securities.
In underwritten offerings, the investment bank guarantees the sale of the
securities at the offering price negotiated with the issuer. In contrast, in
a best efforts offering, the investment bank acts only as a broker and
does not take the risk of having to buy securities.
A shelf registration allows a company to sell shares directly to
investors over a long period of time rather than in a single transaction.
Other ways to issue securities in the primary markets are through
private placements or rights offerings. In a private placement,
companies sell securities directly to a small group of investors, usually
with the assistance of an investment bank. In a rights offering,
companies give existing shareholders the right to buy shares in
proportion to their holdings at a price that is typically set below the
current market price of the shares, thus making the exercise of the rights
immediately profitable.
Liquid secondary markets reduce the costs of raising capital because
investors value the ability to sell their securities quickly to raise cash.
Secondary markets require a trading venue—either physical or
electronic—where trading among investors can take place. Most
secondary market trading globally is now done via electronic trading
systems.
Exchanges are the most common type of trading venue, but alternative
trading venues, which have their own rules, have gained in popularity.
The two main distinctions between exchanges and alternative trading
venues are that exchanges typically have regulatory authority and more
trade transparency than alternative trading venues.
Markets vary in how trades are arranged. In quote-driven markets,
investors trade with dealers at the prices quoted by the dealers. Orderdriven markets arrange trades using rules to match buy orders with sell
orders. In brokered markets, which are usually markets for assets that
are unique, brokers arrange trades among their clients.
A position is the quantity of an asset or security that a person or
institution owns or owes. Investors have long positions when they own
assets or securities. Long positions benefit when prices rise. In contrast,
positions that benefit when prices fall are short positions, which
involve borrowing assets, selling them, and repurchasing them later to
return to their owner.
When investors borrow some of the purchase price to buy securities,
they are said to buy securities on margin and leverage their positions.
Leveraged positions expose investors to more risk and higher potential
gains and losses than otherwise identical debt-free positions.
Orders are instructions to trade. They always specify what security to
trade, whether to buy or sell, and how much should be bought or sold.
They usually provide several other instructions as well, such as
execution instructions about how to fill an order; exposure instructions
about whether, how, and by whom an order should be seen; and time-inforce instructions about when an order can be filled.
Market orders are instructions to obtain the best price immediately
available when filling the order. They generally execute immediately
but can be filled at disadvantageous prices. A limit order specifies a
limit price—a ceiling price for a buy order and a floor price for a sell
order. They generally execute at better prices, but they may not execute
if the limit price on a buy order is too low or if the limit price on a sell
order is too high.
Stop orders specify stop prices; the order is filled when a trade occurs
at or above the stop price for a buy order and at or below the stop price
for a sell order. Traders often use stop orders to stop losses on their
long positions.
Intermediaries help traders clear and settle orders that have been filled.
The most important clearing activity is confirmation, which is
performed by clearing houses. Settlement follows confirmation; at
settlement, the seller must deliver the security to the clearing house and
the buyer must deliver cash.
The costs associated with trading are called transaction costs and
include two components: explicit costs and implicit costs. Brokerage
commissions are the largest explicit trading cost. Implicit trading costs
result from bid–ask spreads, price impact, and opportunity costs.
Traders usually choose order submission strategies that minimise
transaction costs.
Well-functioning financial markets are operationally, informationally,
and allocationally efficient. Operationally efficient markets have low
transaction costs. Informationally efficient markets have prices that
reflect all available information about fundamental values.
Allocationally efficient economies put resources to use where they are
most valuable.
CHAPTER REVIEW QUESTIONS
© 2014 CFA Institute. All rights reserved.
1. A company sells new shares to the public in the:
A. call market.
B. primary market.
C. secondary market.
2. The market where an investor sells shares of a publicly traded company
she bought in an initial public offering (IPO) three years ago is known
as the:
A. primary market.
B. secondary market.
C. private placement.
3. Compared with a regular public offering, in a shelf registration, a
company:
A. sells the shares in a single transaction.
B. faces lower public disclosure requirements.
C. can sell shares over a longer period of time.
4. An investment bank is exposed to the greatest risk with:
A. a rights offering.
B. a best efforts offering.
C. an underwritten offering.
5. The proportional ownership of shareholders who fail to exercise their
options under a rights offering will:
A. decrease.
B. remain the same.
C. increase.
6. Relative to public offerings, private placements provide:
A. slower access to capital and less regulatory oversight.
B. quicker access to capital and less regulatory oversight.
C. quicker access to capital and higher regulatory compliance costs.
7. Compared with exchanges, alternative trading systems:
A. may be less transparent.
B. require the use of brokers.
C. exercise regulatory authority over their subscribers.
8. Dealers arrange all trades in:
A. a brokered market.
B. a quote-driven market.
C. an order-driven market.
9. Stock exchanges most likely use trading systems that are:
A. price-driven.
B. order-driven.
C. quote-driven.
10. Unique assets, such as real estate, are most likely traded in:
A. a dealer market.
B. a brokered market.
C. an order-driven market.
11. An investor’s loss is limited to the amount of the initial investment in a:
A. long position
B. short position
C. leveraged position
12. An investor takes a short position in a security by:
A. buying the security.
B. lending the security to another trader.
C. borrowing the security and then selling it to another trader.
13. If the price of a security falls, the loss experienced by an investor who
bought the security on margin relative to the loss experienced by an
investor who did not use leverage will most likely be:
A. lower.
B. higher.
C. the same.
14. Which of the following orders will most likely be executed
immediately?
A. Stop order
B. Limit order
C. Market order
15. From the investor’s perspective, the main drawback to using a limit
order to buy shares is that it may:
A. not execute.
B. execute immediately.
C. execute at an unacceptable price.
16. Which activity is a clearing activity?
A. Exchanging cash for securities
B. Confirming the terms of the trade
C. Reporting the trade to the company’s transfer agent
17. Which of the following statements about the settlement cycle is correct?
A. The settlement cycle is the same across markets.
B. A long settlement cycle reduces counterparty risk.
C. The settlement cycle refers to the timing of the procedures used to
settle trades.
18. The price concessions that occur as large-trade buyers push prices up
and large-trade sellers push prices down are called:
A. price impact.
B. bid–ask spreads.
C. opportunity costs.
19. The costs associated with orders failing to execute are best described
as:
A. opportunity costs.
B. price impact costs.
C. brokerage commissions.
20. Markets that can absorb large orders without substantial price impacts
are classified as:
A. operationally efficient.
B. allocationally efficient.
C. informationally efficient.
21. An economy that uses resources where they are most valuable can be
described as being:
A. operationally efficient.
B. allocationally efficient.
C. informationally efficient.
ANSWERS
1. B is correct. Primary markets are the markets in which issuers sell their
securities to investors. If the company is selling shares in a public
market for the first time, it is an initial public offering (IPO). If the
company has previously sold shares in a public market, the sale of new
shares is a seasoned offering. A is incorrect because a call market is
where participants can arrange trades only once per day and is not the
sale of newly issued shares to the public. C is incorrect because
secondary markets are the markets in which securities trade between
investors.
2. B is correct. The investor will sell the shares to another investor, and
trading of securities between investors takes place in the secondary
market. A is incorrect because the purchase of the shares in the IPO
three years ago took place in the primary market—that is, the market in
which the company sold shares to investors for the first time. C is
incorrect because a private placement is a primary market transaction in
which a company sells shares to a small group of qualified investors.
