Chapter 2

 Financial market integrity refers to financial markets that are ethical and transparent and provide investor
protection.
 Ethics is defined as a set of moral principles, or the principles of conduct governing an individual or a group.
 Ethical dilemmas are situations in which values, interests, and/or rules potentially conflict.
 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 decision- making process.
 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.
 A conflict of interest arises when either the employee’s personal interests or the employer’s interests conflict
with the interests of the client.
 Individuals working in the investment industry are expected to place the client’s interests above their own and
their employer’s interests.
 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.
 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.
 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.
 To protect the financial system in these cases, ethical standards should guide the behaviour of market
participants.
 Fundamental ethical and professional principles that are applicable to the investment industry professional
include the following: ■ Client interests are 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
 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.
 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.
 Consequence for client-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.
 Consequence for employer-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.
 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.
 ■ 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 3
 Customers can also be harmed if a company in the investment industry misuses customer assets.
 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.
 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.
 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.

OBJECTIVES OF REGULATION

 1 Protect consumers.
 2 Foster capital formation and economic growth
 3 Support economic stability
 4 Ensure fairness
 5 Enhance efficiency
 6 Improve society

The Regulatory Process

 1 Identification of perceived need

 2 Identification of legal authority
 3 Analysis
 4 Public consultation
 5 Adoption
 6 Implementation
 7 Monitoring
 8 Enforcement
 9 Dispute resolution
 10 Review

Classification of Regulatory Regimes

 Regulatory regimes are often described as “principles- based” or “rules- based”.

 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 case- by- case basis.
 Rules- based regimes provide explicit regulations that, in theory, offer clarity and legal certainty to investment
industry participants.
 Regulatory systems can also be designed as “merit- based” or “disclosure- based”.
 In merit- based regulation, regulators attempt to protect investors by limiting the products sold to them
 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

TYPES OF FINANCIAL MARKET REGULATION

 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
 Financial products. Financial products must generally comply with numerous regulations before they can be sold
to the public.
 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.
 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.
 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.
 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
 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
 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 mark- ups 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.
 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).
 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.
 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.
 Front running - 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.
 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

CHAPTER 4
 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.
 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.
 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
 microeconomic concepts help investors allocate their savings. Investors try to provide capital to companies that
will make the most efficient use of it
 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.
 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.
 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.
 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.
 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.
 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
 The sign of price elasticity of demand provides information about how the quantity demanded changes relative to
a change in price.
 The magnitude of price elasticity of demand provides information about the strength of the relationship between
quantity demanded and changes in price.
 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.
 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.
 Income elasticity of demand is the percentage change in the quantity demanded of a product divided by the
corresponding percentage change in income.
 The accounting profit considers only the explicit costs
 Economists, however, take a broader view of costs and also deduct implicit costs from revenues and explicit costs
to arrive at economic profit.
 An opportunity cost is the value forgone by choosing a particular course of action relative to the best alternative
that is not chosen
 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.
 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.
 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.
 where there is no competition, a market is said to be a monopoly.
 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.
 There are significant barriers to entry that prevent other companies from entering the industry. Such an industry
is called a 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.
 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.
 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.