Professional Documents
Culture Documents
1
CONTENTS
MODULE 1: INDUSTRY OVERVIEW 4
CHAPTER 4 Microeconomics
CHAPTER 5 Macroeconomics
CHAPTER 6 Economics of International Trade
CHAPTER 7 Financial Statements
CHAPTER 8 Quantitative Concepts
2
MODULE 5: INDUSTRY STRUCTURE 15
EXAM WEIGHTING 22
3
MODULE 1
INDUSTRY OVERVIEW
4
CHAPTER 1
THE INVESTMENT INDUSTRY:
A TOP-DOWN VIEW
After completing this chapter, you should be able to do
the following:
5
MODULE 2
ETHICS AND REGULATION
6
CHAPTER 2 CHAPTER 3
ETHICS AND INVESTMENT PROFESSIONALISM REGULATION
After completing this chapter, you should be able to do After completing this chapter, you should be able to do
the following: the following:
• Describe the need for ethics in the investment industry; • Define regulations;
• Identify obligations that individuals in the investment • Describe objectives of regulation;
industry have to clients, prospective clients, employers, • Describe potential consequences of regulatory failure;
and co-workers; • Describe a regulatory process and the importance of
• Identify elements of the CFA Institute Code of Ethics; each step in the process;
• Explain standards of practice (professional principles) • Identify specific types of regulation and describe the
that are based on the CFA Institute Code of Ethics; reasons for each;
• Describe benefits of ethical conduct; • Describe elements of a company’s policies and
• Describe consequences of conduct that is unethical or procedures to ensure the company complies with
unprofessional; regulation;
• Describe a framework for making ethical decisions. • Describe potential consequences of compliance failure.
7
MODULE 3
INPUTS AND TOOLS
8
CHAPTER 4 CHAPTER 5
MICROECONOMICS MACROECONOMICS
After completing this chapter, you should be able to do After completing this chapter, you should be able to do the
the following: following:
9
CHAPTER 6 CHAPTER 7
ECONOMICS OF INTERNATIONAL TRADE FINANCIAL STATEMENTS
After completing this chapter, you should be able to do After completing this chapter, you should be able to do
the following: the following:
• Define imports and exports and describe the need for • Describe the roles of standard setters, regulators,
and trends in imports and exports; and auditors in financial reporting;
• Describe comparative advantages among countries; • Describe information provided by the balance sheet;
• Describe the balance of payments and explain the • Compare types of assets, liabilities, and equity;
relationship between the current account and the • Describe information provided by the income statement;
capital and financial account; • Distinguish between profit and net cash flow;
• Describe why a country runs a current account deficit • Describe information provided by the cash
and describe the effect of a current account deficit on flow statement;
the country’s currency; • Identify and compare cash flow classifications of
• Describe types of foreign exchange rate systems; operating, investing, and financing activities;
• Describe factors affecting the value of a currency; • Explain links between the income statement, balance
• Describe how to assess the relative strength of sheet, and cash flow statement;
currencies; • Explain the usefulness of ratio analysis for financial
• Describe foreign exchange rate quotes; statements;
• Compare spot and forward markets. • Identify and interpret ratios used to analyse
a company’s liquidity, profitability, financing,
shareholder return, and shareholder value.
10
CHAPTER 8
QUANTITATIVE CONCEPTS
After completing this chapter, you should be able to do
the following:
11
MODULE 4
INVESTMENT INSTRUMENTS
12
CHAPTER 9 CHAPTER 10
DEBT SECURITIES EQUITY SECURITIES
After completing this chapter, you should be able to do After completing this chapter, you should be able to do
the following: the following:
13
CHAPTER 11 CHAPTER 12
DERIVATIVES ALTERNATIVE INVESTMENTS
After completing this chapter, you should be able to do After completing this chapter, you should be able to do
the following: the following:
14
MODULE 5
INDUSTRY STRUCTURE
15
CHAPTER 13 CHAPTER 14
STRUCTURE OF THE INVESTMENT INDUSTRY INVESTMENT VEHICLES
After completing this chapter, you should be able to do After completing this chapter, you should be able to do
the following: the following:
• Describe needs served by the investment industry; • Compare direct and indirect investing in securities
• Describe financial planning services; and assets;
• Describe investment management services; • Distinguish between pooled investments, including
• Describe investment information services; open-end mutual funds, closed-end funds, and
• Describe trading services; exchange-traded funds;
• Compare the roles of brokers and dealers; • Describe security market indices including their
• Distinguish between buy-side and sell-side firms in construction and valuation, and identify types of indices;
the investment industry; • Describe index funds, including their purposes and
• Distinguish between front-, middle-, and back-office construction;
functions in the investment industry; • Describe hedge funds;
• Identify positions and responsibilities within firms in • Describe funds of funds;
the investment industry. • Describe managed accounts;
• Describe tax-advantaged accounts and describe the
use of taxable accounts to manage tax liabilities.