3. C is correct. A shelf registration allows a company to sell the shares
directly into the secondary market over time when it needs additional
capital. A shelf registration gives a company more flexibility with the
timing of selling the shares. A is incorrect because in a shelf
registration, unlike in a regular public offering, a company that issues
shares does not have to sell the shares in a single transaction. The sale
of additional shares can be timed over several months or even years. B
is incorrect because in a shelf registration, the company makes the same
public disclosures that it would for a regular offering. Companies face
lower public disclosure requirements when they issue shares via a
private placement.
4. C is correct. In an underwritten offering, the investment bank buys the
securities from the issuer at an offering price that is negotiated with the
issuer. The objective of the investment bank is to set a price at which it
can sell all of the securities and not become a long-term shareholder. If
all the shares are not sold, the investment bank risks its own capital in
the residual shareholding. A is incorrect because a rights offering
allows existing shareholders to buy shares at a fixed price and does not
involve the investment bank’s capital. B is incorrect because with a best
efforts offering, the investment bank acts only as a broker and thus does
not expose its own capital to buy the securities.
5. A is correct. The proportional ownership of existing shareholders who
do not exercise their option in a rights offering will decrease. They will
hold the same number of shares of the company but the total number of
shares outstanding has increased.
6. B is correct. Private placements allow for quicker access to capital
with less regulatory oversight and lower cost of regulatory compliance
than public offerings. A is incorrect because access to capital is
quicker. C is incorrect because the cost of regulatory compliance is
lower.
7. A is correct. Alternative trading systems may be less transparent than
exchanges. Many alternative trading systems are known as dark pools
because of a lack of transparency; they do not display the orders that
their clients send to them. Large investment managers especially like
these systems because market prices often move to their disadvantage
when other traders know about their large orders. B is incorrect
because alternative trading systems do not require the use of brokers.
Most of them allow institutional traders to trade directly with each other
without the intermediation of dealers or brokers, which makes them
lower-cost trading venues. C is incorrect because alternative trading
systems are trading venues that function like exchanges but do not
exercise regulatory authority over their subscribers whereas exchanges
do.
8. B is correct. Quote-driven markets (also called dealer markets), pricedriven markets, or over-the-counter markets are markets in which
investors trade with dealers at the price quoted by the dealers. A is
incorrect because brokered markets are markets in which brokers
arrange trades between their clients. Assets traded in brokered markets
are usually unique and of interest to only a limited number of people or
institutions; they are also infrequently traded and expensive to carry in
inventory. C is incorrect because order-driven markets are markets in
which a broker, an exchange, or an alternative trading system arranges
trades using rules to match buy orders and sell orders.
9. B is correct. Many shares trade on exchanges that use order-driven
trading systems. Order-driven markets arrange trades by using rules to
match buy orders with sell orders. A and C are incorrect because pricedriven and quote-driven markets are the same thing; they are also called
over-the-counter markets. They are markets in which investors trade
with dealers at the prices quoted by the dealers. Almost all bonds and
currencies and most commodities for immediate delivery (spot
commodities) trade in price-driven/quote-driven markets.
10. B is correct. Unique assets, such as real estate, are likely to be traded in
a brokered market. Brokers organise markets for assets that are unique
and thus of interest to only a limited number of buyers and sellers.
Successful brokers spend most of their time building their client
networks. A is incorrect because dealer markets are markets in which
investors trade with dealers at the prices quoted by the dealers. Dealers
are not likely to make markets in real estate because real estate is
infrequently traded and expensive to carry in inventory. C is incorrect
because unique assets, such as real estate, are not likely to be traded in
order-driven markets because too few traders would participate.
11. A is correct. Investors have long positions when they own assets or
securities, such as stocks, bonds, currencies, commodities, or real
assets. The potential gain in a long position generally is unlimited. But
the potential loss on a long position is limited to no more than 100%—a
complete loss of the initial investment—for a long position with no
associated liabilities (debt). B is incorrect because the potential gains
and losses in a short position are mirror images of the potential losses
and gains in a long position. Thus, the potential gain on a short position
is limited to no more than 100%, but the potential loss is unlimited. C is
incorrect because a leveraged position involves buying securities on
margin—that is, by borrowing some of the purchase price. Buying
securities on margin increases the potential gains or losses for a given
amount of equity in a position because the buyer can buy more securities
on margin than otherwise. The buyer thus earns greater profits when
prices rise. But the buyer suffers greater losses when prices fall—
losses that potentially could exceed the amount of the initial investment.
12. C is correct. Investors take short positions when they sell securities that
they do not own, a process that involves borrowing securities, selling
them, and repurchasing them later to return them to their owner. If the
security falls in price, the investor profits because she can repurchase
the security at a lower price than the price at which she sold it. If the
security rises in price, she loses. A is incorrect because if the investor
buys the security, she takes a long, not short, position in the security. B
is incorrect because if the investor lends the security to another trader,
she becomes the security lender.
13. B is correct. Buying securities on margin is risky, because leverage
(debt) magnifies gains and losses. Thus, if the price of a security falls,
the loss experienced by an investor who bought the security on margin
(leveraged position) will be higher than the loss experienced by an
investor who did not use leverage (debt-free position).
14. C is correct. A market order instructs the broker or exchange to obtain
the best price immediately available when filling an order. B is
incorrect because a limit order also instructs the broker or exchange to
obtain the best price immediately available, but it sets conditions on
price. The price to be paid on a purchase cannot be higher than the
specified limit price, or the price to be accepted on a sale cannot be
lower than the specified limit price. Thus, the order may not execute. A
is incorrect because a stop order is an order for which the trader has
specified a stop condition. The order may not be filled until the stop
condition has been satisfied.
15. A is correct. The main drawback with a limit order is that it may not
execute. Limit orders do not execute if the limit price on a buy order is
too low or if the limit price on a sell order is too high. B is incorrect
because a limit order will only execute immediately if the limit price
matches the bid or ask price of other traders. C is incorrect because by
placing a limit order, the investor ensures that the buy order is executed
at an acceptable price.
16. B is correct. The most important clearing activity is confirming the
terms of the trade. A and C are incorrect because exchanging cash for
securities and reporting the trade to the company’s transfer agent are
activities that occur after clearing activities and are settlement
activities.
17. C is correct. The settlement cycle refers to the timing of the procedures
used to settle trades. Settlement may occur in real time
(instantaneously), or it may take up to three trading days. A is incorrect
because settlement cycles vary across markets. B is incorrect because a
short, not long, settlement cycle reduces counterparty risk.
18. A is correct. Price impact is the price concessions that occur as largetrade buyers push prices up and large-trade sellers push prices down. B
is incorrect because the bid–ask spread is the difference between the
bid price and the ask price and is not the price concession associated
with large-trade buys or sells. C is incorrect because opportunity costs
are the costs of not trading and not the price concessions associated
with large-trade buys and sells.
19. A is correct. The costs associated with orders failing to execute are
called opportunity costs. Traders lose the opportunity to profit if their
buy orders fail to execute when prices are rising, and they lose the
opportunity to avoid losses if their sell orders fail to execute when
prices are falling. Thus, opportunity costs represent the costs of not
trading. B and C are incorrect because price impact costs and brokerage
commissions are only incurred if orders execute—that is, if trading
happens. Price impact costs are price concessions that often occur over
time as large-trade buyers push prices up and large-trade sellers push
them down in multiple transactions. For large institutions, the price
impact of trading large orders generally is the biggest component of
their transaction costs. Brokerage commissions are the commissions that
market participants pay their brokers to arrange their trades. These
commissions usually are a fixed percentage of the principal value of the
transaction or a fixed price per security or contract.
20. A is correct. Operationally efficient markets have relatively low
transaction costs, and they can absorb large orders without substantial
price impacts. B is incorrect because allocationally efficient is used to
describe economies that use resources where they are most valuable. C
is incorrect because informationally efficient markets are markets in
which prices reflect all available information about fundamental values.
