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CHAPTER 1
THE INVESTMENT INDUSTRY:

A TOP-DOWN VIEW
by Ian Rossa O’Reilly, CFA
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.

The Financial Services Industry 5
INTRODUCTION 1
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 entre-
preneur 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.
THE FINANCIAL SERVICES INDUSTRY 2

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.
1 Bolded 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.
© 2014 CFA Institute. All rights reserved.
6 Chapter 1 ■ The Investment Industry: A Top-Down View
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 men-
tioned earlier, shareholders (also known as stockholders) have ownership in a
company. The company has no obligation to either repay the money the share-
holders 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 receiv-
ing 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.
The Financial Services Industry 7
Exhibit 1 Overview of the Financial Services Industry
Direct Finance
Financial Markets
Where savers and spenders
Savers can buy and sell securities. Spenders
(Providers of Capital) (Users of Capital)
Financial Services
Industry
Financial Intermediaries
Channel funds from
savers to spenders.
Indirect Finance
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 associa-
tions 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.
2 In 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.
How Economies Benefit from the Existence of the Investment Industry 9
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.
HOW ECONOMIES BENEFIT FROM THE EXISTENCE OF THE

INVESTMENT INDUSTRY
4
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, gov-
ernments 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 indus-
tries. 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.
How Investors Benefit from the Existence of the Investment Industry 11
The investment industry plays an important role in providing and processing infor-
mation 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 sat-

isfy 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.
HOW INVESTORS BENEFIT FROM THE EXISTENCE OF THE

INVESTMENT INDUSTRY
5
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 invest-
ment products and portfolios.
5.1 How the Investment Industry Serves Investors

Below are some of the most important features that define a well-functioning invest-
ment 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 satis-
factory 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, rel-
evant 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.
How Investors Benefit from the Existence of the Investment Industry 13
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 pro-

tect 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 inves-
tors and focus on the main investment industry participants that can help them to
invest their money.
Investment Industry Participants 15
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 com-
panies 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 govern-
ments seeking capital. The investment banks pay close attention to the types of invest-
ments 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 regula-
tions. 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 designa-
tion “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 depend-
ing 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 sig-
nificant 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
Investment
Investment Information
Financial Management Trading
Planning Custodial
Savers
(Providers of Capital)
Institutional Investors Individual Investors

Investment Industry Participants 17
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 oper-
ates, 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 invest-
ments. These investors often buy investment products created and managed by invest-
ment 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 imple-
ments 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 provid-
ers to keep it updated with the latest market develop-
ments. Aus Ltd. has a broker that carries out trades on its
behalf and a custodian that safeguards clients’ money and
assets.
Key Forces Driving the Investment Industry 19
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.
KEY FORCES DRIVING THE INVESTMENT INDUSTRY 7

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.
Competition
Regulation
Technology
Investment
Industry
Globalisation
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 indus-
try 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 buy-
ers of insurance contracts with providers of capital who are willing to bear the
insured risks, but also among the largest investors.
Summary 21
■■ 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, com-
petitive 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 Individual investors with the least

amount of investable assets
High-net-worth Individual investors with a higher
investors amount of investable assets
Institutional Organisations that invest to advance
investors their mission or on behalf of their
clients
Financial advisory Financial planners Professionals who help their clients
service providers understand their future financial
needs and define their investment
goals
Investment man- Asset managers Professionals who help their clients
agement service carry out investments to achieve their
providers investment goals
Investment informa- Buy-side analysts Professionals who review potential
tion service providers investments
Data vendors Organisations that provide informa-
tion resources
Investment research Organisations that produce informa-
providers tion reports
(continued)
Categories Participants Key Characteristics

Trading service Exchanges Organised and regulated financial
providers markets that allow investors to trade
Brokers Professionals and their firms that
facilitate trading between investors,
acting as agents (they do not trade
with their clients)
Dealers Professionals and their firms that
facilitate trading between investors,
acting as principals (they trade with
their clients)
Clearing houses and Organisations that confirm and settle
settlement agents trades
Custodial service Custodians and Organisations that hold money and
providers depositories securities on behalf of their clients
■■ Four key forces that drive the investment industry are competition, technology,
globalisation, and regulation.
Chapter Review Questions 23
CHAPTER REVIEW QUESTIONS
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 trans-
action 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 process-
ing costs is:
A regulation.
B technology.
C globalisation.
11 Globally, regulation of the investment industry has:
A increased.
B decreased.
C remained stable.
Answers 25
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 increas-
ing 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 pre-
paring detailed reports (sell-side 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 incor-

rect 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 compe-

tition, 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.
CHAPTER 2
ETHICS AND INVESTMENT
PROFESSIONALISM
by Gerhard Hambusch, CFA
LEARNING OUTCOMES
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.

Introduction 33
INTRODUCTION 1
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 invest-
ment 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 invest-
ment 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 stan-
dards 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.
1 CFA Institute and Edelman, “CFA Institute & Edelman Investor Trust Study” (2013): www.cfainstitute.
org/learning/products/publications/ccb/Pages/ccb.v2013.n14.1.aspx.
2 Alan M. Meder, “Creating a Culture of Integrity,” CFA Institute (2011): www.cfainstitute.org/learning/
products/publications/contributed/Pages/creating_a_culture_of_integrity.aspx.
34 Chapter 2 ■ Ethics and Investment Professionalism
Ethics
Rules
Professional 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 invest-
ment 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.
Individuals who work in the investment industry but outside of the investment man-
agement 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.
Why Ethical Behaviour Is Important 35
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
Investor
Confidence
Success of Integrity of
the Investment the Investment
Industry Profession
Fairness High Integrity of

of Financial Ethical Financial
Markets Markets
Standards
Efficiency Clients’
of Financial Investment
Markets Goals
Public Clients’
Trust Trust
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 co-workers. 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 co-workers 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, safe-
guarding 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 profes-
sional 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.
Obligations of Employees in the Investment Industry 37
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 mar-
kets. 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.
He bought ten thousand shares of She bought ten thousand shares

his friend Robert’s company for of another stock for John Smith’s
John Smith’s portfolio in order to portfolio that was better aligned
help Robert avoid a hostile takeover. with his investment goals.
She overheard information at work He overheard information at work

that would cause ABC company’s that would cause ABC company’s
stock prices to fall. She called her stock prices to fall. He kept the
broker and sold her shares before information to himself and did not
the news was made public. act on it.
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 port-

folio 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 cli-
ent’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.
Obligations of Employees in the Investment Industry 39
Exhibit 2 (Continued)
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 mem-
bers 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 carry-
ing 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 far-reaching consequences that co-workers should not have to face. By contrast,
ethical conduct—including competence, care, and respect towards co-workers—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 sig-
nificant 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?

Ethical Standards 41
These questions are intended to identify major obligations, but they are not compre-
hensive. They can be adapted to identify and consider standards applicable to any
employee’s work environment.
ETHICAL STANDARDS 4
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 inconsis-

tencies 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 pro-
fessionals 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 fun-
damental 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, employ-
ees, 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 recommen-
dations, taking investment actions, and engaging in other professional
activities.
Ethical Standards 43
■■ 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 main-

tain 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 princi-
ples 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, judg-
ment, 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 indus-
try 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 stakehold-
ers 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 intelli-
gent and informed decisions. Those in the investment industry who make false
or misleading statements harm investors and reduce investor confidence in
financial markets.
3 The Standards of Practice Handbook can be accessed at www.cfapubs.org/toc/ccb/2014/2014/4.

■■ 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 Selected Aspects of the CFA Institute Code of Ethics
■■ 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 rele-
vant 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.
Benefits of Ethical Conduct and Consequences of Unethical Conduct 45
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 com-
pensation 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.
BENEFITS OF ETHICAL CONDUCT AND CONSEQUENCES OF

UNETHICAL CONDUCT
5
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.
Profita
bili
t
y
Liquidity Efficiency
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 infor-
mation 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 par-
ticipation 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 com-
panies 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 con-
sequences. 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 invest-
ment 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 busi-
nessman 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
4 Ponzi 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.
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 finan-
cially 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 diversifica-
tion, 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
5 A 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.
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 commod-
ity 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 deriv-
atives 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 co-
workers 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 prose-
cuted, 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 invest-
ment 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 ille-
gal 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 indi-

viduals use a framework to help them make ethical decisions. The four-step 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).
Framework for Ethical Decision Making 51
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 Application of a Framework for Ethical Decision Making
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 loy-

alty, 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 indi-
vidual 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?

(continued)
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 author-

ity 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 discuss-

ing 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.
(continued)
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 high-
lighting 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 phon-

ing friends and family to inform them of changed investment recommen-
dations 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 bank-

ruptcy 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 port-
folio 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 con-
tain 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 respon-

sible for negotiating cell phone service for company employees is consid-
ering 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 invest-
ment 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 reimburse-

ment 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 com-
petence, diligence, and reasonable care; act respectfully and ethically; and use
independent judgment.
Summary 57
■■ 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 con-
duct 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 conse-
quences 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.

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 prin-
ciples 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, recom-

mends 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 judg-
ment in ethical decisions?
A Incentives
B Rationalization
C Authority figures
Answers 61
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 mar-
kets. 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 increas-
ing 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 run-
ning) 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 employ-
ees 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 inter-
ests when fulfilling their work obligations.
5 A is correct. Supervisory duties should only be assumed when the work envi-
ronment 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, profes-
sional, and organisational standards. B and C are incorrect because if deficien-
cies 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 invest-
ment professionals because increased trust from clients increases the likelihood
that clients will seek their advice, thus enhancing the security of their employ-
ment. 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 infre-
quent market innovations, the need is not so apparent. C is incorrect because
activities that occur in different jurisdictions can be complicated by inconsis-
tencies in legal obligations, which would make the need for ethical standards
important. But in different jurisdictions where legal obligations are unambigu-
ous 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 employ-
ers. 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 inde-

pendence by creating a bias that may affect judgment. A is incorrect because
maintaining client confidentiality is related to the fundamental ethical princi-
ple 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 compa-
nies 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,
Answers 63
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 deter-
mining 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 sup-
ported 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 prefer-
able 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 invest-
ment 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.
CHAPTER 3
REGULATION
by James J. Angel, PhD, CFA
LEARNING OUTCOMES
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.

Introduction 67
INTRODUCTION 1
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 regula-
tion. 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 reg-
ulation 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.

68 Chapter 3 ■ Regulation
Laws and
Company Regulations
Rules
TRUST
IN THE
INDUSTRY
Professional
Ethical Standards
Principles
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 econo-
mies 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 compa-
nies and governments. The allocation of capital to productive uses is essential
Consequences of Regulatory Failure 69
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 inter-
connections 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 infor-
mation 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 trans-

mit 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.
CONSEQUENCES OF REGULATORY FAILURE 3

Inadequate regulation and failure to enforce regulation can have a variety of conse-
quences, 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 dam-
age 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
n
d y t a tio n tion
e t l i o lu
d Ne hori n su n tat ng
t
en Res
o
e u t is C o n e r i m
rc eiv al A alys blic optio plem nito force pute view
g
Pe Le An Pu Ad Im Mo En Dis Re
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
A Typical Regulatory Process 71
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 indus-
try, 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 reg-
ulations 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 informa-
tion 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 compli-
ance 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 pur-
chases 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 cease-and-desist
orders and monetary fines, fees, and settlements. In the case of individuals,
1 For 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).
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 tribu-
nal, 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, regula-
tions 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 “rules-based”. In a

principles-based regime, regulators set up broad principles within which the invest-
ment industry is expected to operate. This avoids legal complexity and allows regula-
tors 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. 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 defini-
tion of insider trading—prosecutions are made under the broad anti-fraud provisions
Types of Financial Market Regulation 73
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 “disclosure-based”. 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 reg-
ulators sometimes impose extra burdens of disclosure and restrict access to products
that they think lack merit, are highly risky, or are poorly understood.
TYPES OF FINANCIAL MARKET REGULATION 5

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
2 To 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.”
■■ 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 indus-

try 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 regula-
tions 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’ invest-
ment 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 regu-
lations, 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 prac-
tices 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 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. 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 recommen-
dation 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 stan-
dard 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 manip-

ulation. 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 trad-
ing. 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 cus-
tomers, 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.
3 CFA 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.
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 com-
panies. 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 higher-level 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 indus-
try, 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.
Consequences of Compliance Failure 79
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 empha-
sise 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 com-
pliance 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 documen-
tation, 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 moti-
vate 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.
CONSEQUENCES OF COMPLIANCE FAILURE 7

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, man-
agers 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 suf-
fer 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 regu-
lation. Those that fail to do so face sanctions that can be severe.
■■ Financial services and products are highly regulated because a failure or disrup-
tion in the financial services industry, which includes the investment industry,
can have catastrophic consequences for individuals, companies, and the econ-
omy 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.
Summary 81
■■ A typical regulatory process involves determination of need by a legal authority;

analysis, including costs and benefits; public consultation on proposals; adop-
tion and implementation of regulations; monitoring for compliance; enforce-
ment, 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, trad-
ing, 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 (supervi-

sors) 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 signif-
icant consequences for employees, managers, customers, the firm, the invest-
ment industry, and the economy.
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 ben-
efits 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 individu-
als 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 bar-
riers 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 stan-
dards 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 reduc-
tion 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 spe-
cific 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 trans-
port 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 indus-
try do not engage in practices that could disrupt the economy.
6 B is correct. Regulations seek to maintain fair and orderly markets by promot-

ing rules that eliminate unfair advantages to select participants. A is incor-
rect 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.
Answers 87
7 C is correct. Both inadequate regulation and failure to properly enforce regula-

tions 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 pro-

tect 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 disclosure-based system, reg-
ulators 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 informa-

tion. A is incorrect because trading for internal company accounts before plac-
ing 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 con-
trols 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 compe-
tency 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 incor-
rect because operational rules are related to how a company operates; oper-
ation 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 reg-
ulation. 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 corpo-

rate 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 respon-
sibility 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.
CHAPTER 4
MICROECONOMICS
by Michael J. Buckle, PhD, James Seaton, PhD, Sandeep Singh, PhD, CFA, CIPM, and
Stephen Thomas, PhD
LEARNING OUTCOMES
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.
Introduction 95
INTRODUCTION 1
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 under-
standing 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 profit-
ability 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.
1 A 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.
96 Chapter 4 ■ Microeconomics
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 cap-
ital 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 prod-
ucts 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 cou-
pled 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
Demand and Supply 97
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 satisfac-
tion 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
High Some Low

Satisfaction Satisfaction Satisfaction
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
2 For 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.
Exhibit 2 Hypothetical Demand Curve for Pizza
D
3.0
2.8
2.6
Price
2.4
2.2
2.0
1 2 3 4 5
Quantity Demanded
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
D D1
Price
Quantity Demanded
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 rela-
tionship 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 com-
pany 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
S1
S
Price
Quantity Supplied
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 gen-
erated 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
D S
Price
EP
Quantity
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
D D1 S
Price
EP 1
EP
Quantity
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 com-
panies 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 will-
ing 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
Elasticities of Demand 105
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 per-
centage 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

Percent change in the quantity demanded of the product
Perceent change in the price of the product
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
+15%
= −1.5.
−10%
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
−20%
= −2.
+10%
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 elas-
ticity 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 elas-
ticities. 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 Inelastic: For a given percentage increase in price, the
than 1 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.
Elasticities of Demand 107
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

Percent change in the quantity demanded of Product 1
Percentt change in the price of Product 2
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
−7%
= −1.4.
+5%
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
+7%
= +1.4.
+5%
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 cross-price 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 con-
trast, if consumers purchase less of a product as their income increases, the income
Profit and Costs of Production 109
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 Type of Product Based on Income Elasticity of Demand
Necessity
Product
Inferior Normal Luxury
Product Product Product
Income Elasticity of Demand
O 1
PROFIT AND COSTS OF PRODUCTION 4

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 restau-
rant 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

Costs
Fixed Costs
Number of Units
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
Costs
Total
Costs
Variable Costs
Fixed Costs
Number of Units
For example, raw materials tend to be a variable cost because the more units the com-
pany 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
fit
Pro
Breakeven
Point
Costs
sts
t a l Co
To e
s nu
Los eve
R
Number of Units
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 produc-
tion 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
Total Output
3
2
1
Number of Workers
1 Increasing marginal returns: Total output increases rapidly.
Diminishing marginal returns: Total output increases but at

2 a decreasing rate.
3 Negative marginal returns: Total output decreases.
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 pro-
duces 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 steel-
making 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 vari-
able 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 ship-
building 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 produc-
ing 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 composi-
tion, 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.
Market Environment 115
MARKET ENVIRONMENT 6
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, advertis-

ing, 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 com-
puters. 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 monop-
olies 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 government-regulated 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 com-
petition 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 abnor-
mal 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 con-
sider 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
Summary 117
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 will-
ingness 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 prod-
uct 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 pref-
erences, 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 pro-
duced 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 sub-
stitute 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 prod-
uct. 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 comple-
mentary products, whereas a positive cross-price elasticity of demand charac-
terises substitute products in many but not all cases.
■■ Income elasticity of demand measures the effect of changes in income on quan-

tity 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
Summary 119
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 charac-
teristics, 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 compe-
tition. 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.
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 indi-
viduals 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 quanti-
ties 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, consum-
ers 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 complemen-
tary product, not a substitute product, will decrease if the price of the prod-
uct 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 print-
ers 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.
Answers 125
8 B is correct. If price elasticity is low or inelastic, changes in price are accompa-

nied 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 per-
centage 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 pro-
duction. 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 gener-
ally 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.
CHAPTER 5
MACROECONOMICS
by Michael J. Buckle, PhD, James Seaton, PhD, and Stephen Thomas, PhD
LEARNING OUTCOMES
a Describe why macroeconomic considerations are important to an invest-

ment 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.

Gross Domestic Product and the Business Cycle 129
INTRODUCTION 1
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, consum-

ers, 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.
GROSS DOMESTIC PRODUCT AND THE BUSINESS CYCLE 2

“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 popula-
tions. 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.

130 Chapter 5 ■ Macroeconomics
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 foreign-produced 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 GDP Components for the United States and Japan in 2010
80
70
68%
60
59%
Percent of GDP
50
40
30
20 21%
20% 20%
10 14%
1%
–3%
0
–10 Consumer Gross Government Exports Minus
Spending Investment Spending Imports
United States 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 phys-
ical 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 Real GDP per Capita for the United States, 1981–2010
50,000
45,000
40,000
Real GDP per Capita ($)

35,000
30,000
25,000
20,000
15,000
10,000
5,000
0
1981 1986 1991 1996 2001 2006 2011
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 produc-
tivity, 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 9.1%
India 5.4
Brazil 4.0
United States 2.9
Canada 2.9
Japan 2.6
France 2.3
United Kingdom 2.2
Germany 2.0
World 3.2

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 activ-
ity 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 varia-
tions 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
Peak
GDP Growth Rate
Peak te
wth Ra
n
P G ro
sio
Co nd in GD
ntr Tre
n
pa
ac
Ex
tio
n Recovery
Trough
Time
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 con-
trol 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 econ-
omy, 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. THE HOUSING SECTOR AND THE BUSINESS CYCLE
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 invest-
ing 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 stim-
ulate 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 employ-
ment 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 expe-
rienced 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
Annual GDP Growth (%)

4
–2
–4
–6
1971 1976 1981 1986 1991 1996 2001 2006 2011
United States Germany United Kingdom
Note: Annual percentage growth of GDP is calculated at market prices based on constant local
currency.
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 con-
sidered 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)

Industrial
Gross Domestic Product Production Consumer Prices Unemployment
Latest Qtr* 2013† 2014† Latest Latest Year Ago 2013† Rate, %
China +7.7 Q4 +7.4 +7.7 +7.3 +9.7 Dec +2.5 Dec +2.5 +2.6 4.0 Q3§
France +0.2 Q3 –0.5 +0.2 +0.8 +1.5 Nov +0.7 Dec +1.3 +1.0 10.8 Nov
Germany +0.6 Q3 +1.3 +0.5 +1.7 +3.5 Nov +1.4 Dec +2.0 +1.5 6.9 Dec
Japan +2.4 Q3 +1.1 +1.7 +1.5 +4.8 Nov +1.6 Nov –0.2 +0.2 4.0 Nov
United +2.0 Q3 +4.1 +1.8 +2.7 +3.7 Dec +1.5 Dec +1.7 +1.5 6.7 Dec
States
*% 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.
Inflation 141
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 tempo-
rary 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 simultane-
ously 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
10
Inflation Rate (%) 4
–2
–4
–6
1989 1994 1999 2004 2009
UK RPI UK CPI US CPI

US Core CPI US PPI
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 broadest-based 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.
Inflation 143
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 invest-
ment 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 com-
panies 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 govern-
ments, 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 consum-
ers 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 hyperinfla-
tion 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
Monetary and Fiscal Policies 145
■■ 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 responsibili-
ties 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 stim-
ulate 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 mar-
ket 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 infla-
tion 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.
Monetary and Fiscal Policies 147
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 stimulat-
ing 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 con-

sumer 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 indi-
rectly 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 recogni-
tion 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 reduc-
tion 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
Summary 149
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 mon-
etary 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 eco-
nomic 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 compari-
sons 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 fluc-
tuations 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, com-
panies, 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, stag-
flation, and hyperinflation.
■■ Economic growth, inflation, and unemployment are major concerns of central

banks and governments. They each use different financial tools to affect eco-
nomic 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 influ-
ence the level of aggregate demand in an economy and thus the level of eco-
nomic 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.
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 155
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 incor-
rect 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 pop-
ulation 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 popu-
lation. 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 follow-
ing 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 unem-
ployment (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 coun-
tries, 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 eco-
nomic 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 inde-
pendent 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 stim-
ulate 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 busi-

nesses and consumers to stimulate or slow the economy. One of the drawbacks
is that consumers and businesses may not respond as expected, leading to
Answers 157
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
LEARNING OUTCOMES
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.

Introduction 161
INTRODUCTION 1
When you walk into a supermarket where you can buy Scottish salmon, Kenyan veg-
etables, 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 coun-
tries. 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 under-
standing of how international trade and foreign exchange rate fluctuations affect econ-
omies, 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 for-
eign exchange rate fluctuations affect both your daily life and the work of investment
professionals.
1 Data are from www.wto.org/english/res_e/booksp_e/anrep_e/wtr12-1_e.pdf (accessed 12 September 2012).

2 Information is from http://www.nestle.com/aboutus/annual-report (accessed 24 March 2014).
162 Chapter 6 ■ Economics of International Trade
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 exam-
ple, 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 ser-
vices. 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.
Imports and Exports 163
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 cer-

tification, licensing, sanctions, or embargoes, that make it more difficult and
expensive for foreign producers to compete with domestic producers.
No Barrier to Trade Trade Barrier
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 resolu-
tion 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 perish-
able 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, met-
als, 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:
Shoes Kettles
Growland 10 units 10 units

Makeland 20 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.
Balance of Payments 165
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 max-
imises productivity and increases consumption opportunities in both countries,
which ultimately benefits both economies.
BALANCE OF PAYMENTS 4
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 inter-
national 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).
3 IMF, “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).
Analysing a country’s balance of payments helps in understanding the country’s

macroeconomic environment. Questions that can be answered by analysing a coun-
try’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
Current Account
Goods and Services

Exports − Imports = Net exports
= Balance of trade
Income
Salaries + Income on financial
investments
Current Transfers
Unilateral transfers, such as
gifts or workers’ remittance
4.1.1 Components of the Current Account

The goods and services account is usually the largest component of a country’s cur-
rent 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 pay-
ments 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.
4 Balance 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.
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 trans-
fers 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
Current Account Balance

Rank Surplus (+) or Deficit (–)
Country (out of 193) ($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
United States 193 –360.7
Source: Based on data from https://www.cia.gov/library/publications/the-world-factbook/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 fol-
low-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 domes-
tic 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
Capital and Financial Account
Capital
Capital transfers between
domestic and foreign entities
Financial
Direct investments + Portfolio
investments + Other investments
+ Reserve 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 +1,097.3
Imports of goods –909.1
Net exports of goods +188.2
Accounts Amount (€ billions)
Supplementary trade items –27.3

Net exports of services –3.1
Trade surplus +157.8
Income +64.4
Current transfers –36.8
Current account surplus +185.4
Capital and financial account
Capital account surplus +0.0
Direct investments –47.0
Portfolio investments –65.7
Other investments –120.9
Reserve account –1.3
Financial account deficit –234.9
Capital and financial account deficit –234.9
Errors and omissions +49.5

Total 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 invest-
ments. 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 coun-
try 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 secu-
rities) 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 curren-
cies—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 curren-
cies 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.
Foreign Exchange Rate Systems 173
FOREIGN EXCHANGE RATE SYSTEMS 5

International trade requires payments. These payments involve an exchange of cur-
rencies 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 cer-
tain 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.

Currency Values 175
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 self-adjusting.
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. EFFECT OF INFLATION ON A COUNTRY’S CURRENCY
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 €1.20 £1.00 €1.20/£1

June €1.20 £1.10 €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 per-
formance. 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 liber-
alises 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.
Currency Values 177
Exhibit 5 Major Factors Affecting the Value of a Currency
Factor Effect on the Value of the Currency
Balance of payments A current account deficit tends to lead to a depre-

ciation of the domestic currency.
Level of inflation High inflation tends to lead to a depreciation of
the domestic currency.
Level of interest rates High interest rates tend to lead to an appreciation
of the domestic currency.
Level of government debt High government debt tends to lead to a deprecia-
tion of the domestic currency.
Political and economic Political instability and poor economic prospects
environment 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 quan-
tities 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 finan-
cial 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 cur-
rency 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 retail-
ers 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
Currency Values 179
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 over-
valued relative to the US dollar.
EXAMPLE 4. PURCHASING POWER PARITY EXCHANGE RATES
In January 2014,
Cost of a Big Mac in the United States US$4.62

Cost of a Big Mac in South Africa (in R23.50
rands)
Implied exchange rate 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
India –66.8
South Africa –53.3
Malaysia –51.8
New Zealand –1.1
United States
Britain .1
Switzerland 54.5
Venezuela 54.7
Norway 68.6
–80 –60 –40 –20 0 20 40 60 80
2014 Under-/Overvaluation against the Dollar, %
Source: “Big Mac Index,” Economist, http://www.economist.com/content/big-mac-index (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 valu-
ations, 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 bar-
riers 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.
Foreign Exchange Market 181
FOREIGN EXCHANGE MARKET 7

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 illus-
trative 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:
Bid Offer
British pound (£) $1.50/£1 $1.60/£1
Customer A, who has just arrived from the United Kingdom, wants to con-
vert £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 cur-
rency (£), 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.
Foreign Exchange Market 183
Let us return to the example of the French supermarket chain importing dairy prod-
ucts 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 Exchange rate changes to

€1.15/£1 €1.25/£1
It takes 5 cents less to It takes 5 cents more to
buy 1 pound. Thus, the buy 1 pound. Thus, the
euro appreciated relative euro depreciated relative
to the pound. to the pound.
French supermarket French supermarket
chain must pay chain must pay
£100,000 × €1.15/£1 = £100,000 × €1.25/£1 =
€115,000 €125,000
Euro appreciation relative Euro depreciation rela-
to the pound is beneficial tive to the pound is det-
for the French importer. rimental 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 fur-
ther 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 ser-
vices that other countries can produce relatively more efficiently. The combina-
tion of specialisation and international trade ultimately benefits all countries,
leading to a better allocation of resources and increased wealth.
Summary 185
■■ The balance of payments tracks transactions between residents of one coun-

try 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 sur-
plus, 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, allow-
ing exchange rates to adjust to correct imbalances, such as current account defi-
cits. 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 pay-
ments, inflation, interest rates, government debt, and the political and eco-
nomic 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 par-
ity 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.
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 refrig-
erators 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 compa-
ny’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 finan-
cial 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 coun-
try’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 interna-
tional 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.
Answers 191
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 coun-

try’s currency. A and C are incorrect because high interest rates and high eco-
nomic 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 for-
eign 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 cur-
rency. 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 for-
ward 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.
CHAPTER 7
FINANCIAL STATEMENTS
LEARNING OUTCOMES
a Describe the roles of standard setters, regulators, and auditors in finan-

cial 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, profit-

ability, financing, shareholder return, and shareholder value.
Introduction 195
INTRODUCTION 1
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 infor-
mation to various stakeholders, such as investors, management, employees, and com-
petitors. 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 account-
ing 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.

196 Chapter 7 ■ Financial Statements
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 gen-
erally accepted accounting principles (US GAAP), but non-US-based 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 state-
ments 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 enforc-

ing 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 inde-
pendent 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
Financial Statements 197
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.
FINANCIAL STATEMENTS 3
A company is required to keep accounting records and to produce a number of finan-
cial 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 sharehold-
ers’ 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!
Assets Liabilities
Equity
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 alterna-
tive 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 paren-
theses 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 20X2 20X1
($ millions)
Assets
Cash 25 16
Accounts receivable 40 35
Inventories 95 90
Other current assets 5 5
Total current assets $165 $146
Gross property, plant, and equipment 460 370
Accumulated depreciation (160) (120)
Net property, plant, and equipment $300 $250
Intangible assets 100 100
Total non-current assets $400 $350
Total assets $565 $496

Liabilities and Equity
Accounts payable 54 50
Accrued liabilities 36 36
Current portion of long-term debt 10 10
Total current liabilities $100 $96
Long-term debt 232 200
Total non-current liabilities $232 $200
Total liabilities $332 $296
Common stock 85 85
Retained earnings 148 115
Total owners’ equity $233 $200
Total liabilities and equity $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. Non-current 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 capital-
ised, 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, how-
ever, 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 accu-
mulated 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 long-term
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 lia-
bilities must be repaid in the next year and include operating debt, such as accounts
payable (credit extended by suppliers, sometimes called creditors), short-term bor-
rowing (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 pur-
chase 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 valu-
able. 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 $650
Cost of sales (450)
Gross profit $200
Other operating expenses
Selling expenses $(30)
General and administrative expenses (20)
Depreciation expense (40)
Total other operating expenses (90)
Operating income $110
Interest expense (15)
Earnings before taxes $95
Income taxes (19)
Net income $76

Additional information:
Dividends paid to shareholders $43
(continued)
Number of shares outstanding 50 million

Earnings per share $1.52
Dividend per share $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); sell-
ing, 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.
1 Note 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.
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 approxima-
tion 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 long-term 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 state-
ment 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 $76
Plus depreciation expense 40

Minus increase in accounts receivable (5)
Minus increase in inventories (5)
Plus increase in accounts payable 4
Net cash flow from operating activities $110
Investment activities
Minus investment in property, plant, and equipment $(90)
Net cash flow used in investing activities $(90)
Financing activities
Cash inflows from borrowing (long-term debt) $32
Cash inflows from new share issues 0
Minus dividends paid to shareholders (43)
Net cash flow used in financing activities $(11)
Net increase (decrease) in cash $9
Beginning cash 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 issu-
ance 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 com-
pany’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 mil-
lion 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 activ-
ities 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 ($90 million) and a cash outflow on the cash flow statement, but they
only show up on the income statement when the cost of the fixed asset is expensed
or depreciated over time. As noted earlier, depreciation is a non-cash expense repre-
senting the annual expense for the fixed assets.
The balance sheet reflects financial conditions at a certain point in time, whereas the
income and cash flow statements explain what happened between two points in time.
So, although the three financial statements show different kinds of information and
have different purposes, they are all related to each other and should not be read in
isolation.
Some links between ABC’s financial statements are described in Exhibit 4 and in the
table below.
Exhibit 4 Links between Financial Statements
Balance Sheet
As of 31 December 20X2 20X1
($ millions)
Assets 1
Cash 25 16 Income Statement
Accounts receivable 40 35
($ millions)
Inventories 95 90
Revenues $650
Other current assets 5 5
Cost of sales (450)
Total current assets 2 $165 $146
Gross profit $200
Gross property, plant, and equipment 460 370
Other operating expenses
Accumulated depreciation (160) (120)
Selling expenses $(30)
Net property, plant, and equipment $300 $250
General and administrative expenses (20)
Intangible assets 100 100
Depreciation expense (40)
Total non-current assets $400 $350
Total other operating expenses (90)
Total assets $565 $496
Operating income $110
Interest expense (15)
Liabilities and Equity
Earnings before taxes $95
Accounts payable 54 50
Income taxes 3 (19)
Accrued liabilities 36 36
Net income $76
Current portion of long-term debt 10 10
Total current liabilities $100 $96
Additional information:
Long-term debt 232 200
Dividends paid to shareholders $43
43
Total non-current liabilities $232 $200 +
Total liabilities $332 $296 Additions to retained earnings $33
Common stock 85 85
Retained earnings 148 115
Total owners’ equity $233 $200
Total liabilities and equity $565 $496
$148 = $115 + $33 Cash Flow Statement

($ millions)
Operating activities
Net Income $76
Plus depreciation expense 40
Minus increase in accounts receivable (5)
Minus increase in inventories (5)
Plus increase in accounts payable 4
Net cash flow from operating activities $110
Investment activities
Minus investment in property, plant, and equipment $(90)
Net cash flow used in investing activities $(90)
Financing activities
Cash inflows from borrowing (long-term debt) $32
Cash inflows from new share issues 0
Minus dividends paid to shareholders (43)
Net cash flow used in financing activities $(11)
Net increase (decrease) in cash $9
Beginning cash 16
Ending cash $25
Financial Statement Analysis 209
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
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
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.
FINANCIAL STATEMENT ANALYSIS 4

Financial statement analysis involves the use of information provided by financial state-
ments 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
Current assets
Current ratio =
Current liabilities
and
Current assets − Inventories
Quick ratio =
Current liabilities
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 liabil-
ities. 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 indi-
cate 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?
165
ABC’s current ratio = = 1.65
100
165 − 95 70
ABC’s quick ratio = = = 0.70
100 100
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 bal-
ance 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.
Net income
Net profit margin =
Revenues
This ratio measures the percentage of revenues that is profit—that is, the percent-
age 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?
76
ABC’s net profit margin == 0= .1169 11.69%
650
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).

