Claritas Sample Chapter 1

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THE INVESTMENT INDUSTRY:A TOP-DOWN VIEWby Ian Ro ssa OReilly, CFA

CHAPTER 1


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LEARNING OUTCOMES

Ater completing this chapter, you should be able to do the ollowing:

a Explain how an economy benefts rom the existence o the investment

industry;

b Explain how an individual benefts rom the existence o the investment

industry;

c Describe types and unctions o participants that collectively comprise

the structure o the investment industry;

d Describe orces that aect the evolution o the investment industry.


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Introduction

INTRODUCTION

People work to sustain themselves and their dependents. Oten, they earn money or

their labor and use that money to purchase goods and services. I they spend less thanthey earn, they have savings. I they expect to earn a return on their savings, they

are investing. For example, an individual might lend her savings to a neighbor who is

starting a new business. I she realistically expects to get more money back than she

lent, she is making an investment.

One reason why the fnancial services industry exists is to provide a link between

savers (also called lenders or investors) that have unds to invest and spenders (also

called borrowers) that need unds. Ater all, not all savers have savvy neighbors who

are starting promising businesses. As a result, they have to look elsewhere or oppor-

tunities to earn a return on their money.

Lenders invest their savings in a wide range o assets. Assets are items that have value

and include real assets and fnancial assets. Real assets are physical assets, such asland, buildings, cattle, and gold. In contrast, financial assets are claims on real assets.

For example, a share o stock represents ownership in a company. Tis share gives its

owner, called a shareholder (or stockholder), rights to some o the companys assets

and earnings.

Financial assets that can be traded are called securities. Te two largest categories

o 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 fxed, debt securities

are also called fixed-income securities. Tey are also known as bonds, andinvestors in bonds are reerred to as bondholders. More inormation about debt

securities is provided in Chapter 10.

Equity securities are also called stocks, shares o stock, or shares. As men-

tioned, shareholders have ownership in the company. Te company has no

obligation to either repay the money the shareholders contributed or to make

regular payments, called dividends. However, investors who buy stocks 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 dis-

cussed urther in Chapter 9.

Places where buyers and sellers can trade securities are known as securities markets orfinancial markets. A distinction is sometimes made within fnancial markets between

money markets, or securities that have a maturity shorter than a year, and capital

markets, or securities that have a maturity longer than a year. How securities are

issued, bought, and sold is explained in Chapters 13 and 15.

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Copyright 2012 CFA Institute


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Chapter 1 The Investment Industry: A Top-Down View4

Te primary role o fnancial markets is to channel unds rom savers to spenders.

Savers include individuals (households), companies (frms), and governments with

excess money to invest. Note that in this chapter and in the rest o the curriculum,

the terms money, cash, unds, and financial capital (or capital) may be used inter-

changeably. Savers provide capital to spenders.

Spenders include individuals, companies, and governments. For example, individualsborrow to pay or houses, tuition, and unoreseen expenses. Companies borrow to

invest in real assets, such as land, buildings, or machinery. Tese real assets represent

a companys means (or actors) o production, and they are sometimes reerred to as

physical capital. Governments borrow when their current tax receipts are insucient

to und their current spending plans.

Savers and spenders sometimes interact through fnancial markets. Te movement

o unds rom those who have unds to invest (the savers who become providers o

capital) to those who need unds (the spenders who become users o capital) through

fnancial markets is called direct fnance. Savers and spenders oten rely on individuals

in the investment industry to help them navigate fnancial markets. Te investment

industry is a subset o the fnancial services industry. It comprises all the players that

are instrumental in helping savers invest their money and borrowers get the unds theyrequire. Te major investment industry participants, such as exchanges, investment

brokers (brokers), investment dealers (dealers), fnancial advisers, and investment

analysts (analysts), are introduced in Section 4 o this chapter and discussed urther

in Module 5.

Savers and borrowers oten rely on fnancial intermediaries to fnd each other and to

channel unds between each other. Tis is indirect fnance. Financial intermediaries

act as middlemen between those who have unds to invest and those who need unds.

Credit institutions, such as banks, are a typical example o fnancial intermediaries.

Tey collect savings rom lenders and transorm them into loans to borrowers. Tis

transormation process is known as financial intermediation, hence the reason why

banks are called fnancial intermediaries. Other types o fnancial intermediaries arediscussed in Chapter 13.

Financial intermediaries and the investment industry play important roles in the

fnancial services industry. Many savers do not have the time or the expertise to iden-

tiy and select individuals, companies, and governments to lend to or invest in. Once

savers have lent money, they have to monitor the borrowers behavior and fnancial

health to ensure that they will get their money backa task that is time-consuming

and costly. Matching savers and borrowers and monitoring borrowers are unctions

that fnancial intermediaries can perorm better and more cheaply than most investors

can do on their own. Te investment industry helps investors evaluate the behavior

and fnancial health o the companies and governments they invest in.