16
CHAPTER 15
THE FUNCTIONING OF FINANCIAL MARKETS
After completing this chapter, you should be able to do
the following:
17
MODULE 6
SERVING CLIENT NEEDS
18
CHAPTER 16 CHAPTER 17
INVESTORS AND THEIR NEEDS INVESTMENT MANAGEMENT
After completing this chapter, you should be able to do After completing this chapter, you should be able to do
the following: the following:
• Describe the importance of identifying investor needs • Describe systematic risk and specific risk;
to the investment process; • Describe how diversification affects the risk
• Identify, describe, and compare types of individual of a portfolio;
and institutional investors; • Describe how portfolios are constructed to address
• Compare defined benefit pension plans and defined client investment objectives and constraints;
contribution pension plans; • Describe strategic and tactical asset allocation;
• Explain factors that affect investor needs; • Compare passive and active investment management;
• Describe the rationale for and structure of investment • Explain factors necessary for successful active
policy statements in serving client needs. management;
• Describe how active managers attempt to identify and
capture market inefficiencies.
19
MODULE 7
INDUSTRY CONTROLS
20
CHAPTER 18 • Compare use of arithmetic and geometric mean rates
of returns in performance evaluation;
RISK MANAGEMENT
• Describe measures of risk, including standard
After completing this chapter, you should be able to do deviation and downside deviation;
the following: • Describe reward-to-risk ratios, including the Sharpe
and Treynor ratios;
• Define risk and identify types of risk; • Describe uses of benchmarks and explain the
• Define risk management; selection of a benchmark;
• Describe a risk management process; • Explain measures of relative performance, including
• Describe risk management functions; tracking error and the information ratio;
• Describe benefits and costs of risk management; • Explain the concept of alpha;
• Define operational risk and explain how it is managed; • Explain uses of performance attribution.
• Define compliance risk and explain how it is managed;
• Define investment risk and explain how it is managed;
• Define value at risk and describe its advantages and
CHAPTER 20
weaknesses. INVESTMENT INDUSTRY DOCUMENTATION
After completing this chapter, you should be able to do
CHAPTER 19 the following:
PERFORMANCE EVALUATION
• Define a document;
After completing this chapter, you should be able to do • Describe objectives of documentation;
the following: • Describe document classification systems;
• Describe types of internal documentation;
• Describe a performance evaluation process; • Describe types of external documentation;
• Describe measures of return, including holding-period • Describe document management.
returns and time-weighted rates of return;
21
EXAM WEIGHTING
Questions in the examination will be allocated approximately as follows:
Module 1 5%
Module 2 10%
Module 3 20%
Module 4 20%
Module 5 20%
Module 6 5%
Module 7 20%
Note: These weightings may be subject to slight variation to allow for effective question
trialing and to achieve an equal balance of difficulty for all candidates.
22
LEARNING OUTCOMES
A TOP-DOWN VIEW d Explain how economies benefit from the existence of the investment
industry;
by Ian Rossa O’Reilly, CFA
e Explain how investors benefit from the existence of the investment
industry;
TERMINOLOGY
INTRODUCTION 1 Typically, the term saver characterises those who have accumulated savings.