Net income
Return on assets
= ROA =
Total assets
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.
Operating income
Basic earning power =
Total assets
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?
76
= 0=
ABC’s return on assets = .1345 13.45%
565
110
ABC’s basic earning power = = 0=
.1947 19.47%
565
ABC’s ratios are higher than the industry averages so it appears to be gen-
erating more income from its assets than comparable companies. Th is 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 compa-
rable companies, return on assets can be separated into two components:
Net income Net income Revenues
Return on assets = ROA = = ×
Total assets Revenues Total assets
Similarly, the basic earning power ratio can be separated into two components:
Operating income Operating income Revenues
Basic earning power = = ×
Total assets Revenues Total assets
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?
76
= 0=
ABC’s net profit margin = .1169 11.69%
650
110
= 0=
ABC’s operating profit margin = .1692 16.92%
650
650
ABC’s asset turnover = = 1.15
565
The fi rst 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 com-
panies 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 debt-to-equity ratio:
Debt
Debt-to-equity ratio =
Equity
This ratio measures how much debt the company has relative to equity. Typically,
the debt considered is only interest-bearing debt, including short-term 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.

Total assets
Financial
= leverage Equity
= multiplier
Equity
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?
10 + 232 242
ABC’s debt-to-equity ratio = = = 1.04
233 233
565
ABC’s equity multiplier = = 2.42
233
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 com-
panies 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 lever-
age. 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).
Net income
Return on equity
= ROE =
Equity
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
Net income Net income Revenues Total assets
Return on equity = ROE = = × ×
Equity Revenues Total assets Equity
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 com-
ponents 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
Net income
■■ generate profits from revenues, expressed as net profit margin = ;
Revenues
Revenues
■■ generate revenues from assets, expressed as asset turnover = ; and
Total assets
■■ use borrowing to finance its assets, expressed as financial leverage
Total assets
= .
Equity
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 com-
pany’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 com-
pany’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
76
= 0=
ABC’s return on equity (ROE) = .3262 32.62%
233
Broken into its components
ABC’s return on equity = Net profit margin × Asset turnover × Financial

leverage
2 The differences between 32.62%, 32.53%, and 32.55% are due to rounding.
76 650 565
= × ×
650 565 233
= 11.69% × 1.15 × 2.42 = 32.53%
Or
ABC’s return on equity = Return on assets × Financial leverage
76 565
= × = 13.45% × 2.42 = 32.55%
565 233
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 20X2 Industry

Ratio Formula Value Value
Current assets
Current ratio 1.65 1.92
Current liabilities

Quick ratio 0.70 0.75
Current liabilities
Net income
Return on assets 13.45% 10.00%
Total assets
Operating income
Basic earning power 19.47% 15.00%
Total assets
Net income
Return on equity Equity
32.62% 27.30%
Net income
Net profit margin 11.69% 5.56%
Revenues
Operating profit Operating income

16.92% 8.33%
margin Revenues
ABC’s 20X2 20X2 Industry

Ratio Formula Value Value
Revenues
Asset turnover 1.15 1.80
Total assets
Total assets
Financial leverage Equity
2.42 2.73
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 pow-
erful 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 aver-
age, 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:
Market price per share
Price-to-earnings ratio =
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-to-earnings ratio is higher for one com-
pany 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:
Market price per share

Price-to-book ratio =
Equity book value per share
where
Equity reported on the balance sheet
Equity book value per share =
Number of shares outstaanding
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 compa-
ny’s past and forecasted performance.
■■ Accounting standards guide the gathering, analysis, and presentation of infor-

mation in financial statements.
■■ Regulators support accounting standards by recognising them and enforcing

them.
■■ Auditors are independent accountants who express an opinion about the finan-
cial 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 state-
ment, 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.
Summary 219
■■ 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 opera-
tions) 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 state-

ments 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 Formula
Current assets
Current ratio
Current liabilities

Quick ratio
Current liabilities
Net income
Return on assets
Total assets
Operating income
Basic earning power
Total assets
(continued)
Ratio Formula
Net income
Return on equity Equity
Net income
Net profit margin
Revenues
Operating income
Operating profit margin
Revenues
Revenues
Asset turnover
Total assets
Total assets
Financial leverage Equity
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, respec-
tively, 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 obliga-
tions 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 finan-

cial 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 oper-
ating 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 num-
ber 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 com-
mon 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 liabil-

ities—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.
Answers 227
8 C is correct. Net property, plant, and equipment is included in non-current

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 pay-
ments 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 state-
ment. 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 com-
pany 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 rev-
enues 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 prop-

erty, 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 state-
ment and make adjustments to arrive at cash flows from operations. A is incor-
rect 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 informa-
tion 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 exam-
ple, 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 ongo-
ing 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 activi-
ties typically relate to purchases or sales of long-term assets, such as equipment
or buildings.
Answers 229
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 build-

ing 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 opera-
tions 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 his-
torical 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 deter-
mine 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.
CHAPTER 8
QUANTITATIVE CONCEPTS
LEARNING OUTCOMES
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 fre-
quency 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.

Time Value of Money 233
INTRODUCTION 1
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 informa-
tion in making decisions, including financial decisions. For example, summary infor-
mation about a company’s or market’s performance can help in investment decisions.
In short, quantitative concepts are fundamental to the investment industry. For any-
one 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.
TIME VALUE OF MONEY 2

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.

234 Chapter 8 ■ Quantitative Concepts
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.
Lends Money
Pays Interest
Lender Borrower
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 inter-
est 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: oppor-
tunity 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
Borrowers and lenders can be people, companies, financial

institutions, and so on. Here are some examples of borrowers and
lenders that you may be familiar with.
Borrow Money If you get money from the bank

and pay interest, you are the
borrower and the bank is the
Pay Interest lender.
If you put money into a savings

Save Money account and earn interest, you
are a saver who lends your
savings to the bank and the bank
Receive Interest
is the borrower.
If people invest in a
Invest Money company and earn interest
by buying bonds, they are
the lenders and the
Receive Interest
company is the borrower.
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
160
Interest per Year
150
£10
140
£10
130
Pounds (£)
£10
120
£10 End of Previous
110 Year Balance
£10 (Principal + Interest)
100
...
Original Principal
0
Original Year 1 Year 2 Year 3 Year 4 Year 5
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 Compound Interest of 10% on £100 Original Principal
160
Interest per Year £14.64
150
140 £13.31
130
Pounds (£)
£12.10
120
£11.00 End of Previous
110 Year Balance
£10.00 (Principal + Interest)
100
... Original Principal

0
Original Year 1 Year 2 Year 3 Year 4 Year 5
Principal
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 Effects on Savings of Simple and Compound Interest
700
600
500
Balance (£)
400
300
200
100
0
0 5 10 15 20
Years
Simple Interest Compound Interest
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.
 Number of periods per year 

APR 
EAR = 1 +   −1
 Number of periods per year  
 
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 Compound Interest Rate

or APR or EAR
 365
0.1524  
Credit card 15.24% 16.46% = 1 +   −1
 365  

 12 
0.024 
Bank deposit 2.4% (= 0.2% × 12) 2.43% = 1 +   −1
 12  
 4
0.06  
Loan 6.0% 6.14% = 1 +   −1
 4  

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.
Present Interest Rate (r%) Future

Value Value
Present Future
Time Time
Discount Rate (r%)

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.
£100 £121
Present Interest Rate (10%) Future
Value Value
Today In 2 Years
£100 £121
Present Discount Rate (10%) Future
Value Value
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 invest-
ments under consideration. The following equations generalise the calculation of
future and present values:
Future value = Present value × (1 + Interest rate)Number of periods

Future value
Present value =
(1 + Discount rate) Number of periods
Note that the interest and discount rates are the same percentage rates, but the termi-
nology 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%

£1, 000 £1, 000
= = = £772.18
(1.09)3 1.295
Present value of £1,350 in five years discounted at 9%
£1,350 £1,350
= = = £877.41
(1.09)5 1.5386
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 reas-
sessed 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%

£1,350 £1,350
= = = £671.19
(1.15)5 2.0114
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 five-year 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 effec-
tive 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 dis-
counted 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 posi-
tive 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 = £1,210

The first annual £250 payment becomes £250 × (1+ 0.10) = £275
The second annual payment is received at the end and earns
no interest = £250
The total future value = £1,735
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) = £1,100
You withdraw £250 and begin the second year with an amount = £850
At the end of the second year, you have £850 × (1 + 0.10) = £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.
£8
The first year’s interest payment is worth = £7.27.
1.101
£8
The second year’s interest payment is worth = £6.61.
1.102
The repayment of the loan’s principal value in two years is
£100
worth = £82.64.
1.102
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 arrange-
ments 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 remain-
ing 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.
Descriptive Statistics 245
Withdrawal
Annuity Balance (Payment by
at Beginning Balance at End of Year Insurance
Year of Year before Withdrawal Company)
1 €10,000 €10,600 (= 10,000 × 1.06) €2,375

2 €8,225 €8,719 (= 8,225 × 1.06) €2,375
3 €6,344 €6,725 (= 6,344 × 1.06) €2,375
4 €4,350 €4,611 (= 4,350 × 1.06) €2,375
5 €2,236 €2,370 (= 2,236 × 1.06) €2,370
6 €0
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 Total
at Beginning Mortgage Principal
Year of Year Payment Interest Paid Reduced
1 £60,000 £13,706 £2,760 (= 60,000 × 0.046) £10,946

2 £49,054 £13,706 £2,257 (= 49,054 × 0.046) £11,449
3 £37,605 £13,706 £1,730 (= 37,605 × 0.046) £11,976
4 £25,630 £13,706 £1,179 (= 25,630 × 0.046) £12,527
5 £13,103 £13,706 £603 (= 13,103 × 0.046) £13,103
6 £0
As you can see in Example 6, both the annuity and mortgage balances decline to zero
over time.
DESCRIPTIVE STATISTICS 3
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 exam-
ple, 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 ten-
dency 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 proba-
bility 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
25
26.4%
20
Annual Returns (%)
15
10
8.0% 7.2%
4.2% 5.2%
5 3.7% 3.7%
2.4%
1.3% 0.8%
1 2 3 4 5 6 7 8 9 10
Year
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.

25
26.4%
20
Annual Returns (%)

15
10
8.0% 7.2%
Mean
5
2.4% 4.2% 5.2%
1.3% 0.8% 3.7% 3.7%
1 2 3 4 5 6 7 8 9 10
Year
(1.3 + 2.4 + 0.8 + 3.7 + 8.0 + 3.7 + 7.2 + 26.4 + 4.2 + 5.2)
= 6.3% Mean
10
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%.
25
26.4%
20
Outlier
Annual Returns (%)
15
10
8.0% 7.2%
5.2%
5 Mean without Outlier 4.2%
1.3% 0.8% 3.7% 3.7%
2.4%
1 2 3 4 5 6 7 8 9 10
Year
(1.3 + 2.4 + 0.8 + 3.7 + 8.0 + 3.7 + 7.2 + 4.2 + 5.2)

= 4.1% Mean
9
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.
8% 3% 7%
Present Year 1 Year 2 Year 3
[(1 + 8%) × (1 + 3%) × (1 + 7%)] 1/3 – 1 6.0%

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 accumu-
lated 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:

1/ t
Geometric mean return = (1 + r1) ×  (1 + rt ) −1
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 arith-
metic mean of the fifth and sixth ordered observations.
Annual Returns Ordered Low to High
0.8% 1.3% 2.4% 3.7% 3.7% 4.2% 5.2% 7.2% 8.0% 26.4%
(3.7 + 4.2)
≈ 4.0% Median
2
25
26.4%
20
Annual Returns (%)
15
10
8.0% 7.2%
4.2% 5.2%
5 Median
1.3% 0.8% 3.7% 3.7%
2.4%
1 2 3 4 5 6 7 8 9 10
Year
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.

0.8% 1.3% 2.4% 3.7% 3.7% 4.2% 5.2% 7.2% 8.0% 26.4%
3.7% Mode
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 cen-
tral 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 $50,000, but in one company most salaries are clustered close to the
average, whereas in the second they are spread out with many people earning very
little and some earning a lot. It would be useful to have a measure of dispersion that
can help identify such differences between data sets.
140
120
100
Salary ($ thousands)
80
60 Average
Annual Salary
40
20
0
Company A Company B
Another reason why measures of dispersion are important in finance is that invest-
ment 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 invest-
ment 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%.

0.8% 1.3% 2.4% 3.7% 3.7% 4.2% 5.2% 7.2% 8.0% 26.4%
26.4% − 0.8% = 25.6% Range

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.

0.8% 1.3% 2.4% 3.7% 3.7% 4.2% 5.2% 7.2% 8.0% 26.4%
8.0% − 0.8% = 7.2% Range
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 cal-
culations, you may find it helpful to look at the formula for how standard deviation
is calculated.
2
Standard deviation =
[X1 − E ( X )]2 + [X 2 − E ( X )]2 + ... + [X n − E ( X )]
n
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%.
8% 3% 7%
Present Year 1 Year 2 Year 3
(0.08 − 0.06)2 + (0.03 − 0.06)2 + (0.07 − 0.06)2

Standard deviation =
3
(0.02)2 + (−0.03)2 + (0.01)2

=
3
(0.0004) + (0.0009) + (0.0001)

=
3
(0.0014)
= = 0.0216 = 2.16%
3
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
Number of Employees
Salary ($) Company X Company Y
15,000–20,000 5 1
20,001–25,000 8 1
25,001–30,000 20 3
30,001–35,000 30 8
35,001–40,000 22 10
40,001–45,000 12 15
45,001–50,000 6 20
50,001–55,000 2 9
55,001–60,000 1 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
35
Number of Employees
30
25
20
15
10
5
0
15–20 20–25 25–30 30–35 35–40 40–45 45–50 50–55 55–60
Salary Range ($ thousands)
Exhibit 7B Salaries of Employees at Company Y
25
Number of Employees
20
15
10
0
15–20 20–25 25–30 30–35 35–40 40–45 45–50 50–55 55–60
Salary Range ($ thousands)
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 distri-
bution 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
0.3413 0.3413
0.0228 0.0228
0.1359 0.1359
SD
–3 –2 –1 0 1 2 3
68.26%
95.44%
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
Normal Distribution Distribution with Fat Tails

Distribution with 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 cor-
related. 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 correla-
tion 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 diver-

sification. 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 invest-
ment 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.
Summary 263
■■ 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 ten-
dency 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 bell-shaped

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.

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 compa-
ny’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 bor-
rower 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 deter-
mined 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 pay-
ments 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; conse-

quently, 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, com-
pound 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.
Answers 271
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 tim-
ing 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 pay-
ment 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 accumu-
lation assuming that returns are compounding. A is incorrect because invest-
ment 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 invest-
ment. 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 distribu-
tion, 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 distri-

bution 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.
Answers 273
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 nega-
tively correlated, if unemployment is expected to increase, then the inflation
rate is likely to decrease
CHAPTER 9
DEBT SECURITIES
by Lee M. Dunham, PhD, CFA, and Vijay Singal, PhD, CFA
LEARNING OUTCOMES
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.

Features of Debt Securities 279
INTRODUCTION 1
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.
If people invest in a
Invest money company and earn interest
by buying bonds, they are
the lenders and the
Receive interest
company is the borrower.
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 oth-
erwise 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.
FEATURES OF DEBT SECURITIES 2

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.

280 Chapter 9 ■ Debt Securities
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 prom-
ised 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
Features of Debt Securities 281
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.
Par Value = £100

Coupon Rate = 6%
Maturity = 3 Years
Coupon Payment = £6.00
£100
+
£6.00 £6.00 £6.00
£100 Year Year Year

1 2 3
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.

Types of Bonds 283
Exhibit 1 Seniority Ranking of Debt Securities
1. Secured Debt
Unsecured Debt
2. Senior Unsecured Debt
3. Senior Subordinated Debt
4. Junior Subordinated Debt
TYPES OF BONDS 4
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, irrespec-
tive 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 mar-
ket. 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,
floating-rate 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 gov-
ernments. 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-R ATE BOND
On 16 August 2011, the Walt Disney Corporation, a US company, raised $1.85 bil-

lion 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.
5-year, 10-year, 30-year,

1.35% Bonds 2.75% Bonds 4.375% Bonds
Total par value $750 $750 $350

(millions)
Number of bonds 750,000 750,000 350,000
issued
Par value of one $1,000 $1,000 $1,000
bond
Coupon rate 1.35% 2.75% 4.375%
(annual)
Types of Bonds 285
5-year, 10-year, 30-year,

1.35% Bonds 2.75% Bonds 4.375% Bonds
Semiannual cou- $6.75 $13.75 $21.875
pon payment per
bond
Maturity date 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 floating-rate bond is usually linked
to a reference rate. The London Interbank Offered Rate (Libor) is a widely used ref-
erence 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) creditwor-
thiness 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.
Floating rate = Reference rate + Spread

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-R ATE 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 three-month 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.
Floating rate = Reference rate + Spread

Calculation for Coupon Principal
Date Libor Coupon Payment Payment Payment
31 March 120 bps

1.20%
100 bps (0.0120 + 0.0140)

30 June × £2,000,000 = £13,000
1.00% 4
30 September 112 bps (0.0100 + 0.0140)

× £2,000,000 = £12,000
1.12% 4
(0.0112 + 0.0140)
31 December × £2,000,000 = £12,600 £2 million
4
4.2.1 Inflation-Linked Bonds

An inflation-linked bond is a particular type of floating-rate bond. Inflation-linked
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.
Types of Bonds 287
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 bond-
holder 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 zero-coupon

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 matu-

rity, 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.
6.80%
Required Rate of Return
No Coupon Payments
1 December 2008 1 December 2028
Investor pays Investor receives
€268.31 €1000 Par Value
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
1 In the exceptional circumstance of negative interest rates, zero coupon bonds may not be issued at a
price below par.
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.
8.0%
Required Rate of Return
1 December 2008 1 December 2009 1 December 2028

Investor pays Investor sells, receives
€268.31 €231.71
5 BONDS WITH EMBEDDED PROVISIONS
Many bonds include features referred to as embedded provisions. Embedded provi-

sions 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 provi-
sion 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,
Bonds with Embedded Provisions 289
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 pro-
vision 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 inter-
mediary 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 repay-
ments 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 predict-
able than the risks of the individual assets, asset-backed 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.
Valuation of Debt Securities 291
VALUATION OF DEBT SECURITIES 7

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
CF1 CF2 CF3 CFn
V0 = + + ++
(1 + r)1
(1 + r) 2
(1 + r)3
(1 + r)n
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
$30 $30 $30 $30 $30 $1, 030
V0 = + + + + +
1 2 3 4 5
(1.035) (1.035) (1.035) (1.035) (1.035) (1.035)6
V0 = $973.36.
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
$30 $30 $30 $30 $30 $1, 030
V0 = + + + + +
1 2 3 4 5
(1.040) (1.040) (1.040) (1.040) (1.040) (1.040)6
V0 = $947.58.
of the bond is $1,000.00, calculated as
$30 $30 $30 $30 $30 $1, 030
V0 = + + + + +
1 2 3 4 5
(1.030) (1.030) (1.030) (1.030) (1.030) (1.030)6
V0 = $1, 000.00.
of the bond is $1,027.54, calculated as
Valuation of Debt Securities 293
$30 $30 $30 $30 $30 $1, 030

V0 = + + + + +
1 2 3 4 5
(1.025) (1.025) (1.025) (1.025) (1.025) (1.025)6
V0 = $1, 027.54.
Example 5 also illustrates how the relationship between the coupon rate and the dis-
count 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

CF1 CF2 CF3 CFn
P0 = + + ++
n
(1 + rytm ) (1 + rytm ) (1 + rytm ) (1 + rytm )
1 2 3
where P0 represents the current market price of the bond, and r ytm 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 r ytm:
$20 $20 $20 $1, 020
$914.70 = + + ++ .
(1 + rytm ) (1 + rytm ) (1 + rytm ) (1 + rytm )
1 2 3 10
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, r ytm 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 gov-
ernment 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%.
Risks of Investing in Debt Securities 295
Exhibit 2 US Treasury Yield Curve, 22 April 2014
4.0
22/Apr/14
3.0
Yield (%)
2.0
1.0
0
1Mo 3Mo 6Mo 1Yr 2Yr 3Yr 5Yr 7Yr 10Yr 20Yr 30Yr
Maturity
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 down-
ward 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 matu-
rity 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.
RISKS OF INVESTING IN DEBT SECURITIES 8

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 regu-
lators 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 investment-grade

bonds, investors with a willingness to take on greater risk in exchange for higher
expected returns dominate the high-yield bond market.
Exhibit 3 Rating Systems Used by Major Credit Rating Agencies
Standard &
Poor’s Moody’s Fitch
AAA Aaa AAA
AA+ Aa1 AA+
AA Aa2 AA
AA– Aa3 AA–
Investment A+ A1 A+
Grade A A2 A
A– A3 A–
BBB+ Baa1 BBB+
BBB Baa2 BBB
BBB– Baa3 BBB–
Creditworthiness
BB+ Ba1 BB+
BB Ba2 BB
BB– Ba3 BB–
B+ B1 B+
B B2 B
B– B3 B–
Non-Investment CCC+ Caa1 CCC
Grade CCC Caa2
CCC– Caa3
Ca
C
DDD
DD
D D
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 com-
monly 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 rela-
tive 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 zero-coupon 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 environ-

ment 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 infla-
tion 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 secu-
rities 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, bond-
holders 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 collat-
eral) 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 pay-
ments 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 securi-
ties. 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
Summary 301
from the debt security. The discount rate used to estimate present value rep-
resents the required rate of return on the debt security based on market condi-
tions 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 govern-
ment 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, inter-
est 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.
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 opera-
tions 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.
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.
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 issu-
ance, 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 graphi-

cal 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 differ-
ent 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 gen-

erally 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 subordi-
nated 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
floating-rate 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.
Answers 307
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 pro-
vision. 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 bor-
rower (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 appro-
priate 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 graph-
ical 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 govern-
ment bond with the same maturity.
20 C is correct. An asset-backed security pools a large number of related under-

lying 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.
CHAPTER 10
EQUITY SECURITIES
by Lee M. Dunham, PhD, CFA, and Vijay Singal, PhD, CFA
LEARNING OUTCOMES
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.

Introduction 311
INTRODUCTION 1
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
Borrows Money,
Issues Bonds Issues Shares
Debt Equity
Securities Securities
Investor Issuer Investor
Lends Money, Lends Money,

Acquires a Claim Becomes an Owner
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 understand-

ing 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.
1 Recall 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.
2 Security market indices are discussed further in the Investment Vehicles chapter.
312 Chapter 10 ■ Equity Securities
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 com-
mon 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 activ-
ities 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.
Types of Equity Securities 313
TYPES OF EQUITY SECURITIES 3

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 BRK.B
Cash flow rights 1 = 1,500

Voting rights 1 = 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 pref-
erence 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 obli-
gation 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.
3 These are ticker symbols, which are used to identify a particular stock, share class, or issue on a par-
ticular stock exchange.
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 prom-
ised, 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. PREFERRED STOCK
Par Value
Cumulative/ (Canadian
Issue Non-Cumulative dollars) Annual Dividend Rate Redeemable
Royal Bank of Non-cumulative C$25.00 6.25%, reset after five years Yes, redeemable on or after
Canada, Series B and every five years there- 24 February 2014 at par
after to 3.50% over the five-
year Government of Canada
bond yield
Canadian Cumulative C$25.00 4.90% Yes, redeemable after 1
Utilities Limited, September 2017, redemption
Series AA price begins at C$26.00 and
declines over time to 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 com-
pany 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 actu-
ally 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 com-
parable 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, bondhold-
ers 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 share-
holder 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 pre-specified
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 pre-specified 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 war-
rants 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.
Risk and Return of Equity and Debt Securities 319
RISK AND RETURN OF EQUITY AND DEBT SECURITIES 4

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 Proportional

board of directors to ownership
Preferred stock Right to promised dividends if declared None
by the board of directors; board does
not have a legal obligation to declare the
dividends
Debt security Legal right to promised cash flows 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 prior-
ity 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
1. Secured Debt
Unsecured Debt
2. Senior Unsecured Debt
3. Senior Subordinated Debt
4. Junior Subordinated Debt

Equity Securities
5. Preferred Stock
6. Common Stock
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 propor-
tionately 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.
4 The priority of claims of debtholders is discussed in the Debt Securities chapter.

5 An exception is cases of fraud and wilful negligence; in such situations, management and the board of
directors may be held personally liable.
Risk and Return of Equity and Debt Securities 321
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 securi-
ties. 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 non-shaded rows present return and risk data for three bond
indices.
Exhibit 3 Historical Annual Returns on Equity and Debt Securities, 1980–

2010
Standard
Deviation of
Index Annual Return Returns
S&P 500 10.80% 15.60%
Russell 2000 10.35 19.94
MSCI Europe 10.81 17.80
Equity
MSCI Pacific Basin 7.89 21.13
FTSE All World 7.26 15.98
MSCI EAFE 7.09 17.71
Lehman Brothers Corporate Bond 8.82 7.23
Barclays Capital Government Bond 8.15 5.51 Debt
Merrill Lynch World Government Bond 7.88 7.04
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
6
Real Annualised Return (%)
–2
–4
Italy
Belgium
Germany
France
Spain
Ireland
Japan
Norway
Switzerland
Europe
Netherlands
World ex-US
Denmark
United Kingdom
Finland
World
New Zealand
Canada
United States
Sweden
South Africa
Australia
Equities Bonds
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.
Valuation of Common Shares 323
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:
4.00 4.20 4.50 150.00
Value = + + + = €111.02
1 2 3
(1 + 0.14) (1 + 0.14) (1 + 0.14) (1 + 0.14)3
14% Discount Rate
Estimated Estimated
Stock Value Stock Price
€111.02 €150.00
€4.00 €4.20 €4.50
1 January December December December

2012 2012 2013 2014
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 con-
clude that the stock is overvalued and decide not to buy.
The DCF valuation approach can also be used to value preferred shares. Valuing pre-
ferred 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, compa-
rable 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 calcu-
lates the average P/E for the three companies as 9 [= (8 + 10 + 9)/3].
Valuation of Common Shares 325
Current Next Year’s

Company Stock Price Estimated EPS P/E
General $40.00 $5.00 $40.00/$5.00 = 8

Motors
Toyota $85.00 $8.50 $85.00/$8.50 = 10
Honda $36.00 $4.00 $36.00/$4.00 = 9
Average (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 calculat-
ing 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 pur-
chased), 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 offer-
ing, referred to as a seasoned equity offering or secondary equity offering
■■ Buying back existing shares from shareholders, referred to as a share repur-

chase 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.
Company Actions That Affect Equity Outstanding 327
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 pro-
ceeds. 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).
$566 Million
(7%)
Money Raised after Costs
Transaction Costs
$7,330 Million
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.
$183 Million
(‹2%)
Net Proceeds after Costs

Issuance Costs
$11,823 Million
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 inves-
tors 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 share-
holder’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. EFFECTS OF A STOCK SPLIT AND A STOCK DIVIDEND
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.
Stock Number of Shares

Price Outstanding Total Value
Before Stock Split
Company €75.00 24,000 €1,800,000
Investor 75.00 900 67,500
After Stock Split
Company €50.00 36,000 €1,800,000
Investor 50.00 1,350 67,500
Before Stock Dividend
Company €75.00 24,000 €1,800,000
Investor 75.00 900 67,500
After Stock Dividend
Company €50.00 36,000 €1,800,000
Investor 50.00 1,350 67,500
As Example 11 illustrates, a stock split or stock dividend does not change each share-
holder’s proportional ownership of the company. Shareholders do not invest any addi-
tional 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 oper-
ations 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 unaf-
fordable 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 min-
imum 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 acquir-
ing 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 pro-
viders. 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 import-

ant 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 share-
holders 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 own-
ership 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.
Summary 333
■■ 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 pres-
ent 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 charac-
teristics 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 out-
standing. Such actions include initial public offerings, seasoned equity offerings,
share repurchases, stock splits, stock dividends, acquisitions, and spinoffs.
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 non-cumulative

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 conver-

sion 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 com-
parable, 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 war-
rants 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 institu-
tion 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, irre-
spective 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 bond-

holder, 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.
Answers 339
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 equity-like security that enti-
tles 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 expira-
tion 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-to-earnings 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 compa-
rable, 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 cap-
ital 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 share-
holders. 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 com-
pany 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 com-
pany 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 out-
standing. 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 exist-

ing 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 com-
mon 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
Answers 341
outstanding but does not change any single shareholder’s proportional owner-
ship. 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.
CHAPTER 11
DERIVATIVES
by Vijay Singal, PhD, CFA
LEARNING OUTCOMES
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.

Uses of Derivatives Contracts 345
INTRODUCTION 1
When you plan a vacation, you do not usually wait until you get to your planned des-
tination 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, sim-
ply, derivatives.
Derivatives are contracts that derive their value from the performance of an underly-
ing 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.
USES OF DERIVATIVES CONTRACTS 2

Derivatives can be created on any asset, event, or outcome, which is called the under-
lying. 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
1 Information from “Centrally Cleared Derivatives: Clear and Present Danger”, Economist (4 April 2012).
346 Chapter 11 ■ Derivatives
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.
Underlying
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.
Key Terms of Derivatives Contracts 347
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 underly-
ing 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 commit-
ments 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 mid-September, 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.
Forwards and Futures 349
Underlying
Maturity (six months)

March September
(contract signed) (contract ends)
Exercise Price: Farmer:
$8.50 per bushel Delivers 50,000 bushels
Size: Cereal Producer:
50,000 bushels Pays $8.50 per bushel
Settlement:
Physical Delivery
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 per-
formance 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.
2 Over-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.
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. GAINS AND LOSSES ON A FORWARD CONTRACT
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 settle-
ment 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, how-
ever, 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 estab-
lishes 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 con-
tinues 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 expira-
tion 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 set-
tle 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 dif-
ficult 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 clear-
ing 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 broker-
age 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.
3 Recall 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.
Option Contracts 355
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 Differences
■■ Both types of contracts exist on a wide ■■ Forwards are customised contracts that
range of underlyings, including shares, trade in private over-the-counter mar-
bonds, agricultural products, and kets, whereas futures are standardised
precious and industrial metals, among contracts that trade on exchanges.
others.
■■ Counterparty risk is high with forward
■■ For both types of contracts, both the contracts, but limited with futures
buyer and seller have obligations. contracts. Requirements imposed by
exchanges, such as initial and main-
■■ Both types of contracts allow locking in tenance margins and daily marking to
a price today for a transaction that will market, reduce the counterparty risk
occur in the future. 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 posi-
tion in a futures contract can be settled
(closed) by taking an opposite position
in the same contract.
OPTION CONTRACTS 5
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 obli-
gation), 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.