Because savers are assigning responsibilities to fnancial intermediaries and participantsin the investment industry, trust is essential to the proper unctioning o the fnancial

services industry. Savers should have confdence that they will earn a return on their

investments and that they will be treated airly by borrowers, fnancial intermediaries,

and investment industry participants. I trust is lacking, savers will be reluctant to

invest, and the economy will suer.


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How Economies Benefit from the Existence of the Investment Industry

Exhibit 1 summarizes graphically how unds can be channeled between savers and

spenders, either directly through fnancial markets or indirectly through fnancial

intermediaries.

Exhibit 1 Overview of the Financial Services Industry

Spenders/Borrowers/

Users of Capital

Financial Intermediaries

Financial Markets

DIRECT FINANCE

INDIRECT FINANCE

Funds

Funds

Funds Funds

Savers/Lenders/

Providers of CapitalFunds

Source: Based on data rom the European Central Bank (http://www.ecb.int/mopo/eaec/structure/

html/index.en.html).

HOW ECONOMIES BENEFIT FROM THE EXISTENCE OF THE

INVESTMENT INDUSTRY

Economic systems can take many orms, rom pure capitalism with ree markets to

planned economies with centralized authority. Te goal o all economic systems is the

ecient allocation o scarce resources to their most productive uses.

Resources, such as labor, real assets, and fnancial capital, are necessary to produce

goods and services. People have an unlimited desire or goods and services, but

resources are limited. o illustrate this concept o scarcity, assume that an individualhas a limited budget; his fnancial capital is scarce. Should he spend his money on

buying ood, paying his mortgage, purchasing a new car, or going on an expensive

holiday? Similarly, should governments spend money on health care, education,

deense, or inrastructure?

Because resources are scarce, decisions must be made regarding the allocation o these

resources. All economic systems must address three questions: (1) Which goods and

services should be produced? (2) How should the goods and services be produced?

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(3) Who should receive the goods and services that are produced? Te allocation o

scarce resources is ecient i the scarce resources are used to produce goods and

services that best satisy the needs o consumers.

2.1 Market Economies

Capitalism is an economic system that avors private ownership as the means o pro-

duction and markets as the means o allocating scarce resources. Markets are places

where buyers meet sellers to trade. Markets include goods and services markets as

well as fnancial markets.

In a pure, ree 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 manuacture and provide, and

they get to keep the profts rom their activities. I everything goes according to plan,

scarce resources are deployed in the most ecient manner through the markets and

the economy grows at a healthy rate.

Pure ree market capitalism is something that exists only in theory. In the real world,governments play a role in all economies. In some capitalistic economies, such as in

Western economies, the governments role in business is airly minimal. In countries

largely based on extraction o natural resources, such as some ormer Soviet Republics,

some Middle Eastern countries, and some South American countries, the government

maintains signifcant control over key national industries. In transition economies,

which are moving rom socialist planned economies to market economies, the govern-

ment plays a signifcant role in the economy and business. Chinas economy is oten

described as state capitalism because the Chinese central and local governments have

signifcant ownership o many businesses. In China, however, people can create and

invest in businesses and a great deal o market competition exists.

2.2 Benefits Provided by the Investment Industry

Te investment industry brings several benefts to the economy. It acilitates lending

and borrowing. As mentioned above, the investment industry is instrumental in

channeling unds between savers who have money but no immediate use or it and

spenders who have projects to fnance but insucient capital to do so.

Te investment industry contributes to the ecient allocation o resources in the

economy. Without the investment industry, suppliers and users o capital would have

to spend signifcant resources fnding each other. Tese resources would be expended

on the search rather than on more productive uses, resulting in less eciency.

Te investment industry plays an important role in providing and processing inor-mation about investment opportunities. Many investment industry participants help

investors collect and analyze macroeconomic data and inormation about individuals,

companies, and governments capital needs and asset values. Some o the tools and

inputs these participants use are described in Module 3.


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How Individuals Benefit from the Existence of the Investment Industry

Investment industry participants package investment opportunities so that they sat-

isy the needs o lenders and borrowers. Te investment industry oers a wide range

o products and services that make it easier or savers to invest and or spenders to

access the unds they need. Tese investment products and services are discussed in

Modules 4 and 5.

Te investment industry also provides liquidity. Liquidity reers to the ease o buyingor selling an asset without aecting its price. Some assets, such as real estate, are

inherently illiquid. For example, i you wish to sell a house, it will likely take some time

to sell even i it is priced airly compared with other houses in the market. I you want

to sell a house quickly, you may have to sell it at a lower price than you think is air.