As illustrated in the example earlier, these savings are often invested. When
Like it or not, the vast majority of us have to work. We work to sustain ourselves savers have made investments, they are typically called investors and become
and our dependents. Often, we earn money for our labour and use that money to 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,
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 the term spender characterises those who need money. When spenders have
savings, we are investing. 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
To explain how savers become investors, consider the example of a Canadian entre- there are times when the terms savers/investors/lenders/providers of capital or
preneur who needs money to set up a new business. She needs to find savers who are spenders/borrowers/users of capital are used interchangeably.
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.
Savings can be invested in a wide range of assets. Assets are items that have value and
The entrepreneur is happy because she can now start her business. But the search for include real assets and financial assets. Real assets are physical assets, such as land,
money has taken a long time; it could have been so much quicker and easier for her buildings, machinery, cattle, and gold. They often represent a company’s means (or
to find the money if there was a system that connected those who need money with factors) of production and are sometimes referred to as physical capital. In contrast,
those who have savings and are willing to invest these savings. Well, there is such a financial assets are claims on real, or possibly other financial, assets. For example, a
system! It is called the financial system. 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
THE FINANCIAL SERVICES INDUSTRY 2 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
The financial system helps link savers who have money to invest and spenders who are repaid. Because interest payments on many loans are fixed, debt securities
need money. Within the financial system, the financial services industry offers a range are also called fixed-income securities. They are also known as bonds, and
of products and services to savers and spenders and helps channel funds between investors in bonds are referred to as bondholders. More information about debt
them. Note that in this chapter and in the rest of the curriculum, the terms money, securities is provided in the Debt Securities chapter.
cash, funds, and financial capital (or capital) are used interchangeably.1
■ Equity securities are also called stocks, shares of stock, or shares. As men-
Savers include individuals (households), companies, and governments that have tioned earlier, shareholders (also known as stockholders) have ownership in a
money to invest. Spenders also include individuals, companies, and governments. company. The company has no obligation to either repay the money the share-
For example, individuals borrow to pay for houses, education, and other expenses. holders paid for their shares or to make regular payments, called dividends.
Companies borrow to invest in land, buildings, and machinery. Governments borrow However, investors who buy shares expect to earn a return by being able to sell
when their current tax receipts are insufficient to meet their current spending plans. 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
1 Bolded terms are glossary terms. Many important terms are introduced in this chapter, but only the that have money to invest (the savers that become providers of capital) and those that
terms that are critical to your understanding of what is discussed in this chapter are bolded. The terms that need money (the spenders that become users of capital). Key industry participants
are discussed more thoroughly in subsequent chapters are bolded in those chapters.
and processes are described in more detail later in this chapter.
© 2014 CFA Institute. All rights reserved.
The Financial Services Industry 5 6 Chapter 1 ■ The Investment Industry: A Top-Down View
3 FINANCIAL INSTITUTIONS
Direct Finance
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
Financial Markets
institutions are banks and insurance companies.
Where savers and spenders
Savers can buy and sell securities. Spenders
(Providers of Capital) (Users of Capital)
3.1 Banks
Financial Services Banks collect deposits from savers and transform them into loans to borrowers. In
Industry 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,
Financial Intermediaries and the bank has a claim on the borrower through the loan. Banks are also called
Channel funds from deposit-taking institutions (or depository institutions) because they take deposits.
savers to spenders. 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.
Indirect Finance
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
Providers and users of capital may interact through financial markets or through banks provide banking products and services to individuals and small businesses.
financial intermediaries. The movement of funds through financial markets is called These products and services include checking and savings accounts, debit and credit
direct finance because the providers of capital have a direct claim on the users of cards, and mortgage and personal loans. An increasing number of retail banking
capital. For example, if you own shares of Nestlé, you have a claim on the assets and transactions are now performed either electronically via automated teller machines
earnings of Nestlé. (ATMs) or over the internet. Commercial banks provide a wide range of products
and services to companies and other financial institutions.
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 Co-operative and mutual banks are financial institutions that their members own
financial intermediaries act as middlemen between savers and spenders; the former and sometimes run. They may specialise in providing mortgages and loans to their
do not have direct claims on the latter. Financial intermediaries may also create new members. Some co-operative and mutual banks may offer a wider range of products
products and securities that depend on other assets. and services, similar to those offered by commercial banks. Depositors benefit because
they earn a return (in interest, transaction services, dividends, or capital appreciation)
Financial intermediaries play an important role in the financial services industry. on their capital without having to locate the borrowers, check their credit, contract
Many savers do not have the time or the expertise to identify and select individuals, with them, and manage their loans.