Option Contracts 357
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.
4 The number of shares associated with an option varies with the exchange.
■■ A put option is “out of the money” if the market price is greater than the exer-
cise 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 Increases Decreases

Exercise price Decreases Increases
Time to expiration Increases Increases
Underlying’s volatility Increases Increases
Swap Contracts 359
SWAP CONTRACTS 6
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 inter-
est 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 invest-
ments 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 contin-
gent 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.
Summary 361
■■ 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 Increases Decreases

Exercise price Decreases Increases
Time to expiration Increases Increases
Underlying’s volatility 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 denomi-
nated 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.
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 perfor-
mance, 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 underly-
ing, 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 con-
tracts. 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 con-
tract 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 ongo-
ing 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 incor-
rect 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
Answers 365
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 coun-
terparty risk.
CHAPTER 12
ALTERNATIVE INVESTMENTS
by Sean W. Gill, CFA
LEARNING OUTCOMES
a Describe advantages and limitations of alternative investments;
b Describe private equity investments;
c Describe real estate investments;
d Describe commodity investments.

Introduction 369
INTRODUCTION 1
If a public company needs funds to invest in a project, perhaps to build a new produc-
tion 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, entrepre-
neurs 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 invest-
ment. 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 met-

als (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.

370 Chapter 12 ■ Alternative Investments
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
Percentage of Average Percentage of

Respondents Holding the Portfolio Invested in
Type of Asset This Type of Asset This Type of Asset
Equity 98% 41.0%

Fixed income (debt) 99 33.2
Cash 61 3.2
Alternatives (total) 94 22.4
Private equity 64 5.1
Private real estate 66 4.7
Public real estate 32 1.3
Commodities 22 1.0
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/communi-
que_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.

Why Invest in Alternatives? 371
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
12
Historical Return (%)
10 10.8
8 9.4
6 7.2
6.2
4 4.5
2
0
Equity Debt Private Real Commodities
Equity Estate
Asset Class
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 tradi-
tional 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,
Private Equity 373
the answer is venture capitalists. The entrepreneur could have sold some of her com-
pany’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 com-
panies 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 produc-
tion 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 com-
pany’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 addi-
tion 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 compa-
ny’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.
Private Equity 375
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 part-
nership. 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
Fund Manager
Fixed Fees
Limited Capital Calls Incentive Fees
Partner Company
Management Fees W
A Carried Interest Investments
Limited
Partner Company
B X
Private Equity Firm/
General Partner
Limited
Partner Company
C Y
Cash Realisations
Limited Distributions
Partner Company
D Z
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 invest-
ing. 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
Private Equity 377
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 lim-
ited 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 part-
ner 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
800
600
400
Dollars (Thousands)
200
–200
–400
–600
–800
–1000
1 2 3 4 5 6 7 8 9 10
Year
Capital Calls and Management Fees

Cash Distributions
Cumulative Net Cash Flow
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 investment-related purposes, such as renting out holiday
homes.
Real Estate 379
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 Country Share
United States 25.4%

Japan 10.1
China 7.0
Germany 6.1
United Kingdom 5.2
France 4.7
Italy 3.7
Brazil 3.3
Canada 2.9
Spain 2.6
Australia 2.5
Russia 2.3
South Korea 1.8
Netherlands 1.4
Mexico 1.4
India 1.3
Switzerland 1.1
Remaining Countries 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 usu-
ally 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 sig-
nificant 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.
1 Michael Corkery, “Calpers Confronts Huge Housing Losses”, Wall Street Journal (13 November 2008).
Real Estate 381
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 invest-
ments. Their structure and mechanics are similar to those of the private equity partner-
ships 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 prop-
erties. 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 explo-
ration, 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, inves-

tors 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.
Summary 383
■■ 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 alterna-
tive 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, buy-
outs, 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 partner-

ships. 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 rep-
resenting 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.
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 prop-

erties 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 invest-

ments 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 owner-
ship. 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 lim-
ited partners; these investors face limited liability, which means that they can-
not 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 appre-
ciating 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
Answers 387
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 invest-

ments. 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.
CHAPTER 13
STRUCTURE OF THE
INVESTMENT INDUSTRY
by Larry Harris, PhD, CFA
LEARNING OUTCOMES
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.
How the Investment Industry Promotes Successful Investing 7
INTRODUCTION 1
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.
Investment
Investment Information
Financial Management Trading
Planning Custodial
Savers
(Providers of Capital)
Institutional Investors Individual Investors
HOW THE INVESTMENT INDUSTRY PROMOTES SUCCESSFUL

INVESTING
2
The investment industry provides services to those who have money to invest—indi-
vidual 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.

8 Chapter 13 ■ Structure of the Investment Industry
■■ 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 actuar-
ies—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 con-
sultants 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
1 Recall from the Investment Industry: A Top-Down View chapter that retail investors are individual
investors with a low amount of investable assets.
Investment Management Services 9
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.
INVESTMENT MANAGEMENT SERVICES 4

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 ser-
vices 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 charac-
teristics of many potential investments.
Investment analysis involves estimating the fundamental value of potential invest-

ments 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.
Investment Information Services 11
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 recom-
mending 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.
INVESTMENT INFORMATION SERVICES 5

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 pro-
duce 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.
Macro-
Economic
Data
Industry
Data
Firm
Data
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.
Investment Information Services 13
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
Macroeconomic data Information about economic activity and inter- Investment professionals use macroeco-
national trade. nomic data to better understand the envi-
ronment in which companies operate and
compete.
Accounting data Information about a company’s financial state- Investment professionals use accounting
ments, including the balance sheet, income data to assess a company’s financial per-
statement, and cash flow statement. formance and to estimate the fundamental
value of its securities, such as common
shares.
Historical market data Information about past market prices and trad- Investment professionals use historical
ing volumes. 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 compa-
nies’ 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.
Trading Services 15
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 practi-
tioners 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 cen-
tral 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.
Settlement Clearing
Buyer’s Seller’s
Broker Broker
Clearing House
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, bro-
kers 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 counter-
parties 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.
Trading Services 17
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
■■ Promote liquidity by reassuring investors that their trades

will be settled
Settlement agents ■■ Arrange final exchange of cash for securities
(continued)
Custodians ■■ Hold money and securities for safekeeping on behalf of

clients
■■ May offer other services for clients, such as trade settle-

ment 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.
Sell Side Buy Side

Investment Banks Pension Funds
Brokers Endowment Funds
Dealers Foundations
Sovereign Wealth
Funds
However, the buy-side/sell-side classification does not apply to all firms in the invest-
ment industry. For example, it is not relevant for the investment information services
presented in Section 5. In addition, the buy-side/sell-side classification is somewhat
arbitrary and not easily applied to many large, integrated firms. For example, many
Organisation of Firms in the Investment Industry 19
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 genera-
tion. 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 con-
sider 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, infor-
mation 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 fraud-
ulently 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 opera-
tions. 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.
Clients
Orders
Executions
Front Office Middle Office Back Office

Handle client-facing Support front office activities Provide administrative
activities, such as capturing by validating, booking, and support by clearing and
and executing trades. confirming trades. settling trades, as well as
Trades Trades providing accounting and
financial support.
• Sales • Risk Management
• Marketing • Information Technology • Accounting
• Customer Service • Corporate Finance • Human Resources
• Portfolio Management • Payroll
• Research • Operations
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) Manages the firm.

Chief financial officer (CFO) Responsible for financing the firm and for financial
reporting.
Chief operating officer Responsible for the day-to-day management of the
(COO) firm.
Chief investment officer Responsible for any investment advice that the firm
(CIO) provides to its clients and for the investment deci-
sions that the firm makes for itself and on behalf of its
clients.
Head trader Responsible for all trading operations. At firms that
engage in proprietary trading, the head trader is
responsible for all positions, risks, and profits.
Chief accountant (also Responsible for the accounting and financial systems.
known as finance controller)
Treasurer Responsible for cash management, including the
investment of receipts and payment of invoices.
Chief risk officer Responsible for identifying and managing the risks to
which the firm and its clients are exposed.
Chief compliance officer Responsible for ensuring that the firm complies with
all constraints placed on it by laws, regulations, and
clients.
Chief audit executive Leads the internal audit department, which is respon-
sible for providing independent assessments of the
firm’s operational systems as well as suggestions for
improvement.
General counsel Leads the legal department, which reviews and helps
write contracts, responds to or initiates lawsuits, and
interprets regulations, among many other activities.
Organisation of Firms in the Investment Industry 21
At many firms, especially smaller ones, some people hold multiple titles and responsi-
bilities. 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 cli-
ents 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 inter-
ested 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 inves-
tors 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 inves-

tors 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 cli-
ents 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 pro-
vide direct revenue generation. The middle office includes the core activities of
the firm, such as risk management, information technology, corporate finance,
Summary 23
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 profes-

sionals. Leadership titles and responsibilities vary among firms. At many firms,
especially smaller ones, some people hold multiple titles and responsibilities.
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 fundamen-

tal 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 27
ANSWERS
1 B is correct. Financial planners are investment professionals who create sav-

ings 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 participat-
ing 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 poten-
tial investments and identify attractive securities. C is incorrect because port-
folio 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 port-
folio to invest in various asset classes. C is incorrect because portfolio construc-
tion 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 appro-
priate 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 provid-

ers 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 real-time data about compa-
nies 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 secu-
rity, 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 secu-
rities 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 incor-
rect 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 find-
ing 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 settle-
ment 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 counter-
parties or take custody of assets. Clearing houses arrange for the final settle-
ment 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 invest-
ment 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.
Answers 29
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 incor-
rect 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 incor-

rect 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 depart-
ment, 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 ensur-
ing 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.
CHAPTER 14
INVESTMENT VEHICLES
LEARNING OUTCOMES
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 valua-

tion, 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.
Direct and Indirect Investments 33
INTRODUCTION 1
Investment professionals offer a great number of financial services, which were dis-
cussed in the previous chapter, and products to help their clients address their invest-
ment 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.
DIRECT AND INDIRECT INVESTMENTS 2

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, inves-
tors 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 advan-
tages of being part of a large group. The resulting economies of scale can significantly
improve investment returns.

34 Chapter 14 ■ Investment Vehicles
Direct Investment
$ Commodities
¥€
Real Estate
Stocks & Bonds
Indirect Investment
Commodities
$ Investment $
¥€ Vehicle ¥€
Real Estate
Stocks & Bonds
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 oth-
ers. 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
Direct and Indirect Investments 35
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, self-serving 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 recom-

mend 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, prof-
itable. 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 over-
see 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 own-
ership 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 organ-
ise 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 Investments 37
Pooled investment vehicles are overseen by a board of directors, a board of trust-

ees, 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 redemp-
tion 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 inves-
tors 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. Front-end 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 pre-specified 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.
Pooled Investments 39
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 pas-
sively 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 invest-
ments. 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 open-end 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 div-
idends) 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 inves-
tors, 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.
Index Funds 41
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, Closed-End Funds, and ETFs
Open-End Mutual Funds,

including
Money Market Funds Closed-End Funds Exchange-Traded Funds
Managed Yes, actively or passively Yes, primarily actively Yes, primarily passively
Exchange traded No Yes, but not traded Yes, traded continuously
continuously
If exchange traded, size of Can be large, usually trade Small, usually trade at close
the gap between the price at a discount to the NAV to the NAV
and the net asset value
Redeemable Yes No Yes
Risky Yes Yes Yes
Management accountability Few issues, particularly Management not particu- Few issues, particularly if
if funds are passively larly responsive to share- funds are passively managed
managed holders’ concerns
Management fees High if actively managed, High because actively Low if passively managed
low if passively managed managed
INDEX FUNDS 4
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 manage-

ment. 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, sepa-
rate 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 Funds 43
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 equal-weighted.
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 low-priced 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 cap-weighted

indices, market-weighted indices, or value-weighted indices). The weight assigned
to each security depends on the security’s market capitalisation. Market capitalisa-
tion 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 strat-
egy 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.
Hedge Funds 45
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.
Assets under management: £1 million

Compensation: 2 and 20
Annual management fee: £1,000,000 × 2% = £20,000
Performance fee:
12% excess 20% × 12% × £1,000,000 = £24,000
17% return
5% hurdle
Total compensation = £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 ini-
tial investment and not for returns that recoup previous losses. This provision is also
called the loss-carryback provision.
Hedge Funds 47
Exhibit 2 High-Water Mark
High-Water Mark
Net Asset Value of Fund
High-Water Mark
High-Water Mark
Period 1 Period 2 Period 3
Earning Performance Fees Not Earning Performance Fees
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 incen-
tives 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 manag-
ers’ 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.
Fund
$€ 1
¥
$ Fund $ Fund
¥€ of
Funds
¥€ 2
$
¥€
Fund
3
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 suc-
cessful in the future and then invest in funds that implement those strategies. Both
types of managers try to hold well-diversified 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 manage-
ment 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
Tax-Advantaged Accounts and Managing Tax Liabilities 49
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.
MANAGED ACCOUNTS 7
Many investors contract with investment professionals to help manage their invest-
ments. 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 invest-
ment professionals. Retail investors often obtain the services of fee-based 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.
TAX-ADVANTAGED ACCOUNTS AND MANAGING TAX

LIABILITIES
8
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 invest-
ment 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, con-
tributions 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 tax-advantaged

accounts. After-tax funds are the amounts that remain after taxable income and gifts
are received and taxed. When placed in tax-advantaged 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 advan-
tageous 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 advanta-
geous 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
Summary 51
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 fre-
quently 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 min-
imise 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 compa-
nies 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 indi-
vidual 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 diversi-
fication, 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 invest-
ment 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 pro-
duce 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. Fund-of-
funds managers seek to add value by selecting managers who will outperform
their peers rather than by selecting securities that will outperform other securi-
ties. 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.
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 deci-
sions. 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 primar-
ily 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 propor-
tion 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 secu-

rity 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.
Answers 57
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 effi-
cient 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, man-
agement 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 peri-
ods 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
LEARNING OUTCOMES
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 poten-
tial 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.
Primary Security Markets 61
INTRODUCTION 1
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 understand-
ing 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.
PRIMARY SECURITY MARKETS 2

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

62 Chapter 15 ■ The Functioning of Financial Markets
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 sea-
soned 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.
Issue New Securities Securities (Buyer) or

(IPO) Cash (Seller)
Primary Secondary
Market Market
Issuer Investor Issuer Exchange/ Investor
The issuer receives Broker
no cash (capital) in
Cash secondary market Cash (Buyer) or
(Capital) transactions. Securities (Seller)
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 under-
written offering. In an underwritten offering, the investment bank acts as an under-
writer. 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 share-
holder 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 secu-
rities, 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 undersub-
scribed 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 secu-
rity’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 appe-
tite 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 negoti-
ated 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 inves-
tors, 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 expe-
rience to recognise the risks that they assume, so most countries require less disclo-
sure 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.
Sell New or Existing Securities
Private
Placement
Qualified
Issuer Investors
Capital
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 com-
pany’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 secu-
rities 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 share-
holders 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 govern-
ments 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.
Trading Venues 67
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 trad-
ing 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 partici-
pants. 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 reg-
ulatory 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 mar-
kets. 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.
Positions 69
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.
POSITIONS 5
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 posi-
tions. 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.
Positions 71
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 two-sided market. The high-
est 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.
Orders 73
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, gen-
erally 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 mem-
bers 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 confi-
dently 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.
Clearing and Settlement 75
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*
Order Placed
No Yes
Market
Order?
Order Order Executed

Yes Executed?
No Yes
Order
Remains
Open?
No
Order Closed Order Settled
* 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 fi lled and fi nancial 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.
Transaction Costs 77
Peter Robinson Amina Al-Subari
Contacts with Submits Stock

Market Order Order Exchange James Armistead
Ord
Asset Exe er
Broker cut
Manager ed
Settles Order
and Keeps Record
Custodian
Bank
TRANSACTION COSTS 8
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 gener-
ally 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 men-
tioned before, use hidden orders or dark pools so other market participants cannot
see their orders and exploit them.
Summary 79
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 strate-
gies 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.
EFFICIENT FINANCIAL MARKETS 9

As described in the previous section, low transaction costs are an important char-
acteristic 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 invest-
ment 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 trad-
ing 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. Order-driven 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 posi-
tions 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
Summary 81
how to fill an order; exposure instructions about whether, how, and by whom an
order should be seen; and time-in-force 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 allo-

cationally efficient. Operationally efficient markets have low transaction costs.
Informationally efficient markets have prices that reflect all available informa-
tion about fundamental values. Allocationally efficient economies put resources
to use where they are most valuable.
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 clas-
sified 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 secu-
rities 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 inves-
tors 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 secu-

rities 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 reg-
ulatory 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.
Answers 87
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 trad-
ing 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), price-driven

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 sys-
tems. Order-driven markets arrange trades by using rules to match buy orders
with sell orders. A and C are incorrect because price-driven 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 bro-
kered 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 invest-
ment—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 unlim-
ited. 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 repur-
chasing 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) mag-

nifies 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 report-
ing 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 large-trade

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.
Answers 89
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, oppor-
tunity 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 trans-
action costs. Brokerage commissions are the commissions that market partici-
pants 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 informa-
tion 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.
CHAPTER 16
INVESTORS AND THEIR NEEDS
by Alistair Byrne, PhD, CFA
LEARNING OUTCOMES
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.
Types and Characteristics of Investors 97
INTRODUCTION 1
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 indi-
vidual 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.
TYPES AND CHARACTERISTICS OF INVESTORS 2

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

98 Chapter 16 ■ Investors and Their Needs
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 ser-
vices 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 inves-
tors’ 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 high-net-

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
longer-term 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 per-
sonnel. 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 mem-
bers, 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 gen-
erations 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 non-financial 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 invest-
ments 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 invest-
ments 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 contri-
bution—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 pen-
sion 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. Member’s benefit in retirement is not

defined.
Employer’s contributions are not defined. Employer’s contributions are defined.
Defined Benefit Plan Defined Contribution Plan

Investments are chosen by a pension fund Investments are chosen by the member.
manager(s).
Risk that investments do not perform Risk that investments do not perform
as expected is borne by the employer. as expected is borne by the member.
Employer may need to make additional Member may need to adjust lifestyle or
contributions. 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 pur-

pose 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 spend-
ing. 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 mil-
lion. 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 deter-
mined 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 non-financial
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 typ-
ically 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 investment-grade 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 distin-
guished 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.
Pays Invests Premiums

Premium in a Reserve Fund
Insured or Insurance Diversified

Investor Company Portfolio
Pays Out Claims/ Generates

Annuity Payments Investment Returns
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 peo-

ple’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.
Isabel Robilio
Zhang Li
Money to Makes
Be Invested Investment
Premiums Financial
Markets
Returns
Insurance
Company
Zhang Li, the retail investor described in Section 2.1.1, purchased life insur-
ance 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, circum-

stances, 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 strat-
egy need to be understood. Other investors will have already accumulated sufficient
Factors That Affect Investors’ Needs 109
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.
Risk Tolerance
Ability to Willingness
Take Risk to Take Risk
Liquidity Time Horizon Investing Investment

Experience Knowledge
Assets Attitude
toward 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 inter-
mediaries, 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 trans-
action costs and changes in price low) when the cash is needed.
Factors That Affect Investors’ Needs 111
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 retire-
ment 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
Maximum
Maximum Foreign
Public Equity Public Equity
Investments (% Investments (%
Country of portfolio) of portfolio) Other
Brazil 70% 10% Foreign investment restricted to MERCOSUR countries

for equities (other asset classes are more flexible)
Canada No limit No limit Maximum of 10% of market value invested in any one
entity or related entities
Egypt 15% 0% Not allowed to invest in foreign assets
Estonia 75% No limit —
Japan No limit No limit —
Switzerland 50% No limit Total real estate exposure limited to 30%. These limits
may be extended if general principles of prudent man-
agement, security, and risk diversification are met.
United States No limit No limit 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.
Investment Policy Statements 113
INVESTMENT POLICY STATEMENTS 4

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 con-
straints. Each section has its own subsections. The IPS identifies the investor’s cir-
cumstances 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 insti-
tutional 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 invest-
ments 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 115
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 compa-
nies, 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, regu-
lation, 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 invest-
ment 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.
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 indi-

vidual 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 gen-
erally 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 rel-
atively 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 invest-
ments fail to perform as expected, the employer may be required to make addi-
tional contributions to the fund based on regulatory requirements. B is incor-
rect 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 invest-

ment decisions are made by the plan member. A is incorrect because the plan
sponsor is not responsible for investment decisions within a defined contribu-
tion pension plan. C is incorrect because the investment manager is not respon-
sible 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
Answers 119
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 infla-
tion. 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 state-
ment 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
LEARNING OUTCOMES
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 managers attempt to identify and capture market

inefficiencies.
Systematic Risk, Specific Risk, and Diversification 123
INTRODUCTION 1
Investors expect the industry participants that serve them to act ethically, to comply
with regulation, and to be well organised. Just as importantly, they expect a return on
the money they invest. Competent investment management is critical to achieving
returns and helping investors meet their financial goals.
As discussed in the Investors and Their Needs chapter, an investment policy statement
(IPS) captures information about a client and the client’s needs. The IPS serves as a
guide to what is required of and what is acceptable in the investment portfolio. The
IPS helps guide asset allocation—that is, which asset classes and how much of each
asset class should be included in the investor’s portfolio.
The results of academic studies have indicated that asset allocation is the most import-
ant determinant of portfolio return. Most investors—both individual and institutional—
hold a diversified portfolio of investments rather than a portfolio concentrated in just
a few investments. A key reason for this diversification is the desire to manage risk,
which is consistent with the saying, “Don’t put all your eggs in one basket.”
SYSTEMATIC RISK, SPECIFIC RISK, AND DIVERSIFICATION 2

How well investment risk is managed is a key determinant of the success of invest-
ment management. Risk occurs when there is uncertainty—meaning that a variety of
outcomes are possible from a particular situation or action. In investment terms, risk
is the possibility that the actual realised return on an investment will be something
other than the return originally expected on the investment. There will be times when
the return fails to meet an investor’s expectations and times when the return exceeds
expectations. Fluctuations in the prices and values of investments (capital gains and
losses) reflect the risk of investing. Income (e.g., dividends and interest) may also
differ from what was expected.
Most investors prefer higher returns and lower risks. That is, they prefer better out-
comes and more certainty, all other things being equal. The trade-off between risk
and return is a fundamental issue in investment management. Typically, the higher
the risk of an investment, the higher the expected return; the lower the risk, the lower
the expected return.

124 Chapter 17 ■ Investment Management
2.1 Systematic and Specific Risk

The returns on investments, such as shares, bonds, and real estate, will be affected by
general economic conditions. Returns will also be affected by issues that are specific
to the particular investment. These two types of risk are called systematic risk and
specific risk, respectively.
■■ Systematic risk: The risk created by general economic conditions is known as

systematic or market risk because the risk stems from the wider economic sys-
tem. For example, if the economy enters a recession, many companies will see a
downturn in their revenues and profits.
■■ Specific risk: Risk that is specific to a certain company or security is vari-

ously known as specific, idiosyncratic, non-systematic, or unsystematic risk.
Examples include the share price response when a company launches a success-
ful new product (e.g., the Apple iPad) or the response to the negative news that
a promising new drug has failed in trials.
The distinction between systematic and specific risk is important because the two
types of risk have different implications for investors. Investors can reduce specific
risk by holding a number of different securities in their portfolios. Holding a number
of different securities that are not correlated diversifies away specific risk. The extent
to which two asset classes (or securities) move together is captured by the statistical
measure of correlation, which is presented in the Quantitative Concepts chapter. The
greater the correlation between asset classes (or securities), the more similar their
price movements will be.
Investors cannot diversify away systematic risk. They can do little to avoid systematic
risk because all investments will be affected to some extent by systematic risk—for
instance, a recession. Diversifying an equity portfolio by adding different types of
investments, such as real estate, will not eliminate systematic risk because rents and
real estate values are affected by the same broad economic conditions as the stock
market. Because systematic risk cannot be avoided or diversified away and because
risk is undesirable, investors have to be compensated for taking on systematic risk.
More exposure to systematic risk tends to be associated with higher expected returns
over the long term.
Portfolio theory suggests that taking on more specific risk does not necessarily lead
to higher returns on average because specific risk can be diversified away. But some
investors may try to identify shares that they expect to outperform (to earn higher
returns than expected based on their risk) and invest in them rather than diversifying.
In the process, investors take on specific risk; if they turn out to be correct, they may
earn a higher return as a result of taking on more risk.
2.2 Diversification
Diversification is one of the most important principles of investing. When assets and/
or asset classes with different characteristics are combined in a portfolio, the overall
level of risk is typically reduced.
Systematic Risk, Specific Risk, and Diversification 125
Mathematically, a portfolio that combines two assets has an expected return that is
the weighted average of the returns on the individual assets.1 Provided that the two
assets are less than perfectly correlated, the risk of the portfolio (measured by the
standard deviation of returns) will be less than the weighted average of the risk of
the two assets individually.2 Overall, this means the risk–return trade-off, which is a
key concern for investors, is better for a portfolio of assets than for individual assets.
Most investors hold more than two securities in their portfolios. Adding more secu-
rities to a portfolio will reduce risk through diversification, although eventually the
additional benefits begin to lessen. Exhibit 1 shows the levels of risk—total, specific,
and systematic—for portfolios of shares chosen at random from all of the shares in
the US market. Specific risk is reduced by combining additional shares, but as the
portfolio moves beyond 30 shares, the incremental risk reduction becomes small and
the associated trading costs may outweigh any incremental benefit of risk reduction.
Exhibit 1 illustrates the concepts of specific risk and diversification. Specific risk is
highest at the left side of the exhibit (one share) and lowest at the right side of the
exhibit because much of the specific risk is diversified away.
Exhibit 1 Portfolio Risk
Specific
Risk
Total Risk
Risk
Risk of Market
Portfolio
Systematic
Risk
1 5 10 20 30
Number of Shares
Exhibit 1 assumes randomly chosen shares. There is the potential for greater risk
reduction when shares with low correlation to each other are chosen.
Combining different asset classes can also improve diversification and reduce a
portfolio’s risk by reducing specific risk. For example, an investor might combine
investments in various stock and bond markets with investments in real estate and
commodities to reduce the overall risk of a portfolio.
1 The expected return on a portfolio of x assets is the weighted average of the returns on the individual assets.
2 The systematic risk (measured by beta) of a portfolio is the weighted average of the systematic risks of
the individual assets. Systematic risk cannot be diversified away.
3 ASSET ALLOCATION AND PORTFOLIO CONSTRUCTION
After developing the investment policy statement (IPS), which includes—among other
information—an investor’s willingness and ability to take risk, the asset allocation of
the portfolio is determined. This determination involves decisions regarding which
asset classes are suitable (e.g., global equities, domestic government bonds, commod-
ities, or domestic real estate investment trusts) and the proportion of the portfolio to
invest in each asset class. In some cases, the asset allocation decision is documented
as part of the IPS; in other cases, asset allocation is regarded as part of the subsequent
implementation of the IPS.
3.1 Strategic Asset Allocation

Strategic asset allocation is the long-term mix of assets that is expected to meet the
investor’s objectives. The desired overall risk and return profile of the portfolio is a
factor in determining the strategic asset allocation. A portfolio with a strategic asset
allocation dominated by equities would be expected to have a higher return and be
more volatile than a portfolio dominated by, say, bonds because bonds generally have
lower risk than equities and thus produce lower returns. The strategic asset allocation
that is suitable for one investor may not be suitable for another.
Academic studies have demonstrated that strategic asset allocation significantly affects
the average return on a portfolio. Thus, asset allocation warrants considerable attention
from investors, investment managers, and investment advisers.
Consider the following example of strategic asset allocation.
EXAMPLE 1 STRATEGIC ASSET ALLOCATION
An institutional investor requires a 7% return on its portfolio. The investment

committee decides to invest in global equities and in European government
bonds. At the time the investment is made, European government bonds are
yielding 4%, and the committee’s expectation for the long-term return on the
global equity market is 9%.
A portfolio allocation of 40% bonds and 60% equity gives an expected return
of 7%:
(0.40 × 0.04) + (0.60 × 0.09) = 0.07 or 7%
The committee has to consider the level of risk implied by this asset allocation.
If the committee is not comfortable with the risk, the return requirement may
need to be reduced. The portfolio mix can be adjusted as bond yields change and
the committee revises its expectations for the return on the global equity market.
Asset Allocation and Portfolio Construction 127
Strategic asset allocation typically requires investment managers to estimate the

expected risk and return of each asset class. Historical returns can be used as a guide,
but estimates need to be forward-looking. Managers also need to determine the cor-
relation of returns between the asset classes so they can calculate the diversification
benefits that may be achieved by combining the various assets in a portfolio.
Bonds Bonds Bonds

Equities Equities Equities
Maintains the same target asset allocation over time.

The chosen strategic asset allocation is expected to meet the investor’s long-term risk
and return objectives. An investor may set the strategic asset allocation and simply
hold a portfolio for the life of the investment. If the investor does so, the proportions
of the portfolio will likely depart from the original weights chosen as the different
asset classes provide different rates of return over time and their values thus increase
or decrease by different amounts. As a result, the portfolio has to be adjusted through
a process called rebalancing.
Rebalancing involves selling some of the holdings that have increased as a proportion
of the portfolio and investing the proceeds into the holdings that have decreased as a
proportion of the portfolio. Because there are trading costs associated with rebalanc-
ing, most investors will not rebalance on a continual basis but will instead rebalance
at specified intervals or weightings.
3.2 Tactical Asset Allocation

Although the chosen strategic asset allocation is expected to meet the investor’s
objectives over the long term, there are times when shorter-term fluctuations in asset
class returns can be exploited to potentially increase portfolio returns. A short-term
adjustment among asset classes is known as tactical asset allocation.
Bonds Bonds Bonds

Equities Equities Equities
Changes asset allocation over time.