Other assets are more liquid, such as shares that trade actively. However, an investor

may hold such a large position (i.e., so many shares) that the sale o her position may

alter the price in the market. For example, i an investor owns 100 shares in a com-

pany with actively traded shares, she will likely be able to sell her shares quickly and

without aecting the stock price. However, i she owns 100,000 shares, she may not

be able to sell those shares quickly without aecting the price in the market. Liquidity

is a very important aspect o well- unctioning fnancial markets because highly liquid

markets allow investors to complete a transaction quickly (and to reverse it quickly i

they change their minds) and to have confdence that they are getting the best price

at that particular moment.

All these benefts increase the willingness o suppliers o capital to provide unds

to those who need them. Capital put to better use osters growth, which ultimately

benefts the economy.

HOW INDIVIDUALS BENEFIT FROM THE EXISTENCE OF THE

INVESTMENT INDUSTRY

In a well-unctioning investment industry, investors are treated airly and honestly.

As a result, they have confdence to commit their savings to investments. Investment

industry participants compete airly or investors business, and they are competent

and trustworthy in managing investment products and portolios, executing invest-

ment transactions, and advising on investment matters.

3.1 Benefits Provided by the Investment Industry

Below are some o the most important eatures that defne a well-unctioning invest-

ment industry and, in turn, beneft investors.

Te frst important eature that characterizes a well-unctioning investment industry

is the availability o a broad range o investment products and services that meet

investors needs. Investment products are not limited to the debt and equity securities

already presented. Other investment instruments, such as derivatives and alternative

investments, are described in Chapters 11 and 12, respectively.

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Investment industry participants may also buy and sell various real and fnancial

assets and then package them to create new investment products (requently reerred

to as investment vehicles) and structures that suit the needs o investors better than

the original assets. Mortgage-backed securities provide an example. Tey represent

a claim on the cash ows that are expected to materialize not rom a single mortgage

but rom a large number o mortgages that have been grouped together in a process

called securitization. Other examples o investment vehicles and structures are pro-vided in Chapter 14.

In addition to being able to choose rom a broad range o investment products, inves-

tors beneft when they have access to a broad range o investment services that help

them make better decisions and implement those decisions. Te investment industry

oers fnancial advisory, inormation, and trading services that are valuable to inves-

tors. How investment industry participants assess and serve the needs o investors is

discussed urther in Module 7.

Investors beneft when fnancial markets are competitive. Markets in general and

fnancial markets in particular are competitive i a large number o players compete

with one another without any one o them having an undue inuence on supply or

demand. Supply reers to the quantity o a good or service sellers are willing and ableto sell, whereas demand reers to the quantity o a good or service buyers desire to buy.

More inormation about supply and demand and how the interaction o supply and

demand aects prices o goods and services is presented in Chapter 6. Competitive

markets promote higher production eciency and help keep prices o goods and

services, including investment products and services, down.

Investors also beneft when fnancial markets are liquid and transaction costs are low.

As mentioned earlier, liquidity ensures that investors can quickly buy or sell an asset

without aecting 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. Te combination o liquidity and low trans-

action costs ensures that investors can trade as much (or as little) as they wish underthe best possible conditions.

o make reasonable judgments about their investments, investors need inormation

about the companies and governments to which they provide or may provide capital.

Tereore, access to relevant and reliable fnancial inormation is important. By helping

collect and process fnancial inormation, investment industry participants provide

benefts to investors. imely access to this inormation is also critical because securities

prices may change quickly in response to new, relevant inormation. For example, the

stock price o an oil company that announces it has discovered a large new oil feld

will likely increase at the prospect o higher revenues and proft.

Another important eature that characterizes a well-unctioning investment industry

is the ability to transorm and transer risk. Risk is defned as the eect o uncertainuture events on an organization or on the outcomes the organization achieves; risk

is discussed in greater detail in Chapter 17. Risk is an inherent element o investing,

and investors should always consider both return and risk when they make investment

decisions. For example, the individual who lent her savings to her neighbor aces the

risk that her neighbors business ails and she never gets her money back. Although

the prospect o investing in the next Apple, Google, or Microsot may be appealing,

the investor may fnally decide not to lend her money to her neighbor i losing her

entire savings would have a devastating eect on her liestyle. Te investment industry


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How Individuals Benefit from the Existence of the Investment Industry

oers those who want to reduce risk the opportunity to do so. For example, products

that represent some orm o insurance may be available or purchase. Tose who are

willing to take on risk may sell insurance or oer investments that allow others to

reduce their risks.

