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Chapter 1

The Investment Industry: A Top-Down View



Types of Assets: Real assets or physical assets: Real assets represent factors of production of a company. These include land, buildings, machinery, cattle, and gold. Financial assets: Financial assets represent claim on real assets e.g. share of stock represents ownership claim in a company.
The buyer of share is called a shareholder or stockholder. The shareholder has the right on some of the companys assets and earnings.

current tax receipts < current spending needs. Types of Financial Markets: 1. Money markets: Financial markets where short-term (less than one-year) debt securities are issued and traded are called money markets. E.g. Treasury bills (Tbills), Commercial paper (CP). 2. Capital markets: Financial markets where long-term (greater than one-year) securities are issued and traded are called capital markets. E.g. Common stock, Preferred stock, corporate bond, Treasury bond, Municipal bond. Direct Finance: When borrowers borrow funds directly from lenders, it is called direct finance. E.g. a commercial paper sold to an individual by a firm. Indirect Finance: When funds are transferred between savers and borrowers through a financial intermediary(acting as a middleman), it is called an indirect finance. E.g. a bank accepts deposits from savers and lends those funds to borrowers (i.e. companies or individuals). In an indirect finance, the process of transformation of savings from savers into loans to borrowers is known as financial intermediation.

Securities: Financial assets that can be traded in the market are called securities. There are two major types of securities: 1. Debt securities: Loans made by lenders to borrowers are called debt securities. Borrowers in debt securities have obligations to repay the funds (principal) to lenders and to make periodic interest payments. Bonds: Debt securities with fixed interest rate payments are called fixed-income securities or bonds. Investors that invest in bonds are known as bondholders. 2. Equity securities: Stocks or shares of stocks are called equity securities. Borrowers in equity securities have no obligations to repay the funds to shareholders or to make regular dividend payments. There are two sources of return in equity securities investment i.e. Return = Capital appreciation + Dividend payments Financial or Securities markets: The places where buyers and sellers can trade securities are known as financial markets. Financial market facilitates flow of funds from savers to spenders. Savers: Savers are those who have excess funds available to invest. They are also referred to as lenders or investors. Savers provide funds/capital to spenders. Savers include: Individuals (households) Companies (firms) Governments: Governments lend funds when their current tax receipts > current spending needs. Spenders: Spenders are those who need funds. They are also referred to as borrowers. Spenders include: Individuals Companies Governments: Governments borrow funds when their

Financial intermediaries include: Commercial banks Finance companies Insurance companies Investment banks Investment companies

Benefits of Financial Intermediaries: Financial intermediaries help bring together lenders (investors) and borrowers. Financial intermediaries can collect information and

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Chapter 1

The Investment Industry: A Top-Down View

monitor borrowers more efficiently, effectively and inexpensively. Financial intermediaries help investors (savers) to better evaluate the behavior and financial health of the borrowers. Due to economies of scale from their specialization, financial intermediaries result in reduction in transaction and search costs for savers and spenders. 2. HOW ECONOMIES BENEFIT FROM THE EXISTENCE OF THE INVESTMENT INDUSTRY

Economic Resources are the basic items that are needed to produce goods and services. These resources include labor, real assets, and financial capital. However, these resources are scarce or limited but wants are unlimited. Due to scarcity of resources, an economic system needs to address following three questions 1) What to produce? 2) How to produce it? 3) Whom to produce it for? Hence, the primary objective of an economic system is the efficient allocation of scarce resources i.e. producing those quantity of goods/services at which total surplus is maximized. 2.1 Market Economies

Scarce resources are allocated by the market forces; Market is free of government control; Government plays a minimal role in the economy; Economic decisions are made by individuals and companies themselves; Companies and individuals are profit motive; Example: Western economies i.e. U.S. Planned economies: In a planned economy, all means of production are owned and controlled by the government and economic choices decisions are made by the government. However, in reality, an economy can neither be purely capitalistic nor purely socialist; rather, a mixed economic system prevails where economic decisions are made both by the government and market forces. For example, In economies primarily based on extraction of natural resources (i.e. Middle Eastern countries), key industries are largely controlled by the state. In transition economies which are gradually transforming from socialist planned economies to market economies, the government plays a significant role in the economy and business.

There are various forms of Economic systems including Pure capitalism: Features of Capitalism Economic System: Resources and factors of production are privately owned; 3.