To illustrate, we will extend the earlier example in which an investor has a strategic
asset allocation of 60% global equities and 40% European government bonds. The
investment manager may think the global equity market is overvalued and likely to
produce poor returns in the short term. In response, the manager could adjust the asset
allocation to 50% equities and 50% bonds. If the manager’s expectation is correct, this
50/50 tactical allocation will perform better in the short term than the strategic asset
allocation of 60/40. The manager will have added return for the investor compared
with maintaining the strategic weights on a static basis. But forecasting markets is
difficult, and tactical allocation does not always benefit the investor. The difficulty of
financial forecasting means investors may choose to maintain their strategic asset
allocation within predetermined ranges. For example, an acceptable strategic asset
allocation may be determined to be 56%–64% global equities and 36%–44% European
government bonds, rather than 60% global equities and 40% European government
bonds. Such ranges allow for some tactical asset allocation and reduce the need for
and expense of frequent portfolio rebalancing.
An investor or manager typically uses a variety of tools and inputs to make tactical
allocation decisions. The decisions may be based on
■■ fundamental analyses of economic and political conditions and their likely

effects on market returns,
■■ market valuation measures relative to past data, or
■■ trends and momentum in markets.
When considering tactically altering a portfolio’s asset allocation, a manager may look
at the strength of the economy and likely future trends to gain a perspective on how
the central bank might change interest rates and on what might happen to corporate
profits. The manager may then look at the level of the price-to-earnings ratio of the
stock market and how it compares with recent decades as a measure of valuation or
with the level of bond yields relative to historical ranges. The manager could also look
at stock and bond market trends as a way of gauging investor sentiment.
Tactical asset allocation represents an attempt to add value to a portfolio by deviating

from the strategic asset allocation. Tactical asset allocation is a form of active portfolio
management, which we will discuss in the next section.
4 PASSIVE AND ACTIVE MANAGEMENT
Beyond deciding on asset allocation, an investor must decide whether to use a passive
or active management approach to asset selection.
■■ Passive managers manage a portfolio designed to match the performance of a

specified benchmark.
■■ Active managers attempt to add value to a portfolio by selecting investments

that are expected, on the basis of analysis, to outperform a specified benchmark.
Passive and Active Management 129
Performance
Time
Active Management Benchmark
Passive Management
The choice between the two approaches typically hinges on the relative costs of active
management compared with passive management and on the investor’s expectation of
the success of active management. The expectation is related to the investor’s beliefs
about the efficiency of the markets being invested in. An investor may decide to use
a passive approach in some markets and an active approach in other markets based
on an assessment of the efficiency of each market.
As discussed in The Functioning of Financial Markets chapter, an informationally

efficient market is one in which the prices of investments reflect available informa-
tion about the fundamental values and return prospects of the assets they represent.
For example, in a stock market context, a company with good prospects should have
a high stock valuation, which reflects the future profits that will likely accrue to the
shareholders. A company with poor prospects will have a low valuation to reflect the
anticipated low future profitability of the company. If stock markets are believed to be
informationally efficient, the investor will believe there is little point to actively manag-
ing stock market investments because share prices already reflect the potential of the
underlying companies. In other words, there is little to uncover via further research.
In contrast, in an inefficient market some shares may be over- or undervalued relative
to the company’s prospects, and an investor may be rewarded with excess returns by
successfully identifying such shares.
Sometimes, whole markets—rather than just individual shares—can be inefficiently

priced. Some investors argue that stock markets in developed economies are relatively
efficient but that markets in emerging economies are less so. They argue that public
information flows may not be as extensive or reliable in emerging economies and that
it is possible for some investors to access and use information that is not available
to others. This situation may exist because there may be less market regulation in
emerging economies than in more developed economies or because there may be an
absence of skilled analysts investigating markets in emerging economies. Similarly,
some investors argue that shares of smaller companies are less efficiently priced than
shares of larger companies because fewer investors and analysts take the time to
research smaller companies in detail and information is less available. The most effi-
cient markets tend to be those with a large number of active, informed participants.
The markets for such investments as real estate or private equity may not be efficient
for a number of reasons. For instance, information on these investments may not be
publicly available and trading is less active and done privately rather than in a public
market in which prices and volumes can be observed. As a result, some investors
may have access to information and deals that are not available to other investors.
In cases where inefficiency is believed to exist, it is reasonable to believe that active
management may be a successful approach.
4.1 Passive Management

Passive investment managers seek to match the return and risk of a benchmark.
Benchmarks include broad market indices, indices for a specific market segment,
and specifically constructed benchmarks. Passive investment managers attempt to
minimise tracking error. Recall from the Performance Evaluation chapter that the
tracking error is the deviation of the return on the portfolio from the return on the
benchmark being tracked. Passive managers may try to fully replicate the benchmark
by holding all the securities in the benchmark in proportions equivalent to their
weighting in the benchmark.
But many benchmarks are difficult and costly to fully replicate, sometimes because
of the number of securities or because of liquidity and availability issues. So, instead
of full replication, passive managers may use a tracking approach and hold a subset
of the market that is expected to closely track the benchmark’s returns and risk. For
example, a passive manager in the UK equity market has the choice of replicating
the FTSE 100 market index directly or attempting to track the index by selecting a
subset of shares to represent each industrial sector of the market. Bond index funds
are typically restricted to the tracking approach because it is almost impossible to
own every bond issue in an index.
Whatever passive investment approach is used, a passive investor must be willing to

accept the risk of the underlying market.
4.2 Active Management

Active investment managers use a variety of approaches. They may attempt to select
assets that will outperform the benchmark. These active managers focus on selecting
individual securities or assets in an asset class or classes. Active managers may also
try to time a market (buying when they believe the market is undervalued and selling
when they believe the market is overvalued). Tactical asset allocation is an example
of trying to time markets. How active mangers identify assets or asset classes to buy
and sell and to identify market timing opportunities is discussed in Section 5.
4.3 Factors Needed for Active Management to Be Successful

Active management is a challenging task, but there are managers who have impres-
sive long-term records of success. For active managers to be consistently successful,
they have to be better than other investors at assessing the potential of investments.
When active managers buy a security or investment because their analysis suggests
it has good return potential, they may be buying it from another active manager who
believes the prospects for the security are poor.
Passive and Active Management 131
For active managers to identify outperforming securities on a consistent basis, they

must either have access to better information than other investors or be able to respond
and use the same information faster or with better models to process the information.
The ability to do this is difficult because so many other investors have access to the
same information and resources.
In many markets, corporate disclosure regulations mean that information on company

fundamentals must be made available to all investors at the same time. In fact, laws
typically prohibit selective disclosure of material information on company prospects
or performance. With many profit-motivated investors digesting corporate informa-
tion, it is a challenge to interpret the information faster and better than the aggregate
market view.
Also, for active management to be successful, any mispricing of investments has to

be substantial enough to cover the costs of exploiting this mispricing. Investing in
an undervalued security is only worthwhile if the excess return covers the cost of the
research required to identify the undervaluation and the trading costs involved in
investing in the security.
Accurately predicting mispricing is difficult because prices generally should already

reflect most publicly available information about fundamental values. It is interesting
to note that prices would not necessarily reflect most publicly available information if
active managers (investors) did not gather and analyse the information and act on it.
Much academic and practitioner research has shown that most active managers do
not consistently outperform the market over long time periods, after accounting for
fees and expenses. Unfortunately, identifying active managers who will outperform
the market in the future is generally as difficult as identifying individual assets that
will outperform the market.
4.4 Choosing between Passive and Active Management

Is investing passively in an index, such as the Hang Seng Index, the S&P 500 Index,
or the FTSE 100 Index, the best way to increase your wealth? Or is hiring an active
investment manager with a record of past success a better option? Unfortunately, it is
never possible to know for sure. But the choice between passive and active management
is a key issue for investors and the decision must be weighed carefully.
Passive management is typically cheaper to implement than active management

because successfully replicating or tracking a benchmark requires fewer analytical
resources than researching and identifying investments with superior return poten-
tial. The passive approach requires some skill, such as knowing which investments to
include in the benchmark and their respective values and weights in the benchmark.
Although the costs of passive management are lower than the costs of active manage-
ment, the return earned by the passive investor will typically be less than the index
return because of costs.
Passive management of equity portfolios is a well-established discipline and replicating

an equity market index is quite straightforward. But for some markets, such as real
estate, in which all properties are unique and trading is done in private transactions
rather than on a public stock exchange, it is less clear how a passive approach can be
used. There may not be a suitable index for passive managers to track. In addition,
real estate assets themselves have to be managed (maintained, rented, refurbished,
and so on) in a way that equity investments do not. So, most investments in real estate
are actively managed to some extent. A similar argument applies to private equity
and venture capital.
Active approaches require a more detailed analysis of each relevant investment or

asset class, which is costly because investment firms need skilled employees and/or
expensive technology. Active management typically also has higher transaction costs
because of more frequent trading in the portfolio. If active management does achieve
returns that are higher than the benchmark, the excess return may compensate for
the higher employee, technology, and transaction costs and the net returns to the
investor may be higher.
Proponents of active management argue that good active managers can more than
cover their costs and thus deliver net benefit to investors. Conversely, proponents of
passive management argue that the difficulty of identifying superior investments means
it is not worth paying higher costs for that effort and that passive management will
deliver higher net-of-costs returns over the longer term. Concerns about the costs, the
average or below-average performance of most active managers, and the difficulties of
identifying active investment managers who will outperform in the future have made
passive investment strategies increasingly popular over time. Despite these concerns,
active management still remains popular.
As noted earlier, an investor may decide to use a passive approach in some markets
and an active approach in other markets based on an assessment of the efficiency of
each market.
5 IDENTIFYING AND CAPTURING MARKET INEFFICIENCIES
Active investment managers use various methods to try to identify future performance.
Managers using fundamental analysis focus on macroeconomic, industry-specific, and
company-specific factors that make securities and assets valuable. Other managers
use technical and behavioural models to identify trends and momentum in the market
and to predict how trading by other market participants may change future market
prices. Some active managers build statistical or quantitative models to try to identify
shares that are likely to outperform or underperform. In practice, many managers use
a blend of the techniques discussed in the following sections. Based on their analysis,
active managers purchase assets that are expected to have superior returns and sell
assets that are expected to underperform.
5.1 Fundamental Analysis

Active managers often try to identify and capture market inefficiencies through fun-
damental analysis. For equity investors, this process means conducting a thorough
analysis of a company’s business model, its prospects, and its financial situation. This
analysis may involve meeting company management and interviewing them about
their strategy and the prospects of the company. Analysts must take care not to violate
laws and regulations when gathering information. Their goal is to identify companies
Identifying and Capturing Market Inefficiencies 133
that have better prospects than the stock market price reflects. Typically, an analyst
or investment manager performs some form of fundamental analysis to arrive at an
estimated value for a company’s shares. If the share price is significantly below the
estimated value, the manager will increase the weighting of the shares in the portfolio
or add the shares to the portfolio.
As explained in the Equity Securities and Debt Securities chapters, the value of a
security can be viewed as the present value of all the cash flows the security will gen-
erate in the future. For example, recall that investors can estimate the value of a stock
by discounting all the dividends they expect to receive while they hold the stock and
adding the proceeds from selling the stock. Value that is estimated this way is called
the stock’s fundamental value or intrinsic value. Although fundamental values are not
observable, many active investment managers work hard to accurately estimate them.
Managers using fundamental analysis operate on the premise that security market
prices tend to move toward their estimates of fundamental values. They can produce
exceptional returns when they accurately estimate values and make the appropriate
investments before other market participants.
To estimate fundamental values, they must forecast future cash flows and estimate the
rates at which these cash flows are discounted. Managers using fundamental analysis
take into account many issues when forming investment opinions. The issues most
important to their opinions vary according to the type of asset they are analysing.
For example, when analysing fixed-income securities (such as bonds, notes, and bills),
managers consider borrowers’ ability and willingness to pay their debts—that is,
borrowers’ creditworthiness and trustworthiness. Lenders consider borrowers to be
creditworthy if they expect that the borrowers will be able to pay interest, principal,
and preferred dividends when due. They consider borrowers to be trustworthy if they
expect that borrowers will arrange their affairs to ensure that they can and will make
these payments. Managers consider financial data and past borrowing histories to
determine whether borrowers are creditworthy and trustworthy.
When analysing equities, they pay close attention to an issuer’s future prospects for
earning money and producing valuable assets. Among many other issues, they con-
sider the following:
■■ Demand for the company’s products
■■ Cost of producing those products
■■ Profit margins of the company and whether the margins are sustainable
■■ Competitiveness of the company and whether it can remain competitive
■■ Quality, stability, and security of the company’s management, workforce, and

physical and intellectual assets
■■ Productivity of its research and development efforts
■■ Amount of debt the company uses to fund its operations and investments
■■ Value of options to suspend or expand operations or to engage in new initiatives

■■ Prospects for disruptive technological innovations, the imposition or removal

of significant regulatory constraints, and legal or extra-legal expropriations that
may affect the company’s viability
■■ Macroeconomic issues, such as prospects for inflation, national economic

growth, and unemployment
■■ Legal and regulatory environment the company operates within and whether
any major changes are planned
■■ Corporate governance problems that may allow corporate managers to waste or

misuse corporate earnings that otherwise could be distributed to shareholders
or be retained to pay off debt holders
When analysing alternative investments, the issues considered will also differ. For
example, when analysing real estate investments, managers consider how the value
of the property compares with similar properties in the area, how its rental prospects
might develop in the future, and whether there is scope to add value to the property
through redevelopment. Managers using fundamental analysis consider the specific
factors that are expected to affect the value of the type of asset being analysed.
5.2 Technical and Behavioural Analysis

Managers using technical analysis study market information, including price patterns
and trading volumes, whereas managers using behavioural analysis focus on indica-
tors of market sentiment, such as manufacturers’ new orders or indices of consumer
expectations.
Some investment managers use a technical approach, seeking to assess price and
trading volume trends in the stock market to identify shares that may outperform or
underperform. For example, an active manager who believes in momentum will try
to invest in shares that have recently been rising in the market, which is based on the
notion that a rising share will continue to rise. Other managers might look for signs of
imbalance between the potential buyers and sellers of a share to try to predict which
direction the share is likely to move.
Recall from the discussion about supply and demand in the Microeconomics chapter
that an increase in demand or a decrease in supply will typically cause prices to increase.
Similarly, a decrease in demand or an increase in supply will typically cause prices to
decrease. Investment managers who use technical and behavioural approaches try to
buy a particular security or asset before an increase in buyer interest or a decrease
in seller interest causes the price of the security to rise, and they try to sell before
an increase in seller interest or a decrease in buyer interest causes the price of the
security to fall.
5.3 Quantitative Analysis

Some managers build statistical models to try to identify shares that are likely to
outperform. By analysing data, they identify characteristics that have typically been
associated with share price outperformance. For example, the analysis might suggest
that companies with below-market average valuation levels (for example, the ratio
Summary 135
of the share price to earnings per share, known as P/E) and above-average expected
earnings growth tend to outperform. This insight can then be used to search for
shares that show those characteristics. Managers using this approach are often called
“quants”, because of the quantitative models they use.
As noted earlier, managers may use a combination of the types of analysis. Also,
depending on the asset, asset class, or market being analysed, the approach(es) used
and the precise variables of interest will differ.
SUMMARY
In your workplace, you may not be directly involved in investment management, but
knowing how assets are selected and how portfolios are constructed for investors is
important to better understand the investment industry.
Some important points to remember about investment management include the

following:
■■ Asset allocation is the largest contributor to portfolio return. An investor,

sometimes in conjunction with an investment manager, must decide on the
asset allocation in an investment portfolio.
■■ The trade-off between risk and return is a fundamental issue in investment

management. Typically, the higher the risk of an investment, the higher the
expected return; the lower the risk, the lower the expected return.
■■ Returns on investments, such as shares, bonds, and real estate, are likely to be
affected by general economic conditions. Risk created by general economic
conditions is known as systematic risk. Risk specific to a certain security or
company is variously known as specific, idiosyncratic, non-systematic, or unsys-
tematic risk.
■■ Portfolio theory maintains that systematic risk cannot be avoided, but that spe-
cific risk can be diversified away. Investors should be compensated for system-
atic risk but not necessarily for specific risk. Thus, taking on more specific risk
does not necessarily lead to higher returns.
■■ Diversification is an important concept in investment theory. When shares or

other investments with different characteristics are combined in a portfolio, the
overall level of risk is typically reduced. The combination of two or more assets
in a portfolio results in an expected return on the portfolio that is the weighted
average of the returns on the individual assets. Provided the assets are less
than perfectly correlated, however, the risk of the portfolio will be less than the
weighted average of the risk of the assets.
■■ Strategic asset allocation is the long-term mix of assets that is expected to meet
an investor’s objectives. Strategic asset allocation is a decision that has a great
impact on the long-term returns on a portfolio.
■■ Although the strategic asset allocation should meet the investor’s objectives
over the longer term, the manager or investor can potentially increase returns
by exploiting short-term fluctuations in asset class returns. The process of
exploiting these short-term fluctuations by adjusting the asset class mix in the
portfolio is known as tactical asset allocation.
■■ An informationally efficient market is one in which prices reflect the fundamen-

tal values and prospects of the assets they represent.
■■ Passive management is managing a portfolio designed to track the performance

of a benchmark.
■■ Active management attempts to add value to the portfolio through the selection
of investments that are expected to outperform the benchmark and/or through
tactical asset allocations.
■■ Passive management is typically cheaper to implement than active management

because fewer analytical resources are required to successfully track a market
index than to research and identify investments expected to have superior
returns. If active management does achieve a return that is higher than the
benchmark, the excess return may compensate for the higher costs. But it is not
certain that the active manager can consistently identify superior investments;
consistently successful active management is challenging to achieve.
■■ The choice between the active and passive approaches typically hinges on the
costs of active management and on investors’ expectations of the chances of
success using active management. The expectation of success is related to the
investor’s beliefs about the efficiency of the markets being invested in.
■■ The successful active manager needs access to better information or the ability
to process information faster and/or better than other investors. These require-
ments are demanding. Any mispricing of investments has to be substantial
enough to cover the costs of exploiting it.
■■ Active managers often attempt to identify and capture market inefficiencies by

using fundamental analysis to identify mispriced securities. Some managers use
technical and behavioural analysis to assess price and volume trends to identify
securities that will outperform. Other managers (quants) attempt to build statis-
tical models to identify shares that are likely to outperform. In practice, many
managers use a blend of these techniques.
1 Systematic risk is the portion of total risk that:
A is related to a certain company or security.
B is created by general economic conditions.
C results from a lack of portfolio diversification.
2 An investor currently owns a portfolio of five securities. If the investor adds

another security to the portfolio that is less than perfectly positively correlated
with the other five securities, the portfolio’s:
A total risk will likely increase.
B specific risk will likely decrease.
C systematic risk will likely decrease.
3 The benefits of risk reduction are most likely to be greater by combining securi-
ties whose expected returns have a:
A low correlation.
B perfectly positive correlation.
C high, but less than perfect, correlation.
4 The long-term mix of assets that is expected to meet an investor’s objectives

best describes:
A diversification.
B tactical asset allocation.
C strategic asset allocation.
5 The act of an investment manager adjusting his or her portfolio to take advan-
tage of short-term fluctuations in asset class returns most likely describes:
A rebalancing.
B tactical asset allocation.
C strategic asset allocation.

6 Which of the following statements best describes passive management? Passive

investment managers:
A attempt to outperform the benchmark.
B tend to earn higher returns than the benchmark.
C seek to match the risk and return of the benchmark.
7 Active investment managers are more likely than passive investment managers
to:
A try to time a market.
B use strategic asset allocation.
C seek to minimise tracking error.
8 Active investment management is most likely to be favoured over passive

management:
A for real estate investments.
B when markets are informationally efficient.
C when transaction costs are high.
9 The factor most likely to contribute to the success of active management is the:
A existence of trading costs.
B existence of inefficient markets.
C inability for active managers to consistently access better information than

other investors.
10 Active managers that focus on sentiment to identify investment opportunities

most likely use:
A behavioural analysis.
B quantitative analysis.
C fundamental analysis.
11 Analysts who review share price and trading volume trends in an effort to iden-
tify shares that might outperform are most likely:
A technical analysts.
B fundamental analysts.
C quantitative analysts.
Answers 139
ANSWERS
1 B is correct. Systematic risk (also known as market risk) is the risk created by
general economic conditions. A is incorrect because the risk that is related to a
certain company or security is known as specific, idiosyncratic, non-systematic,
or unsystematic risk. C is incorrect because specific risk, not systematic risk, is
the result of a lack of diversification.
2 B is correct. Adding securities that are less than perfectly positively correlated
with the other securities in the portfolio will likely decrease the specific risk
and, therefore, the total risk. A is incorrect because the total risk of the portfo-
lio will likely decrease, not increase, as a result of the decrease in specific risk. C
is incorrect because the portfolio’s systematic risk is independent of the number
of securities in the portfolio.
3 A is correct. When securities with different characteristics are combined in a

portfolio, the overall level of risk is typically reduced as a result of diversifica-
tion. The risk reduction benefits resulting from diversification are greatest when
the securities have returns that exhibit a low correlation with each other. B is
incorrect because there will not be any diversification benefit when the securi-
ties in the portfolio have returns that exhibit a perfectly positive correlation. C
is incorrect because a less than perfect correlation will reduce risk but not as
significantly as a low correlation.
4 C is correct. Strategic asset allocation is the long-term mix of assets that is

expected to meet the investor’s objectives. The desired overall risk and return
profile of the portfolio is a factor in determining the strategic asset allocation.
A is incorrect because diversification is the process of combining assets with
different characteristics in a portfolio for the purpose of reducing risk. B is
incorrect because tactical asset allocation refers to short-term adjustments
among asset classes. Although the chosen strategic asset allocation is expected
to meet the investor’s objectives over the longer term, there may be times when
shorter-term fluctuations in asset class returns may be exploited to potentially
increase returns.
5 B is correct. Tactical asset allocation refers to portfolio adjustments to the stra-

tegic asset allocation in an effort to take advantage of short-term fluctuations
in asset class returns. Although the chosen strategic asset allocation is expected
to meet the investor’s objectives over the longer term, there may be times when
shorter-term fluctuations in asset class returns may be exploited to poten-
tially increase returns. A is incorrect because rebalancing refers to resetting a
portfolio to its initial strategic weights. Rebalancing involves selling some of the
holdings that have increased as a proportion of the portfolio and investing the
proceeds into the holdings that have decreased as a proportion of the portfolio.
C is incorrect because strategic asset allocation is the long-term mix of assets
that is expected to meet the investor’s objectives.
6 C is correct. Passive investment managers seek to match the risk and return of
an appropriate benchmark. A is incorrect because passive investment managers
do not try to outperform the benchmark. B is incorrect because although the
costs of passive management are lower than the costs of active management,
the return earned by the passive investor will typically be less than the bench-
mark return because of these costs.
7 A is correct. Active managers may try to time a market (buying when they
believe a market is undervalued and selling when they believe a market is over-
valued). B is incorrect because passive investment managers, rather than active
managers, tend to use strategic asset allocation. C is incorrect because passive
investment managers, rather than active managers, attempt to minimise track-
ing error.
8 A is correct. Active management may be preferred in less efficient markets

and also for unique assets in which trading occurs in private transactions. Real
estate assets are generally unique and are traded in private transactions, thereby
increasing the need for and opportunities from active management. B is incor-
rect because if markets are efficient, there is little point to actively managing
investments; asset prices already reflect available information and the potential
of the underlying investments. C is incorrect because when transaction costs
are high, active management is less likely to identify opportunities with excess
return sufficient to cover the transaction costs.
9 B is correct. The existence of inefficient markets creates an environment in

which security mispricing may occur, and active management may prove benefi-
cial in exploiting such mispricing. If markets are efficient, there is little point to
actively managing investments because asset prices already reflect the available
information and the potential of the underlying investments. A is incorrect
because trading costs reduce the expected benefit of active management and
may limit the success of active management. For active management to be suc-
cessful, any mispricing of investments has to be substantial enough to cover the
costs of exploiting the mispricing. C is incorrect because the success of active
management will be limited if active managers cannot consistently access better
information than other investors. Active managers may also be able to use the
same information faster than other investors or have better models to process
the information.
10 A is correct. Behavioural analysis studies indicators of market sentiment, such

as manufacturing new orders or indices of consumer expectations, to identify
investment opportunities. B is incorrect because quantitative analysis is based
on creating statistical models to identify investment opportunities. C is incor-
rect because fundamental analysis is based on a thorough analysis of a company,
its prospects, and its financial situation to identify investment opportunities.
11 A is correct. Technical analysts use price and trading volume trends within
the stock market to identify stocks that may outperform or underperform. For
example, managers might look for imbalances between the potential buyers and
sellers of a stock as a sign of which direction the share may move. B is incorrect
because fundamental analysts conduct a detailed and thorough analysis of a
company’s business model, its prospects, and its financial situation to identify
shares that will outperform or underperform. C is incorrect because quantita-
tive analysts build statistical models to identify shares that are likely to outper-
form or underperform.
CHAPTER 18
RISK MANAGEMENT
by Hannes Valtonen, CFA
LEARNING OUTCOMES
a Define risk and identify types of risk;
b Define risk management;
c Describe a risk management process;
d Describe risk management functions;
e Describe benefits and costs of risk management;
f Define operational risk and explain how it is managed;
g Define compliance risk and explain how it is managed;
h Define investment risk and explain how it is managed;
i Define value at risk and describe its advantages and weaknesses.

Definition and Classification of Risks 147
INTRODUCTION 1
Risk is part of your daily life, and whether you realise it or not, you often act as a risk
manager. Before crossing a busy road, you first assess that it is safe for you to do so; if
you take a toddler to the swimming pool, you make sure that she is wearing inflatable
armbands before she gets into the water and that she is never left unattended; you
have probably purchased car, home, and/or health insurance to protect you and your
family against accidents, disasters, or illnesses. Thus, in the course of your life, you are
well acquainted with identifying risks, assessing them, and selecting the appropriate
response, which is what risk management is about.
This chapter puts the emphasis on the types of risks that companies in the invest-
ment industry (investment firms) and people working for these companies face. It is
important for companies to develop a structured process that helps them recognise
and prepare for a wide range of risks. Although risk management is sometimes
viewed as a specialist function, a good risk management process will encompass the
entire company and filter down from senior management to all employees, giving
them guidance in carrying out their roles. Any action that you take as an employee
may affect your company’s risk profile, even if these actions are “only” regular daily
activities. An unintentional error can cause substantial damage to a company, so it is
important that you gain a good understanding of the types of risks companies in the
investment industry face and that you learn how these risks are managed.
Risk
M a nage m e n t
DEFINITION AND CLASSIFICATION OF RISKS 2

Risk can take different forms. Although there is no universal classification of risks,
this section identifies typical risks to which companies in the investment industry
are exposed.
2.1 Definition of Risk

Risk arises out of uncertainty. It can be defined as the effect of uncertain future events
on a company or on the outcomes the company achieves. One of these outcomes
is the company’s profitability, which is why the effects of risk on profit and rates of
return are often assessed.

148 Chapter 18 ■ Risk Management
Events that have or could have a negative effect, leading to losses or negative rates
of return, tend to be emphasised in discussions of risk. Some of these events are
external to the company. For example, a bank that has a large portfolio of commercial
loans may suffer substantial losses if the economy goes into recession and corporate
defaults increase. Other events, such as internal fraud or network failure, are inter-
nal to the company. But not all outcomes from events are negative. Some events can
have a positive effect on the company, creating opportunities for gains. For example,
a company that takes the risk of investing in a country with tight capital controls (or
controls on flows in financial markets) may benefit if the capital controls are lifted
and the company becomes one of the few foreign companies licensed to buy and sell
securities in that country. So, the assessment of risk needs to include opportunities
as well as threats.
2.2 Classification of Risks

Risks are classified according to the source of uncertainty. There is a long list of sources
of uncertainty, so there is a correspondingly long list of risks. Relatively well-defined
categories of risk exist, but no standard risk classification system applies to all com-
panies because risks should be classified in a manner that helps managers make better
decisions in the context of their particular company and its environment.
All companies face the risk of not being able to operate profitably in a given com-
petitive environment, typically because of a shift in market conditions. For example,
a company’s ability to grow and remain profitable may be affected by changes in
customer preferences, the evolution of the competitive landscape, or product and
technology developments.
There are three risks to which companies in the investment industry are typically
exposed and that are discussed in this chapter:
■■ Operational risk, which refers to the risk of losses from inadequate or failed
people, systems, and internal policies and procedures, as well as from external
events that are beyond the control of the company but that affect its operations.
Examples of operational risk include human errors, internal fraud, system mal-
functions, technology failure, and contractual disputes.
■■ Compliance risk, which relates to the risk that a company fails to follow all
applicable rules, laws, and regulations and faces sanctions as a result.
■■ Investment risk, which is the risk associated with investing that arises from
the fluctuation in the value of investments. Although it is an important risk for
investment professionals, it is less important for individuals involved in support
activities, so it receives less coverage than operational and compliance risks in
this chapter.1
1 Investment risks are discussed elsewhere in the curriculum. It was introduced in the Quantitative
Concepts chapter and discussed further in the Investment Management chapter.
The Risk Management Process 149
THE RISK MANAGEMENT PROCESS 3

A good risk management process helps companies reduce the likelihood and severity
of adverse events and enhance management’s ability to realise opportunities. The
consequences of inadequate risk management include investment losses and even
bankruptcy. Other costly consequences are also possible, such as sanctions for the
breach of regulations, loss of licenses to provide financial services, and damage to the
company’s reputation and the reputations of its employees.
A risk management process provides a framework for identifying and prioritising risks;
assessing their likelihood and potential severity; taking preventive or mitigating actions,
if necessary; and constantly monitoring and making adjustments. A company’s risk
management process is not always consistently planned; it often evolves in response
to crises, incorporating the lessons learned and the new regulatory requirements that
sometimes follow these crises. Well-run companies, however, benefit from people and
processes that enable forward-looking attention to emerging risks.
3.1 Definition of Risk Management

Risk management is an iterative process used by organisations to support the identifi-
cation and management of risk (or uncertainty) and reduce the changes and/or effects
of adverse events while enhancing the realisation of opportunities and the ability to
achieve company objectives. These objectives may take different forms, but they are
typically driven by a company’s mission and strategy. A common corporate objective
is to create value in a business environment that is usually fraught with uncertainty.
So, an important objective of the risk management process is to help managers deal
with this uncertainty and identify the threats and opportunities their company faces.
One of the main functions of risk management is to find the right balance between
risk and return. Shareholders in a company or investors in a fund have invested their
money for the promise of a return at some risk level. By limiting the effect of events
that may derail the company’s ability to achieve its objectives while benefiting from
opportunities to grow the company profitably, risk management plays an important
role in delivering value for these shareholders and investors.
The involvement of the board of directors and senior management in risk management
is critical because they set corporate strategy and strategic business objectives. Although
directors and senior managers are in charge of setting the appropriate level of risk to
support the corporate strategy, risk management should involve all employees. One
employee making an inaccurate or fraudulent assessment can damage the reputation
of his or her company and even lead to its demise. Reputations take years to build but
they can be lost in an instant. Markets are increasingly interdependent, and media and
the internet can spread the news of a mistake or scandal across the globe in a matter
of minutes. Thus, risk management is critical to protecting reputations as well as
maintaining confidence among market participants and trust in the financial system.
3.2 Steps in the Risk Management Process

A structured risk management process generally includes five steps, as illustrated in
Exhibit 1.
Exhibit 1 Risk Management Process
tive
s IdenDetec
bjec tify t
O E
an ents
t
Se
d
v
Risk
Management
C o n t ro i t o r
Process
iti s n d
e Ris k
Mon
io r s s a
l an
Pr s s e
d
A
S ele
ct a Ris k
Re s p o n s e
3.2.1 Set Objectives

Setting objectives is an important part of business planning. Risk management enables
management to identify potential events that could affect the realisation of those
objectives. A company may set strategic objectives, which are typically high-level
objectives connected to its mission. It may also define objectives that are related to its
operations. Many of these objectives depend on external factors that may be difficult
for companies to influence and control, which leads to a high degree of uncertainty.
A strong risk management process helps decision makers ensure that the company
is on track to achieve its objectives.
An important element in the setting of objectives is the company’s risk tolerance.