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 If borrowers default, banks still must pay their depositors and other lenders. If the
they will get their money back—a task that is time consuming and costly. Matching banks cannot collect sufficient money from their borrowers, the banks will have to
savers and borrowers and monitoring borrowers’ behaviour and financial health are use their owners’ capital to pay their debts.2 The risk of losing capital should focus
functions that financial intermediaries can perform better and more cheaply than the banks’ attention so that they do not offer credit foolishly. However, notable lapses
most investors can do on their own. 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 7 8 Chapter 1 ■ The Investment Industry: A Top-Down View
The investment industry contributes to the efficient allocation of resources in the 5.1 How the Investment Industry Serves Investors
economy. Without the investment industry, savers would have to spend significant
resources finding individuals, companies, and governments offering suitable investment Below are some of the most important features that define a well-functioning invest-
opportunities. Resources would also be spent on the search for capital rather than on ment industry and, in turn, benefit investors.
considering how to best use it, which would result in less efficiency. An important feature that characterises a well-functioning investment industry is
The investment industry plays an important role in providing and processing infor- the availability of a broad range of investment opportunities that meets investors’
mation about investment opportunities. It helps investors collect and analyse data needs. Investors can invest in debt and equity securities and they can also invest in
about economies and information about individuals, companies, and governments. derivatives and alternative investments. These investments are described in more
It also assists investors in determining the value of real and financial assets. The types detail in the Investment Instruments module. Investors may also choose to save
of inputs and tools used by investment industry participants are described in the through investment vehicles that exist solely to hold investments on behalf of their
chapters in the Inputs and Tools module. shareholders, partners, or unitholders (units refer to shares and bonds for equity and
debt securities, respectively). The ownership interests of these companies are called
Investment industry participants package investment opportunities so that they sat- pooled investment vehicles because investors in these vehicles pool their money for
isfy the needs of investors. In particular, the investment industry offers a wide range common management. Types and characteristics of investment vehicles are discussed
of services and products that makes it easier for savers to invest. These investment in the Investment Vehicles chapter.
services and products are discussed in the chapters in the Industry Structure module.
Investment industry participants may also buy and sell various real and financial
The investment industry also provides liquidity. Liquidity refers to the ease of buying assets and then package them to create new assets that suit the needs of investors
or selling an asset without affecting its price. Some assets, such as real estate (land better than the original assets. Mortgage-backed securities are an example; they
and buildings), are inherently illiquid. For example, if you want to sell your house, it represent a claim on the money generated by a large number of mortgages that have
will likely take some time to sell, even if it is priced fairly compared with other houses been grouped together in a process called securitisation, which is further discussed
in your neighbourhood. If you want to sell your house quickly, you may have to sell in the Debt Securities chapter.
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 In addition to being able to choose from many investment opportunities, investors
the shares quickly could have a negative effect on the share price. For example, if an benefit from having access to a broad range of investment services that help them
investor owns 100 shares in a company with actively traded shares, she will likely be make better decisions and implement those decisions. The investment industry
able to sell her shares quickly and not affect the share price. But if she owns 100,000 offers services of value to investors including planning, management, information,
shares, she may not be able to sell her shares quickly without affecting the share and trading services. These services are discussed in the Structure of the Investment
price. As a result, she may have to accept a lower price for some or all of the shares Industry chapter. How investment industry participants assess and serve the needs
she wants to sell. Liquidity is a very important aspect of well-functioning financial of investors is discussed further in the chapters in the Serving Client Needs module.
markets. Highly liquid markets allow investors to complete a transaction quickly (and Investors benefit when financial markets are competitive. Competitive markets lead
to reverse it quickly if they change their minds) and to have confidence that they are to fair prices, which ensure that buyers pay and sellers receive a reasonable and satis-
getting a fair price at that particular moment. factory price. Markets in general and financial markets in particular are competitive
All of these benefits increase the willingness of savers to supply funds to those who if a large number of participants compete with one another without any one of them
need them. Capital that is put to more productive use fosters economic growth, which having an undue influence on supply or demand. Supply refers to the quantity of
ultimately benefits society. 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
HOW INVESTORS BENEFIT FROM THE EXISTENCE OF THE
INVESTMENT INDUSTRY
5 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
In a well-functioning investment industry, investors are treated fairly and honestly.
lower the transaction costs, the better.