3.1 & 2.2

Benefits Provided by the Investment Industry

Investment industry: The investment industry is a subset of the financial services industry. The investment industry provides various useful services to investors including financial advisory, information, and trading services. Benefits Provided by the Investment Industry The investment industry facilitates lending and borrowing between market participants. The investment industry facilitates efficient flow of funds from savers to spenders.

The investment industry helps market to efficiently allocate resources in the economy. The investment industry provides and process information about investments for the investors. The investment industry provides a variety of investment products and services to satisfy needs of lenders and borrowers and provides borrowers an easy access to the capital. The investment industry also provides liquidity* in the financial market. An efficient and sound investment industry promotes economic growth.

Chapter 1

The Investment Industry: A Top-Down View

NOTE: *Liquidity refers to investors ability to buy/sell assets quickly and at its fair price. Some assets are illiquid (e.g. real estate). In addition, a considerably ownership in a greater number of shares is also relatively illiquid. Features or Characteristics of a well-functioning Investment Industry: 1) Availability of a wide range of investment products and services: A well-functioning investment industry provides a wide range of investment products/services to satisfy needs of lenders and borrowers. Investment products include debt, equity securities, derivatives, alternative investments & other investment vehicles e.g. mortgage- backed securities which represent a claim on the cash flows on a large number of mortgages. An access to a variety of investment products facilitates investors to make & implement better investment decisions. 2) Competitive financial markets: A well-functioning investment industry is comprised of a large number of players that compete fairly with one another. In addition, no single player has the ability to influence supply or demand. Competitive financial markets help to increase production efficiency in an economy. Competitive financial markets help to keep prices of investment goods/services low. 3) Liquid financial markets with low transaction costs: A well-functioning investment industry is highly liquid. The higher the liquidity and the lower the transaction (trading) costs, the higher the investors return. 4) Access to relevant and reliable financial information: In a well-functioning investment industry, investment industry participants provide investors easy and timely access to relevant and reliable financial information and efficiently process that information on behalf of investors. 5) Facilitates investors to modify their risk exposures: transform and transfer risk: In a well-functioning investment industry various investment products are available that enable investors to transform or transfer their risks e.g. investors willing to avoid/reduce risks can buy insurance while those willing to take on risk may sell insurance. 6) Trust among investors: In a well-functioning investment industry, investors have trust. To develop this trust, it is important that borrowers, financial intermediaries, and investment industry participants should fairly and honestly treat savers (investors). Lack of trust impedes savers to invest and as a result, negatively affect economic growth.

7) Competent and trustworthy investment industry participants: A well-functioning investment industry consists of competent and trustworthy investment industry participants with regard to managing investment products and portfolios, executing investment transactions, and advising on investment matters. Major Investment Industry Participants: There are many investment industry participants that help to channel funds from savers to borrowers. These include A. Trading Service Providers: These include 1. Exchanges: Exchanges represent organized and regulated financial markets that assist, regulate and control business of buying, selling and dealing in securities. 2. Brokers: Brokers act as agents of the investors and facilitate trading between buyers and sellers by bringing willing buyers and sellers together, by negotiating prices, and by executing their orders. Brokers provide liquidity in the market and help to reduce transaction costs. 3. Dealers: Dealers act as principals and facilitate trading by standing ready and willing to buy a financial asset for their own account (known as proprietary trading). Dealers Make markets in securities by acting as buyers for investors willing to sell and as sellers for investors willing to buy. Dealers provide liquidity in the market and help to reduce transaction costs. 4. Clearing and Settlement Agents: They are the investment industry participants that clear and settle trades once they have been arranged and guarantee performance of the traders. B. Custodians: Custodians provide custodial services to investors i.e. they hold money and securities on behalf of their clients. C. Investment Information Service Providers: These include investment research providers and analysts. They provide data, research and other information about the companies to buy-side analysts, financial advisors and asset managers. D. Investors: Investors can be categorized into two types. 1. Institutional investors: Institutional investors are professionals (typically organizations) who invest money of a financial institution on behalf of their clients. E.g. pension funds invest money on behalf of current and future retirees.
Institutional investors employ buy- side analysts who collect and analyze information about companies for buying the securities.