3.2 Laws, Regulations, and Trust

Laws and regulations are necessary to ensure that investors are treated airly and

honestly. Usually, laws are passed by a legislative body, such as Congress in the United

States, Parliament in the United Kingdom, or the Diet in Japan. Regulations are created

by agencies, such as the Canadian Securities Administrators in Canada, the Autorit

des Marchs Financiers in France, or the Securities & Futures Commission in Hong

Kong. Both laws and regulations are enorceable, and enorcement is critical or laws

and regulations to be eective.

Te orm and extent o laws and regulations vary between countries and change

over time, but there are some general principles that apply consistently. Laws and

regulations are designed to

prevent raud;

protect investment industry participants, in particular investors; and

promote and maintain the integrity, transparency, and airness o fnancial

markets.

For example, trading based on nonpublic inormation that could aect a securitys

price, called insider trading, is generally orbidden across most jurisdictions. An analyst

who learns during a private meeting with a companys 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 ocially announced the acquisition. I the

analyst were to trade beore this inormation is available to all market participants, he

could gain rom his inside inormation and the integrity and airness o the fnancial

market would be compromised.

Although the investment industry is subject to laws and regulations, these laws and

regulations cannot cover every situation and cannot prevent raud or market abuse

rom happening. Tis is why it is important that

individuals who work in the investment industry behave ethically, in accordance

with a set o moral principles, and act proessionally; and

organizations that employ these individuals promote cultures o integrity.

Ethical behavior on the part o investment industry participants is paramount to

protecting the reputation o the industry and to maintaining trust in the industry.

Without trust, savers may be less likely to make investments, which would ultimately

be detrimental to the economy.

We return to the discussion o ethics and regulation in Chapters 2 and 3, respectively.

Chapter 17 also addresses the issue o compliance with laws and regulations.


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INVESTMENT INDUSTRY PARTICIPANTS

Tere are many investment industry participants who help savers invest their unds

and help lenders get the unds they require. Anybody working in the investmentindustry or using services provided by the investment industry is bound to come in

contact with several o these players.

4.1 Major Players

o introduce some o the major players, consider the example o a Canadian company

that needs unds to support its growth. Te company may generate unds rom its

current operations, but i the unds are not enough to support its growth plans, it will

have to turn to providers o capital. Te investment industry can help the company

raise the unds it needs and allow investors to participate in the companys growth.

We frst discuss investment industry participants that may help the Canadian companyto raise unds. Ten we discuss investors and investment industry participants that

may help them to invest unds.

4.1.1 Raising Funds and Investment Industry Participants

Te Canadian company wants to issue shares to raise additional equity capital. Until

now, it has been private; it has not raised unds by issuing shares publicly. It wants to

take the equity issuance opportunity to become a public company and have its stock

listed on the oronto Stock Exchange. Stock exchanges are organized and regulated

fnancial markets that allow buyers and sellers to trade shares with each other.

Te company contacts an investment bank. Investment banks have expertise in helping

companies and governments raise unds globally. Te investment bank will organizethe companys frst equity issuance, called an initial public offering (IPO). Chapter 9

provides more details about IPOs and equity issuances in general.

Te investment bank will help determine the price at which the new shares will be

issued. o do so, it not only has to assess the companys value, but it also has to gauge

investor interest in purchasing shares o the company. Te investment banks ana-

lystsoten called sell-side analysts because they work or the organization selling

the securitieswill collect and analyze inormation about the company and prepare

detailed reports that can be shared with potential investors.

Once the investment bank has determined the price o the new shares, the IPO will

take place in the primary marketthat is, the market where new securities, IPOs,

and subsequent oerings are issued and sold to investors. In exchange or providingmoney to the company, investors will receive shares in the company. Companies get

unds when they issue new securities in primary markets. Ater the IPO, the companys

shares will be traded in the secondary marketthat is, the market where investors buy

and sell securities to each other. Te Canadian company will not receive any capital

rom the trading o its shares in the secondary market.

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Investment Industry Participants

Now that the Canadian company is a public company, it will have to comply with the

rules set orth by the oronto Stock Exchange and with relevant Canadian laws and

regulations. One typical rule is related to fnancial reporting; the Canadian company

will have to fle quarterly fnancial statements and audited annual fnancial state-

ments. Auditors, who evaluate a companys accounting and internal controls, play

a very important role. Tey ensure that investors receive reliable inormation, a key

eature o a well-unctioning investment industry. More inormation about fnancialstatements is provided in Chapter 4.

4.1.2 Investing Funds and Investment Industry Participants

Te Canadian company may have sold its shares to many investors. When investors

want to buy (sell) shares in the secondary market, they need to fnd another investor

who is willing to sell (buy) shares. Brokers and dealers are very important investment

industry participants who acilitate trading between investors. Brokers act as agents.