As a result, they have confidence to commit their savings to investments. Ideally,
investment industry participants compete fairly for investors’ business, and they are To make reasonable judgments about what to invest in, savers need relevant and
competent and trustworthy in advising on investment matters and managing invest- reliable information about the companies and governments to which they provide or
ment products and portfolios. may provide capital. By helping collect and process financial information, investment
industry participants provide benefits to investors. The timeliness of this information
How Investors Benefit from the Existence of the Investment Industry 11 12 Chapter 1 ■ The Investment Industry: A Top-Down View
is also critical because securities prices may change quickly in response to new, rel- For example, trading based on non-public information that could affect a security’s
evant information. For example, the share price of an oil company that announces it price—known as insider trading—is forbidden in most jurisdictions. For example, an
has discovered a large new oil field will likely increase as investors anticipate that the analyst who learns during a private meeting with a company’s management that the
company will make higher profit. 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.
Another important feature of a well-functioning investment industry is the ability to If the analyst trades before this information is available to all market participants, he
deal with risk. Risk refers to the effect of uncertain future events on an organisation could gain from this inside information and the integrity and fairness of the financial
or on the outcomes the organisation achieves and is discussed in greater detail in the market would be compromised. In many jurisdictions, the analyst could also face
Risk Management chapter. Risk is an inherent element of investing, and investors punitive legal or regulatory measures.
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 Although the investment industry is subject to laws and regulations, these laws and
the risk that the friend’s business fails and he never gets his money back. Although regulations cannot cover every situation and cannot prevent fraud or market abuse
the friend’s business could turn out to be the next Apple, Google, or Microsoft, the from happening. This risk is why it is important that
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 ■ individuals who work in the investment industry behave ethically, in accordance
assess how risky the investment is. with a set of moral principles, and act professionally, and
The investment industry also provides ways of reducing risk. For example, contracts ■ organisations promote cultures of integrity.
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
Ethical behaviour on the part of investment industry participants is paramount to pro-
investments. Those who are willing and able to take on risk may sell insurance or
tect the reputation of and maintain trust in the industry. Without trust, savers are less
offer investments that allow others to reduce their risks.
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
5.2 Need for Trust, Laws, and Regulations Regulation module. The Risk Management chapter addresses the issue of compliance
with 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,
6 INVESTMENT INDUSTRY PARTICIPANTS
savers will be reluctant to invest, and the economy and society will suffer.
There are many investment industry participants who help spenders raise capital and
Laws and regulations are necessary to ensure that investors are treated fairly and savers invest their money. Anybody working in the investment industry or purchasing
honestly. Usually, laws are passed by a legislative body, such as Congress in the United products and services provided by the investment industry is likely to come in contact
States, Parliament in the United Kingdom, and the Diet in Japan. Regulations are with a number of these participants. Key participants are introduced in Sections 6.1
created by agencies, such as the Canadian Securities Administrators in Canada, the and 6.2. The rest of the curriculum provides more information about how investment
Autorité des Marchés Financiers in France, and the Securities & Futures Commission industry participants operate and how they interact with investors and with one another.
in Hong Kong. Laws and regulations must be enforceable to be effective.
As a way of introducing some of the main investment industry participants, let us
The form and extent of laws and regulations vary between countries and change over take a look at the Canadian entrepreneur’s company five years later. Over that time,
time, but a number of general principles are widely applied. Laws and regulations are the company has been successful, and it now needs new capital to continue growing.
designed to 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.
■ prevent fraud, 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
■ protect investment industry participants, in particular investors, and 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
promote and maintain the integrity, transparency, and fairness of financial
invest their money.
markets.