Chapter 1

The Investment Industry: A Top-Down View

2. Individual investors: Individual investors are individuals who invest a portion of their own money. These include
High net-worth (wealthy) investors: Individual investors who have a greater amount of assets are called high-net-worth investors. Due to lack of time and expertise, high-net-worth investors may seek investment professionals assistance. Retail investors: Individual investors who have a smaller amount of assets are called retail investors. Besides lack of time and expertise, retail investors lack financial resources to hire asset managers. Hence, they can invest in professionally managed investment vehicles created and managed by banks, insurance companies, or investment management firms e.g. a mutual fund.

set of moral principles. Financial organizations and companies must encourage culture of integrity. 4.1.1) Raising Funds and Investment Industry Participants A company can raise funds or capital by issuing its shares in the stock market. When a company issues its shares, it becomes a public company and its shares are listed on the stock exchange. Investment Bank: The investment bank helps the companies and governments in their first equity issuance (known as Initial public offering) by advising them on the type of security to issue, the pricing of a security, the marketing, and the registration of the shares on an organized exchange. o An Initial public offering (IPO) occurs when a company offers stock for sale to the public for the first time. o The price of the new shares is determined based on the value of a company and the degree of investor interest in the shares of a company. o The investment banks employ sell-side analysts who collect and analyze information about the company and prepare a detailed report on it for the purpose of selling its securities to the public. When a company becomes a public company, it is obligated to comply with all the rules and regulations of the organized stock exchange e.g. it must file quarterly financial statements and audited annual financial statements. Role of Auditors: Auditors must ensure that companies provide fair and reliable information to the public in their annual financial statements. Types of Markets: 1. Primary Market: The market where securities are initially sold to the investors is called primary market. In the primary market, the issuer receives the proceeds from the sale of securities. E.g. an IPO takes place in the primary market. 2. Secondary Market: The market where previously issued securities are traded between investors is called secondary market. In the secondary markets, the seller of the securities receives the proceeds, not the issuer. 4.2 Duty of Care

E. Investment Professionals: They include 1. Financial advisory service providers (Financial advisors): They provide advice about investments to their clients by incorporating investors financial risk and return objectives. 2. Investment management service providers (Investment Managers or Asset Managers): They are the financial advisors who, besides advising about investments, also have authority to manage the investments on behalf of their high-net-worth clients. 3.2 Laws, Regulations, and Trust

To ensure that investors are treated fairly and honestly, financial services industry needs laws and regulations. Laws: Laws are passed by a legislative body i.e. Congress in the U.S. Regulations: Regulations are developed by agencies i.e. the Securities & Futures Commission in Hong Kong. For laws and regulations to be effective, they must be enforceable. The form and scope of laws and regulations vary between countries and change over time. Primary objectives of Laws and Regulations: a) To prevent fraud; b) To safeguard investment industry participants, especially investors; c) To promote and maintain the integrity, transparency, and fairness of financial markets: For example, in most jurisdictions, insider trading (trading based on material, non- public information). For maintaining trust in the Investment Industry, it is important that Investment industry participants must behave ethically, professionally and in accordance with a

Duties of Care refer to legal obligations of investment professionals to act in the best interests of their clients. They are used to mitigate conflicts of interests. The level of duties of care depends on following factors: a) Title or type of investment professional b) Laws and regulations where the investment professional is located: Laws and regulations vary considerably across regions. E.g., In U.S., there are two levels of duties of care i.e.

Chapter 1

The Investment Industry: A Top-Down View

1) The Fiduciary Standard: It represents a high standard of care under which the investment advisor is obligated to advice the best investment product to his clients. 2) The Suitability Standard: It represents a low standard of care under which the investment advisor is only obligated to advice the investment product that satisfies the objectives and constraints of his clients rather than recommending the best investment product. In European Union, duties of care are governed by the Markets in Financial Instruments Directive (MiFID) and there are two levels of duties of care i.e. 1) The Suitability Standard: It represents a high standard of care under which the investment advisor is only obligated to advice the investment product consistent with the objectives and constraints of his clients. 2) The Appropriateness Standard: It represents a low standard of care under which the investment advisor is obligated to assess a clients level of

understanding only; he is not required to evaluate clients objectives and constraints.

c) Role of the investment professional with regard to advising his clients.



Following are the Four Key Forces that drive the investment industry:

1) Competition: The competition depends on Innovative investment products offered in the investment industry; Pricing of investment products; Service of investment products; Performance of investment products; 2) Computerization: It refers to technological advancements in the investment industry. Computerization provides following benefits: Reduction in operating costs and trade processing costs; Increase in trade processing capacity; Development and promotion of innovative types of investment products;

3) Globalization: Globalization facilitates investors to invest in various securities globally and as a result, help investors to diversify their portfolios and to achieve higher returns. 4) Regulation: Regulations attempt to protect investors and their interests by promoting disclosure and transparency and by maintaining integrity in the investment industry.

Practice: Practice all the questions given at the end of Chapter 1.