21. B is correct. Allocationally efficient economies are economies that use
resources where they are most valuable. A is incorrect because markets
in which trades are easy to arrange and have low transaction costs are
operationally efficient. C is incorrect because informationally efficient
prices reflect all available information about fundamental values.
Informationally efficient prices are crucial to an economy’s welfare
because they help ensure that the resources available to the economy,
such as labour, capital, material, and ideas, are used wisely.
Module 6
Serving Client Needs
© 2014 CFA Institute. All rights reserved.
CONSIDER THIS
You are opening a new bank account and decide to compare
account offerings at two banks. A representative at Bank A
provides you with a standard form to complete and a brochure
about Bank A’s account offerings. The representative at Bank B
invites you to sit down and discuss what you need. The
representative at Bank B asks you questions about your banking
habits. Do you prefer telephone or internet banking? How many
checks do you write a month? Do you need foreign exchange
services? The representative suggests and explains a range of
accounts with different charges and rates of interest that may meet
your needs. Which bank would you choose?
Bank B would probably be many people’s choice. The staff assess a client’s
individual needs and provide expert knowledge of the accounts that are
available. This level of knowledge and attention inspires trust.
The investment industry provides a range of services—including brokerage,
investment advice, and investment management—to a wide variety of clients.
Because each investor is unique, it is important to understand each investor’s
needs in order to provide the best possible service. It is not possible to act in
an investor’s best interests if those interests are not understood and
recognised. No matter what role you play in the investment industry, a focus
on meeting clients’ needs and acting in their best interests will serve you and
your organisation well.
This module describes how investment firms serve their clients’ investment
needs. It explains
how firms assess a client’s needs,
how firms determine the appropriate asset allocation for a client’s
portfolio, and
the investment management approaches firms use.
Assessing client needs.
An important part of the investment process is identifying the client’s needs
and documenting them. Clients and their needs can vary widely; it is
necessary to identify their unique circumstances and requirements. These
requirements should be documented in an investment policy statement, which
guides the construction and ongoing management of the investment portfolio.
Choosing the appropriate asset allocation.
Using the investment policy statement as a guide, the investor’s portfolio
manager or investment adviser considers the proportions of the portfolio to
invest in each asset class. The amount of risk to take is a key consideration in
the construction of a portfolio because it affects potential returns.
Adopting an Investment Management Approach.
After selecting the appropriate asset allocation, an investment management
approach must be adopted. An important aspect of this step is whether to
apply “passive” or “active” investment management. Passive management
attempts to capture the broad return from an asset class or market. Active
management involves detailed research to identify mispriced assets, asset
classes, or markets.
The two chapters in this module are: Investors and Their Needs, Chapter 16,
and Investment Management, Chapter 17.
Chapter 16
Investors and Their Needs
by Alistair Byrne, PhD, CFA
© 2014 CFA Institute. All rights reserved.
LEARNING OUTCOMES
After completing this chapter, you should be able to do the following:
a. Describe the importance of identifying investor needs to the investment
process;
b. Identify, describe, and compare types of individual and institutional
investors;
c. Compare defined benefit pension plans and defined contribution
pension plans;
d. Explain factors that affect investor needs;
e. Describe the rationale for and structure of investment policy statements
in serving client needs.
1. INTRODUCTION
The investment industry provides a range of services—including financial
planning, trading, and investment management—to a wide variety of clients.
Individual investor clients range from those of modest means to the very
wealthy. The investment industry also provides services to many types of
institutional investors, such as pension funds, endowment funds, and
insurance companies. Because investors are all unique, it is important to
understand each of their specific circumstances in order to best meet their
financial needs. It is not possible to act in a client’s best interests if those
interests are not understood and incorporated into the chosen investment
strategy.
Clients differ in terms of their financial resources, personal situations (if they
are individual clients), objectives, attitudes, financial expertise, and so on.
These differences affect their investment needs, what services they require,
and what investments are appropriate for them. For example, elderly clients
with significant resources may be very concerned with estate (inheritance)
planning, but elderly clients with modest resources may be more concerned
about outliving their resources. A shortfall in investment returns may have
significant consequences for the latter but have less impact on the former.
Investors can hold securities, such as shares and bonds, directly, or they can
invest in professionally managed funds to get exposure to the assets they want
to hold. Investors may choose securities or funds themselves or engage an
investment professional to assist in the selection. Investment professionals
must get to know their clients well if they are to provide appropriate
investment services to meet the clients’ needs.
The most basic distinction among investors is that between individual and
institutional investors. Individual investors trade (buy or sell) securities or
authorise others to trade securities for their personal accounts. Institutional
investors are organisations that hold and manage portfolios of assets for
themselves or others. The characteristics that define individual investors are
usually different from those that define institutional investors.
2. TYPES AND CHARACTERISTICS OF
INVESTORS
Investors are not a homogeneous group; both individual and institutional
investors have distinct characteristics.
2.1. Individual Investors
Individual investors are often differentiated based on their resources. Most
will have relatively modest amounts to invest. Other, more affluent
individuals will have larger amounts. The term “retail investor” can be used
to refer to all individual investors, but it is common to use the term to refer to
individual investors with modest resources to invest. Many investment firms
make a distinction between their retail clients, more affluent clients with
larger amounts, and high- and ultra-high-net-worth investors with the largest
amounts of investable assets.
There is no defined standard in the industry to classify individual investors
by investable assets; each investment firm designates its own categories and
values within those categories. For example, one firm may use four
categories (retail, mass affluent, high net worth, and ultra-high net worth),
whereas another firm may use six categories (retail, affluent, wealthy, high
net worth, very high net worth, and ultra-affluent). Firms that use the same
categories may have different cutoff points. For example, one firm may
classify retail clients as those with investable assets up to €100,000, and
another firm may use a cutoff point of €250,000.
The services offered by investment firms and the investments available will
typically vary by the amount of money the client has to invest. Some
specialist funds may require minimum sizes of investment (e.g., $1 million),
and some portfolio management services may have minimum fees, making
them uneconomical for smaller account sizes.
An investment firm that focuses on retail investors has to service the needs of
a large number of relatively small accounts. Often, this means consolidating
the retail investors’ assets into a smaller number of funds and having
automated processes for the administration of client fund holdings.
An investment firm or division within an investment firm focussing on highnet-worth investors may have fewer clients, but higher average account
balances, than one that focuses on retail investors. Investor assets may still
be invested in funds, but some high-net-worth investors will prefer their own
segregated accounts (known as separately managed accounts). Wealthy
clients may have higher expectations of client service than retail customers,
and usually the services that are provided to them are more personalised.
Individual investors vary in their level of investment knowledge and
expertise. Some individual investors have relatively limited investment
knowledge and expertise, and others are more knowledgeable, perhaps as a
result of their education or work experience. Because individual investors
are often thought of as less knowledgeable and less experienced than
institutional investors, regulators in many countries try to protect them by
putting restrictions on the investments that can be sold to them. For example,
in the United States, the Securities and Exchange Commission (SEC), as of
2013, restricts investments in hedge funds to accredited investors. An
individual qualifies as an accredited investor if he or she earned income of
$200,000 or more in each of the prior two years and reasonably expects to
earn at least $200,000 in the current year or has (alone or together with a
spouse) a net worth (excluding his or her primary residence) greater than $1
million. This restriction is presumably based on the logic that wealthier
investors are expected to have a higher level of investment knowledge or at
least be better able to pay for advice and better able to bear risk.
Additional aspects of the personal situations of individual investors—such
as age and family obligations—will also differ and affect their investment
needs and decision making. The expected holding period (time or investment
horizon) for investments, risk tolerance, and other circumstances also affect
investors’ needs.