Investment Industry Participants 13 14 Chapter 1 ■ The Investment Industry: A Top-Down View
6.1 How Companies and Governments Raise Capital categories of individual investors varies across countries, currencies, and investment
firms. But as a general rule, retail investors have the lowest amount of investable
The Canadian company wants to issue shares to raise capital. Until now, it has been a assets, whereas high-net-worth investors have higher amounts of investable assets.
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 The services that the investment industry provides to individual investors differ depend-
Stock Exchange. Stock exchanges are organised and regulated financial markets that ing on the investor’s wealth and level of investment knowledge and expertise, as well as
allow buyers and sellers to trade securities with each other. on the regulatory environment. Retail investors tend to receive standardised services,
whereas wealthier investors often receive services specially tailored to their needs.
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- Institutional investors that invest to advance their missions include the following:
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 ■ Pension plans, which hold and manage investment assets for the benefit of
case of the Canadian company, the equity issuance is called an initial public offering future and already retired people, called beneficiaries.
(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 ■ Endowment funds, which are long-term funds of not-for-profit institutions,
about IPOs and other equity issuances. such as universities, colleges, schools, museums, theatres, opera companies,
hospitals, and clinics.
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- ■ Foundations, which are grant-making institutions funded by financial gifts and
ments that investors most want so that they can help companies and governments by the investment income that they produce.
design securities that will suit the needs of the company or government and appeal
■ Sovereign wealth funds, which typically invest a government’s surpluses.
to investors. By offering securities that investors want to purchase, companies and
governments are able to obtain capital at a lower cost. Governments may accumulate surpluses by collecting taxes in excess of current
spending needs, by selling natural resources, or by financing the trade of goods
The investment bank will help the Canadian company determine the price at which the and services. These surpluses are usually invested. Some governments with sig-
new shares will be issued. To do so, the investment bank has to gauge investor interest nificant surpluses have created sovereign wealth funds to invest their surpluses
in purchasing the company’s shares. The investment bank’s analysts—often called for the benefit of current and future generations of their citizens.
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 Institutional investors that invest on behalf of others include investment firms and
a detailed report that can be shared with potential investors. 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.
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- Despite the differences between investors and their needs, many of the services they
tions. It will, for instance, have to file quarterly financial statements and audited annual require are common to all of them. Some of these services are shown in Exhibit 2.
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. Exhibit 2 Investor Services
Investment Investment
6.2 How the Investment Industry Helps Savers Invest Their Financial Management Information Trading
Custodial
Money Planning
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- Savers
tion “individual investor” is self-explanatory; an individual investor is simply a person (Providers of Capital)
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 Institutional Investors Individual Investors
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
Investment Industry Participants 15 16 Chapter 1 ■ The Investment Industry: A Top-Down View
When investors want to buy or sell shares, they need to find another investor who
MEET SOME OF THE INVESTMENT INDUSTRY PARTICIPANTS
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 Zhang Li is a retail investor. She earns 5,000 Singapore
to trade with buyers and sellers in what is known as proprietary trading. They “make dollars a month and wants to save for a deposit on an
markets” in securities by acting as buyers when investors want to sell and as sellers apartment in the suburbs of Singapore. She also wants to
when investors want to buy. They often have thousands of clients so if one client wants save to pay for her son’s university education. She goes to
to sell shares at a certain price, the dealer can usually identify another client who is her bank for investment advice.
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 Mike Smith is a high-net-worth investor who lives in
agents, which confirm and settle trades after they have been agreed on. Custodians California. He has recently sold his technology company
and depositories hold money and securities on behalf of their clients. and has $10 million to invest. He hires a financial planner
to help him define his investment objectives in terms of
Institutional investors may employ analysts to review potential investments. These return and risk.