Risk tolerance is the level of risk that the company is able and willing to take on.
The ability to handle risk is primarily driven by the company’s financial health and
depends on its level of earnings, cash flows, and equity capital. Its willingness to take
on risk, which is also called its risk appetite, depends on its attitude toward risk and
on its risk culture.
3.2.2 Detect and Identify Events

The next step in the risk management process is to detect and identify events that
may affect achieving the company’s objectives. As previously mentioned, the outcome
of events can be negative—potentially leading to loss of earnings or assets—or they
can be positive.
The aim of risk management is to try to capture the full range of risks, including hidden
or undetected ones. Therefore, companies should involve employees in many differ-
ent roles and business areas in order to detect and identify as many risks as possible.
But there will always be unforeseen hazards. No matter how hard companies try to
identify and reduce threats, they can never be completely identified or eliminated.
The complexity of the business environment makes it impossible to understand and
model the large number of possible outcomes and combinations of outcomes. What
risk management provides is a robust framework to help companies prepare for adverse
events, identify their occurrence as early as possible if they do materialise, and thus
reduce their effect. The process of identifying potential risks can also reveal hidden
value-enhancing opportunities.
3.2.3 Assess and Prioritise Risks

No matter what form risk takes, two elements of it are typically considered, in particular
for undesirable events: the expected frequency of the event and the expected severity
of its consequences. Different expected levels of frequency and severity of outcomes
can be specified, as illustrated in Exhibit 2. This type of risk matrix can be used to
prioritise risks and to select the appropriate risk response for each risk identified.
Exhibit 2 Risk Matrix
Catastrophic
Extremely
Expected Severity
Harmful
Harmful
Slightly
Harmful
Negligible
Highly Unlikely Possible Likely Highly
Unlikely Likely
Expected Frequency
Depending on their expected level of frequency and severity, risks will receive different
levels of attention:
■■ Green. Risks in the green area should not receive much attention because they
have a low expected frequency and a low expected severity.
■■ Yellow. Risks coded yellow are either more likely but of low severity, or more
severe but unlikely. They should receive a little more attention than risks in the
green area, but less attention than risks in the orange area.
■■ Orange. Risks in the orange area have a higher expected frequency or higher
expected severity than risks coded yellow, so they should be monitored more
actively.
■■ Red. Risks coded red should receive special attention because they have a rela-
tively high expected frequency and their effect on the company would be severe.
■■ Black. Risks in the black area are highly unlikely but would have a catastrophic
effect. These risks are sometimes called “black swans”, which is in reference to
the presumption in Europe that black swans did not exist and is a belief that
persisted until they were discovered in Australia in the 17th century. These risks
are usually not identified until after they occur.
In practice, the selection of key risk measures is important for the risk management
function to be proactive and predictive. Key risk measures should provide a warning
when risk levels are rising. They require the collection and compilation of data from
various internal and external sources. The types of key risk measures vary among
industries and companies, and they need to be reviewed regularly to ensure that the
measures are still relevant and sensitive to risk events.
Example 1 shows two of the many key risk measures that may be used by a securities
brokerage firm. The example identifies the measure, the type of risk it is concerned
with, the source of data, and how to interpret the measure.
EXAMPLE 1. TWO KEY RISK MEASURES USED BY A SECURITIES

BROKERAGE FIRM
Key Risk Source of

Measure Type of Risk Data Interpretation
Client satis- Operational Client A decrease in the client satisfac-

faction index risk surveys tion index may be an indication
that the quality of client services
is deteriorating, which may have
a negative effect on the firm’s
ability to generate revenue and
profit.
Number of Compliance Legal or An increase in the number of
fines paid risk compliance fines paid may be an indication
department that the firm does not comply
with the required laws and regu-
lations, which may result in the
firm losing its ability to operate.
3.2.4 Select a Risk Response

The next step in risk management is to formulate responses to deal with the risks
identified in the previous step. For each risk, management must select an appropriate
response and develop actions to align the company’s risk profile with its risk tolerance.
It is important to recognise that all companies must take risks in the course of their
business activities to be able to create value. The restriction of activities to those that
have no risk would not generate sufficient returns for shareholders or investors, who
would thus be less willing to provide capital to companies or to invest their savings
in the range of investments available.
Therefore, each company must determine the risks that should be exploited, which are
often risks the company has expertise in dealing with and can benefit from. Companies
must also determine the risks that should be mitigated or eliminated, which are often
risks it has little or no expertise in dealing with. A risk management process that
enables managers to distinguish between the risks that are most likely to provide
opportunities and the risks that are most likely to be harmful helps companies generate
superior returns. Risk response strategies can be classified into four “T” categories:
■■ Tolerate. This strategy involves accepting the risk and its effect. In some cases,
the risk is well understood and taking it provides opportunities to create value.
In other cases, the risk must be taken because other risk response strategies are
unavailable or too costly.
■■ Treat. This strategy involves taking action to reduce the risk and its effect.
■■ Transfer. This strategy involves moving the risk and its effect to a third party.
■■ Terminate. This strategy involves avoiding the risk and its effect by ceasing an
activity.
Example 2 illustrates the use of the four risk response strategies by a bank.
EXAMPLE 2. RISK RESPONSE STRATEGIES FOR A BANK
Assume that a bank has expertise in making loans to small companies in its home
country. A neighbouring country is opening its economy and experiencing strong
growth. The bank is looking for value-enhancing opportunities and decides to
use its business expertise to make loans to small companies in the neighbouring
country. At this stage, the bank is willing to tolerate the risks of doing business
in a foreign country because the opportunity is potentially significant.
A few years later, the bank has a large portfolio of loans in the neighbouring
country, but the economic situation there is deteriorating. The bank is concerned
about the risk of an increasing number of borrowers defaulting on their loans;
this risk is called credit risk and is discussed in Section 6.2. Thus, the bank
decides to treat this credit risk by implementing stricter criteria before granting
loans to small companies and by obtaining additional collateral to back each
loan. Recall from the Debt Securities chapter that collateral refers to the assets
that secure a loan.
The economic situation in the neighbouring country continues to deteriorate

and the bank decides to transfer some of the credit risk to another financial
institution that is willing to purchase part of the bank’s portfolio of loans.
A few months later, the neighbouring country faces a recession, which leads
to social and political unrest. The bank makes the decision that it no longer wants
to do business there. It sells its remaining portfolio of loans to another financial
institution and ceases all activities in the neighbouring country. In doing so, the
bank terminates all risks.
In practice, investment firms set internal risk limits that incorporate the company’s
overall risk tolerance and risk management strategy—for example, by specifying the
maximum amount of a risky security that can be held or the maximum aggregate
exposure to one asset type or to one counterparty. Defining limits and then controlling
and monitoring those limits allows firms to implement risk response strategies.
3.2.5 Control and Monitor

Taking action in response to risk involves a range of controlling and monitoring
activities that must be performed in a timely manner. Policies and procedures pro-
vide a framework to help ensure that the risk responses are effectively implemented
and monitored. Relevant information must be identified, captured, and reported
accurately to enable people to carry out their responsibilities. Risk management, like
many processes, should be iterative and subject to regular evaluations and revisions.
Results must be used to make appropriate adjustments, which leads to a constant
improvement in the risk management process.
At some point, risks must be consolidated and managed at the company level, bringing
together different risks into an overall risk exposure. Enterprise risk management
(ERM) helps a company manage all its risks together in an integrated way rather than
managing each risk separately. The advantage of this approach is that it aligns risk
management with objectives at all levels of the company, from the corporate level to
the business unit level to the project level.
3.3 Risk Management Functions

If you process transactions, recruit people, manage information technology (IT)
projects, or interact with clients, you are an integral component of your company’s
operations. Any failure to follow the appropriate policies and procedures may have a
negative effect on your company.
Risk management functions vary by company, but it is typical for companies in the
investment industry to have a stand-alone risk management function with a senior
head, often called the chief risk officer, who is capable of independent judgment and
action. The chief risk officer often reports directly to the board of directors. The
purpose of establishing a strong independent risk management function is to build
checks and balances to ensure that risks are seriously considered and balanced against
other objectives, such as profitability.
Despite the existence of specialist risk managers, risk management remains everyone’s
responsibility. Risk managers assess, monitor, and report on risks, and in some cases,
they may have an approval function or veto authority. But it is the members of the
business functions, such as portfolio managers or traders, who “own” the risk of their
deals. These employees have the most intimate knowledge of what they trade, and they
must monitor their deals on a regular basis. The risk manager must ensure that all
relevant risks are identified, but the final judgment on the business decision lies with
the decision makers. Therefore, it is important for risk management to be part of the
company’s corporate culture and to be fully integrated with core business activities.
Companies will often use a three-lines-of-defence risk management model, as illus-

trated in Exhibit 3 below.
Exhibit 3 Three Lines of Defence
Risk
ployees / Manager
Em s
e m ent and C
g om
ana pl
M ternal Audi
In t
ia
k
nc
Ris
Front-line employees and managers, through their daily responsibilities, form the first
line of defence. The risk management and compliance groups operate as a second
line of defence, assisting and advising employees and managers while maintaining a
certain level of independence. An internal audit function then forms the third line of
defence. Internal audit is an independent function. Internal auditors follow risk-based
internal audit programmes, delving into the details of business processes and ensuring
that information technology and accounting systems accurately reflect transactions.
Proactive auditors may also advise managers on how to improve risk management,
controls, and efficiency. Best practice suggests that internal auditors should report
directly to the audit committee of the board of directors to ensure their independence.
Thus, risk and audit committees of the board will often hear presentations from the
heads of risk management, compliance, and internal audit.
3.4 Benefits and Costs of Risk Management

Risk management provides a wide range of benefits to a company. It can help by
■■ supporting strategic and business planning;
■■ incorporating risk considerations in all business decisions to ensure that the

company’s risk profile is aligned with its risk tolerance;
■■ limiting the amount of risk a company takes, preventing excessive risk taking
and potential related losses, and lowering the likelihood of bankruptcy;
■■ bringing greater discipline to the company’s operations, which leads to more

effective business processes, better controls, and a more efficient allocation of
capital;
■■ recognising responsibility and accountability;
■■ improving performance assessment and making sure that the compensation sys-
tem is consistent with the company’s risk tolerance;
■■ enhancing the flow of information within the company, which results in better
communication, increased transparency, and improved awareness and under-
standing of risk; and
■■ assisting with the early detection of unlawful and fraudulent activities, thus
complementing compliance procedures and audit testing.
All of these benefits should enhance the company’s ability to create value.
The costs of establishing risk management systems include tangible costs, such as hiring
dedicated risk management personnel, putting in place procedures, and investing in
systems, and intangible costs, such as slower decision making and missed opportunities.
So, allocation of resources to risk management should be based on a cost–benefit

analysis. It is difficult to weigh the costs and benefits of risk management precisely
because it is impossible to observe, let alone measure, the cost of potential catastro-
phes that are averted. It is only in hindsight that the cost–benefit trade-offs can be
identified. A case in point is Barings Bank’s collapse in 1995, which was triggered by
trading losses hidden in the bank’s Singapore branch. At the time, there was no ade-
quate and effective system for reconciling client orders and trades on a global basis.
Such a system could have revealed the losses before they wiped out all of the bank’s
equity capital. It is estimated that implementing this system would have cost about
£10 million, a small price to pay compared with the £827 million loss that brought
down Barings.
4 OPERATIONAL RISK
As mentioned earlier, operational risk is the risk of losses from inadequate or failed
people, systems, and internal policies and procedures, as well as from external events
that are beyond the control of the company but that affect its operations.
4.1 Managing People

Human failures range from unintentional errors to fraudulent activities. Many compa-
nies are exposed to occupational fraud (sometimes called internal fraud or employee
fraud), which is when an employee abuses his or her position for personal gain by
Operational Risk 157
misappropriating the company’s assets or resources. In a survey carried out by the

Association for Certified Fraud Examiners (ACFE), anti-fraud experts estimated that
globally companies lose, on average, 5% of their annual revenues to fraud.2
One example of operational risk that has a human component and that is more fre-
quent in the financial services industry than in any other industry is rogue trading.
Rogue trading refers to situations wherein traders bypass management controls and
place unauthorised trades, at times causing large losses for the companies they work
for. Rogue trading may involve fraudulent trading that is done for personal enrich-
ment or to make up losses. Exhibit 4 lists a number of rogue trading incidents that
occurred in the past.
Exhibit 4 Historical Examples of Rogue Trading Incidents
Year of the
Loss Company Rogue Trader Estimated Loss
1995 Barings Bank Nick Leeson £827 million

1995 Daiwa Bank Toshihide Iguchi US$1.1 billion
1996 Sumitomo Corporation Yasuo Hamanaka ¥285 billion
2002 Allied Irish Banks John Rusnak US$691 million
2004 National Australia Bank Gianni Gray and AU$360 million
others
2004 China Aviation Oil Chen Jiulin US$550 million
2008 Société Générale Jérôme Kerviel €4.9 billion
2008 Groupe Caisse d’Epargne Boris Picano-Nacci €751 million
2011 UBS Kweku Adoboli $2.3 billion
Source: Thomas S. Coleman, A Practical Guide to Risk Management (Charlottesville, VA:

Research Foundation of CFA Institute, 2011):91–92.
Banks, like most companies, have tried to learn from past events and plug the holes
in their systems and controls to prevent similar events from occurring. The failure
of Barings Bank in 1995 revealed the danger of not segregating front and back office
activities properly. In the small bank branch of Barings in Singapore, the same indi-
viduals managed both types of activities. An initial trading loss (a front office activity)
because of a human error was hidden in the accounting system (a back office activity),
and subsequent losses accumulated until they exceeded the bank’s equity capital.
Following Barings’ collapse, banks were required to establish a clear separation between
their front and back offices.
Companies can mitigate operational risks through education, by clearly communicating

policies and procedures and by having efficient and effective internal controls. Good
human resource management processes are also critical; hiring the right people and
motivating them with the right incentives are well-known ingredients for success.
2 Information from http://www.acfe.com/press-release.aspx?id=4294973129.

To avoid the risk of recruiting the wrong people, companies typically take various
precautions, such as the following:
■■ Carrying out background checks, such as checking criminal records and disci-
plinary records with regulators for new hires
■■ Verifying credentials and previous work experience
■■ Performing personality assessment tests
■■ Getting character references to confirm suitability
Although these precautions may appear to be standard, studies have shown that dis-
crepancies between presented and actual credentials are common. Cases in which
background checks of senior executives were not appropriately performed are regularly
reported. Because of a loss of trust, some of these executives had to resign when the
truth was revealed, even if they had performed successfully in their position.
Risk taking should also be considered in the structure of compensation, for example
when defining bonus payments for employees. It is particularly important for employees
who expose the company to significant risks, such as traders and investment staff. A
good compensation system should take into account the level of risk undertaken for
a given level of return and should reward those who achieve returns without taking
excessive risks. An example of an incentive that could lead to perverse behaviour is
rewarding traders for profits regardless of the risks they take. This approach would
give them all the upside for trading gains, but less downside for taking on risks and
trading losses. In practice, traders generating substantial losses typically lose their
jobs and reputations, but they usually do not have to pay back much compared with
the compensation they previously received. Some authorities are now imposing new
compensation structures that include deferred compensation to take into account
long-term performance as well as claw-back provisions, whereby employees may have
to return their bonuses if reported profitable deals result in losses later.
4.2 Managing Systems

Companies rely heavily on information technology (IT) systems. Consequently, tech-
nology has become an increasingly important source of operational risk. Automated
processes can reduce the frequency and severity of operational errors, but they are
not infallible. Failures of IT and communication systems can paralyse business oper-
ations or greatly reduce their efficiency, harming the company’s profitability via lower
revenues, higher costs, or a combination of both.
IT networks are inherently vulnerable to disruptions and outside interference because

of technical limitations and human factors. One source of risk is the behaviour of
employees who do not follow internal policies and, for instance, download unautho-
rised applications for personal or business use. The dangers of this practice include
malicious viruses and unlicensed, and perhaps incompatible, software getting into
company systems. In addition, IT departments are in a constant battle with hackers
who exploit weaknesses to penetrate systems. Key controls to protect systems and
business information include the establishment and communication of internal policies
Operational Risk 159
for users and IT technical staff, the creation of appropriate security standards and
configurations for systems, and the allocation of adequate personnel and technical
resources to maintain a well-controlled IT environment.
The protection of confidential information is also important in the investment industry.

Data privacy has received a great deal of prominence recently because of a number
of cases in which companies and government agencies have allowed people’s private
information to enter the public domain, exposing them to the risk of fraud. A company
should understand how data are produced and flow internally, classify the information
by sensitivity, assess the risks of data loss, and adopt appropriate preventative mea-
sures. Many countries have strict laws and regulations for protecting customer data,
along with severe penalties for violating these laws and regulations.
4.3 Complying with Internal Policies and Procedures

The structure of a company varies with size and business activities engaged in, but
there are features common to all companies. For instance, power and authority are
delegated and responsibilities are assigned within most companies. In smaller entre-
preneurial companies, such assignments may be communicated informally, with
employees understanding their individual roles and degrees of authority. In larger
and more complex companies, the roles and levels of authority will be formally
defined and the business processes mapped out in more detail, usually embedded
in corporate management systems. Policies and procedures should explicitly set out
the delegation of authority and define clear responsibilities and accountability. These
definitions form the basis for the monitoring of and control over business processes
and provide feedback mechanisms.
The segregation of duties is an important principle that international companies

and regulators and other authorities in many countries require and recommend. As
mentioned earlier, a clear separation needs to exist between front and back offices. In
accounting departments, there should also be a clear separation between those who
enter items into the accounts and those who reconcile the bank statements with the
cash balances in the accounting system. This separation of roles reduces the risk that
employees who control cash will commit fraud or embezzle funds.
Compliance and internal audit functions are key to ensuring that employees are actually
following internal policies and procedures.
4.4 Managing the Environment

The type of environment in which a company operates can add layers of uncertainty
that need to be addressed.
4.4.1 Political Risk

Political risk is the risk that a change in the ruling political party of a country will lead
to changes in policies that can affect everything from monetary policy (money supply,
interest rates, and credit) and fiscal policy (taxation) to investment incentives, public
investments, and procurement. Some industries are heavily influenced by governments
that, for example, control natural resources or set prices of raw material inputs or
products. In these instances, a change in administration or policies can affect the

value of an investment. Political risk is inherent in all countries and should always be
considered, even if it is perceived to be relatively remote.
4.4.2 Legal Risk

Legal risk is the risk that an external party will sue the company for breach of contract
or other violations. A company should consider how it identifies and conforms to all
legal commitments it has undertaken.
The role of an in-house legal expert is crucial to controlling legal risk. Most areas of
a company have dealings with external parties, such as deal counterparties, business
partners, suppliers, and service providers. An important control in managing the
legal risk of these external relationships is to have legal experts review every contract.
Companies should clearly delegate authority and specify who should review and
approve which type of contracts. The most significant deals usually require approval
at the level of the board of directors. Another control is to use template agreements
and standard contract terms and conditions that have been reviewed and approved
by the legal team.
The storage of records, documents, and all forms of communication must also be in
line with legal requirements for all relevant jurisdictions, a topic that will be discussed
in the Investment Industry Documentation chapter.
4.4.3 Settlement Risk

Settlement risk (or counterparty risk) is the risk that when settling a transaction, a
company performs one side of the deal, such as transferring a security or money, but
the counterparty does not complete its side of the deal as agreed, often because it
has declared bankruptcy. This risk is sometimes also called Herstatt risk because of
an incident in 1974 when the German Herstatt Bank ceased operations after coun-
terparties had honoured their obligation to transfer Deutsche Marks to Herstatt, but
before Herstatt honoured its obligation to transfer the equivalent amount in US dollars
back to these counterparties.
Although there are usually legal means to compel a counterparty to perform its obli-
gations, such measures are costly and time-consuming. A counterparty is more likely
to find it difficult to fulfil its obligations during challenging economic times or when
bankruptcy is imminent than during profitable times. In the case of bankruptcy, it
may take months or years to receive assets through a bankruptcy resolution proce-
dure and the proceeds may only be a fraction of the original nominal amount of debt.
It is important to distinguish the risks inherent in bilateral arrangements from those

in transactions contracted through central counterparties, such as clearing houses. As
discussed in the Structure of the Investment Industry chapter, clearing houses may
step in to assume the risk of a counterparty failing to meet its contractual obligations.
Other arrangements to reduce this risk are margin requirements, discussed in the
Derivatives chapter, or standardised agreements.
Compliance Risk 161
COMPLIANCE RISK 5
Compliance risk is the risk that a company fails to comply with all applicable rules,
laws, and regulations. The risk of non-compliance with laws and regulations is higher
than non-compliance with internal policies and procedures because sanctions can
be applied. These sanctions can affect both individuals and companies and may be
severe. Ensuring compliance with rules and regulations has often been viewed as a
rather mundane chore, but the rapidly changing regulatory environment has recently
brought compliance to the forefront of business priorities. Many people believe that
the trend toward less regulation contributed to the global financial crisis that began
in 2008. The trend has reversed with the re-imposition of greater regulation and
oversight. This increased legislation, in turn, has led to more compliance activities
and more compliance risk.
5.1 Framework for Legal and Regulatory Compliance

Every company has to follow a set of rules, beginning with the statutory laws and
other regulations imposed by regulatory bodies. In addition, many investment firms
must follow guidelines from regulators, stock exchanges, and industry associations
that have been given powers to oversee members. Because of their importance in
the financial system, banks and insurance companies have historically been subject
to heavy regulation, with detailed rules and scrutiny from regulatory authorities. For
example, banks are subject to the Basel Accords. Accords are international agreements
that usually take the name of the location where they are signed. The Basel Accords,
which define international standards regarding banks’ capital, leverage, and liquidity
requirements, are discussed on a regular basis in Basel, Switzerland. As of May 2014,
the latest version of these accords is Basel III.
Complying with applicable laws and regulations is required of every company. The
consequences of not doing so can be severe and can include financial penalties, loss
of business licenses, lawsuits by clients, and in serious cases, prison terms. Often the
greatest consequences are the damage to the company’s reputation and the loss of
existing and potential business opportunities.
Companies should have internal reporting procedures to encourage employees to

come forward and report instances in which they suspect someone has violated inter-
nal policies, procedures, laws, or regulations. This process is called whistle-blowing.
Whistle-blowing has become an important way for authorities to learn of violations,
and provisions to protect and reward whistle-blowers have been strengthened in the
wake of financial scandals.
5.2 Example of Key Compliance Risks

Types of regulation and how to comply with them are outlined in the Regulation
chapter. Below are just a few examples of key compliance risks that have the potential
to inflict serious damage on investment firms and their employees.
5.2.1 Corruption
Corruption, which is defined as the abuse of power for private gain, has received height-
ened attention because of tightened laws and regulations on bribery and increased
regulatory scrutiny, investigations, prosecutions, and fines. Some national authorities
may apply these laws extra-territorially, even to foreign entities. Firms that operate
through agents and other third parties should be aware that their responsibility for
preventing corruption extends to the actions of these third parties. Ignoring the
practices of third parties does not constitute a defence in the event of a regulatory
investigation.
To safeguard against corruption, companies must start by establishing a tone at the

top, with senior management communicating an unambiguous policy of zero tolerance
for unethical business practices and bribery. Risk assessments should identify major
risk areas and susceptible employees. For instance, employees who deal with govern-
ment officials for licensing or deal with government or state-owned entities should be
given enhanced training and be monitored closely. Controls over corporate gifts and
hospitality, especially in payment-processing areas, are crucial for the prevention of
illegal or unethical payments.
5.2.2 Tax Reporting

Compliance with tax regulations is complicated because the principles and rules vary
considerably by jurisdiction. Companies are continuously developing financial and
legal structures, often with the intention of minimising taxes overall. Uncertainty
exists in how tax authorities will apply their rules, which is compounded by the fact
that rules change regularly. A conservative approach is to conform to tried-and-tested
precedents. A more aggressive approach is to seek to exploit loopholes in the tax code,
low-tax jurisdictions (so-called offshore tax havens), and other grey areas.
There is a technical difference between “tax avoidance”, which means using tax code
provisions to minimise the tax that is owed, and “tax evasion”, which means not
paying taxes in violation of the tax law. In practice, however, the line between tax
avoidance and tax evasion is not always clear and expert tax advice is necessary. From
a risk-management perspective, tax risk should be managed in a consistent manner,
incorporating the appropriate expertise at each stage of a transaction or financial
reporting cycle.
5.2.3 Insider Trading

There are laws that prohibit the trading of a security when in possession of important
confidential information pertaining to the security in question. Most markets have
recently tightened laws regulating insider trading. Another trend is an increase in inves-
tigations of insider trading; some such investigations are even relying on techniques
similar to those used in investigations of organised crime cases—including tapping
telephones, using evidence already collected to make peripheral suspects co-operate,
and gradually closing in to catch the central participants of the scheme. Companies
must implement policies and procedures to ensure that traders understand the laws
and that nobody in the company will be in the position to violate them. Investment
firms that face a high risk of insider trading, such as investment banks, have “control
rooms” to monitor information flowing between teams. They also have virtual walls
or information barriers to restrict and segregate information and to manage other
conflicts of interest.
Investment Risk 163
5.2.4 Anti-Money-Laundering
Anti-money-laundering legislation is a set of rules to prevent money derived from
criminal activities from entering the financial system and acquiring the appearance
of being from legitimate sources. These rules require companies in the financial ser-
vices industry, including those in the investment industry, to obtain sufficient original
or certified documentation to perform a formal risk assessment on each client and
counterparty; the procedures of such an assessment are called know-your-customer
procedures.
International agreements defining basic principles and requirements for anti-money-

laundering frameworks have been developed and are implemented with slight varia-
tions according to the jurisdiction. A notable feature of most anti-money-laundering
regulation is a strict liability approach to compliance. That is, a company can be sub-
ject to severe sanctions as a result of not following required procedures and record
keeping, regardless of whether any suspicious transactions are handled or any actual
damage is caused.
INVESTMENT RISK 6
Risk is a critical element of investment decisions. Investors, for instance, buy equity
securities, commodities, or real estate. When they do, they are exposed to investment
risk—that is, the risk associated with investing. For example, investors may face losses
if the company in which they bought common shares loses value or goes bankrupt or
if commodity or real estate prices fall.
Investment risk can take different forms depending on the company’s investments and
operations. Companies in the investment industry typically experience three broad
types of investment risk:
■■ Market risk, which is the risk caused by changes in market conditions affecting
prices.
■■ Credit risk, which is the risk for a lender that a borrower fails to honour a con-
tract and make timely payments of interest and principal.
■■ Liquidity risk, which is the risk that an asset or security cannot be bought or
sold quickly without a significant concession in price.
A common theme for success in all types of investment risk management is the need
to understand the risks and price them accurately.
6.1 Market Risk

Market risk, which arises from price movements in financial markets, can be classified
into the risks associated with the underlying market instruments: equity price risk,
interest rate risk (for debt securities), foreign exchange rate risk, and commodity
price risk.
Many investment firms are in the business of assuming investment risks, and they tend
to tolerate market risks. But like any other company, they must align their risk profiles
with their risk tolerance. They often implement an approach called risk budgeting to
determine how risk should be allocated among different business units, portfolios,
or individuals. For example, an asset management firm may use the following risk
budgeting steps:
■■ Quantify the amount of risk that can be taken by the firm
■■ Set risk budgets and limits for each asset class and/or investment manager
■■ Allocate assets in compliance with the risk budgets
■■ Monitor to ensure that risk budgets are respected
Market risks that cannot be tolerated must be mitigated, and companies have different
alternatives available. One of them is to hedge unwanted risks by using derivative
instruments. The Derivatives chapter and Economics of International Trade chapter
offer examples of how companies can hedge unwanted risks.
6.2 Credit Risk

When assessing the creditworthiness of borrowers, it is important to consider both
their ability and willingness to repay their debts. For example, after the fall in real
estate prices in 2008, many homeowners in the United States were left with mortgage
loan balances that exceeded the market value of the property. Some of those borrow-
ers still had the ability to keep paying their mortgage loans but decided to default
and let the bank take possession of the property. This potentially unethical decision
is rational from a purely financial perspective, apart from the worse credit profile for
future borrowing.
The expected loss from credit exposure is a function of three elements: the amount of
money lent to a particular borrower, the probability that the borrower defaults, and
the loss that would be incurred if the borrower defaults. The amount that is at risk
may be reduced if collateral or guarantees from third parties are included. Enforcing
contract provisions to take possession of collateral, however, can be a time-consuming
legal process. The value of collateral assets for a lender depends on their liquidity and
marketability—that is, how easy it is to sell the assets to a third party and at how much
of a discount if sold on short notice. Assets for which a steady market demand exists
and that can be moved and easily transferred are more valuable than assets that are
traded less frequently and are less mobile.
Various sources of independent information exist on borrower creditworthiness,

such as credit rating agencies, which should be used in conjunction with internal risk
analysis. Any analysis, whether internal or external, should involve a degree of critical
judgment and scepticism.
There are various approaches to managing credit risk, including the following:
■■ Set limits on the amount of exposure to a particular counterparty or level of

credit rating allowed. For example, a maximum limit of 5% exposure could be
set for a particular counterparty.
Value at Risk 165
■■ Require additional collateral and impose covenants. Covenants, discussed in the

Debt Securities chapter, are terms for loans that specify both what a borrower
must do (positive covenants) and what a borrower is not allowed to do (negative
covenants). For example, a bank may restrict borrowers from issuing more debt,
paying dividends, or entering into highly risky business ventures. When one of
the restrictive conditions is broken, the lender may recall the loan or demand
some action, such as the assignment of additional collateral.
■■ Transfer risk by using derivative instruments. Credit default swaps are often
used when companies want to protect themselves against the risk of a loss
in value of a debt security or index of debt securities, as discussed in the
Derivatives chapter.
Lending to governments or state-owned companies creates another type of credit risk.

Sovereign risk is the risk that a government will not repay its debt because it does
not have either the ability or the willingness to do so. The unique aspect of sovereign
risk is that lenders have limited legal remedies available to compel the borrower to
repay or to be able to recover the assets themselves. A government can also prevent
borrowers in its country from repaying their debts to foreign investors—for example,
by implementing currency controls to make it difficult or impossible for money to
leave the country.
6.3 Liquidity Risk

Liquidity refers to the ability to buy and sell quickly without incurring a loss. It is a
core concern for companies and is often neglected when sources of financing, such
as bank credit, are plentiful. But during the global financial crisis of 2008, an acute
shortage of liquidity in the financial systems in many countries led to failures. These
failures occurred because some companies were unable to maintain access to sufficient
money to finance their working capital (inventories and receivables from customers
net of payables from suppliers) and, therefore, to keep their companies going.
Firms in the investment industry face a greater level of liquidity risk than, say, man-
ufacturers. To operate profitably, they need markets that can accommodate their
trades without significant adverse effects on prices. When markets are illiquid—either
temporarily, such as during financial crises, or more structurally, such as in some
emerging markets—the ability to trade assets is substantially reduced, which has a
negative effect on these firms.
VALUE AT RISK 7
Companies in the financial services industry expect that the assets and securities they
hold will provide them with a positive return. However, they also need to estimate the
potential loss on an investment if their forecasts for the asset or security turn out to be
inaccurate. This potential loss is often measured using a metric known as value at risk.
7.1 Use and Advantages of Value at Risk

Value at risk (VaR) was developed in the late 1980s and is now a widely used metric. It
relies on some of the statistical concepts, such as standard deviation, discussed in the
Quantitative Concepts chapter. VaR gives an estimate of the minimum loss of value
that can be expected for a given period with a given level of probability. For example,
an asset management firm may estimate that a portfolio has a VaR of $1 million for one
day with a probability of 5%. This means that there is a 5% chance that the portfolio
will fall in value by at least $1 million in a single day, assuming no further trading.
Put another way, a loss of $1 million or more for this portfolio is expected to occur,
on average, once in 20 trading days (1/0.05).
VaR offers several advantages:
■■ It is a standard metric that can be applied across different investments, portfo-

lios, business units, companies, and markets.
■■ It is relatively easy to calculate and well understood by senior managers and

directors.
■■ It is a useful tool for risk budgeting if there is a central process for allocating
capital across business units according to risk.
■■ It is widely used and mandated for use by some regulators.
7.2 Weaknesses of VaR

There are also weaknesses inherent in the VaR measure of risk. VaR gives an estimate
of the minimum, but not the maximum, loss of value that can be expected. Referring
back to the earlier example, the asset management firm can expect a loss of at least
$1 million 12 or 13 times a year (5% of the approximately 250 trading days a year).
VaR does not indicate the maximum loss of value the portfolio manager can expect
to bear in one day, and it does not guarantee that a loss in excess of $1 million will
not happen more frequently than a dozen times a year.
In practice, VaR often underestimates the frequency and magnitude of losses, mainly
because of erroneous assumptions and models. First, VaR primarily relies on historical
data to forecast future expected losses. But past returns may not be a good predictor
of future returns. In addition, history is not helpful in forecasting events that have
far-reaching effects, but are unforeseen or considered impossible—that is, black swan
events. Second, VaR makes an assumption regarding the distribution of returns. For
example, it is often assumed that returns are normally distributed and follow the bell-
shaped distribution presented in Exhibit 8 in the Quantitative Concepts chapter. The
use of historical data and the assumption of a normal distribution may work relatively
well in normal market conditions but not during periods of market turmoil.
The global financial crisis of 2008 is a case in point. Until 2007, most banks had a low
daily VaR, which gave them a false sense of security. Once the crisis hit, the number
of days when trading losses exceeded the daily VaR and the amount of those losses
were substantially higher than predicted. Some banks reported that the frequency of
losses was 10 to 20 times higher than the VaR predictions, and some banks recorded
losses that significantly reduced their equity capital.
Summary 167
To address these weaknesses, companies—in particular, banks—often use comple-

mentary risk management techniques in addition to VaR. These complementary
techniques include scenario analysis and stress testing, which focus on the effect of
more extreme situations that would not be fully captured or evaluated with VaR. For
example, an asset management firm may perform a scenario analysis by identifying
different scenarios for the economy (strong growth, moderate growth, slow growth,
no growth, mild recession, and severe recession) and then determining how each
scenario would affect the value of a portfolio and the firm’s earnings and equity cap-
ital. The firm may also engage in stress testing by examining the effect of extreme
market conditions, such as a liquidity crisis, to make sure that it would be resilient
and would survive the crisis.
It is worth noting that the weaknesses related to VaR apply to all measures that rely on
models. The risk arising from the use of models is collectively known as model risk.
This risk is associated with inappropriate underlying assumptions, the unavailability
or inaccuracy of historical data, data errors, and misapplication of models.
SUMMARY
Although most companies in the investment industry have dedicated risk manage-
ment functions, it is important to remember that risk is not just the responsibility of
the risk management team—everyone is a risk manager. So, even if you are not a risk
management specialist, you should still seek to understand risk management process,
systems, and tools and participate in risk management activities in your organisation.
The points below recap what you have learned in this chapter about risk management:
■■ Risk is defined as the effect of uncertain future events on a company or on

the outcome that the company achieves. Types of risks are often categorised
according to the source of risk: operational risk, compliance risk, and invest-
ment risk. The latter category includes market risk, credit risk, and liquidity
risk.
■■ Risk management is an iterative process that helps companies reduce the

chances and effects of adverse events while enhancing the realisation of oppor-
tunities. This process includes five steps: setting objectives, detecting and
identifying events, assessing and prioritising risks, selecting a risk response, and
controlling and monitoring activities.
■■ Risk assessment involves the identification of undesirable events and the esti-
mation of their expected frequency and the expected severity of their conse-
quences. It is important for a company to build a risk matrix and select key risk
measures to prioritise risks and warn when risk levels are rising.
■■ Risk response strategies include exploiting risks that the company has expertise
dealing with and can benefit from as well as mitigating or eliminating risks that
the company has little or no expertise in dealing with. Risk response strategies
include tolerating, treating, transferring, or terminating risk.
■■ Companies often use a three-lines-of-defence risk management model, in which

employees and managers form the first line of defence, the risk management
and compliance groups operate as a second line of defence, and an internal
audit function forms the third line of defence.
■■ Allocation of resources to risk management should be based on a cost-benefit

analysis. Typical costs include tangible costs, such as hiring dedicated risk
management personnel, putting procedures in place and investing in systems,
and intangible costs, such as slower decision making and missed opportunities.
Overall, risk management should have a positive effect on a company’s ability to
achieve its strategic objectives and improve its operations, ultimately leading to
value creation.
■■ Operational risk is the risk of losses from inadequate or failed people, systems,
and internal policies and procedures, as well as from external events that are
beyond the control of the company but that affect its operations. The reduction
of operational risk requires companies to manage people to reduce human fail-
ures ranging from unintentional errors to fraudulent activities; manage systems,
particularly IT and communication systems, and ensure compliance with inter-
nal policies and procedures; and manage political, legal, and settlement risks.
■■ Compliance risk is the risk that a company fails to comply with all applicable
rules, laws, and regulations. The company may face sanctions and damage to
its reputation as a result of non-compliance. Examples of key compliance risks
that have the potential to inflict serious damage on investment firms and their
employees include corruption, inadequate tax reporting, insider trading, and
money laundering.
■■ Investment risks take different forms depending on the company’s investments

and operations. Investment firms typically experience: market risk, caused by
changes in market conditions affecting prices; credit risk, caused by borrow-
ers’ inability and/or unwillingness to make timely payments of interest and
principal; and liquidity risk, caused by difficulties in buying or selling assets or
securities quickly without a significant concession in price.
■■ Value at risk, which provides an estimate of the minimum loss of value that can
be expected for a given period of time with a given probability, is a widely-used
metric to measure risk. By relying on historical data and making assumptions
about the distribution of returns, VaR suffers from weaknesses that are typical
of all measures that rely on models.
1 The type of risk characterised by failed internal policies and procedures is clas-
sified as:
A operational.
B compliance.
C investment.
2 Which of the following situations best represents a compliance risk?
A Failure of an IT network paralyses business operations.
B A counterparty does not complete its side of a deal as agreed.
C An organisation fails to follow all applicable rules, laws, and regulations.
3 The final step in a risk management process most likely includes:
A controlling and monitoring activities.
B using a risk matrix to prioritise risks.
C hedging unwanted risk by using derivative instruments.
4 A risk matrix classifies risks according to:
A market, credit, and liquidity risk exposures.
B operational, compliance, and investment risk exposures.
C the expected level of frequency of the event and the expected severity of its
consequences.
5 The chief risk officer working at an investment management firm typically

reports directly to the:
A shareholders.
B board of directors.
C chief investment officer.
6 A company’s first line of defence to manage risk is its:
A internal auditors.
B employees and managers.
C risk and compliance officers.