The services that the investment industry provides to individual investors
differ depending on the investors’ wealth and level of investment knowledge
and expertise, as well as the regulatory environment. Retail investors tend to
receive standardised (less personalised) services, whereas wealthier
investors often receive services specially tailored to their needs.
2.1.1. Retail Investors
Retail investors are by far the most numerous type of investor. They buy and
sell relatively small amounts of securities and assets for their personal
accounts. They may select investments themselves or hire advisers to help
them make investment decisions. They also may invest indirectly by buying
pooled investment products, such as mutual fund shares or insurance
contracts.
The investment industry provides mostly standardised services to retail
investors because they generate the least revenue per investor for investment
firms. Many retail investment services are delivered over the internet or
through customer service representatives working at call centres.
INVESTOR PROFILE: ZHANG LI
Zhang Li is a retail investor whom we met in The Investment
Industry: A Top-Down View chapter. She earns 5,000
Singapore dollars a month and wants to save for a deposit on an
apartment in the suburbs of Singapore. She also wants to save
to pay for her son’s university education in 10 years’ time. To
accumulate money for the apartment deposit, she can save using
short-term, low-risk investments. She can save using longerterm investments, such as mutual funds of shares and bonds, for
her son’s education.
2.1.2. High-Net-Worth Investors
Wealthier investors generally receive more personal attention from
investment personnel. Their investment problems often involve tax and estate
planning issues that require special attention. They either pay directly for
these services on a fee-for-service basis or indirectly through commissions
and other transaction costs.
INVESTOR PROFILE: MIKE SMITH
Mike Smith is a high-net-worth investor whom we met in The
Investment Industry: A Top-Down View chapter. He recently
sold his technology company and has $10 million to invest. He
wants to invest not only to meet his lifestyle needs but also to
plan his estate to secure his children’s future and leave a large
charitable donation after his death. He has expressed an
interest in investing globally in real estate.
2.1.3. Ultra-High-Net-Worth Investors and Family
Offices
Very wealthy individuals usually employ professionals who help them
manage their investments, future estates, and legal affairs. These
professionals often work in a family office, which is a private company that
manages the financial affairs of one or more members of a family or of
multiple families. Many family offices serve the heirs of large family
fortunes that have been accumulated over generations. In addition to
investment services, family offices may provide personal services to the
family members, such as bookkeeping, tax planning, managing household
employees, making travel arrangements, and planning social events.
Wealthy families often have substantial real estate holdings and large
investment portfolios. The investment professionals who work in family
offices generally manage these investments using the same methods and
systems that institutional investors use. They pay especially close attention to
personal and estate tax issues that may significantly affect the family’s wealth
and its ability to pass wealth on to future generations or charitable
institutions.
2.2. Institutional Investors
Institutional investors are organisations that hold and manage portfolios of
assets for themselves or others. There are many different types of
institutional investors with varying investment requirements and constraints.
Institutional investors may invest to advance their mission or they may invest
for others to meet the others’ needs. Institutional investors that invest to
advance their missions include pension plans, endowment funds and
foundations, trusts, governments and sovereign wealth funds, and nonfinancial companies. Institutional investors that invest to provide financial
services to their clients include investment companies, banks, and insurance
companies. These institutional investors may also provide services to the
institutional investors that invest to advance their missions.
Some institutional investors manage their investments internally and employ
investment professionals whose job it is to select the investments. Other
institutional investors outsource the investment of the portfolio to one or
more external investment firms. The choice between internal and external
management will often be driven by the size of the institutional investor, with
larger institutional investors better able to afford the resources required for
internal management. Some institutional investors will adopt a mixed model,
managing some assets internally in which they have expertise and outsourcing
more specialised investments—for example, alternative investments—to
external managers. Those institutional investors that choose to outsource
investment management still have complex decisions to make in terms of
which managers to appoint. They may use internal expertise to make manager
selection decisions, or they may employ a consultant.
2.2.1. Pension Plans
Pension plans hold investment portfolios—pension funds—for the benefit
of future and current retired members, who are called beneficiaries. A
company or other entity may set up a pension plan to provide benefits to its
employees. The companies and governments that sponsor these plans are
called pension sponsors or plan sponsors. Money from employer and/or
employee contributions is set aside to provide income to plan members when
they retire. The contributions must be invested until the employee retires and
receives the retirement benefits.
Pension plans differ by whether they are organised as defined benefit or
defined contribution plans.
2.2.1.1. Defined Benefit Plans
Defined benefit pension plans promise a defined annual amount to their
retired members. The defined amount typically varies by member based on
such factors as years of service and annual compensation while employed.
Typically, employees do not have the right to receive benefits until they have
worked for the company or government for a period specified by the pension
plan. An employee’s rights are vested (protected by law or contract) once
they have worked for that period.
Defined benefit pension funds, particularly those of government-sponsored
plans, are among the largest institutional investors. Pension funds may invest
in equity securities, debt securities, and alternative investments because they
typically have relatively long time horizons. As employees retire, new
employees are added to the plan. If new employees are not being added to
the plan, the time horizon of the plan will decrease over time.
In a defined benefit pension plan, the sponsoring employer promises its
members (or employees) a defined amount of benefit. For example, it is quite
common for the employer to promise an annual pension that is a set
proportion of the employee’s final pre-retirement salary. The pension may be
adjusted for inflation over time. The employer will make contributions to the
pension fund to fulfil the promise. Employees may also be asked to
contribute.
In a defined benefit plan, the employer bears the risk—in this case, that the
investments made by the pension fund fail to perform as expected. If the
investments fail to perform as expected, the employer may be required to
make additional contributions to the fund. However, it is possible that
pension sponsors will be unable to make the necessary contributions and that
beneficiaries will not receive the benefits expected. Defined benefit plans
are becoming less common around the globe and are being replaced by
defined contribution plans.
INVESTOR PROFILE: EURO PENSION FUND
Euro Pension Fund is the fund for a defined benefit pension plan
located in Frankfurt, Germany. The plan sponsor remits money to
the fund based on estimates of pension benefit obligations
compared with pension plan assets. Working members of the plan
also pay a portion of their wages to the fund. Each month, the
fund pays out money to the retired members of the pension plan.
The fund must invest to pay both short-term benefits and benefits
that will be payable many years from now. It needs a complex
blend of investments in a wide range of assets to achieve its
goals. It has an asset management team that devises the fund’s
strategy and implements it. Anna Huber is a member of that team.
2.2.1.2. Defined Contribution Pension Plans
In a defined contribution pension plan, the pension sponsor typically
contributes an agreed-on amount—the defined contribution—to an account
set up for each employee. Employees also generally contribute to their own
retirement plan accounts, usually through employee payroll deductions. The
contributions are then invested, normally in funds that the employee chooses
from a list of eligible funds within the plan. The plan provides enough
choices of funds to allow employees to create a broadly diversified
portfolio. The sponsor generally limits the choices to a set of mutual funds
sponsored by approved investment managers. The pension plan sponsor
should also ensure that the fees charged on the funds are reasonable. At
retirement, the balance that has accumulated in the account is available for
the employee.
In defined contribution plans, the member (or employee) bears the risk that
the pension account’s investments fail to perform as expected. This contrasts
with defined benefit plans, in which the employer bears the risk. In defined
contribution plans, the employer has no obligation to make additional
contributions if the investments perform poorly. If the retirement fund is less
than expected, the employee may have to make do with less retirement
income or, possibly, defer retirement. Because saving enough and choosing
the right investments are very important, defined contribution plan sponsors
are increasingly providing financial guidance to their beneficiaries or
arranging for financial planners to help guide members.