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 Anna Huber is an institutional investor for Euro Pension
that provide information resources and investment research providers that produce Fund, which is located in Frankfurt, Germany. The fund
information reports. receives money to finance the retirement of the Euro
Pension Plan members, invests the money received, and
Individual investors often do not have the time, the inclination, or the expertise to pays out money to the retired members. It has an asset
manage the entire investment process on their own, so many of them seek the help management team that devises its strategy and imple-
of investment professionals. Financial planning service providers, such as financial ments it, managing a €50 billion portfolio invested in a
wide range of assets. Huber is a member of that team.
planners, help their clients understand their future financial needs and define their
investment goals. Investment management service providers, such as asset managers, Peter Robinson is an asset manager for Aus Ltd., which is
make and help their clients make investment decisions in order to achieve the clients’ based in Sydney. Aus Ltd. invests money on behalf of its
investment goals. clients in shares, bonds, and alternative investments. It
hires a data vendor and two investment research provid-
Many investors, particularly retail investors, are willing to invest but lack sufficient ers to keep it updated with the latest market develop-
financial resources to contract with an investment manager to look after their invest- ments. Aus Ltd. has a broker that carries out trades on its
ments. These investors often buy investment products created and managed by invest- behalf and a custodian that safeguards clients’ money and
ment firms, banks, and insurance companies. For example, an individual who wants to assets.
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.
Key Forces Driving the Investment Industry 17 18 Chapter 1 ■ The Investment Industry: A Top-Down View
Competition
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 Regulation
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.
Technology
James Armistead is with Big Bank Financial Services, Investment
a custodian with offices all over the world. When an Industry
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.
Globalisation
■ The investment industry, a subset of the financial services industry, includes all
Categories Participants Key Characteristics
participants that help savers invest their money and spenders raise capital in
financial markets. Trading service Exchanges Organised and regulated financial
providers markets that allow investors to trade
■ A goal of economic systems is the efficient allocation of scarce resources to Brokers Professionals and their firms that
their most productive uses. Financial markets and the investment industry help facilitate trading between investors,
allocate capital, a scarce resource, to the most productive uses, which fosters acting as agents (they do not trade
economic growth and benefits society. with their clients)
Dealers Professionals and their firms that
■ The investment industry provides numerous benefits to the economy, including
facilitate trading between investors,
the efficient allocation of scarce resources, better information about investment acting as principals (they trade with
opportunities, products and services that are appropriate for providers and their clients)
users of capital, and liquidity.
Clearing houses and Organisations that confirm and settle
■
settlement agents trades
The benefits for investors of a well-functioning investment industry include a
broad range of investment products and services that meet their needs, com- Custodial service Custodians and Organisations that hold money and
petitive markets that provide liquidity and keep transaction costs low, timely providers depositories securities on behalf of their clients
and efficient disclosure of information, and the ability to modify their risk ■ Four key forces that drive the investment industry are competition, technology,
exposures. globalisation, and regulation.
■ 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.
ETHICS AND INVESTMENT c Identify elements of the CFA Institute Code of Ethics;
Ethics
INTRODUCTION 1 Rules
Ethics play an essential role in protecting financial market integrity and the functioning Professional Standards
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 A culture of integrity based on ethical standards can be built and developed at a
sound. 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:
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 1 Set high standards and put them in writing,
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 2 Get adequate and ongoing training on professional and ethical standards,
CFA Institute Board of Governors, put it earlier, “A tarnished reputation is difficult to
3 Assess the integrity of individuals and groups you encounter, and
clean. . . . The investment profession is built on trust as much as it relies on expertise.”2
4 Take action when breaches of integrity and ethical standards are observed.
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 These steps help individuals to identify, assess, and deal with ethical dilemmas.
will slow. So, it is important that investors are treated fairly because society benefits Ethical dilemmas are situations in which values, interests, and/or rules potentially
from well-functioning financial markets. conflict. Sometimes, the ethical dilemma and the appropriate ethical response seem
obvious. In other instances, neither the ethical dilemma nor the appropriate ethical
The creation and maintenance of trust depends on the behaviour, actions, and integrity response is obvious. To identify and deal with an ethical dilemma, it is useful to be
of entities participating in the financial markets. These market participants include able to consult a framework that guides ethical decision making. An example of such
companies and governments raising capital, investment firms (companies in the invest- a framework is described in Section 6. Individuals following such a framework are
ment industry), rating agencies, accounting firms, financial planners and advisers, more likely to identify ethical dilemmas and to ensure that they and others around
regulators, and institutional and individual investors. Ultimately, trust relies on the them behave ethically.