Tey do not trade directly with market participants; they only help buyers and sellers

fnd one another and trade with each other. In contrast, dealers act as principals.

Tey use their own accounts and their own capital to trade with buyers and sellers in

what is known as proprietary trading. Tey make markets in securities by acting asbuyers when investors want to sell and as sellers when investors want to buy. Brokers

and dealers provide liquidity and help reduce transaction costs; as mentioned earlier,

liquidity and low transaction costs are benefcial to investors.

Tere are also investment industry participants that provide trading support. Tey

include clearing and settlement agents that confrm and settle trades ater they

have been arranged. Custodians also provide trading support by holding money and

securities on behal o their clients.

Tere are dierent categories o investors, which are discussed urther in Chapters 13

and 19. Institutional investors are typically organizations that invest or themselves to

advance their mission or invest or others to meet the others needs. For example, pen-

sion funds manage portolios or the beneft o current and uture retirees. Institutionalinvestors usually rely on their own analysts to review a potential investment. Tese

analysts are called buy-side analysts because they work or the organization buying

the securities. Tey rely on investment inormation service providers, such as data

vendors and investment research providers, to gather data about the company and

its environment.

Individual investors oten do not have the time, the inclination, or the expertise to

perorm their own analysis. Some o them, such as wealthy individuals called high-

net-worth investors, may seek the help o investment proessionals, such as fnancial

advisers (also called investment advisers). Financial advisers help their clients under-

stand their uture fnancial needs and the risks they ace when investing as well as

provide advice about investments. High-net-worth investors very oten give authority

to their advisers to manage the investments on their behal. Tese advisers are called

investment managers or asset managers.

Many investors may be willing to invest but lack sucient fnancial resources to

contract an asset manager to look ater their investments. Tese investors, called

retail investors, very oten buy investment products created and managed by banks,

insurance companies, or investment management frms. For example, an individual


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who wishes to plan or her retirement may need a convenient and inexpensive way

o investing money regularly. She may buy shares in a mutual fund, a proessionally

managed vehicle that has investments in a range o securities.

Exhibit 2 summarizes the investment industry participants introduced in this section.

Tey are grouped into categories that are discussed urther in Chapter 13. Te rest

o the curriculum provides more inormation about how these participants operateand how they interact with one another and with investors.

Exhibit 2 Investment Industry Participants

Funds

Funds

Investment

Information Service

Providers

Investment

research providers,

analysts

Financial Advisory

Service Providers

Financial advisers

Investment

Management

Service Providers

Asset managers

Investment Banks

Savers/

Lenders/Providers of Capital

Retail, high-net-

worth, and

institutionalinvestors

Spenders/

Borrowers/

Users of Capital

Individuals,

companies,

governments

Financial

Markets

Custodial Service

Providers

Custodians

Trading Service

Providers

Exchanges,

brokers, dealers,

clearing and

settlement agents

All these players can aect trust in the investment industry through their relationships

with one another and with their clients. rust in the investment industry is only as

strong as the trust in its weakest link; it is thus critical that all players act with integrity.


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Investment Industry Participants 1

4.2 Duty of Care

As presented above, there are dierent types o investment proessionals, such as

fnancial advisers and asset managers, who provide advice to investors. Investment

proessionals are held to dierent duties o care to their clients. Duty of care reers to

the legal obligations that investment proessionals have when acting or or on behal o

their clients. Te level o care depends not on the title o the investment proessionalbut on the laws and regulations where the investment proessional is based and the

role the investment proessional plays when advising his clients.

In the United States, there are two levels o care: a high standard o care, called the

fduciary standard, and a lower standard o care, called the suitability standard. o

dierentiate these two levels o care, consider the example o a fnancial adviser who

has to recommend an investment product to her client. Whether the adviser is held to

a fduciary or suitability standard, she must understand her clients objectives in terms

o risk and return and any constraints her client may have. Te process o identiying

an investors needs and constraints is described in Chapter 19. I the investment adviser

is held to the fduciary standard, she is required to recommend the best investment

product. In contrast, i the investment adviser is held to the suitability standard, she

has to recommend an investment product that meets her clients objectives and con-straints, but it does not have to be the best investment product. It is sucient or the

investment product to meet the clients objectives and constraints even i there is a

better alternative available. Te distinction between the fduciary and the suitability

standard is particularly important i the adviser represents certain unds or products.

Laws and regulations across Asia vary greatly, but in some places, such as Singapore

and Hong Kong, the legal concept o fduciary duty is based on the British legal system.