2.2.1.3. Comparison of Defined Benefit and Defined Contribution
Pension Plans
Defined Benefit Plan
Defined Contribution Plan
Member’s benefit in retirement is
defined.
Employer’s contributions are not
defined.
Investments are chosen by a
pension fund manager(s).
Risk that investments do not
perform as expected is borne by the
employer. Employer may need to
make additional contributions.
Member’s benefit in retirement is
not defined.
Employer’s contributions are
defined.
Investments are chosen by the
member.
Risk that investments do not
perform as expected is borne by the
member. Member may need to
adjust lifestyle or defer retirement.
In the past, most pension plans were defined benefit pension plans. Because
these plans promise defined benefits to their beneficiaries, they are
expensive obligations for the sponsor (employer) and many sponsors no
longer offer them. This change explains why defined contribution pension
plans are increasingly replacing defined benefit plans in most countries.
2.2.2. Endowment Funds and Foundations
Endowment funds and foundations are also significant institutional investors
in many countries. Endowment funds are long-term funds of non-profit
institutions, such as universities, colleges, schools, museums, theatres, opera
companies, hospitals, and clinics. These organisations use their endowment
funds to provide some services to their students, patrons, and patients.
Foundations are grant-making institutions funded by gifts and by the
investment income that they produce. Most foundations do not directly
provide services. Instead, they fund organisations that provide services in
such areas as the arts or charities. Foundations often own endowment funds,
which invest the foundation’s money.
Endowment funds and foundations typically have a charitable or
philanthropic purpose and receive gifts from donors interested in supporting
their activities. In many countries, donations to these organisations are tax
deductible for the donors. That is, donations reduce the income on which the
donors have to pay taxes. Investment income and capital gains that these
organisations receive from investing these funds may also be tax-exempt.
Endowment funds are usually intended to exist in perpetuity and, as such, are
regarded as very long-term investors. But they are also typically required to
spend annually on the charitable or philanthropic purpose for their existence,
so money needs to be drawn from their funds. Many endowment funds and
foundations establish spending rules; for example, they may set spending
goals of a percentage range of their assets. Often, their challenge lies in
balancing long-term growth with shorter-term income or cash flow
requirements.
Each endowment fund or foundation has its own specific circumstances.
Some are able to raise money on an ongoing basis, whereas others are
restricted from raising more money. Some endowment funds and foundations
are required to spend a fixed portion of the portfolio each year, whereas
others have more flexibility to vary spending. These differences have
implications for how the institutional investor’s assets are invested. An
endowment client that is restricted from fundraising has to meet its financial
needs from income or the sale of assets, but an endowment client that has no
restriction on fundraising may also raise money to meet its financial needs.
Most organisations with endowment funds hire professional investment
managers to manage the funds. Some manage portions of their funds
internally, in some cases through an investment management company that
they own.
INVESTOR PROFILE: PHILANTHROPY FOUNDATION
Philanthropy Foundation was started in 1950 with a gift of $1
million. The foundation invested its money, raised no additional
money, and now has assets of $250 million. The foundation
supports various charitable causes and is committed to donating
$5 million every year, although it typically makes donations in
excess of this amount. Gertrude Ahlbergson is the chief
investment officer for Philanthropy Foundation. She has
determined that because the foundation is designed to exist
forever, it can have some very long-term investments. It can
afford to take considerable investment risk because it is only
committed to donating a small proportion of its assets to charity
every year. It can increase the payments if investment returns are
sufficient.
2.2.3. Governments and Sovereign Wealth Funds
Governments receive money from collecting taxes or selling bonds. When
they do not have to spend this money immediately, they usually invest it.
Some governments have accumulated enormous surpluses from selling
natural resources that they control or from financing the trade of goods and
services. They have created sovereign wealth funds to invest these
surpluses for the benefit of current and future generations of their citizens.
Sovereign wealth funds typically invest in long-term securities and assets.
They also may purchase companies. Sovereign wealth funds either manage
their investments in-house or hire investment managers to manage their
money.
INVESTOR PROFILE: CROWN STATE MONEY
Crown State Money is a sovereign wealth fund created 10
years ago by the (fictional) country of Crown State to invest
some of the revenues from Crown State’s oil fields. Crown
State knows that its oil will not last forever, so the fund invests
for the long term in order to sustain the country’s development
and benefit future generations if oil revenues fall. Neil
Thornmarshal is employed by Crown State Money to manage
the money it allocates to alternative investments.
2.2.4. Non-Financial Companies
Analysts often identify companies as either financial companies or nonfinancial companies. Financial companies include investment companies,
banks and other lenders, and insurance companies. These companies provide
financial services to their clients. In contrast, non-financial companies
produce goods and non-financial services for their customers.
Non-financial companies invest money that they do not presently require to
run their businesses. This money may be invested short-term, mid-term, or
long-term. The corporate treasurer usually manages the short-term investment
assets. These assets typically include cash that the company will need soon
to pay salaries and accounts payable and financial vehicles that are safe and
liquid, including demand deposits (checking accounts), money market funds,
and short-term debt securities issued by governments or other companies.
Long-term investments are usually managed under the direction of the chief
financial officer or the chief investment officer, if the company has one.
Companies often invest long-term to finance future research, investments, and
acquisitions of companies and products. Companies may invest long-term
directly, or they may hire investment managers to invest on their behalf.
INVESTOR PROFILE: UK TECHNOLOGY
UK Technology develops and sells computer software and
hardware. It produces consistently strong revenues year after
year. It invests a proportion of these revenues in research and
development, but in spite of this regular investing, it has
accumulated a significant amount of cash that it has invested in
short-term and long-term bonds and equity. It does not want to
return the excess cash to its shareholders because it anticipates
some major acquisitions in the future. Stanton Whitworth is
employed by the investment management company hired to
advise UK Technology on its investments.
Many companies invest directly in the shares and bonds of their suppliers
and in the shares of potential merger partners to strengthen their relationships
with them. Practitioners call these investments “strategic investments.” These
types of investments are common in Asian countries, such as Japan and South
Korea, and in European countries, such as France, Germany, and Italy.
2.2.5. Investment Companies
Investment companies include mutual funds, hedge funds, and private
equity funds. These companies exist solely to hold investments on behalf of
their shareholders, partners, or unitholders (units refer to shares and bonds
for equity and debt securities, respectively). As discussed in the Investment
Vehicles chapter, these companies are called pooled investment
vehicles because investors in these companies pool their money for
common management. Investment companies are managed by professional
investment managers who work for investment management firms. These
management firms often organise and market the investment companies that
they manage and thus serve as the investment sponsors.
Mutual funds pool the assets of many investors into a single investment
vehicle, which is professionally managed and benefits from economies of
scale. There are thousands of mutual funds managed by investment
management firms. Mutual funds are typically categorised by their
investment(s). Investments eligible for inclusion may be narrowly or broadly
defined and based on types of assets, geographic area, and so on. For
example, mutual funds may indicate that they invest in Chinese equities
identified as having growth potential, global equities, long-term investmentgrade European corporate bonds, or commodities. The investment
management firm receives a fee for managing the fund. Although a mutual
fund can be regarded as an institutional investor, the term “mutual fund” also
refers to the investment vehicle, shares of which an individual or institutional
investor can hold in a portfolio.
Hedge funds and private equity funds can similarly be considered
institutional investors that manage private investment pools and as investment
vehicles. They are distinguished by their use of strategies beyond the scope
of most traditional mutual funds.