7 A significant benefit of implementing a risk management process is most likely:
A the elimination of risk.
B less accountability.
C the more efficient allocation of capital.
8 An intangible cost of risk management is:
A hiring risk managers.
B putting compliance procedures in place.
C slowing down the decision-making process.
9 Rogue trading is best described as an example of:
A investment risk.
B operational risk.
C compliance risk.
10 Which of the following situations most likely increases an organisation’s compli-

ance risk?
A Using agents and third parties
B Separating the front and back offices
C Monitoring and controlling business processes
11 Credit risk is best described as the risk:
A caused by changes in market conditions affecting prices.
B of failing to receive timely payments of interest and principal from

borrowers.
C that an asset cannot be bought and sold quickly without a significant con-
cession in price.
12 Value at risk:
A often overestimates the frequency of losses.
B assumes that the distribution of returns is random.
C provides an estimate of the minimum loss of value that can be expected.

Answers 171
ANSWERS
1 A is correct. Operational risk refers to the risk of losses from inadequate or

failed people, systems, and internal policies and procedures, as well as from
external events that are beyond the control of the organisation but that affect
its operations. B is incorrect because compliance risk relates to the risk that an
organisation fails to follow all applicable rules, laws, and regulations and faces
sanctions as a result. C is incorrect because investment risk is the risk associ-
ated with investing that arises from the fluctuation in the value of investments.
2 C is correct. Compliance risk is the risk that an organisation fails to follow all
applicable rules, laws, and regulations and faces sanctions as a result. B is incor-
rect because the risk that a counterparty does not complete its side of a deal as
agreed describes settlement risk (also called counterparty risk). A is incorrect
because failure of an IT network that paralyses business operations is an exam-
ple of operational risk.
3 A is correct. A risk management process generally includes five steps: set

objectives, detect and identify events, assess and prioritise risks, select a risk
response, and control and monitor activities. Controlling and monitoring activ-
ities are typically the final step of a risk management process. C is incorrect
because hedging unwanted risks by using derivative instruments is a response,
which relates to the fourth step of a risk management process. B is incorrect
because using a risk matrix to prioritise risks is associated with the third step of
a risk management process, assess and prioritise risks.
4 C is correct. A risk matrix is used to assess and prioritise the risks an organ-
isation faces. It classifies risks according to the expected level of frequency of
the event (e.g., highly unlikely, unlikely, possible, likely, or highly likely) and the
expected severity of its consequences (e.g., negligible, slightly harmful, harmful,
extremely harmful, or catastrophic). A and B are incorrect because they are
not related to risk matrices. Market, credit, and liquidity risks refer to types
of investment risks. Operational, compliance, and investment risks are risk
classifications.
5 B is correct. It is typical for companies in the investment industry to have a

stand-alone risk management function with a chief risk officer who is capable of
independent judgment and action and who often reports directly to the board
of directors.
6 B is correct. Employees and managers, through their daily responsibilities, form

the first line of defence against risk. A is incorrect because internal auditors
form the third line of defence against risk. C is incorrect because risk and com-
pliance officers form the second line of defence against risk.
7 C is correct. One of the benefits of implementing a risk management process is

bringing greater discipline to the organisation’s operations, which leads to more
effective business processes, better controls, and the more efficient allocation
of capital. A is incorrect because implementing a risk management process can
serve to incorporate risk considerations in all business decisions to ensure that
the organisation’s risk profile is aligned with its risk tolerance, but it does not
lead to the elimination of risk. Some risks should be eliminated, but others may
be exploited—for example, the risks the organisation has expertise in dealing
with and can benefit from. B is incorrect because implementing a risk manage-
ment process leads to more rather than less accountability.
8 C is correct. The intangible costs of risk management are slower decision mak-
ing and missed opportunities. A and B are incorrect because hiring risk man-
agers and putting compliance procedures in place are tangible, not intangible,
costs of risk management.
9 B is correct. Rogue trading, which refers to situations in which traders bypass

management controls and place unauthorised trades that can cause large losses
for the companies they work for, is an example of operational risk. Operational
risk is the risk of losses from inadequate or failed people, systems, and internal
policies and procedures, as well as from external events that are beyond the
control of the company but affect its operations. A is incorrect because invest-
ment risk is the risk associated with investing that arises from the fluctuation in
the value of investments. C is incorrect because compliance risk relates to the
risk that an organisation fails to follow all applicable rules, laws, and regulations
and faces sanctions as a result.
10 A is correct. Using agents and third parties increases compliance risk. It is more
difficult to monitor and control these agents and third parties than internal
staff, but the company may still be responsible for the actions of these agents
and third parties. B and C are incorrect because separating the front and back
offices and monitoring and controlling business processes decrease compliance
risk.
11 B is correct. Credit risk is the risk for a lender that a borrower fails to honour
a contract and make timely payments of interest and principal. A is incor-
rect because the risk caused by changes in market conditions affecting prices
describes market risk. C is incorrect because the risk that an asset cannot be
bought and sold quickly without a significant concession in price describes
liquidity risk.
12 C is correct. Value at risk gives an estimate of the minimum, but not the
maximum, loss of value that can be expected for a given period of time with a
specified level of probability. A is incorrect because value at risk often underes-
timates, not overestimates, the frequency of losses. B is incorrect because value
at risk makes an assumption regarding the distribution of returns. For example,
it is often assumed that returns are normally distributed.
CHAPTER 19
PERFORMANCE EVALUATION
by Andrew Clare, PhD
LEARNING OUTCOMES
a Describe a performance evaluation process;
b Describe measures of return, including holding-period returns and time-

weighted rates of return;
c Compare use of arithmetic and geometric mean rates of returns in per-

formance evaluation;
d Describe measures of risk, including standard deviation and downside

deviation;
e Describe reward-to-risk ratios, including the Sharpe and Treynor ratios;
f Describe uses of benchmarks and explain the selection of a benchmark;
g Explain measures of relative performance, including tracking error and

the information ratio;
h Explain the concept of alpha;
i Explain uses of performance attribution.

Introduction 175
INTRODUCTION 1
Investors are interested in knowing how their investments have performed. For retail
investors, the performance of their investments may determine whether they will
enjoy a comfortable retirement, whether they will have enough money to send their
children to university, or whether they can afford their dream holiday. Likewise, the
pension plans, foundations, and other institutional investors want to monitor the
performance of their investments to ensure that the assets will be sufficient to meet
their needs. The performance of a fund and its fund manager is also important to an
investment management firm; after all, if the output of the car industry is cars, then
the output of the investment management industry is, arguably, investment returns.
For an investment management company, measuring and understanding fund manager
performance is vital to managing and improving the investment process.
But knowing the return achieved by an investment management company or fund

manager is only part of the process of performance evaluation. Investment management
is a competitive industry. Both investors and investment management companies will
want to know how fund managers have performed relative to familiar and relevant
financial market benchmarks (e.g., a stock index, such as the S&P 500 Index in the
United States or the Hang Seng Index in Hong Kong SAR) and relative to their peers.
In addition, interested parties will want to know how the fund manager achieved the
performance—for example, whether the performance was the result of skill or luck
or perhaps the result of excessive risk taking.
It is only through the robust evaluation of investment performance that investment

management companies and their investors can make informed decisions about their
investments. After reviewing a fund manager’s performance, investors can decide
whether they want to continue to invest with the manager or to move their funds to
another manager. Similarly, the investment management company can decide whether
the manager should be asked to manage additional funds, be supported with more
resources in an effort to improve the company’s performance, or be replaced.
The performance evaluation process includes four discrete but related components:
Measure absolute returns
Adjust returns for risk
Measure relative returns
Attribute performance
These four components are discussed in the following sections.

176 Chapter 19 ■ Performance Evaluation
2 MEASURE ABSOLUTE RETURNS
Absolute returns are the returns achieved over a certain time period. Absolute
returns do not consider the risk of the investment or the returns achieved by similar
investments.
2.1 Holding-Period Returns

The performance of a security, such as an equity (stock) or debt (bond) security, over
a specific time period—called the holding period—is referred to as the holding-period
return. The holding-period return measures the total gain or loss that an investor own-
ing a security achieves over the specified period compared with the investment at the
beginning of the period. The return over the holding period usually comes from two
sources: changes in the price (capital gain or loss) and income (dividends or interest).
The holding-period return from owning an ordinary or common share of a company

typically comes from a change in the price of the share between the beginning and
the end of the period, as well as from the dividends received over the period. The
change in the price of the shares over the period is the capital gain or loss portion
of the return. The dividends received over the period are the income portion of the
return. Similarly, the holding-period returns from owning bonds result from changes
in price (capital gain or loss) and receipt of interest (income).
Example 1 illustrates how holding-period returns are calculated. As always, you are
not responsible for calculations, but the presentation of formulae and calculations
may enhance your understanding.
EXAMPLE 1. HOLDING-PERIOD RETURNS
An investor buys one ordinary share in Company A on 1 January at a price of

£100. On 31 December, Company A pays a dividend per share of £5, and an
ordinary share of Company A is selling for £110 on that date.
In this case, the holding period is one year—from 1 January to 31 December.

The return achieved by the investor from the increase (appreciation) in the share
price over this period is calculated as follows:
Capital component of the holding-period return
110 − 100 10
= = = 0.10 = 10%
100 100
But the holding-period return should also include the dividend paid to the
investor. The return achieved by the investor from the income received on the
share is as follows:
5
Income component of the holding-period return = = 0=.05 5%
100
Measure Absolute Returns 177
The total holding-period return is the sum of the capital and income com-
ponents (i.e., 15%). Mathematically, this sum can be shown as
(110 − 100) + 5 10 + 5
Total holding-period return = = = 0.15 = 15%
100 100
Holding Period Return
£5
dividend
Return = £15
£10
capital gain
£100 £100 Original Investment = £100
1 January 31 December
Holding-period return = Return ÷ Original investment

= (10 + 5) ÷ 100
= .15
= 15%
The return to an investment fund or portfolio over the course of a given period is
typically made up of the capital gains or losses on all of the assets held over that
period plus any income earned on those assets over the same period. This income
may include dividend income from equity securities, interest income for portfolios of
debt securities, and rental income for portfolios of commercial real estate.
HOLDING-PERIOD RETURNS FOR A VARIETY OF PORTFOLIOS
We can see how capital and income components combine to produce returns by
looking at some representative investment portfolios. Exhibits 1A and 1B present
the holding-period returns and the split between the capital gains and losses
portion and the income portion for a range of investment portfolios in 2010.
Exhibit 1A shows the investment performance of four equity portfolios.

The global equity portfolio includes equity securities from around the globe;
the US and European equity portfolios include equity securities listed in the
United States and in Europe; the emerging market equity portfolio includes
equity securities listed in emerging markets, such as Brazil, Russia, India, and
China—widely known as the BRIC countries.
Exhibit 1A Capital Gains, Income, and Total Return for Equity

Portfolios, 2010
20
16
12
Return (%)
0
Global United States Europe Emerging Market
Capital Gain Income Total Return
Source: Based on data from the Centre for Asset Management Research, Cass Business
School, London.
Exhibit 1B presents the investment performance of three bond portfolios and

two commercial property portfolios. The European government bond portfolio
includes bonds issued by eurozone governments, such as France, Germany,
Greece, Italy, Ireland, and Spain; the European corporate bond portfolio includes
bonds issued by companies headquartered in the eurozone; the high-yield bond
portfolio includes bonds that are rated BB+ or below by Fitch and Standard &
Poor’s and Ba1 or below by Moody’s, the credit rating agencies discussed in the
Debt Securities chapter; the last two portfolios include US and UK commercial
property, respectively.
Exhibit 1B Capital Gains, Income, and Total Return for Bond and
Commercial Property Portfolios, 2010
20
15
10
Return (%)
–5 European European European US UK

Government Corporate High Yield Commercial Commercial
Capital Gain Income Total Return
School, London.
Exhibit 1A shows that the total holding-period return of all the equity port-
folios except the European equity portfolio was more than 12% and that the
capital gains portion was much larger than the income portion. The European
equity portfolio’s total holding-period return was approximately 4% and was
made up almost entirely of income return.
Exhibit 1B indicates that the total holding-period returns of the European

government bonds portfolio and the European corporate bonds portfolio were
positive. Each of these portfolios experienced a capital loss, but it was more
than offset by positive income returns. The high-yield bond portfolio and the
two commercial property portfolios had positive total holding-period returns.
Each experienced both a capital gain and a positive income return.
2.2 Cash Flows and Time-Weighted Rates of Return

In the holding-period return calculation in Example 1, the income (the dividend) was
received at the end of the holding period. This time of receipt, plus the fact that no
additional investments were made during the period, makes the calculation of the
return relatively easy. In practice, however, calculating a fund’s holding-period return
is more complex. In particular,
■■ funds may consist of hundreds of individual investments that pay income at

different times throughout the holding period.
■■ clients may make additional investments (cash inflows) in and withdrawals

(cash outflows) from a fund throughout the holding period.
In other words, there is a constant flow of cash into and out of most investment funds
and portfolios. Additional investments and withdrawals by clients will affect the cal-
culation of the performance of the fund. Example 2 illustrates this point.
EXAMPLE 2. EFFECT OF A DEPOSIT ON A FUND’S INVESTMENT

PERFORMANCE
Suppose that an investment fund has a value of $100 million on 1 January. By

31 December, the fund has grown in value to $110 million. The increase in the
value of this fund came from changes in the values of the securities held in the
portfolio and from income received and reinvested during the year. The total
holding-period return on the fund is 10%, calculated as follows:
 $110 million − $100 million 

Fund return =   = 0.10 = 10%
 $100 million 
But suppose that one of the fund’s clients deposited an additional $5 million
into the fund on 30 June. This deposit means that some of the change in the
fund’s value over the year was not from the performance of the securities or
from the income on these securities, but attributable to the receipt of additional
client money. In other words, a total holding-period return of 10% overstates
the fund’s investment performance.
Flows of money into and out of funds over time can be accounted for by dividing
the measurement period into shorter holding periods. A new holding period starts
each time a cash flow occurs—that is, each time money flows into or out of a fund. If
there is only one cash flow during the holding period, the measurement period will
be divided into two shorter holding periods. If there are two cash flows, there will be
three holding periods, and so on. In practice, client cash inflows and outflows may
occur on a daily basis, in which case an annual holding-period return is divided into
daily holding-period returns.
Example 3 illustrates how the total holding-period return is calculated when a cash flow
occurs during the holding period. There are two approaches used to combine returns.
The first approach is to calculate the arithmetic mean by adding the two six-month
returns. This approach, however, does not consider compounding; recall from the time
value of money discussion in the Quantitative Concepts chapter that compounding

is the process by which interest is reinvested to generate its own interest. The second
approach is to calculate the geometric mean, which does consider compounding and
is usually the preferred approach.
EXAMPLE 3. CALCULATION OF A FUND’S RETURN WHEN THERE IS A

DEPOSIT
Suppose that the fund in Example 2 had received one client cash inflow of
$5 million at the close of business on 30 June. No other cash inflows or outflows
occurred in the period; there was no additional cash from clients and there was
no cash from income on holdings of the fund. The holding period of one year
can be divided into two periods of six months. The holding-period return is
calculated as follows:
■■ First, calculate the six-month holding-period return for the period from 1
January to 30 June, before the additional deposit.
■■ Next, calculate the six-month holding-period return for the period from 1
July to 31 December, including the cash inflow of $5 million that increased
the value of the fund on 30 June.
■■ Finally, calculate the annual holding-period return by combining the two

six-month holding-period returns.
There is one final piece of information that is needed to calculate the return
over each of these two six-month periods: the value of the fund on 30 June
immediately before the inflow of $5 million. Assume that the fund’s value was
as follows (the 30 June value does not include the $5 million deposit):
Date Fund’s Value
1 January $100 million
30 June $98 million
31 December $110 million
The holding-period return over the first six months (1 January to 30 June) is
as follows:

Fund return =   = −0.020 = −2.0%
On 30 June, the fund has fallen in value to $98 million. But at this point,
the fund experiences the positive cash inflow of $5 million. This event means
that at the start of the second holding period on 1 July, the fund has a value of
$103 million ($98 million + $5 million). On 31 December, the fund has a value
of $110 million. Thus, the holding-period return for the second six months (1
July to 31 December) is as follows:

Fund return =   = 0.068 = 6.8%
The clients of the fund may want to know the return achieved by the fund
manager over the full calendar year rather than over each six-month period.
Using our current example, the fund return was –2.0% for the first six months
and 6.8% for the last six months. The fund’s arithmetic return for the year is
4.8% (= –2.0% + 6.8%). Alternatively, the fund’s compounded return for the year
is calculated as follows:
Fund return = [(1 – 2.0%) × (1 + 6.8%)] – 1 = 0.0466 = 4.66%
The fund manager achieved an annual holding-period return of 4.66%, which
is the return achieved by the fund manager on the funds under management
between 1 January and 31 December.
Returns calculated in the manner described in Example 3 are known as time-weighted

rates of returns. The time-weighted rate of return calculation divides the overall
measurement period (e.g., one year) into sub-periods representing one month, week,
or day of that year. The timing of each individual cash flow identifies the sub-periods
to use for calculating holding-period returns. Each sub-period has its own separate
rate of return. These sub-period returns are then used to calculate the return for the
whole period. By calculating holding-period returns in this manner, client cash inflows
and outflows do not distort the measurement and reporting of a fund’s investment
performance.
To compare the performance of one fund from one year with the next year or to
compare the performance of one fund with another fund requires that returns be
measured on a consistent basis over time and across fund managers. In 1999, a set of
voluntary investment performance standards—the Global Investment Performance
Standards (GIPS)—was proposed for this purpose. Investment management firms
around the globe have adopted GIPS, and organisations in more than 30 countries
sponsor and promote the Standards, which were created by and are administered by
CFA Institute. GIPS requires the use of the time-weighted rates of return method
because this measure is not distorted by cash inflows and outflows.
3 ADJUST RETURNS FOR RISK
Investors want to get as much return as possible for as little risk as possible. So, if two
investments have a holding-period return of 10% but the first investment has very
little risk whereas the second one is very risky, the first investment is better than the
second one on a risk-adjusted basis.
3.1 Standard Deviation

As discussed in the Risk Management chapter, risk can take different forms. The risk
we refer to in the rest of this chapter is investment risk. Recall from the Quantitative
Concepts chapter that investment risk is often measured using some measure of vari-
ability (or volatility) of returns, and a common measure of variability is the standard
Adjust Returns for Risk 183
deviation. The standard deviation of returns reflects the variability of returns around
the mean (or average) return; the higher the standard deviation of returns, the higher
the variability (or volatility) of returns and the higher the risk.
STANDARD DEVIATION OF RETURNS FOR A VARIETY OF PORTFOLIOS
Exhibits 2A and 2B show the standard deviation of the annual returns for
2006–2010 on the four equity, three bond, and two commercial property port-
folios introduced in Exhibits 1A and 1B.
Exhibit 2A Standard Deviation of Returns in Equity Portfolios
50
Standard Deviation (%)
40
30
20
10
0
School, London.
Exhibit 2B Standard Deviation of Returns in Bond and Commercial

Property Portfolios
10
Standard Deviation (%)

6
0
European European European US UK
School, London.
Exhibits 2A and 2B support the common perception that equities are riskier
than bonds. As shown in Exhibit 2A, the standard deviation of annual returns
for the equity portfolios exceeded 20%, reaching 41% for the emerging market
equity portfolio. In contrast, Exhibit 2B indicates that the standard deviation
of annual returns for the bond and commercial property portfolios are much
less than for the equity portfolios: less than 5% for the European government
and corporate bond portfolios and less than 10% for the high-yield bond and
the two commercial property portfolios.
There are at least two reasons why investors care about historical variability (the
standard deviation of past returns). First, past variability of returns might be indic-
ative of how variable returns may be in the future. But it is important to be aware
that volatility can change over time and that there is no guarantee that future returns
will behave like past returns. Second, the variability of returns may affect an inves-
tor’s objectives. Pension funds invest to generate the returns necessary to pay their
beneficiaries, insurance companies invest to generate returns to meet the claims on
their policies, and individuals invest because they usually have a future expenditure
in mind. Investing in a portfolio or fund whose returns vary significantly over time
could potentially disrupt investors’ plans. If returns are very negative one year, then
the investors’ commitments, such as paying pensions, may be harder to meet. Retail
investors may need to sell some of their investments because of unforeseen circum-
stances, such as a decline in dividend income.
3.2 Downside Deviation

Standard deviation is a convenient measure of the variability (or volatility) of returns
around the mean. Sometimes there is a positive deviation—that is, the return is greater
than the mean—and sometimes there is a negative deviation—that is, the return is
less than the mean. Which of these two types of deviation do you think investors
would be more concerned about? Well, psychologists and economists have discovered
that investors dislike losses more than they like equivalent gains. So, investors might
be reasonably happy about achieving an investment return of +10%, but extremely
unhappy about achieving a return of –10%. Because of this asymmetry in the way
investors view the dispersion around the average, some investment professionals use
a modified version of standard deviation known as downside deviation.
Downside deviation is calculated in almost exactly the same way as standard devia-
tion, but instead of using all the deviations from the mean—positive and negative—
downside deviation is calculated using only negative deviations. In other words, it is
a measure of return variability that focuses only on outcomes that are less than the
mean. Downside deviation may also be calculated by focussing on outcomes that are
less than a specified return target; this target does not have to be the mean.
Exhibit 3 shows the standard and downside deviations of returns associated with
investing in a diversified portfolio of UK equities and in a diversified portfolio of UK
government bonds.
Exhibit 3 Standard Deviation vs. Downside Deviation, 2001–2010
25
20
Deviation (%)
15
10
0
UK Equity UK Bond
Standard Deviation Downside Deviation
Source: Based on data from the Centre for Asset Management Research, Cass Business School,
London.
As we see, the downside deviations are lower than the standard deviations; this out-
come is expected because downside deviations only consider the negative deviations.
But both measures convey the same message: the risk of the bond portfolio is lower
than that of the equity portfolio.
3.3 Reward-to-Risk Ratios

Investors prefer to achieve a high return rather than a low return on their invest-
ment portfolios. So all things being equal, they also prefer lower risk (less variability
of returns) to higher risk (more variability of returns). In other words, investors are
interested in maximising the return on their investments while simultaneously trying
to minimise the risks. That is, they prefer investments that have a high return per unit
of risk—investments with a high reward-to-risk ratio.
A reward-to-risk ratio is a metric that takes the following basic form:

Measure of portfolio return
Reward-to-risk ratio =
Measure of portfolio risk
The higher the value of the reward-to-risk ratio, the better the risk-adjusted return—
that is, the higher the return per unit of risk.
A commonly used reward-to-risk ratio is the Sharpe ratio, so-called because it was
first suggested by Nobel Prize–winning economist William Sharpe.1 The portfolio
reward is measured as the portfolio’s excess return, which is equal to the difference
between the portfolio’s holding-period return and the return on a “risk-free” investment.
Risk-free investment is usually approximated by the return achieved from investing in
short-term government bonds because in most countries government bonds are the
investments that carry the lowest level of risk. The chosen measure of portfolio risk
is the standard deviation of the portfolio returns, a measure of the portfolio’s total
risk. So the Sharpe ratio is calculated as follows:
Sharpe ratio
Return on portfolio − Risk-free return Excess return on portfolio
= =
Standard deviation of portfolio returns Standard deviation of portfolio returns
Another commonly used reward-to-risk ratio is the Treynor ratio, suggested by Jack
Treynor.2 The measure of portfolio reward is the same as that used in the Sharpe ratio
but the measure of portfolio risk is different. The chosen measure of portfolio risk is
beta of the portfolio, a measure of the portfolio’s systematic risk (also called market
or non-diversifiable risk). Systematic risk is discussed in the Investment Management
chapter. The Treynor ratio is calculated as follows:
Treynor ratio
Return on portfolio − Risk-free return Excess return on portfolio
= =
Beta of portfolio returns Beta of portfolio returns
Example 4 illustrates the calculation of the Sharpe and Treynor ratios.
1 William F. Sharpe, “Mutual Fund Performance,” in Part 2: Supplement on Security Prices, Journal of
Business, vol. 39, no. 1 (January 1966):119–138.
2 Jack L. Treynor, “How to Rate Management of Investment Funds,” Harvard Business Review, vol. 43, no.
1 (January–February 1965):63–75.
EXAMPLE 4. CALCULATION OF SHARPE AND TREYNOR RATIOS
Suppose that over a year, the holding-period return on an investment fund was
10% and the return achievable from investing in government bonds (“risk-free”
investments) was 4%. Also assume that the standard deviation and beta of the
investment fund’s returns over this period were 5% and 1.8, respectively.
The Sharpe ratio for this fund is

10% − 4%
Sharpe ratio = = 1.2
5%
The Treynor ratio for this fund is
10% − 4%
Treynor ratio = = 3.33
1.8
Each of these ratios can be compared with the same ratios for similar funds or port-
folios to evaluate the fund’s or portfolio’s performance. As stated earlier, the higher
the value of the reward-to-risk ratio, the better the risk-adjusted return—that is, the
higher the return per unit of risk.
SHARPE RATIO FOR A VARIETY OF PORTFOLIOS
Exhibits 4A and 4B present the Sharpe ratios for the four equity, three bond, and
two commodity property portfolios we examined in Exhibits 1A, 1B, 2A, and 2B.
Exhibit 4A Sharpe Ratios for Equity Portfolios, 2006–2010
0.5
0.4
Sharpe Ratio
0.3
0.2
0.1
0
School, London.
Exhibit 4B Sharpe Ratios for Bond and Commercial Property

Portfolios, 2006–2010
0.2
–0.2
Sharpe Ratio
–0.4
–0.6
–0.8
–1.0
European European European US UK
School, London.
Exhibit 4A shows that the Sharpe ratios of all the equity portfolios were
positive, ranging from 0.10 to 0.40. The emerging market equity portfolio had
the highest Sharpe ratio. Put another way, this portfolio provided the highest
amount of reward for the risk incurred. Exhibit 4B shows that the bond portfo-
lios also had positive Sharpe ratios, although lower than the equity funds. But
the commercial property portfolios had negative Sharpe ratios, indicating that
these funds generated lower returns than the government bond portfolios during
2006–2010. That is, they provided a negative reward for the risk taken. But you
should not conclude that commercial property portfolios are necessarily poor
investments. The 2006–2009 period was not typical given that it was marked by
a global financial crisis that saw a significant drop in property prices.
The Sharpe ratio, along with other reward-to-risk ratios, is an important metric for
understanding the quality of the returns produced by a portfolio. A portfolio with
high returns but with high risk might be said to have produced lower-quality returns
than a portfolio with similarly high returns but with much lower risk. So, in a sense,
reward-to-risk ratios, such as the Sharpe ratio, are one of the main quality control
checks that investors need to apply to their investments. Such ratios are also helpful
for comparing investments.
Measure Relative Returns 189
MEASURE RELATIVE RETURNS 4

By measuring relative returns—that is, returns relative to a suitable benchmark—inves-
tors can determine whether they could have made more money in other investments.
Measuring relative returns allows them to assess their opportunity cost and determine
whether their investments are generating appropriate returns.
4.1 Benchmarks and the Calculation of Relative Returns

The calculation of a reward-to-risk ratio, such as the Sharpe ratio, allows investors to
compare the performance of one investment fund with another. Many investors also
want to compare the performance of their fund or portfolio with that of a financial
market benchmark, such as a stock index. It is common practice in all industries,
and indeed in many areas of life, to benchmark or compare performance. Olympic
sprinters, for instance, may compare themselves against a time benchmark or against a
close competitor. Beating the time benchmark or beating the competitor allows them
to judge how they are performing.
Benchmarks can be used to assess the quality and/or quantity of a company’s per-
formance by comparing its performance with that of its peers and competitors; you
have already seen an application of this use of comparison in the Financial Statements
chapter with ratio analysis.
4.1.1 Benchmarks
Fund managers may not only use a benchmark for assessment, but some, such as index
fund managers, may also manage their portfolios to a benchmark.3 This means that
managers must regularly compare the composition and performance of their portfolios
with the composition of a financial market index, such as the FTSE 100 Index or the
S&P 500. For investors, knowing the financial market index that a fund manager uses
as a benchmark will give them some idea of the return and risk that they can expect
from investing in that fund.
Before engaging a fund manager, institutional investors will often specify the finan-
cial market benchmark that they intend to use to assess the performance of the fund
manager. For example, a US equity fund manager may be asked, or mandated, to
manage a portfolio of US equities for a client and told that they will be “benchmarked
against” the S&P 500. A fund manager may simply be a passive index fund manager
using S&P 500 as the reference index. Alternatively, a manager might be given a spe-
cific mandate reflecting specific risk requirements, return targets, or style or sector
preferences, such as investing in biotech companies. In this case, simply holding the
500 US stocks that make up the S&P 500 in their appropriate proportions will not
produce the performance demanded (and paid for) by clients. To beat this benchmark,
the manager will have to be an active manager and to use analytical and trading skills
and deliver high levels of client service to satisfy the mandate.
3 Index funds are described in the Investment Vehicles chapter.