Duties o care, similar to the suitability standard described earlier, are usually defned

by laws and regulations that are country specifc.

Duty o care in the European Union is governed by the Markets in Financial Instruments

Directive (MiFID). Te options in the EU are either a suitability standard or an appro-

priateness standard. Te appropriateness standard only requires investment proes-sionals to assess a clients level o understanding, not to review the clients objectives

and constraints. Te suitability standard is the higher standard and requires the

investment proessional to review and consider the clients objectives and constraints.

Investors seeking advice rom investment proessionals should understand the laws

and regulations that apply to these investment proessionals and the duty o care these

investment proessionals hold with regard to their clients. Tese issues may inuence

investment proessionals advice signifcantly. In particular, investors must assess when

the interests o investment proessionals may not be aligned with their own interests,

which is known as a conflict of interest. For example, an investment manager might

have a monetary incentive to invest a clients money in a particular investment product

or to buy and sell assets more actively than is justifed or the client.


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KEY FORCES DRIVING THE INVESTMENT INDUSTRY

Te our key orces that drive the investment industry are competition, computeri-

zation, globalization, and regulation.

Competition in the investment industry is based on innovative investment product

oerings. It is also based on pricing, service, and perormance.

Over the years, technological advancements have allowed investment industry par-

ticipants to reduce operating costs. Computerization, in particular, has dramatically

decreased trade processing costs and increased trade processing capacity. It has also

spurred the development and analysis o innovative types o investment products.

Globalization is another orce driving the investment industry. Investors look outside

their domestic markets to diversiy their investments and generate higher returns.

Emerging markets, in particular, hold the promise or higher rates o growth. For

example, China, Brazil, and India are emerging economies that are growing asterthan developed economies. Furthermore, such countries as China, Saudi Arabia, and

Russia, which have trade surpluses, use those surpluses to invest abroad in a variety

o opportunities. Tese oreign investments contribute to economic development as

well as to the overall profts o the investment industry.

Globally, there has been a growing trend toward greater regulation o the investment

industry. Regulation is needed to protect investors and saeguard their investments.

By promoting disclosure and transparency, it is hoped that regulation will prevent the

kinds o mistakes and rauds that have cost investors signifcant amounts o money over

the years. International cooperation among fnancial regulators has played and should

continue to play an important role in raising global standards o securities regulation.

SUMMARY

Te fnancial services industry exists to provide a link between savers/lenders/

providers o capital that have unds to invest and spenders/borrowers/users o

capital that need unds.

Financial intermediaries help channel fnancial capital eciently between savers

and spenders.

Te investment industry comprises all the players that are instrumental in help-

ing savers invest their money and borrowers get the unds they require.

Capitalism takes dierent orms, but two important characteristics are that it

avors private ownership as the means o production and markets as the means

o allocating resources.

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Summary 1

Te investment industry provides several benefts to the economy, including

the ecient allocation o scarce resources, better inormation about investment

opportunities, products and services that are appropriate or suppliers and

users o capital, and liquidity.

Te benefts or investors o a well-unctioning investment industry include a

broad range o investment products and services that meet their needs, com-petitive markets that provide liquidity and keep transaction costs low, timely

and ecient disclosure o inormation, and the ability to modiy their risk

exposures.

Laws and regulations are necessary to protect clients and ensure the integrity,

transparency, and airness o fnancial markets.

Ethical behavior is critical to protecting the reputation o and maintaining trust

in the investment industry.

Investment industry participants include the ollowing:

Categories Participants Key Characteristics

Investors Retail investors Individual investors with the least

amount o assets

High-net-worth

investors

Individual investors with a higher

amount o assets

Institutional

investors

Organizations that invest to advance

their mission or to provide fnancial

services to their clients

Financial advisory

service providers

Financial advisers Proessionals that provide advice

about investments and help clients

understand their needs and the risks

they ace

Investment man-

agement service

providers

Asset managers Proessionals that manage invest-

ments on behal o their clients

Investment inorma-

tion service providers

Data vendors Organizations that provide inorma-

tion resources

Investment research

providers

Organizations that produce inorma-

tion reports

Analysts Proessionals who produce research

reports

(continued)


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Categories Participants Key Characteristics

rading service

providers

Exchanges Financial markets that allow investors

to trade

Brokers Proessionals and their frms that

acilitate trading between investors,

acting as agents (do not trade with

their clients)

Dealers Proessionals and their frms that

acilitate trading between investors,

acting as principals (trade with their

clients)

Clearing and settle-

ment agents

Organizations that confrm and settle

trades

Custodial service

providers

Custodians Organizations that hold money and

securities on behal o their clients

Investment proessionals are held to varying standards o care based on regula-

tory jurisdiction and the investment proessionals role. Some are held to a high

level o care (fduciary standard), whereas others are held to a lower level o

care (suitability standard or appropriateness standard).