2.2.6. Insurance Companies
Insurance companies comprise another important category of institutional
investor. Insurance companies collect premiums from the individuals and
companies they insure. Premiums are payments that insurance companies
require to provide insurance coverage. Some of these premiums are put into
reserve funds from which insurance companies pay out claims. The
premiums in the reserve funds are invested in highly diversified portfolios of
securities and assets that aim to ensure that sufficient funds are always
available to satisfy all claims. Regulators often set requirements to restrict
the types of investments insurance companies can hold. Insurance companies
profit from income that they can earn on the float, which is the amount of
money they have available to use after receiving premiums and before paying
claims.
There are two main types of insurance companies. One type is property and
casualty insurance companies, which protect their policyholders from the
financial loss caused by such incidents as accidents and theft. The other type
is life insurance companies, which make payments to the policyholder’s
beneficiaries in the event the policyholder dies while the insurance coverage
is in force. There are some insurance companies that provide both types of
insurance. Property and casualty insurers have short-term horizons and
relatively unpredictable payouts; therefore, they prefer shorter-term
investments that are more conservative and liquid. In contrast, life insurers
have longer-term time horizons and more predictable payouts and, therefore,
have more latitude to invest in riskier assets. They usually invest their
reserve funds, which often are very large, in securities, commodities, real
estate, and other real assets.
INVESTOR PROFILE: ABC INSURANCE
ABC Insurance is a global insurance company that insures
thousands of people’s lives. It takes the monthly premiums its clients
pay for their insurance and invests them in financial markets. It holds a
mixture of short-term and long-term investments because some
policyholders will die in the short term and some will live for a much
longer period.
Zhang Li, the retail investor described in Section 2.1.1, purchased life
insurance from ABC Insurance to provide money for her family in the
event of her death. Isabel Robilio is the chief investment officer for
ABC Insurance.
Insurance companies try to match their investments to their liabilities. For
example, if they expect to make fixed annuity payments in the distant future,
they may invest in long-term fixed-income securities to match the interest rate
risk of their investments to the interest rate risk of their liabilities. This
strategy of matching investment assets to liabilities, called asset/liability
matching, reduces the risk that the company will fail to pay its claims.
Most large insurance companies manage their investments in-house. They
also may contract with investment managers to manage specialised
investments in industries, asset classes, or geographical regions where they
lack expertise or access.
Investors—individual and institutional—differ in their financial resources,
circumstances, objectives, attitudes, financial expertise, and so on. These
differences affect what services the client requires and what types of
investments are appropriate for the client. Therefore, it is important to
capture the information about the client and the client’s needs.
3. FACTORS THAT AFFECT
INVESTORS’ NEEDS
Each investor—individual or institutional—has different investment
objectives. Key factors that are common to all investors but that will vary for
each investor include the following:
Required return
Risk tolerance
Time horizon
Investors may also have specific needs in relation to liquidity, tax
considerations, regulatory requirement, consistency with particular religious
or ethical standards, or other unique circumstances. Investors’ circumstances
and needs change over time, so it is important to re-evaluate their needs at
least annually.
3.1. Required Return
Investors differ in how much return they need to meet their goals. The rate of
return required—before and after tax—can be calculated using some goal for
future wealth or portfolio value. For example, based on an investor’s age,
initial investable assets, expected savings, and tax situation, an adviser may
calculate that a 6% rate of return before tax on investments is required for the
investor to meet his or her goal of having a €500,000 portfolio value at
retirement. If the required rate of return seems unlikely to be achieved, the
investor’s goals may have to be revised or other factors, such as the level of
savings, may have to be adjusted.
An investor may take a total-return perspective, which makes no distinction
between income (for example, dividends and interest) and capital gains (that
is, increases in market value). The source of return—changes in value or
income—does not matter to a total-return-oriented investor. Alternatively, an
investor may distinguish between income and capital gains, seeking income
for current spending and capital gains for long-term needs.
The return requirement, particularly for a long-term horizon, should be
specified in real terms, which means adjusting for the effect of inflation. This
adjustment is important because it maintains the focus on what the
accumulated portfolio will provide at the end of the time horizon. An
increase in value that simply matches inflation does not give a client
increased spending power.
The investment manager or adviser has to be comfortable that the investor’s
desired rate of return is achievable within the related constraints. Most
clients would like high returns with low risks, but few investments have this
expected profile. The adviser or manager has a role in counselling the client.
Typically, higher levels of expected return will require higher levels of risk
to be taken. Some investors will choose to invest in highly risky assets
because they require high levels of return to meet their goals, but the
potential consequences (the downside risks) associated with this strategy
need to be understood. Other investors will have already accumulated
sufficient assets that they do not need high returns and can adopt a lower-risk
approach with more certainty of meeting their goal. This situation could be
the case for a pension plan that has a high funding level, meaning that its
assets are sufficient, or nearly sufficient, to meet its liabilities. Other
investors that have accumulated significant assets may choose to invest in
riskier assets because they are capable of bearing the risk and able to
withstand losses.
Investors, particularly individual investors, will usually adjust the proportion
they invest in different kinds of assets over time as they age and their
circumstances change. Individual investors with defined contribution pension
plans can also adjust their investments within the defined contribution plan.
3.2. Risk Tolerance
Investors typically have limits on how much risk they are willing and able to
take with their investments. As noted earlier, there is a link between risk and
return. Typically, the higher the expected return, the higher the risk associated
with that return. Equally, the more risk taken, the higher the expected return.
The investor’s risk tolerance is a function of his or her ability and
willingness to take risk.
The ability to take risk depends on the situation of the investor, such as the
balance between assets and liabilities, and the time horizon. If investors have
far more assets than liabilities, any losses that result from risk taking may not
alter their lifestyle. If investors have a long time horizon, they have more
scope to adjust their circumstances to cope with losses by saving more or
waiting for markets to recover, although recovery and its timing cannot be
guaranteed.
Willingness to take risk is also related to the investor’s psychology, which
may be assessed using questionnaires completed by the investor. Willingness
to take risk is often thought of as a more important issue for individual
investors, but even those who oversee institutional investments will have risk
guidelines within which they must operate and that help define their ability
and willingness to take risk.
Some institutional investors, such as insurance companies and other financial
intermediaries, may also face regulatory restrictions on how much risk they
can take with their portfolios.
There may be situations in which an investor’s willingness to take risk and
his or her ability to take risk differ. In such situations, the investment adviser
should counsel the investor on risk and determine the appropriate level of
risk to take in the portfolio, taking into account both the investor’s ability and
willingness to take risk. The lesser of the two risk levels should be the risk
level assumed.
3.3. Time Horizon
The investor and adviser must be clear on the time horizon for the
investments. Some investors will need to access money from their portfolios
in the short term, whereas others will have a much longer time horizon.
On the institutional side, for example, a property and casualty insurance
company that expects to have to meet claims in the next few years will have a
short time horizon, whereas a sovereign wealth fund that is investing oil
revenues for the benefit of future generations will have a long time horizon,
possibly decades.
In the case of individual investors, for example, someone who is planning on
buying a new home or paying for college in two or three years will have a
short horizon for at least a portion of his or her investments. A 20-year-old
saving for retirement will typically have a long horizon, probably more than
40 years.
The investment horizon has important implications for how much risk can be
taken with the portfolio and the level of liquidity that may be required.
Liquidity is the ease with which the investment can be converted into cash.
For example, an illiquid private equity investment with a likely payoff in 10
years would be unsuitable for an investor with a 5-year horizon.
Investors with longer time horizons should be able to take more risk because
they have more time to adapt to their circumstances. For example, they can
save more to compensate for any losses or returns that are less than expected.
History shows that over time, markets go up more often than they go down, so
an investor with a longer time horizon has more potential to accumulate
positive return performance. Longer-term investors are also better able to
wait for markets to recover from a period of poor performance, although
recovery cannot be guaranteed.