To help clients meet their objectives, a benchmark should meet certain criteria:
■■ Investability. The benchmark should be composed of assets that can be bought

and sold by the fund manager. For passive fund managers, it would be difficult
to mimic the benchmark if it contained assets that they could not buy. For
active fund managers, not being able to invest in some of the benchmark’s com-
ponents could limit their ability to outperform it.
■■ Compatibility. The benchmark should have an appropriate composition and

level of risk for the investor. In other words, it should match the investor’s
objectives. For example, investors may not want to invest in assets that carry
credit or default risk and so they may be willing to accept a relatively low return
on their assets. In this case, a financial market index of government bonds
might be compatible (based on historical performance) with investor pref-
erences. A benchmark composed of emerging market equities would not be
compatible.
■■ Clarity. The rules governing the construction of the benchmark should be clear.
This clarity should extend to the weighting of individual benchmark constitu-
ents, to the method used to calculate benchmark returns, and to the process
used to add and remove constituents to and from the benchmark over time.
■■ Pre-specification. The benchmark should be specified before an investment is

made so that the manager is clear about the client’s objectives and expectations
and so the manager can construct a portfolio accordingly.
4.1.2 Indices
A number of organisations produce financial market indices that allow investors to
compare the holding-period return achieved by their fund manager with that generated
by the wider market. For most equity exchanges around the world, there is at least
one index that represents the majority of its stocks. In addition to these broad indices,
stock indices that measure performance of industrial sectors are also available, both
within a particular country and globally. These indices make it possible, for instance,
for investors to compare the performance of a portfolio of global information tech-
nology (IT) stocks with the performance of a portfolio of Indian IT stocks, as long as
the indices have been constructed using the same methodology.
A number of bond indices exist too. Many leading investment banks, such as Barclays
Capital and Goldman Sachs, produce bond indices for different types of issuers located
in developed or emerging countries. Independent index providers also provide a wide
range of bond indices. In addition to aggregate bond indices that are designed to cover
the market as a whole, many index providers offer bond indices classified by maturity,
credit rating, currency, and industrial category. Many index providers, such as FTSE
International, Standard & Poor’s, and Morgan Stanley Capital International, produce
indices for nearly every asset class, including cash, currencies, commercial property,
hedge funds, private equity, and commodities, as well as for bonds and equities.
4.1.3 Relative Returns

The wide range of financial market indices available allows investors to set performance
targets (passive or active) for their fund managers and enables them to compare the
performance of their fund manager over time against an independent benchmark. In
short, a benchmark index allows investors to evaluate relative returns.
Despite the widespread availability of independently constructed financial market

indices covering nearly every conceivable sector and aspect of the world’s financial
markets, some investors prefer to compare their fund managers not with broad bench-
marks constructed by index providers but instead with the fund manager’s peers. For
example, investors may compare the performance of one manager of European equities
with that of other managers of European equities. Each manager is assigned a perfor-
mance ranking within his or her particular sector of the financial markets. Managers
who are in the top 10% of performers among their peers over a specific period are said
to be top-decile performers. The performances of individual fund managers may be
collected and then ranked by independent organisations, such as Morningstar, which
then publishes the data, allowing investors to see the rankings of their particular fund
managers relative to those of other managers that they could have chosen.
4.2 Tracking Error and Information Ratio

The tracking error of an investment fund reflects how the performance of the invest-
ment fund deviates from the performance of its benchmark. The tracking error is
measured by taking the standard deviation of the differences between the returns on
the fund and the returns on its benchmark. The bigger these differences, the larger the
tracking error. A passive fund manager may be expected to have a very low tracking
error because the manager is seeking to replicate a benchmark. But for an active fund
manager, the tracking error will be higher.
Tracking error can also be used to formulate another widely used reward-to-risk
ratio known as the information ratio. The “reward” part of the information ratio is the
difference between the holding-period return on the portfolio and the return on an
appropriate benchmark over the same period; the “risk” part of the information ratio
is based on the tracking error of the fund—that is, its deviation from the performance
of the benchmark. It is calculated as follows:
Difference in average return between portfolio and benchmarrk
Information ratio =
Fund tracking error
Example 5 uses the annual holding-period returns on the UK equity portfolio as seen
in Exhibit 3 to illustrate the calculations of the tracking error and the information ratio.
EXAMPLE 5. TRACKING ERROR AND INFORMATION RATIO
The annual holding-period returns associated with investing in a diversified

portfolio of UK equities and in the FTSE All-Share Index are shown in Exhibit 5.
The last column shows the difference in the annual return achieved by the equity
portfolio relative to its benchmark.
Exhibit 5 Calculating Tracking Error
UK Equity Portfolio FTSE All-Share Index

Year Total Return Total Return Difference
2001 5.00% 5.05% –0.05%

2002 –15.00 –15.30 0.30
2003 –28.00 –28.56 0.56
2004 32.00 32.96 –0.96
2005 15.00 15.45 –0.45
2006 24.00 26.40 –2.40
2007 13.00 14.30 –1.30
2008 –3.00 –3.02 0.02
2009 –29.00 –29.15 0.15
2010 36.00 36.36 –0.36
Mean 5.00% 5.45%
Difference in Average –0.45%
Return
Tracking Error 0.84%
School, London.
The average of the differences in returns is –0.45% per year; in other words, on
average, the equity portfolio underperformed the benchmark by 0.45% each
year over the 10-year period.
The standard deviation of these differences is 0.84%. The formula used to

calculate standard deviation was presented in the Quantitative Concepts chap-
ter, but you are not required to perform this calculation. This 0.84% represents
the tracking error.
The information ratio is, therefore,

−0.45%
Information ratio = = –0.53
0.84%
The information ratio is negative because the fund underperformed its benchmark
over the period. If the information ratio had outperformed the benchmark, it
would have been positive.
4.3 Skill vs. Luck

If a roomful of people each randomly buy 10 stocks and hold them for five years, some
of those people may see the value of their investments rise. Does it follow that they
are skilful investors? At the same time, other people in the room may see the value
of their investments fall. Does that mean that they are poor investors? The answer
to both questions is no. The stocks were chosen randomly, so the performance was
simply attributable to luck. But even when stocks are not chosen randomly, luck can
play a big part in investment returns, so investors need a way to distinguish between
skill and luck.
The calculation and analysis of reward-to-risk ratios allow an understanding of the

price fund investors have to pay in terms of units of reward for each unit of risk—the
total return—generated by the fund’s manager. All things being equal, a manager who
produces a consistently high reward-to-risk ratio could be said to be more skilful
than one who consistently produces a lower ratio. Investors who invest in a fund that
is managed on an active rather than on a passive basis are effectively paying for the
manager’s investment skill and expertise.
Fund manager skill is often referred to as alpha. Perhaps the best way to explain the
concept of alpha is to consider the sources of a fund’s return, which is composed of
three elements:
■■ market return
■■ luck
■■ skill
4.3.1 Market return

Managers of passive investment funds aim to produce returns for investors. These
managers, however, are not looking to add value to the portfolios by picking securi-
ties that they believe will outperform other securities. Instead, they typically buy and
hold in the appropriate proportions those securities that comprise their benchmark.
Although this process requires some skill, it is not so much investment skill as effi-
cient administration. When the passive benchmark rises, the value of the passive fund
tracking it should also rise; conversely, when the benchmark falls, the value of the
passive fund should also fall. Therefore, over time, the fund should produce a return
similar to that of the chosen benchmark minus fees.
Given that most active fund managers benchmark their funds against financial market
indices, such as the S&P 500, some of the return generated by an actively managed
fund will come from market movements over which the active fund manager has no
control. Arguably then, investors in actively managed funds should not pay higher active
fees for fund returns that are generated by the market rather than by the investment
acumen of their fund manager because they can access market returns more cheaply
by investing in passively managed funds.
4.3.2 Luck
Some of the return generated by an investment fund is the result of luck rather than
judgement. The prices of financial assets held in portfolios are affected by events that
cannot be foreseen by a fund manager.
Skilful fund managers may be unlucky on occasion and unskilled fund managers might
enjoy some good luck. Because luck tends to even out over the long term, it is vital that
investors are able to distinguish luck from skill. However, it is not always easy to do so.
4.3.3 Skill
A skilful fund manager is able to add value to a portfolio over and above changes to
the portfolio’s value that are driven by market movements and that could have been
produced by a passive fund manager.
Because luck will tend to even out over time, a skilful manager is one who adds this
value consistently over time, year after year. This outperformance over the returns
from a relevant market benchmark is generally referred to as alpha.
4.3.4 Distinguishing Between Sources of Return

Performance evaluators try to distinguish between these three sources of fund man-
ager return. To do so, factor models are used to determine the factors that make up
returns and the importance of each factor. One such model is the capital asset pricing
model (CAPM),4 from which the term alpha comes. This model includes a measure
of systematic risk: beta. Systematic risk (also called market or non-diversifiable risk)
is the risk that affects all risky investments and cannot be diversified away. Factor
models, such as the CAPM, separate a fund’s performance into return from market
performance (beta), from luck or randomness, or from the investment skills of the
fund manager (alpha).
Most active managers benchmark their performance against an independently cal-

culated financial market index. Just as standard deviation is a standardised measure
of the deviation of a fund’s return relative to its average return, tracking error is a
standardised measure of the difference in the performance of the manager’s fund
relative to the benchmark. And just as the standard deviation of an investment fund’s
return can be used to produce the Sharpe ratio (a reward-to-risk ratio), the tracking
error of an investment fund’s return can be used to calculate another reward-to-risk
ratio known as the information ratio. Both measures are widely used and referred to
in the fund management industry. Finally, alpha is calculated by using factor models
in an effort to identify the return from a fund manager’s skill.
5 ATTRIBUTE PERFORMANCE
Benchmarks form the basis of performance measurement, which is an important

part of performance evaluation. By comparing the performance of a UK equity fund
manager with the performance of an appropriate UK equity index, the fund manager’s
clients can get an idea of how well the fund manager is performing relative to the
market in general, both in terms of average return and in terms of risk, by calculating
the fund’s tracking error or information ratio.
4 William F. Sharpe, “Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk,”
Journal of Finance, vol. 19, no. 3 (September 1964):425−442.
Attribute Performance 195
Benchmarks can also be used to explore the reasons for the fund manager’s perfor-
mance. By using appropriate financial market indices, the fund manager’s performance
can be decomposed to reveal the sources of returns. Depending on the nature of the
fund, the performance itself might come from the following sources:
■■ asset allocation
■■ sector selection
■■ stock selection
■■ currency exposure
Knowing how a fund manager’s performance is derived is useful information both for
the clients of the fund and for the investment management company. For example,
if a fund manager is skilled at stock selection but less proficient at sector selection,
another fund manager may be asked to give advice on the sector selection aspect of the
portfolio, allowing the first fund manager to concentrate on stock selection. Knowing
the strengths of fund managers can also help investors choose an investment fund.
Determining how much of performance is the result of the selection of asset classes,
sectors, individual securities, and currencies is known as performance attribution.
Example 6 provides an illustration of performance attribution.
EXAMPLE 6. PERFORMANCE ATTRIBUTION
Consider a fund manager who manages a portfolio that has a value of £100 mil-
lion on 1 January, the start of an annual evaluation period. The benchmark for
this fund comprises three equity market indices:
■■ the FTSE 100 (United Kingdom),
■■ the S&P 500 (United States), and
■■ the Nikkei 225 (Japan).
The mandate specifies that the benchmark will be 60% of the performance
of the FTSE 100, 30% of the S&P 500, and 10% of the Nikkei 225. We can show
this as
Benchmark composition = (60% × FTSE 100) + (30% × S&P 500)

+ (10% × Nikkei 225)
The fund manager is expected to outperform the benchmark by 1% per year.
Over the course of the year, assume the three financial indices produce the
returns shown in Exhibit 6. For simplicity, the full-year return is equal to the sum
of the returns for the two six-month periods—that is, we ignore compounding.
Exhibit 6 Index and Benchmark Performance over One Year
Return
1 January to 1 July to 1 January to
Index Weight 30 June 31 December 31 December
FTSE 100 60% 6.0% 10.0% 16.0%

S&P 500 30 5.0 8.0 13.0
Nikkei 225 10 15.0 –10.0 5.0
Benchmark 100% 6.6% 7.4% 14.0%
Source: Andrew Clare and Chris Wagstaff, The Trustee Guide to Investment (London:
Palgrave Macmillan, 2011).
Over the full year, the benchmark generated a return of 14%, composed of
6.6% in the first half of the year and 7.4% in the second half. Although the returns
are positive, the components of the benchmark were actually quite volatile over
these two periods. In particular, the Japanese index was up 15% over the first
half of the year, but down 10% over the second half.
Assume that over the full year, the fund manager achieved a return of 15%.
The manager thus satisfied the mandate—the return on the fund (15%) is 1%
higher than the benchmark’s return (14%). But where did the performance
come from? To understand this question, an investor needs more information
about the fund manager’s decisions. In particular, an investor needs to know the
proportions of the funds that the manager allocated to UK, US, and Japanese
equities over the course of the year.
Exhibit 7 shows the fund manager’s allocation to the three markets.
Exhibit 7 Fund Manager Asset Allocation Decisions
Fund Allocations
1 January to 1 July to
Markets 30 June 31 December
UK equities 60% 50%

US equities 30 20
Japanese equities 10 30
Total 100% 100%
Source: Andrew Clare and Chris Wagstaff, The Trustee Guide to Investment (London:
Palgrave Macmillan, 2011).
Exhibit 7 shows that the fund manager reduced the proportion of both UK
and US equities by 10 percentage points each before the second half of the year
and increased the holding of Japanese equities by 20 percentage points.
Attribute Performance 197
It is possible to calculate the returns that the fund manager would have
achieved based on the fund’s allocations to the three markets and the returns
achieved by the indices. In the first half of the year, the fund would have achieved
the following return:
Return from 1 January to 30 June
= (60% × FTSE 100) + (30% × S&P 500) + (10% × Nikkei 225)

= (60% × 6%) + (30% × 5%) + (10% × 15%)
= 6.60%
In the second half of the year, the fund would have achieved the following
return:
Return from 1 July to 31 December
= (50% × FTSE 100) + (20% × S&P 500) + (30% × Nikkei 225)

= (50% × 10%) + (20% × 8%) + (30% × –10%)
= 3.60%
This analysis suggests a return of approximately 10.2% for the full year.
However, the fund manager actually achieved a return of 15%, which means that
4.8% (15.0% – 10.2%) of the return came from a source other than broad asset
allocation decisions. In fact, had the manager held the equity funds passively,
in line with the benchmark proportions, the manager would have achieved a
return of 14% over the year—that is, the return for the full year reported in
Exhibit 6. This result means that the fund manager’s asset allocation decisions
cost the fund 3.8% (14% – 10.2%).
So, the fund manager outperformed the benchmark by 1% even though the
asset allocation decision lost 3.8%. This result means that the manager added
4.8% to the portfolio from a source other than asset allocation. It is possible that
this portion of the return may have been from stock selection or from currency
exposure, which is the change in the relative value of the currencies involved
(the pound, dollar, and yen).
Using the type of techniques outlined here, it would be possible to further

explore the fund manager’s performance to understand whether this manager
chose good US, Japanese, and UK stocks or good stocks in all of these markets.
This attribution analysis is summarised in Exhibit 8.
Exhibit 8 Manager’s Performance Attribution Breakdown
16
14 15.0
14.0 14.0
12
10
10.2
Return (%)
8
4 4.8
2
0.0
0
Total Asset Allocation Stock Selection
Portfolio Benchmark
In Example 6, it was assumed that the return that did not come from the manager’s
asset allocation decision was instead attributable to stock selection or to changes in
currency exchange rates. With more detailed attribution analysis, an investor could
reveal how much of the performance was from exchange rate movements, how much
of the performance in the Japanese fund was from sector selection, and so on.
Modern performance attribution software can allow investment management compa-

nies to drill down into the detail of a fund to reveal all of this performance information.
By doing so, the company may conclude that a particular fund manager is very good
at stock selection but weaker in sector selection. Given this information, the company
might ask another manager with better sector selection skills to make sector-related
decisions, allowing the first manager to continue to add value through picking stocks.
SUMMARY
■■ Performance evaluation is a crucial process for individual and institutional

investors, investment management companies, and fund managers. It includes
a number of separate but related steps: measuring absolute returns, adjusting
returns for risk, measuring relative returns, and attributing performance.
■■ Absolute returns include two components: a capital gain or loss component and
an income component.
Summary 199
■■ Returns need to be measured by taking into account the cash flows into and out
of a fund over time.
■■ Fund or portfolio returns should be calculated using the time-weighted rate of

return method. Time-weighted rates of return are not distorted by cash flows,
so they reflect the true performance of the fund or portfolio.
■■ Standard deviation is a commonly used measure of investment return risk.
■■ Downside deviation is similar to standard deviation, except that it only includes

negative deviations, which are outcomes less than the mean or a specified
return target.
■■ The Sharpe and Treynor ratios are important reward-to-risk ratios that com-
pare a portfolio’s excess return with a measure of portfolio risk. Each reflects
the return achieved per unit of risk taken.
■■ Relative returns allow for the comparison of a fund’s return with the return of
an appropriate benchmark.
■■ The use of a benchmark allows for the calculation of additional measures of

risk, such as tracking error and the information ratio, and also a measure of
fund manager skill, known as alpha.
■■ The use of financial market indices allows for the identification of how much
of a fund’s return is attributable to the fund manager’s choice of asset classes,
sectors, or individual securities or currencies.
1 The first step of performance evaluation is:
A attributing performance.
B measuring relative returns.
C measuring absolute returns.
2 The Sharpe ratio is used in the performance evaluation process to:
A adjust return for risk.
B attribute performance.
C measure absolute returns.
3 The measurement of relative returns involves comparing the fund manager’s

holding-period return with:
A a measure of risk.
B the return on a benchmark.
C the fund manager’s past performance.
4 The measure that best reflects the variability of returns around the mean return
is the:
A standard deviation.
B reward-to-risk ratio.
C downside deviation.
5 The measure that is best suited for investors who dislike losses more than they
like equivalent gains is the:
A Sharpe ratio.
B standard deviation.
C downside deviation.
6 Standard deviation is a measure of the variability of a fund’s return:
A relative to its average return.
B relative to a benchmark return.
C below its average return.

7 The Sharpe ratio is a measure of:
A historical volatility.
B downside deviation.
C risk-adjusted performance.
8 The Sharpe ratio is a measure of the excess return on a portfolio compared with
the:
A beta of portfolio returns.
B portfolio’s tracking error.
C standard deviation of portfolio returns.
9 The criterion that a benchmark should be made up of assets that can be bought
or sold by the fund manager is known as:
A investability.
B compatibility.
C pre-specification.
10 A fund manager who uses analytical and trading skills to try to beat a bench-
mark is best described as a(n):
A active manager.
B index replicator.
C passive manager.
11 Tracking error for a passive investment fund is most likely:
A lower than the tracking error for an active investment fund.
B equal to the tracking error for an active investment fund.
C higher than tracking error for an active investment fund.
12 The consistent outperformance of an investment fund compared with its bench-

mark is best described as:
A beta.
B alpha.
C tracking error.
13 Beta measures the portion of the investment fund’s return attributable to:
A randomness.
B broad market movements.
C the fund manager’s judgment.

14 The process of decomposing a fund manager’s performance to identify the

source(s) of that performance is best described as:
A attribution analysis.
B risk-adjusted analysis.
C relative performance analysis.

Answers 203
ANSWERS
1 C is correct. The performance evaluation process begins with the measurement

of absolute returns. Absolute returns are the holding-period returns. They mea-
sure the total gain or loss that an investor owning a security achieved over the
holding period compared with the investment at the beginning of the period.
Holding-period returns usually come from the changes in the price of the
security between the beginning and the end of the period, as well as the income
received over the period (dividend, interest). B and A are incorrect because
measuring relative returns and attributing performance are the third and fourth
steps of the performance evaluation process, respectively.
2 A is correct. The Sharpe ratio evaluates the reward for each unit of risk. B and
C are incorrect because the Sharpe ratio is not used in the attribution of perfor-
mance or in the measurement of absolute performance.
3 B is correct. The measurement of relative returns involves comparing the fund

manager’s holding-period return with the return on an appropriate benchmark.
A is incorrect because measures of risk, such as the standard deviation, are used
to calculate risk-adjusted returns (the second step of the performance evalu-
ation process) rather than relative returns (the third step of the performance
evaluation process). C is incorrect because the fund manager’s past perfor-
mance is not an appropriate benchmark.
4 A is correct. The standard deviation reflects the variability (or volatility) of

returns around the mean (or average) return. B is incorrect because the reward-
to-risk ratio is a measure of risk-adjusted performance, which indicates how
much return was generated per unit of risk. C is incorrect because the down-
side deviation is calculated by using only deviations that are negative; the down-
side deviation considers only the outcomes that are less than the mean return.
5 C is correct. The downside deviation focuses only on the negative deviations—

that is, the returns that are less than the mean return. Thus, it is an appropri-
ate measure of risk for investors who dislike losses (negative outcomes) more
than they like equivalent gains (positive outcomes). A is incorrect because
the Sharpe ratio is a measure of risk-adjusted performance that reflects the
excess return on a portfolio per unit of risk. B is incorrect because the standard
deviation considers all outcomes, both above and below the mean return. It is
a better measure for investors who like gains as much as they dislike equivalent
losses.
6 A is correct. The standard deviation is a measure of the variability of returns

relative to the fund’s average return. B and C are incorrect because the fund’s
return relative to the benchmark is the tracking error and a measure that
considers a fund’s returns that are less than the average return is the downside
deviation.
7 C is correct. The Sharpe ratio is a commonly used reward-to-risk ratio that is a

measure of risk-adjusted performance; the higher the value of the Sharpe ratio,
the better the risk-adjusted performance. A is incorrect because the measure of
historical volatility is the standard deviation. B is incorrect because the down-

side deviation is a measure of risk that focuses only on the negative devia-
tions—that is, the returns that are less than the mean return.
8 C is correct. The Sharpe ratio is calculated as reward per unit of risk, where
reward is excess return on the portfolio and risk is the standard deviation of
portfolio returns. A is incorrect because the Treynor ratio is calculated as the
excess return on the portfolio relative to the beta, a measure of systematic risk,
of portfolio returns. B is incorrect because the information ratio is calculated
as the difference between average return of the portfolio and the benchmark
relative to the fund’s tracking error.
9 A is correct. The ability to buy and sell the assets in a benchmark means it is
investable. B is incorrect because compatibility means that the benchmark’s
composition and level of risk should be in line with the investor’s objectives,
including desired level of risk. C is incorrect because pre-specification means
that the benchmark should be specified in advance so that the manager is clear
about the client’s objectives.
10 A is correct. Active fund managers use analytical and trading skills to try to
beat a benchmark. They seek out investments that meet the investment man-
date, and their portfolios look different from the benchmark. B and C are incor-
rect because passive fund managers, including index replicators, try to match
the performance of the benchmark.
11 A is correct. The tracking error reflects how the performance of the investment
fund deviates from the performance of its benchmark. Because a passive invest-
ment fund is seeking to replicate a benchmark, the tracking error should be
very low. Active investment funds attempt to select assets in a benchmark that
will outperform the benchmark, and as a result the tracking error is typically
higher than the passive fund. B and C are incorrect because the tracking error
for the passive investment fund is most likely lower than the tracking error for
active investment funds.
12 B is correct. The consistent outperformance of an investment fund compared

with its benchmark is generally referred to as alpha. Alpha reflects the invest-
ment skill of the fund manager. A is incorrect because beta reflects the mar-
ket performance, over which the fund manager has no control. C is incorrect
because the tracking error reflects how much the performance of the invest-
ment fund deviates from the performance of its benchmark.
13 B is correct. Beta measures the portion of the investment fund’s return attribut-
able to broad market movements, over which the fund manager has no control.
A is incorrect because randomness is the portion of the investment fund’s
return attributable to luck. C is incorrect because the portion of the investment
fund’s return attributable to the fund manager’s judgment (or skill) is referred to
as alpha, not beta.
14 A is correct. Attribution analysis is used to identify the source(s) of a fund’s or

fund manager’s performance—that is, how much of the return was attributable
to the manager’s asset allocation, sector selection, security selection, or cur-
rency exposure. B is incorrect because risk-adjusted analysis, such as calculating
reward-to-risk ratios, is used to determine how much return was generated per
Answers 205
unit of risk. C is incorrect because relative performance analysis is the compar-

ison of the fund manager’s holding-period return with the return on an appro-
priate benchmark.
CHAPTER 20
INVESTMENT INDUSTRY
DOCUMENTATION
by Ravi Nevile, CFA, and Robin Solomon
LEARNING OUTCOMES
a Define a document;
b Describe objectives of documentation;
c Describe document classification systems;
d Describe types of internal documentation;
e Describe types of external documentation;
f Describe document management.

Objectives and Classification of Documentation 209
INTRODUCTION 1
Documentation touches every aspect of investing, from internal documents to con-
tracts with external parties. Every time an investment manager places an order and
purchases a security, for instance, a large number of documents are developed to
record the trade.
Documentation provides evidence of how companies operate, interact internally and

externally, and deliver their services. Documentation varies across the investment
industry and across companies in the investment industry. But the general rules,
structure, and logic of internal and external documentation apply to all types of com-
panies. This chapter explains why documentation is important, provides examples of
different types of documents, and describes how documents are managed.
OBJECTIVES AND CLASSIFICATION OF DOCUMENTATION 2

A document is a piece of written, printed, or electronic matter that provides infor-
mation or evidence or that serves as an official record—for instance, of the purchase
or sale of a security. Some documents are for internal use only. They are generally
administrative and reflect a company’s philosophy, approach, and activities. Other
documents are for external use. These documents convey information to and from the
public domain and often help limit the risks that interaction with the public creates.
2.1 Objectives of Documentation

When policies, procedures, and processes are undocumented or poorly documented,
there is room for doubt because these policies, procedures, and processes may be
subject to interpretation or undue influence. Proper documentation removes ambi-
guity and is thus critical.
Policies, procedures, and processes are the fabric of companies. They are essential in
the investment industry to ensure successful outcomes for clients. Recall from the
Regulation chapter that policies are principles of action adopted by a company. They
are typically driven from the top down, with rules cascading down through the vari-
ous business units and functional areas of the company. Procedures identify what the
company must do to achieve a desired outcome. Processes are the individual steps
that the company must take, from start to finish, to achieve that desired outcome.
Documentation of policies, procedures, and processes helps to communicate them
and to ensure compliance with rules, laws, and regulations.

210 Chapter 20 ■ Investment Industry Documentation
As illustrated in Exhibit 1, documentation in the context of the investment industry

does the following:
■■ Educates—informs or provides instruction
■■ Communicates—conveys ideas, concepts, or information
■■ Authorises—provides the basis, and often the authority, for action
■■ Formalises—establishes roles, deliverables, and obligations
■■ Organises—ensures thoroughness and consistency of action, allowing the com-

pany to function more efficiently and effectively
■■ Measures—provides a benchmark for measurement and audit
■■ Records—preserves learning within the company (also known as institutional

memory)
■■ Protects—provides assurance of a system to safeguard interests and manage

risks
Exhibit 1 Objectives of Investment Industry Documentation
Protects Educates
Records Communicates
Objectives
of
Documentation
Measures Authorises
Organises Formalises
From a legal perspective, documents also establish proof: proof of existence, authority,
activity, and obligation.
2.2 Document Classification Systems

When using, developing, or reviewing a document, companies and individuals should
consider three factors: origin, direction, and level of standardisation.
Objectives and Classification of Documentation 211
Origin relates to the source of the document. Documents can be classified by their
source as
■■ original documents,
■■ derived documents, or
■■ associated documents.
Example 1 describes an activity—travelling for work—and the classification of docu-

ments related to this activity.
EXAMPLE 1. CLASSIFICATION OF DOCUMENTS
An employee travels for work and incurs expenses while doing so.
■■ The receipt for a taxi or a train ticket is an original document.
■■ The expense claim form the employee has to fill out when she returns to
the office is a derived document; this document exists because of other
documents—in this case, the taxi or train ticket receipt.
■■ The company’s travel policy is an associated document. When filling out

the expense claim form, the employee may have to refer to the travel pol-
icy to determine which expenses will be reimbursed.
Documents “flow” in different directions. Typically, documents associated with pol-

icies and procedures “flow down” through a company. Referring back to Example 1,
the travel policy document may flow down from the human resources department
to all employees via an employee handbook. In contrast, documents associated with
reporting usually “flow up”. For example, the monthly reports produced by the sales
teams flow up to management for review.
A distinction can be made between standardised and ad hoc documents:
■■ Standardised documents are pre-established. They are crafted for a range of

specific purposes. Some standard contracts are tailored by negotiation, but their
form, content, and purpose are still pre-established.
■■ Ad hoc documents, such as letters, memos, and e-mails, are typically informal.
The free-form nature of ad hoc documents means that they carry additional risk
for the company, particularly if the records are subpoenaed in a legal dispute.
Consequently, companies may implement policies and procedures to impose a
process of peer review for ad hoc communication. Peer review should be docu-
mented and auditable.
Example 2 illustrates the objective, origin, direction, and level of standardisation of

documentation for a policy relating to risk management, a topic covered in a previous
chapter in this module—Risk Management.
EXAMPLE 2. RISK MANAGEMENT POLICY
Objective Authorise, formalise, and communicate in order to explain

the company’s risk tolerance and risk appetite.
Origin Derived from regulation, but specific to the company.
Associated with the company’s mission and strategy and a
variety of related internal documents.
Direction Internal document that flows from the top down.
Level of Standardised policy template, formally drafted, approved
standardisation by the company’s board of directors or similar governance
body, and adopted by management. Implemented by the
risk management and compliance groups.
3 INTERNAL DOCUMENTATION
Internal documents are generally administrative and formalise policies, procedures,

and processes. They help reduce risk by preventing errors and unethical behaviour.
So, internal documents are the backbone of a company’s risk management and are
as important as external documents, such as contracts and regulatory submissions.
Internal documents are fundamental to conveying a company’s philosophy, approach,

and activities. Companies in the investment industry, similar to all companies, are
expected to have policies and procedures in place to ensure compliance by employ-
ees with applicable laws and regulations. As we noted in the Regulation chapter, it is
important to document these policies and procedures so that the company can prove
it is in compliance if it is inspected by regulators. It is also important to document
that the company follows and enforces its policies and procedures.
3.1 Document Creation

An important aspect of document creation relates to the production style—for instance,
the use of a standardised template. Documents that are clearly presented in a style
that most people are familiar with help individuals read and understand these docu-
ments. They are also easier to use and enable individuals, including board members,
to perform their duties more effectively.
A standardised template helps maintain version control. Given the level of legislative
and regulatory activity affecting most companies, it is rare for policy and procedure
documents to remain static. Any changes reflected in a policy document need to be
similarly reflected in all associated procedure and process documents. Simply stating
the document title, the version number, and the date on which the version came into
effect helps ensure that, in case of a review, a company can show it has made efforts
to meet the required standards imposed by the relevant laws and regulations.
Internal Documentation 213
Policies, procedures, and processes are living documents and should be subject to
a regular review and confirmation process as a function of good governance. This
review and confirmation process should not be merely event driven. Even without a
notable event, attitudes and practices change over time. So, if policies, procedures,
and processes are not regularly reviewed, they can become outdated or even obsolete.
A regular review process is often managed with the use of registers, which are doc-
uments containing obligations, past actions, and future or outstanding requirements.
Registers of the previous and next review dates should be maintained by a control
function (generally, the compliance or internal audit function) and scheduled for dis-
cussion. A sign-off process is generally also incorporated into the document template.
To ensure clear communication and compliance, it is critical to understand the context

of the documentation. Rather than just outlining what to do or not to do in a situation,
it is better practice to include a sense of why the policy and required documentation
are in place and to whom they apply. Examples 3 and 4 show how providing context
may improve compliance with a travel policy and limit the risk of insider trading.
EXAMPLE 3. IMPROVING COMPLIANCE WITH A TRAVEL POLICY
A travel policy that simply states that employees must provide both receipts and
boarding cards for air travel is not as effective as one that provides additional
context of the reasons for the policy. The company’s travel policy not only should
clearly state that employees are prohibited from downgrading their class of
seat or ticket, but also should mention that the rule prevents employees from
booking a higher class of seat, downgrading, and then benefiting from either a
cash credit or free flights. The consequences of violating the travel policy should
also be explained.
EXAMPLE 4. LIMITING THE RISK OF INSIDER TRADING
A policy statement that merely states that a company’s employees will not engage
in insider trading is not as effective as one with additional context to make the
statement “real” for the employees. It should be explained that the policy has
its origin in law and that violation carries penalties for the company and the
individual. It should also be explained that the policy applies to everyone who
has access to sensitive information that could be considered “inside information”,
which includes not only decision makers but also anyone with access to sensi-
tive information. For example, the boardroom attendant serving refreshments
during board meetings may have access to sensitive information and, therefore,
would require training.
The importance of understanding the origins of, reasons for, and implications of doc-
umentation, for both the company and the individual, should not be underestimated.
People create and implement policies, procedures, and processes, and they need
context in which to learn them, understand them, and attribute the proper degree
of importance to them. Failure to do so increases operational risk, which can have
severe consequences, as noted in the Risk Management chapter.
3.2 Policy Documentation

Laws and regulations require that companies in the investment industry maintain
certain policy documents. Policy documents often describe the company’s mission,
values, and objectives. These documents should be consistent with the company’s
documents and bylaws, which summarise the legal identity, purpose, and activities
of the company.
One role of the board of directors is to ensure that the company works within the law
and, in doing so, protects and represents the interests of all stakeholders. This over-
sight usually results in policy documents that help a company develop and implement
procedures and processes.
In general, regulation concentrates on outward-facing documentation, such as prod-

uct disclosures and other client-focused material. Regulators may issue guidelines
for internal documents, but those guidelines are usually not prescriptive—that is,
companies generally have flexibility in whether and how to adopt the guidelines or
they can develop their own standards.
Many companies look externally to identify standards that should be followed. There
are numerous standards that can be readily adopted and applied, including those
issued by professional groups. For example, CFA Institute has established the Global
Investment Performance Standards (GIPS) for the presentation of investment perfor-
mance information. In some instances, professional standards are considered “best
practices”.
It may not be economically feasible, however, for smaller companies to adhere to best
practices. An alternative approach for such companies is to apply standards that suit
their own specific circumstances. These standards are known as “fit for purpose”, and
a company using this approach has to critically assess and document its own needs
and requirements. The result should strike a balance between practicality and cost on
the one hand, and between control and assurance on the other hand.
The keys to good policy documentation are simplicity and transparency. Policy state-
ments do not need to be overly detailed, but they should include a statement of intent
that explains the purpose and goals of the policy. The statement of intent should cover
the circumstances under which the policy is invoked and establish any parameters for
its use. The policy document should also clearly designate who needs to comply with
the policy and who is responsible for controlling and monitoring activities.
3.3 Procedure and Process Documentation

The role of procedure documentation is often to provide a bridge between the activ-
ities that are allowed at the policy level and what needs to happen at the process
level. Policies broadly set the rules, procedures help apply policies, and processes
divide procedures into manageable actions. To ensure that policies are embedded in
Internal Documentation 215
a company’s culture, various procedures must typically be adopted across different

business units and functional areas of the company. In addition, a single procedure
could have hundreds of associated processes to be followed.
Example 5 provides an illustration of the relationship between a policy statement and

the procedures and some of the processes associated with it for an investment firm
operating in different jurisdictions.
EXAMPLE 5. POLICY, PROCEDURE, AND PROCESS DOCUMENTATION
To ensure stakeholder confidence, and hence support, the firm must demonstrate the
Statement
application of the highest standards present in the jurisdictions in which it operates.