Te our key orces that drive the investment industry are competition, comput-

erization, globalization, and regulation.


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Chapter Review Questions

CHAPTER REVIEW QUESTIONS

est your knowledge o this chapter at cfainstitute.org/claritasstudy.

1 Te fnancial services industry benefts the economy by providing a link

between providers o capital and:

A savers.

B lenders.

C borrowers.

2 Te investment industry benefts the economy by:

A increasing risk.

B decreasing liquidity.

C increasing eciency.

3 Which o the ollowing bestdescribes a beneft o a well-unctioning investment

industry rom the perspective o an individual investor?

A Risk transormation

B Scarce resource allocation

C Fewer fnancial intermediaries

4 A major beneft o competitive markets or the individual investor is:

A risk transer.

B lower prices.

C greater integrity.

5 Which o the ollowing would most likely assist high-net-worth individuals in

arranging their fnancial aairs?

A Financial advisers

B Investment dealers

C Investment bankers

Copyright 2012 CFA Institute


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6 Which o the ollowing is least likely to acilitate trading and help reduce trans-

action costs?

A Stock exchanges

B Investment dealers

C Investment analysts

7 Relative to the suitability standard o care or investment proessionals, the

fduciary standard o care is:

A lower.

B higher.

C equivalent.

8 Which o the ollowing orces that drive the investment industry promotes

transparency o fnancial markets?

A Competition

B Computerization

C Regulation

9 Globally, regulation o the investment industry has:

A increased.

B decreased.

C remained stable.


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Answers 1

ANSWERS

1 C is correct. Te fnancial services industry exists to provide a link between

providers o capital (also called savers, lenders, or investors) that have unds toinvest and users o capital (also called spenders or borrowers) that need unds.

A and B are incorrect because savers and lenders are providers, not users, o

capital.

2 C is correct. Te investment industry helps savers invest their money and helps

borrowers get the unds they require. In doing so, it reduces the resources that

would be expended on the search rather than on productive uses, thus increas-

ing eciency. A is incorrect because the investment industry helps transorm

and transer risk, not increase it. B is incorrect because the investment industry

increases rather than decreases liquidity.

3 A is correct. In a well-unctioning investment industry, risks can be trans-ormed and transerred. Individuals who want to reduce risk can do soor

example, by buying insurance. B is incorrect because the ecient allocation

o scarce resources through a well-unctioning investment industry is a pri-

mary beneft or the economy, not the individual. C is incorrect because a

well-unctioning investment industry is characterized by competitive markets.

Competitive markets are made up o a large number o fnancial intermedi-

aries (e.g., banks or insurance companies) that compete with one another.

Competitive markets keep prices o investment products and services down.

4 B is correct. Competitive markets promote higher production eciency and

help keep prices o investment products and services down. A is incorrect

because risk transer, although it is a beneft or the individual investor, deals

with transerring risk rom those that want to reduce risk to those that are will-

ing to take on risk; risk transer does not deal with competition. C is incorrect

because greater integrity is achieved by eective laws and regulations and not

through competition.

5 A is correct. Financial advisers typically provide high-net-worth individuals

with advice about how to manage their investments. B is incorrect because

investment dealers acilitate trading between investors. C is incorrect because

investment bankers help companies and governments raise unds globally.

6 C is correct. Investment analysts are primarily engaged in analyzing investment

opportunities and providing recommendations about the investments they

ollow. A is incorrect because stock exchanges acilitate trading o new andexisting securities and, as such, help reduce transaction costs. B is incorrect

because investment dealers acilitate trading by acting as buyers when investors

want to sell and as sellers when investors want to buy. By doing so, they help

reduce transaction costs.

7 B is correct. Investment proessionals who have a fduciary responsibility to

their clients must act in their clients best interests. Te fduciary standard is

a higher standard o care than the suitability standard. A and C are incorrect


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because investment proessionals who have a fduciary responsibility to their

clients have a higher, not lower or equivalent, standard o care than investment

proessionals who must meet the suitability standard o care.

8 C is correct. Regulation promotes transparency. Increased transparency is

designed to prevent mistakes and raud. A is incorrect because competition,

although one o the our orces, does not promote transparency. B is incorrectbecause computerization, although it is one o the our orces, does not pro-

mote transparency. Regulation is the only one o the our orces that promotes

transparency.

9 A is correct. Globally, there has been a growing trend toward greater regulation

o the investment industry. B and C are incorrect because globally, there has

been a growing trend toward increased regulation o the investment industry,

not a trend o decreased or stable regulation.