3.4. Liquidity
Investors vary in the extent to which they may need to withdraw money from
their portfolios. They may need to make a withdrawal to fund a specific
purchase or to generate a regular income stream. These needs have
implications for the types of investments chosen. When liquidity is required,
the investments will need to be able to be converted to cash relatively
quickly and without too much cost (keeping transaction costs and changes in
price low) when the cash is needed.
An individual may also require that a portion of the portfolio be liquid to
meet unexpected expenses. In addition, the individual may have known future
liquidity requirements, such as a planned future expenditure on children’s
education or retirement income needs.
For an institution, the liquidity constraint typically reflects the institution’s
liabilities. For example, a pension fund may expect to begin experiencing net
cash outflows at a particular point in the future (i.e., when pension payments
exceed new contributions to the plan) and will need to sell off some portfolio
investments to meet those needs. It needs to hold liquid assets in order to do
this.
3.5. Regulatory Issues
Some types of investors have regulatory requirements that apply to their
portfolios. For example, in some countries and for certain types of
institutional investors, there are restrictions on the proportion of the portfolio
that can be invested overseas or in risky assets, such as equities. Regulations
on the holdings of insurance companies are typically extensive. Exhibit 1
shows some restrictions that apply to institutional pension funds in several
countries as of December 2016. In the countries shown, restrictions can exist
on the amount of the pension fund that can be invested in an asset class (such
as public equity) and/or on the amount that can be invested outside the
pension plan’s home country.
Exhibit 1. Investment Regulations Applying to Pension Funds
in Selected Countries
Country
Maximum
Public
Equity
Investments
(% of
portfolio)
Maximum
Foreign
Public
Equity
Investments
(% of
portfolio)
Other
Maximum
Public
Equity
Investments
(% of
portfolio)
Maximum
Foreign
Public
Equity
Investments
(% of
portfolio)
Brazil
70%
10%
Canada
No limit
No limit
15%
0%
75%
No limit
50%
No limit
No limit
No limit
Country
Egypt
Estonia
Japan
Switzerland
Other
Foreign investment
restricted to
MERCOSUR
countries for
equities (other
asset classes are
more flexible)
Maximum of 10%
of market value
invested in any one
entity or related
entities
Not allowed to
invest in foreign
assets
—
—
Total real estate
exposure limited
to 30%. These
limits may be
extended if general
principles of
prudent
management,
security, and risk
diversification are
met.
Country
United
States
Maximum
Public
Equity
Investments
(% of
portfolio)
No limit
Maximum
Foreign
Public
Equity
Investments
(% of
portfolio)
No limit
Other
Limits on buying
shares or bonds of
sponsor
Source: Based on data from www.oecd.org.
3.6. Taxes
Tax circumstances vary among investors. Some types of investors are taxed
on their investment returns, and others are not. For example, in many
countries, pension funds are exempt from tax on investment returns.
Furthermore, the tax treatment of income and capital gains can vary. It is
important to consider an investor’s tax situation and the tax consequences of
different investments.
Investors should care about the returns they earn after taxes and fees because
that is what is available to spend. For example, an investor who is subject to
higher tax on dividend income than capital gains will typically desire a
portfolio of investments seeking capital growth (i.e., from an increase in
value of shares) rather than income (i.e., dividends from shares).
Individuals may also face different tax circumstances for different parts of
their wealth. For example, an individual may choose to hold some assets in a
pension account if income and capital gains on assets held in a pension
account are tax-exempt or tax-deferred. The investor may choose to hold
assets expected to generate capital gains in a taxable investment account if
capital gains are taxed at a lower rate than income. Where assets are located
(held) can significantly affect an investor’s after-tax returns and wealth
accumulation.
3.7. Unique Circumstances
Many investors have particular requirements or constraints not captured by
the standard categories discussed so far.
Some investors have social, religious, or ethical preferences that affect how
their assets can be invested. For example, investors may choose not to hold
investments in companies that engage in activities they believe potentially
harm the environment. Other investors may require investments that are
consistent with certain religious beliefs. For example, some investors may
not invest in conventional debt securities because they do not believe they
comply with Islamic law.
Investors may also have specific requirements that stem from the nature of
their broader investment portfolio or financial circumstances. For example,
an individual who is employed by a company may want to limit investment in
that company, which would help the employee reduce single-company
exposure and gain broader diversification. Interestingly, many individuals
are actually inclined to boost their holdings in their employers’ shares on the
grounds of loyalty or familiarity, despite the risk that this strategy entails.
Such a strategy can have severe consequences if the company fails or its
financial position declines. For example, many employees of Enron
Corporation, a US energy company, not only lost their jobs but also suffered
significant investment losses when Enron went bankrupt.
Institutional investors may also have unique and specific requirements as a
result of their objectives and circumstances. For example, a medical
foundation may want to avoid investing in tobacco stocks because it believes
encouraging tobacco smoking is counter to its objectives of improving health.
4. INVESTMENT POLICY
STATEMENTS
It is good practice to capture information about the client and the client’s
needs in an investment policy statement (IPS). An IPS—for both
individual and institutional investors—serves as a guide for the investor and
investment manager or adviser regarding what is required of and acceptable
in the investment portfolio. An IPS also forms the basis for determining what
constitutes success in managing the portfolio.
The IPS should capture the investor’s objectives and any constraints that will
apply to the portfolio. The investor and manager/adviser should agree on the
IPS and review it on a regular basis, typically once a year. It should also be
reviewed when the client experiences a change in circumstances. Creating
and reviewing an IPS is a good opportunity for the investment manager and
client to discuss the client’s goals.
A common format for an IPS is to split it into sections covering objectives
and constraints. Each section has its own subsections. The IPS identifies the
investor’s circumstances and goals within the types of needs and differences
discussed in Section 3. The following format is typical:
Objectives
Return requirement
Risk tolerance
Constraints
Time horizon
Liquidity
Regulatory constraints
Taxes
Unique circumstances
A typical IPS covers objectives and constraints, but many investors,
especially institutional investors, will also include procedural and
governance issues in the IPS. The IPS may set out the role of an investment
committee, its structure, and its authority. It may also set out the roles of
investment managers, the basis on which they will be appointed, and the
criteria on which they will be reviewed. An important role of the IPS is to
provide information that is useful in determining the types and amounts of
assets in which to invest and the way the portfolio will be managed over
time. So, the IPS serves as the basis for determining the appropriate portfolio
strategies and asset allocations. The following section provides more detail
for an institutional investor’s IPS.
4.1. Institutional Investors and the Investment
Policy Statement
Most institutional investors create and adopt a comprehensive IPS. These
statements specify many of the following points:
the general objectives (including return objectives) of the investment
program and their relationship to the mission of the institution
the risk tolerance of the organisation and its capacity for bearing risk
all economic and operational constraints, such as tax considerations,
legal and regulatory circumstances, and any other special circumstances
the time horizon over which funds are to be invested
the relative importance of capital preservation and capital growth
the asset classes in which the institution is allowed to invest
a target asset allocation that indicates what proportion of the investment
funds will be invested in each asset class
whether leverage (use of debt) or short positions are allowed
how actively the institution will trade
how investment decisions will be made
the benchmarks against which the institution will measure overall
investment returns
The board of the institution or its senior leadership formally adopts the
investment and payout policies.
The investment leaders decide whether to manage investments in-house or to
contract with one or more investment managers. Institutional investors that
manage their investments in-house hire a team of investment professionals to
manage their investments.