Policy
1. Identify the 2. Monitor 3. Identify 4. Train employees

highest compliance. breaches and to mitigate
Procedures
standards. implement breaches.

remedial action.
1. Create a register of 1. Check that all 1. Review 1. Conduct

all the legal and employees comply Procedure 2 to compliance
regulatory with firm policies. identify breaches. training for each
obligations across all new employee
Processes
jurisdictions. 2. Check that licensed 2. Remedy each upon hiring.

representatives breach.
2. Monitor changes in comply with all rules, 2. Conduct annual
legal and regulatory laws, and regulations. ... compliance
obligations and training for all
update the register. ... employees.
... ...
Starting from a simple and concise policy statement about adhering to the highest
standards, the firm implements four procedures and processes related to each
procedure. For example, the fourth procedure relates to training employees
to mitigate breaches and lists a couple of possible processes. The first process
listed to train each employee is to ensure that each new employee undergoes
compliance training when hired. The second process listed is to ensure that all
employees go through compliance training every year.
Procedure and process documents communicate how best to undertake an activity

while taking into account internal and external constraints. A company must continually
reassess its procedures and processes and keep them current. But finding fault with
current practices without understanding the circumstances behind their creation is
shortsighted. It is important to understand the history and background of a procedure
or process and the limitations in place at the time of its creation. Companies must also
make sure that all employees receive adequate training regarding existing procedures
and processes, and that they are kept informed when changes are made.
Making changes is never easy, so it is advisable to make processes modular—that

is, they should be made up of separate elements that can be reviewed and replaced
independently of each other. Modular processes allow companies to avoid replac-
ing everything when a single element changes. In addition, some processes may be
repetitive, so a particular process can be documented just once and then referenced
a number of times when drafting procedures.
An important consideration when creating or reviewing procedures is risk man-

agement—without a strong control environment, processes are at risk of error. As
discussed in the Risk Management chapter, failure to follow processes can lead to
damage to the company’s reputation and the loss of existing and potential business
opportunities. Thus, controls should be embedded in the procedure and drafted with
risk management and compliance in mind.
As with policies, context is critical in the creation of procedures and processes.

Understanding where inputs come from, where outputs go, and what they will be
used for provides that context. All procedure documents follow a similar pattern: an
input initiates an activity that results in an output. Process flow diagrams, such as
the one provided in Example 6, are a good visual aid to provide context because they
show the sources of inputs and the uses of outputs in processes. In particular, they
help visualise a chain of linked activities and thus represent a simple and efficient tool
when a number of contingent activities take place.
EXAMPLE 6. PROCESS FLOW DIAGRAM
Assume that an asset management firm has a gift policy stipulating that gifts
worth more than $100 require compliance approval. The policy is intended to
prevent conflicts of interest that might arise if receiving gifts influences employ-
ees’ behaviours. So, the asset management firm has established procedures and
processes that employees must follow when offered gifts.
Suppose an employee receives a case of wine as a gift from a brokerage firm

she regularly uses. Should she accept the gift? The employee faces an ethical
dilemma, similar to those discussed in the Ethics and Investment Professionalism
chapter. Before making a decision about accepting or rejecting the gift, the
employee should refer to her firm’s gift policy, which describes the procedures
and processes to follow. The following procedure and process flow diagram
should guide the employee.
External Documentation 217
POLICY: Gifts worth more than $100 require compliance approval
Statement
to determine potential conflicts of interest.
Policy
PROCEDURE 1: Gift Management

Procedures
PROCESS 1: Record Gift PROCESS 2: Determine Eligibility

No further
action is
Employee s required.
Employee records Compliance Ye
Processes
receipt in is notified to
receives
automated determine gift No
a gift. Employee
system. eligibility. Compliance
Employee s keeps gift.
determines Ye
potential is notified
INPUT ACTIVITY OUTPUT conflicts about gift No
of interest. eligibility. Employee
returns gift,
or gift
becomes
INPUT ACTIVITY OUTPUT property of
company.
The first procedure refers to gift management. The first process in that pro-
cedure starts when the employee receives the case of wine—that is, the input.
Her first activity is to record this gift in the automated system, which triggers
a notification to the compliance department—that is, the output. If the gift is
eligible, the employee receives an automatic notification that she can accept the
gift and no further action is required. Alternatively, the compliance department
may need to determine whether there is a potential conflict of interest, which
would trigger a second process. If the compliance department concludes that
the gift is eligible, the employee can keep the case of wine. But if the compliance
department decides that the gift is not eligible, the employee must either return
the case of wine to the brokerage firm or give the gift to the company.
EXTERNAL DOCUMENTATION 4
External documentation exists between a company and external parties, including
clients, market participants, and service providers. External documents aim to artic-
ulate business relationships and obligations undertaken by the parties involved and
are often legally binding. Examples of external documents in the investment industry
are a contract between a buyer and a seller of an asset, an investment management
agreement between a firm and a client, and a “know-your-client” (some people call
it KYC) document for a new client. Because contracts and other legally binding
documents are governed by law and are enforceable, parties are usually motivated to
comply with them. If any of the parties fail to fulfil their obligations, the law offers the
other party or parties protection or help. The level of protection or help often varies
depending on the jurisdiction that applies to the contract.
External documents may also be used to inform the public or other external parties
about a company’s activities or changes in its business—for example, a press release
announcing the appointment of a new chief executive officer, a marketing presenta-
tion for a new investment product, or a statement about the launch of a new website.
Parties that can be involved in external documents include the following:
■■ Governments, legislators, and regulators
■■ Groups that help organise the market, such as stock exchanges, clearing houses,
and depositories
■■ Market participants active in facilitating investments or transactions, such as

banks, brokers, and asset managers
■■ Professional firms and individuals serving the needs of the industry, including
credit rating agencies, auditors, lawyers, consultants, and trustees
■■ Investors, including retail clients and institutional investors
The relationships between parties dictate how they use documentation to formalise
their relationships.
The rest of this chapter focuses on a typical client interaction and the different types
of external documents that exist at different stages of the client’s investment cycle.
Differences among products, laws, and regulations in different jurisdictions, as well
as the client’s objectives and constraints, affect the nature of the client interaction
and hence the documentation involved.
Exhibit 2 illustrates a typical client interaction cycle. Because it is a cycle, there is

no true beginning or end. The typical stages include marketing, client on-boarding,
funding, ongoing reporting, investment events, and redemption. At each stage of the
cycle, different documents are required. Samples of documentation for each stage are
described in Sections 4.1–4.6.
Exhibit 2 Typical Client Interaction Cycle
Marketing
on
i
pt
On
em
Cliearding
-Bo
Red
nt
Client
Investment
Cycle
I n v e s t nts
Ev e
in g
me
nd
nt
Fu
Re p o
rtin g
4.1 Marketing
Most companies in the investment industry share the same basic objective of winning
clients. So, most companies’ documentation at the marketing stage of the cycle shares
the same purpose: to promote and position the company’s products and services to
persuade the client to invest.
Marketing documentation for a company in the investment industry typically includes

the following:
■■ Presentation materials that provide background on the company, its products,

and/or its services
■■ Offering documentation, such as a prospectus or term sheet, which are legal

documents that contain detailed information about the terms and conditions
of the investment opportunity, highlight various risks, and make other required
disclosures
■■ Fact sheets about the company’s products that provide short summaries of the
investments and typically detail historical performance
For asset management firms, the marketing documentation also contains information
about the managers, including their investment strategy and competitive advantages.
Other features include past performance, risk analytics, and characteristics of the
product, such as liquidity, distributed income, and fees that will be borne by the client.
Marketing materials are typically regulated to ensure that companies in the investment
industry provide fair representations of their products, as discussed in the Regulation
chapter. The regulation is usually more onerous as the client’s level of investment
sophistication decreases. Most developed markets tightly regulate the sale of financial
products to retail investors, who are considered the least sophisticated investor type.
4.2 Client On-Boarding

Client on-boarding is the process by which a company accepts a new client and inputs
the client’s details into its records to enable the company to conduct transactions with
and on behalf of the client. Companies in the investment industry usually have a legal
obligation to verify the identity of a potential client by means of a know-your-client
(KYC) process before commencing a relationship with the potential client. The typical
KYC process requires the client to
■■ complete a questionnaire and provide personal background information,

including documentary proof of identity (for instance a passport), addresses,
and other personal details.
■■ be screened against various global databases to ascertain whether he or she is

known or wanted by local or international law enforcement agencies.
■■ submit to anti-money-laundering checks at on-boarding and thereafter to iden-

tify any potential suspicious transactions that the company would be obligated
to report to a regulator.
■■ provide proof of the source of funds to verify that the money does not originate
from an illegal or criminal source.
Companies must constantly monitor activities and transactions to ensure that they
are not suspicious. If something suspicious does arise, companies must report that
activity or transaction to the authorities. The heavy penalties imposed by most regula-
tors globally help combat identity theft, criminal activity, and the flow of money from
illegal sources into the financial services industry, including the investment industry.
The KYC process also serves to define the client’s level of knowledge and sophistica-
tion, assign associated and specific risk profiles, and assess any possible restrictions.
Depending on the type of client and the purpose of the relationship, different types
of information might be required to ensure that the company provides appropriate
products and services for the client’s needs.
Moreover, the KYC process is important in setting the basis for the relationship, in
particular to differentiate between discretionary and non-discretionary relationships.
Discretionary relationships permit the service provider to act on behalf of the client—
for example, as an investment manager with a specific mandate or as a trustee of a
trust. In such cases, the service provider must act in the best interest of its clients. In
contrast, a non-discretionary relationship permits the service provider to undertake
only specific tasks that are authorised by the client on a per task basis.
4.3 Funding
Once the client on-boarding process is complete and the relationship has been initi-
ated and approved by the compliance department, the next stage is the cash transfer
and the investment of the money. The client authorises his or her bank to make a
payment to the company’s client account, and the bank acts on this instruction and
provides a confirmation of the cash transfer. After receiving the money, the company
initiates the investment transaction and sends a formal confirmation to the client. For
example, the documentation associated with the investment transaction could be a
share certificate or confirmation of an investment in a mutual fund.
Each step in the funding process relies on external documentation to formalise,

legalise, and protect the rights and obligations of each of the parties involved. Service
providers may provide transaction, safekeeping, or administrative services to the client
or the company, and external documentation would also be used to record activities
related to these activities.
4.4 Trading
Documentation is important in trading—to provide a record of which assets were
ordered and traded, in what quantity and at what price. You may be surprised just
how much documentation must be produced for a single order and trade.
The diagram below shows a simplified version of the trading process, as presented in
The Functioning of Financial Markets chapter. It illustrates some of the documents
that may be produced during a trade. Depending on the asset, where it is traded, and
between which counterparties, the documentation required can vary widely.
Documents
Order Placed
Order Document
No Yes Execution
Market
Order? Instructions
Order Order Executed

Yes Executed?
Submitted-for-
Dealing Note
No Yes
Confirmation Note
Order
Remains
Open? Contract Note
Notification to
No Issuer’s Transfer
Order Closed Order Settled
Agent
When an order is placed, a document is sent to the chosen trading venue, specify-
ing what security to trade, whether to buy or sell, and how much should be bought
or sold. Another document is often attached, as discussed in The Functioning of
Financial Markets Chapter, giving instructions about order execution, exposure, and
time-in-force.
Once the order has been received, a number of documents record the progress of the
trade until execution. These include:
■■ A submitted-for-dealing note
■■ Confirmation of dealing
■■ A contract note once the trade is complete
Once the trade has been settled, the settlement agent reports the trade to the issuing
company’s transfer agent. This generates yet another document. Documents will also
be produced by accounting and other departments.
4.5 Reporting
After funding, regular communication will occur between the company and its client.
A valuation (if a market price is available) or an appraisal (that is, an estimation if no
market price is available) of each asset held is sent to the client on a regular basis.
For example, a mutual fund may report the fund’s daily net asset value per unit in a
national newspaper.
Reporting documentation usually takes the form of a statement, often provided by a

third-party custodian or administrator. The statement typically contains information on
the asset, including its fair value per unit and the quantity of units held at a particular
point in time. It may also contain performance information, measured by the change
in value over various periods of time—a quarter, a year, or perhaps a longer period.
Certain standards, such as the GIPS standards mentioned in Section 3.2, apply to how
the valuation is performed or how the performance is presented. Along with valuation
and performance statements, clients may receive a range of other documents, such
as investment reports, annual financial statements, and risk management reports.
4.6 Investment Events

Over the life of the investment, numerous events may take place that affect the client or
require the client to take action. These events lead to further external documentation.
Some events are expected, such as regular income in the form of interest from a bond
investment, dividends from an equity investment, or rental income from a commercial
real estate investment. Typically, income is accompanied by a written confirmation
of payment to the client or of re-investment. Income must be accounted for in future
performance reporting as well as for income tax purposes.
Unexpected events that lead to external documentation include the following:
■■ Merger and acquisition activity. If a company merges with, spins off from, or
acquires another company, its business and operations may change, affecting
the client’s investment.
Document Management 223
■■ Bankruptcy. If a company files for bankruptcy or undergoes a reorganisation,

the client may be affected, depending on the nature of the underlying trans-
action or investment. There will be written communication about the legal
process, the rights of the parties involved, and any liquidation.
■■ Natural disaster. This type of event may affect a real asset or even a financial
asset.
4.7 Redemption
At some stage, a client may want to redeem or sell an investment. Depending on the
type of investment, a written request may be required. After verifying the authenticity
of the client’s instruction, the company arranges for the investment to be sold. The
timing of redemption depends on the type of investment and its liquidity. When the
investment is sold, the company’s authorised signatories allow the bank to release
the cash proceeds. A final written confirmation statement is then sent to the client.
Although redemption is the end of a transaction, it does not necessarily mean the end
of the client relationship. The client may want to invest or conduct other transactions
with the company in the future. The documentation relating to the final transaction
will be retained, as discussed in Section 5, should there be any future dispute or dis-
agreement between the parties.
DOCUMENT MANAGEMENT 5
It should by now be clear that documents serve an important role in establishing the
rules by which a product or service is supplied, in formalising the rights and entitle-
ments of ownership, and in recording events that take place after the purchase of an
asset. Given that millions of typical client interactions occur each day and given the
complexity of all the different parties involved in the investment industry, the amount
of existing external documentation is enormous and constantly growing. This final
section describes some of the aspects of managing documentation, including the role
of information technology and how companies access, secure, retain, and dispose of
documents.
5.1 Information Technology

Information technology (IT) has greatly enhanced our ability to collect, collate, manage,
and distribute documents. It has also greatly advanced the automation of processes,
to a large degree eliminating the need for some traditional internal documentation.
In the past, rules were physically documented, but today, rules-based systems allow
enforcement of processes by building controls into operating systems.
IT has also affected the way external documentation is handled. Thanks to the advent
of straight-through processing (STP), also referred to as straight-through exception
processing (STeP), the need for manual intervention has been removed. It is often
possible to capture inputs—including client interactions—from outside the company

by directly accessing a company’s IT systems. In some instances, the need for physical
documentation has completely disappeared. Examples include the use of internet
banking and online share trading, which eliminate the need for deposit/withdrawal
slips and trade order tickets.
The use of IT can also reduce risk. For example, payments from an investment account
may be subject to fraud. To limit the risk of fraud, payments typically require a dual
sign-off process. If implemented correctly, a dual sign-off process makes collusion
between two parties easier to identify. Automated processes also help reduce errors.
For instance, the manual dual sign-off process involves a physical cheque and two
signatories, which is time consuming and prone to errors. A fully automated process
that relies on dual independent (blind) input with automated reconciliation and release
reduces the risk of errors and time for review.
5.2 Access, Security, Retention, and Disposal of Documents

The importance of document management cannot be over-emphasised. Easy access to
documents is essential for an efficient business operation. Document management also
enhances security, including confidentiality and protection of client information. Given
the huge amount of data available on every client, it is important that companies take
responsibility for the proper retention and disposal of client-related documents too.
Access. Documents that staff need to access should be easily retrievable. Companies
usually have a centralised repository that is often electronic: a read-only drive, docu-
ment database, or documentation management system capable of storing internal and
external documents relevant to the company’s business activities.
Security. As discussed in the Risk Management chapter, protecting confidential infor-

mation is important and often a legal or regulatory requirement. Although documents
should be accessible, they also need to be secure—that is, accessible only to appropriate
people. So, only authorised staff should be able to access restricted documents, such
as compensation data or confidential client information. In addition, companies must
ensure that no outside party can gain access to documents that are for internal use
only. Failure to secure documents can harm a company’s operations and reputation.
Retention. Documents are official records that offer proof and protection. So, it is
important, not only for business reasons but also often for legal or regulatory reasons,
that all documents are retained until the risk associated with the action described in
the document no longer exists. There are generally laws or policies in place to prescribe
document retention. Each legal jurisdiction has its own time frames for retention, and
some types of documents may have more specific time frames than others. Although
most documents today are held electronically, there are still requirements to hold
physical, original documents. These documents include certificates of title, contracts,
and trust deeds. Companies typically store historic information, backups, and physical
documents at an off-site location, which is often managed by a third party.
Disposal. Documents cannot simply be archived and forgotten. Specific destruction

or disposal instructions should be applied to all archived information. Companies have
a responsibility to discard or destroy documentation after the retention period. This
Summary 225
responsibility is particularly important with respect to sensitive information, such as

personal information about individuals. Most developed markets have strict legislation
around data protection and companies’ obligations to permanently delete confidential
information, whether stored in electronic or paper format.
SUMMARY
Whatever your role in the investment industry, you will have to deal with documenta-
tion. Properly prepared documentation can save you and others time, assist everybody
to perform their role better, and help protect you and your company against unethical
behaviour. Key points in this chapter include the following:
■■ Documents provide information or evidence or serve as an official record.
■■ There are many reasons to document information, including educating, com-

municating, authorising, formalising, organising, measuring, recording, and
protecting.
■■ Documents can be classified in terms of origin, direction, and level of

standardisation.
■■ Internal documents are generally administrative and are used to formalise

policies, procedures, and processes. Important features of internal documents
include context, version control, and regular review.
■■ Policy broadly sets the rules, procedures help apply policies, and processes
divide procedures into manageable actions.
■■ Laws and regulations require the creation of a number of policy documents.

Some policy documents reflect professional standards that are considered “best
practices”. Others are “fit for purpose”, meaning that they meet the company’s
needs and requirements.
■■ Procedure and process documents communicate how best to undertake an

activity while taking into account internal and external constraints. They are
critical for mitigating risk.
■■ Policies, procedures, and processes can be supplemented by useful tools, such

as registers and process flow diagrams, to aid users in understanding and com-
pleting a chain of linked activities.
■■ External documents are often contractual and enforceable by law, providing

protection of rights as well as imposing obligations on the parties involved.
■■ A typical client interaction cycle includes documents related to marketing, on-

boarding (including know-your-client and anti-money-laundering processes),
funding, reporting, investment events, and redemption.
■■ Document management requires information technology to access, secure,

retain, and dispose of documents. It is usually subject to legislative and regula-
tory constraints.
1 A document is best described as an:
A official record for internal use only.
B official record for internal or external use.
C unofficial record for internal or external use.
2 A broker receives a purchase order by e-mail from a client and a printed mem-
orandum with some policy updates from the human resources department.
Which of the following statements is most likely correct?
A The client e-mail is considered a document, but not the memorandum.
B The memorandum is considered a document, but not the client e-mail.
C Both the client e-mail and the memorandum are considered documents.
3 The monthly fact sheet of a mutual fund is available electronically on the

mutual fund’s external website. The fact sheet is:
A an official record.
B not an official record because it is in electronic format.
C not an official record because it conveys only information and not evidence.
4 Which objective of documentation is fulfilled when documents ensure thor-

oughness and consistency of action, thus allowing a company to function more
efficiently and effectively?
A Educating
B Organising
C Formalising
5 Documentation that protects a company is best described as providing:
A a benchmark for measurement and audit.
B the basis, and often the authority, for action.
C assurance of a system to safeguard interests and manage risks.

6 A prescribed format for marketing materials used by a company relates to

documenting:
A origin.
B direction.
C level of standardisation.
7 An employee handbook that outlines travel reimbursement guidelines is best

classified as a(n):
A ad hoc document.
B derived document.
C associated document.
8 A document describing principles of action adopted by a company is best

described as a:
A policy document.
B process document.
C procedure document.
9 Which of the following is most likely an example of external documentation?
A Contract between the buyer and seller of an asset
B Process flow diagram that guides employees when they receive gifts from
clients
C Policy document that states the organisation will not engage in insider
trading
10 Compared with external documentation, internal documentation is more likely

to:
A legally bind.
B inform the public.
C document policies, procedures, and processes.
11 Client on-boarding documentation refers to:
A wire transfer documentation.
B documentation required to accept a new client.
C marketing documentation sent to an existing client.

12 When a client wants to sell an investment, the documentation needed from the
client relates to:
A funding.
B reporting.
C redemption.
13 The external document that is most likely used during the reporting stage of the
client investment cycle is a:
A prospectus.
B share certificate.
C monthly statement.
14 Which of the following statements relating to document management is

correct?
A Document retention rules tend to apply only to physical documents.
B Companies should dispose of documentation after the retention period.
C Documents should be moderately difficult to access by authorised staff.
15 In the document management process, ease of data retrieval is best accom-

plished by:
A retaining information after its initial use.
B maintaining a centralised repository.
C using sound practices for safekeeping documentation.

Answers 229
ANSWERS
1 B is correct. A document serves as an official record that may be for internal or

external use.
2 C is correct. Any document serves as an official record. Some documents, such

as the memorandum, are for internal use only. They are generally administrative
and reflect a company’s philosophy, approach, and activities. Other documents,
such as the client e-mail, are for external use. They convey information to and
from the public domain and often help limit the risks that this interaction with
the public creates.
3 A is correct. Fact sheets are documents that provide short summaries of invest-
ments and typically detail historical performance—in this case, the monthly
performance of the mutual fund. Fact sheets represent an official record. B and
C are incorrect because official records can be in electronic or printed format
and can provide information or evidence.
4 B is correct. Organising is the objective of documentation that is fulfilled when

documents ensure thoroughness and consistency of action, thus allowing a
company to function more efficiently and effectively. A is incorrect because
educating is achieved when documents inform or provide instruction. C is
incorrect because formalising is achieved when documents establish roles,
deliverables, and obligations.
5 C is correct. Documentation that protects a company provides assurance of a

system to safeguard interests and manage risks. B is incorrect because doc-
umentation that provides the basis, and often the authority, for action more
appropriately describes the objective of documentation related to authorising.
A is incorrect because documentation that provides a benchmark for measure-
ment and audit more appropriately describes the objective of documentation
related to measuring.
6 C is correct. A prescribed format for marketing materials used by an organ-

isation describes the level of standardisation, a characteristic used to classify
documentation. The level of standardisation determines whether a document is
standardised or ad hoc. Standardised documents have pre-established formats,
whereas ad hoc documents are free form. A is incorrect because origin refers
to the source of the document—that is, whether it is an original, derived, or
associated document. B is incorrect because direction refers to the flow of doc-
umentation—that is, whether the information flows down, for example docu-
ments associated with policies and procedures, or up, for example documents
associated with reporting.
7 C is correct. An employee handbook that outlines travel reimbursement

guidelines is an associated document that employees would refer to in order to
determine which travel expenses may or may not be reimbursed. A is incor-
rect because an ad hoc document is typically informal. Because an employee
handbook usually describes policies and procedures, it is more likely to be a
standardised document rather than an ad hoc document. B is incorrect because
a derived document comes into existence because of other documents. In

this context, an expense claim form would be a better example of a derived
document.
8 A is correct. A policy document describes principles of action adopted by a

company. They are typically driven from the top down, with rules cascading
down through the various business units and functional areas of the company.
B is incorrect because a process document describes the individual steps the
company must take, from start to finish, to achieve a desired outcome. C is
incorrect because a procedure document broadly identifies what the company
must do to achieve a desired outcome. It often provides a bridge between the
activities that are allowed at the policy level and what needs to happen at the
process level. Policies broadly state the rules, procedures help apply policies,
and processes divide procedures into manageable actions.
9 A is correct. A contract between the buyer and seller of an asset or an invest-

ment management agreement between a firm and a client are examples of
external documents. B and C are incorrect because a process flow diagram and
a policy document are typically internal documents.
10 C is correct. Internal documentation typically documents an organisation’s poli-

cies, procedures, and processes. A and B are incorrect because external docu-
mentation is more likely to be legally binding and to inform the public or other
external parties.
11 B is correct. Client on-boarding is the process by which a company accepts a

new client and inputs the client’s details into its records to enable the company
to conduct transactions with and on behalf of the client. Thus, it refers to doc-
umentation required to accept a new client. A is incorrect because wire trans-
fer documentation is best described as funding documentation. C is incorrect
because marketing documentation promotes and positions the organisation’s
products and services to attract and retain clients.
12 C is correct. Redemption documentation is required when a client wants to

redeem or sell an investment. After verifying the authenticity of the client’s
instruction, the firm arranges for the investment to be sold. A is incorrect
because funding documentation refers to the cash transfer and the investment
of the money. B is incorrect because reporting documentation refers to the
regular communication between the firm and its client.
13 C is correct. In the reporting stage of the client investment cycle, the external
document usually takes the form of a statement, often provided by a third-party
custodian or administrator. A is incorrect because an external document, such
as a prospectus or a term sheet, is usually provided during the marketing stage
of the client investment cycle. B is incorrect because a share certificate is an
external document associated with an investment transaction, which occurs
during the funding stage of the client investment cycle.
14 B is correct. Documents cannot simply be archived and forgotten. Specific

destruction or disposal instructions should be applied to all archived infor-
mation. Companies have a responsibility to discard or destroy documentation
after the retention period. A is incorrect because document retention rules
Answers 231
tend to apply to both physical and electronic documentation. C is incorrect

because documents that need to be available to authorised staff should be easily
retrievable.
15 B is correct. Maintaining a centralised repository, with appropriate access

rights, helps data retrieval. This repository is often electronic. A and C are
incorrect because retaining information after its initial use and using sound
practices for safekeeping documentation do not imply that data will be easy to
retrieve.

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CHAPTER 1

THE INVESTMENT INDUSTRY:

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

c Define the investment industry;

d Explain how economies benefit from the existence of the investment

e Explain how investors benefit from the existence of the investment

f Describe types and functions of participants of the investment industry;

g Describe forces that affect the evolution of the investment industry.

THE FINANCIAL SERVICES INDUSTRY 2

Savers include individuals (households), companies, and governments that have

Exhibit 1 Overview of the Financial Services Industry

Financial intermediaries play an important role in the financial services industry.

Financial institutions are types of financial intermediaries. Their role is to collect

3.2 Insurance Companies

HOW ECONOMIES BENEFIT FROM THE EXISTENCE OF THE

4.1 Economic Systems

Capitalism is an economic system that promotes private ownership as the means of

4.2 How the Investment Industry Fosters Economic Growth

The investment industry contributes to the efficient allocation of resources in the

Investment industry participants package investment opportunities so that they sat-

HOW INVESTORS BENEFIT FROM THE EXISTENCE OF THE

5.1 How the Investment Industry Serves Investors

An important feature that characterises a well-­functioning investment industry is

In addition to being able to choose from many investment opportunities, investors

Another important feature of a well-­functioning investment industry is the ability to

5.2 Need for Trust, Laws, and Regulations

■■ protect investment industry participants, in particular investors, and

■■ promote and maintain the integrity, transparency, and fairness of financial

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

■■ organisations promote cultures of integrity.

Ethical behaviour on the part of investment industry participants is paramount to pro-

6 INVESTMENT INDUSTRY PARTICIPANTS

As a way of introducing some of the main investment industry participants, let us

6.1 How Companies and Governments Raise Capital

6.2 How the Investment Industry Helps Savers Invest Their

Within each of these two categories of investors—individual and institutional—there is

categories of individual investors varies across countries, currencies, and investment

■■ Endowment funds, which are long-­term funds of not-­for-­profit institutions,

■■ Foundations, which are grant-­making institutions funded by financial gifts and

■■ Sovereign wealth funds, which typically invest a government’s surpluses.

Exhibit 2 Investor Services

Institutional Investors Individual Investors

Institutional investors may employ analysts to review potential investments. These

MEET SOME OF THE INVESTMENT INDUSTRY PARTICIPANTS

Zhang Li is a retail investor. She earns 5,000 Singapore

Mike Smith is a high-net-worth investor who lives in

Anna Huber is an institutional investor for Euro Pension

Peter Robinson is an asset manager for Aus Ltd., which is

Amina Al-Subari is a broker at Middle East Corp., which

James Armistead is with Big Bank Financial Services,

KEY FORCES DRIVING THE INVESTMENT INDUSTRY 7

■■ Competition. Competition in the investment industry is fierce and manifests

■■ Technology. Technology, and computerisation in particular, has dramatically

■■ Globalisation. Investors look outside their domestic markets to diversify their

■■ Regulation. Globally, there is a trend toward greater regulation of the financial

■■ The financial services industry exists to provide a link between savers/lenders/

■■ Financial intermediaries act as middlemen between savers and spenders.

■■ A goal of economic systems is the efficient allocation of scarce resources to

Exhibit 1 Overview of the Financial Services Industry

An important feature that characterises a well-functioning investment industry is

Another important feature of a well-functioning investment industry is the ability to

■■ Endowment funds, which are long-term funds of not-for-profit institutions,

■■ Foundations, which are grant-making institutions funded by financial gifts and

Exhibit 2 Investor Services

■■ The benefits for investors of a well-functioning investment industry include a

8 A sell-side analyst typically works for a(n):

8 B is correct. Investment (merchant) bank analysts are called sell-side analysts

Exhibit 1 Factors Affected by Ethical Standards in the Investment

Exhibit 2 Examples of Conflicts of Interest

3.3 Obligations to Co-Workers

Obligations to co-workers extend beyond competent and careful work. In addition

Exhibit 3 The CFA Institute Code of Ethics