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GLOSSARY

G

Analysts Analysts select, evaluate, and interpret inormationto arrive at an opinion.

Asset managers See investment managers.

Assets Resources that a company controls as a result o pastevents and that are expected to provide uture economicbenefts.

Auditors An external auditor is an independent accountantthat examines fnancial statements and provides a writ-ten opinion on them. An internal auditor is employed bythe company and evaluates a companys accounting andinternal controls.

Bond A ormal contract that represents a loan rom an investor(bondholder) to an issuer. Te contract describes the keyterms o the debt obligation such as the interest rate andthe maturity.

Brokers Agents who execute orders to buy or sell securitiesor their clients and provide trading services in exchangeor a commission.

Capital markets Financial markets or securities that have amaturity longer than a year.

Capitalism An economic system that avors private ownershipas the means o production and markets as the means oallocating scarce resources.

Clearing and settlement agents Investment industry partici-pants that confrm and settle trades ater they have beenarranged.

Conflict of interest When either the employees personal inter-ests or the employers interests conict with the interestso the client (conicts o interest can also arise whenemployees and employers interests conict).

Custodians Entities that hold money and securities on behalo their customers, help arrange trade settlements, andcollect interest and dividends or their customers.

Dealers Financial intermediaries that allow their clients to

trade when they want to trade by standing ready to buy(sell) when their clients want to sell (buy) by acting asprincipals in trades.

Demand Te desire or a good or service coupled with the abilityand willingness to pay or the desired product.

Duty of care Te legal and proessional obligations that invest-ment proessionals have when acting or or on behal otheir clients.

Financial advisers Investment proessionals who provide bothfnancial planning and investment advisory services totheir clients.

Financial assets Claims on other assets and on uture caows; or example, a share o common (ordinary) storepresents ownership in a company or a claim on tresidual value o the company.

Financial capital Funds provided to corporations and goverments that allow them to purchase physical capital, to hilabor, and to acquire other inputs necessary to produgoods and services.

Financial intermediaries Financial institutionssuch as banksecuritizers, and insurance companiesthat channel unrom savers to spenders; they transorm deposits made savers into loans to borrowers.

Financial intermediation Process o collecting savings rolenders in one orm, such as deposits, and transorminthem into another orm, such as loans, or borrowers.

Financial markets Places where buyers and sellers can trasecurities; also called securities markets.

Fixed-income securities Loans that lenders make to borrowealso called debt securities and bonds.

High-net-worth investors Individual investors who have invetable assets over a certain amount (e.g., USD1 million CNY10 million) and who are oten, but not always, mosophisticated investors.

Initial public offering Te frst issuance o common shares the public by a ormerly private corporation.

Insider trading rading while in possession o material nopublic inormation.

Institutional investors Companies, trusts, and governmenthat invest to advance their missions or to provide fnancservices to their clients.

Investment banks Financial intermediaries that typicaprovide capital raising and strategic advisory servicebrokerage and dealing services, and research services companies and governments.

Investment industry All the players that are instrumentin helping savers invest their money and lenders get tunds they require.

Laws Rules passed by a legislative body, such as Congress the United States, Parliament in the United Kingdom, the Diet in Japan.

Liquidity Measure o the ease o buying or selling an asswithout aecting its price.

Money markets Financial markets or securities that havematurity shorter than a year.


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G-2 GlossaryG-2 Glossary

Mutual fund Investment company that holds portolios oinvestment securities and assets.

Pension funds Institutional investors who hold investmentportolios or the beneft o uture and current retirees.

Physical capital Te means o production; tangible goods such

as equipment, tools, and buildings.

Primary market Te market where new securities, IPOs, andsubsequent oerings are issued and sold to investors.

Proprietary trading When dealers trade using their ownaccounts and their own capital with buyers and sellers.

Real assets Physical assets such as land, buildings, cattle,and gold.

Regulations Rules that set standards or conduct and thatcarry the orce o law.

Retail investors Individual investors who have the least amount

o investable assets and who are oten, but not always, lesssophisticated investors than institutional investors.

Risk Te eect o uncertain uture events on an organizationor on the outcomes the organization achieves.

Secondary market Market in which traders o a security tradewith each other but not with the original security issuer;market in which investors buy and sell securities witheach other.

Securities Financial assets that can be traded.

Stock exchanges Organized and regulated fnancial marketsthat allow buyers and sellers to trade securities with eachother.

Stocks Ownership in a company; also called equity securities,shares o stock, or shares.

Supply Te quantity o a good or service sellers are willing andable to sell at a given price.

Transaction costs Costs that accrue rom brokerage com-missions, bidask spreads, and market impact; the costs

associated with trading.


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