Institutional investors that use outside investment managers may use one
manager to manage all investments or multiple managers. Institutional
investors often use multiple managers to reduce the risk of substantial loss as
a result of poor performance by any one manager. Many institutional
investors use different managers for each asset class in which they invest. By
hiring managers who specialise in particular asset classes, the institutional
investors gain investment expertise and access to investments that a
generalist might not have.
SUMMARY
The investment industry provides services to individual investors—
from those of modest means (retail customers) to the very wealthy with
a substantial amount of money to invest. Investment services are also
provided to many types of institutional investors, such as pension plans,
endowment funds and foundations, governments and sovereign wealth
funds, non-financial companies, investment companies, and insurance
companies.
Needs vary among different investor types. Clients have their own
objectives related to their circumstances and have different constraints
that apply to their portfolios. Key dimensions include
return requirement—before and after tax,
risk tolerance, and
time horizon.
Investors may also have particular requirements related to liquidity, tax,
regulation, and other unique circumstances, including consistency with
particular religious or ethical standards.
It is good practice to capture the needs of an investor in an investment
policy statement. The investment policy statement serves as a guide for
the investment manager or adviser regarding what is required of and
acceptable in the investment portfolio.
The investment policy statement should capture the investor’s
objectives and any constraints that will apply to the portfolio. An
investment policy statement is typically divided into sections that cover
objectives and constraints. Each section has its own subsections.
CHAPTER REVIEW QUESTIONS
© 2014 CFA Institute. All rights reserved.
1. The investment needs of individual investors are most likely:
A. the same among investors of similar ages and wealth.
B. similar in many respects to those of institutional investors.
C. unique to each individual’s circumstances and requirements.
2. Which of the following types of investors is most likely to be identified
as an individual investor?
A. Insurance company
B. Sovereign wealth fund
C. Ultra-high-net-worth investor
3. Which of the following types of institutional investors is most likely to
have the shortest investment time horizon?
A. Life insurer
B. Endowment fund
C. Property and casualty insurer
4. If investments underperform expectations in a defined benefit pension
plan, additional contributions may be required from the:
A. plan sponsor.
B. plan beneficiaries.
C. investment manager.
5. If the investment returns of a defined benefit pension plan exceed
projections, pension benefits will most likely:
A. decrease.
B. remain the same.
C. increase.
6. Asset allocation and investment decisions in a defined contribution
pension plan are made by the:
A. plan sponsor.
B. plan member.
C. investment manager.
7. An investor with a long time horizon will most likely have a:
A. higher tolerance for risk.
B. reduced investment return expectation.
C. lower ability to invest in illiquid investments.
8. The return requirement for an investor should be:
A. specified in nominal terms.
B. achievable within the relevant constraints.
C. higher for investors with low risk tolerances.
9. When an investor’s willingness and ability to take risk differ, the
investment adviser should counsel the investor to use a risk level based
on the:
A. ability to take risk only.
B. willingness to take risk only.
C. lesser of the two risk levels.
10. An investor’s investment policy statement:
A. ensures that investment plan objectives are met.
B. should be reviewed only when the client’s circumstances change.
C. outlines what is required of and acceptable in the investment
portfolio.
11. A difference in investment policy statements for institutional investors
and individual investors most likely relates to the inclusion of:
A. client constraints.
B. investment objectives.
C. procedural and governance issues.
ANSWERS
1. C is correct. Investment needs are directly affected by personal
situations, such as age, wealth level, family obligations, and investment
horizon, which are generally unique among individual investors. A is
incorrect because the investment needs of individual investors tend to
vary among individuals based on factors in addition to wealth and age,
such as family obligations, investment horizon, and so on. B is incorrect
because the characteristics that define individual investors are usually
different from those that define institutional investors. Consequently,
investor needs are likely to be different for individual investors
compared with institutional investors.
2. C is correct. High-net-worth and ultra-high-net-worth investors are
individual investors with the largest amounts of investable assets. A and
B are incorrect because insurance companies and sovereign wealth
funds are institutional investors.
3. C is correct. Property and casualty insurers have short-term horizons
and relatively unpredictable payouts. A is incorrect because life
insurers have longer-term time horizons and relatively predictable
payouts. B is incorrect because endowments are usually intended to
exist in perpetuity and, as such, can be regarded as very long-term
investors.
4. A is correct. A defined benefit pension plan promises a specified
annual benefit to its retired members, typically based on age, years of
service with the firm, and average compensation prior to retirement.
The employer bears the risk associated with the performance of the
pension plan portfolio. If the investments fail to perform as expected,
the employer may be required to make additional contributions to the
fund based on regulatory requirements. B is incorrect because the plan
beneficiaries would not be required to make additional contributions to
a defined benefit pension plan as a result of poor performance. C is
incorrect because the investment manager is hired to manage the pension
plan assets and does not guarantee investment performance results.
5. B is correct. The benefits associated with a defined benefit pension plan
are established independent of specified investment targets. If the
performance of the fund exceeds projections, a pension surplus may be
created that improves the funding status of the plan but does not alter the
benefit payments made to plan members.
6. B is correct. In a defined contribution pension plan, asset allocation and
investment decisions are made by the plan member. A is incorrect
because the plan sponsor is not responsible for investment decisions
within a defined contribution pension plan. C is incorrect because the
investment manager is not responsible for the asset allocation decisions
within a defined contribution plan.
7. A is correct. Investors with longer time horizons can take on more risk
because they have more time to adapt to their circumstances. B is
incorrect because investors with long time horizons, and consequently a
greater ability to take on risk, are likely to have higher return
requirements given their higher level of assumed risk. C is incorrect
because investors with long time horizons have a greater ability to
invest in illiquid investments.
8. B is correct. The investment manager or adviser has to be comfortable
that the investor’s desired rate of return is achievable within the related
constraints. A is incorrect because the return requirement, particularly
for a long-term horizon, should be specified in real terms, which means
adjusting for the effect of inflation. Adjusting for the effect of inflation is
important because it focuses on what the accumulated portfolio will be
able to purchase rather than just the nominal monetary value. C is
incorrect because for investors with lower risk tolerances, the return
requirement will be lower because of the low level of risk in the
portfolio.
9. C is correct. There may be situations in which an investor’s willingness
to take risk and his or her ability to take risk are different. In such
situations, the investment adviser should counsel the investor about risk
and determine the appropriate level of risk to take in the portfolio,
taking into account both the investor’s ability and willingness to take
risk. The lesser of the two risk levels should be the risk level assumed.
A and B are incorrect because both the ability and willingness to take
risk must be considered.
10. C is correct. The investment policy statement serves as a guide for the
investor and investment manager regarding what is required and what is
acceptable in the investment portfolio. A is incorrect because the
investment policy statement outlines the investment plan objectives and
serves as a guide to achieving the objectives but it cannot ensure that
investment plan objectives will be met. B is incorrect because the
investor and manager/adviser should agree on the investment policy
statement and review it on a regular basis, typically at least once a year.
If the client experiences a change in circumstances, the investment
policy statement may be reviewed more frequently.
11. C is correct. Procedural and governance issues are constraints specific
to many institutional investors. A and B are incorrect because the
investment policy statement for both institutional investors and
individual investors will include client constraints and investment
objectives.
Chapter 17
Investment Management
by Alistair Byrne, PhD, CFA
© 2014 CFA Institute. All rights reserved.
LEARNING OUTCOMES
After completing this chapter, you should be able to do the following:
a. Describe systematic risk and specific risk;
b. Describe how diversification affects the risk of a portfolio;
c. Describe how portfolios are constructed to address client investment
objectives and constraints;
d. Describe strategic and tactical asset allocation;
e. Compare passive and active investment management;
f. Explain factors necessary for successful active management;
g. Describe how active