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 2 WHY ETHICAL BEHAVIOUR IS IMPORTANT
rules is, therefore, critical. In the end, trust depends on individuals choosing to comply
with rules and to act ethically.
Global financial markets have grown in size and complexity over the last few decades.
Ethical standards, and some professional standards, are based on principles that Investment products and financial services offered have also increased in breadth
support and promote desired values or behaviours. Ethics is defined as a set of moral and complexity. Such growth and increased complexity increase the likelihood of
principles, or the principles of conduct governing an individual or a group. Professional ethical dilemmas occurring. This likelihood is further enhanced as organisations
organisations, such as CFA Institute, establish codes of ethics and professional stan- and individuals conduct business across borders and under different regulatory and
dards based on fundamental ethical principles to guide practice. Ethics and rules are cultural frameworks.
intertwined; ethical standards help guide the development of rules, and rules help
individuals and groups, such as professional associations, think about, develop, and Investment professionals help provide access to and information about these invest-
apply ethical standards. 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-
1 CFA Institute and Edelman, “CFA Institute & Edelman Investor Trust Study” (2013): www.cfainstitute. agement functions are also critical to the functioning of the investment industry. These
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/
individuals include employees working in fund administration, securities trading and
products/publications/contributed/Pages/creating_a_culture_of_integrity.aspx. account services, and other support activities—including legal, human resources,
© 2014 CFA Institute. All rights reserved. marketing, sales, and information technology.
Why Ethical Behaviour Is Important 25 26 Chapter 2 ■ Ethics and Investment Professionalism
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.
3 OBLIGATIONS OF EMPLOYEES IN THE INVESTMENT
INDUSTRY
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. To establish and maintain high ethical standards, it is critical to understand general
This support may be provided from within the investment firm or, in some cases, by obligations to clients, prospective clients, employers, and co-workers. Considering how
third parties, such as legal or tax consulting firms. Such support also extends to the to meet these obligations will help guide behaviour. Failure of investment professionals
use of third-party information, such as credit ratings and investment research. When to meet these obligations may adversely affect clients, employers, co-workers, and even
using such support and information, individuals working in the investment industry the financial system as a whole. Negative effects can have far-reaching consequences
must be careful and conduct due diligence to ensure the reliability of the information because of the interconnection among financial system participants. The general
and its sources. If all parties are committed to acting in the best interests of the client, obligations to clients, prospective clients, employers, and co-workers are similar for
the client’s trust in the professional relationship is more likely to be sustained. all employees in the investment industry.
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
3.1 Obligations to Clients
investment industry behave ethically. Some of the factors, including success of the The client relationship is critical to the functioning of the investment industry.
investment industry, affected by ethical standards are shown in Exhibit 1. High ethical Therefore, all individuals working in the investment industry, whether involved directly
standards support these factors, and a breach of ethical standards can undermine them. or indirectly with clients, have an obligation to act competently and carefully when
For example, when investors hear about insider trading (trading while in possession fulfilling their responsibilities. Fulfilling this obligation means using the required
of information that is not publicly available and that is likely to affect the price, often professional knowledge and skills, managing risks that can affect client interests, safe-
referred to as material, non-public information) or misrepresented financial reports, guarding client information, and treating clients consistently, fairly, and respectfully.
it brings into question the integrity and fairness of financial markets and lowers public
trust and investor confidence in them. 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
Exhibit 1 Factors Affected by Ethical Standards in the Investment investment industry are expected to place the client’s interests above their own and
Profession 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
Investor investment, risk, cash flow management, and retirement planning. Clients place great
Confidence trust and confidence in this advice. Financial planning and investment advice result in
Success of Integrity of a much higher level of responsibility than that associated with a financial salesperson
the Investment the Investment committed to selling specific investment products or brands.
Industry Profession 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-
Fairness High Integrity of sional obligation to exercise independent judgment when identifying and advising on
of Financial Financial suitable investment products and to pursue the best interest of the client at all times.
Ethical Particular care must be taken to ascertain whether an adviser’s interests have the
Markets Markets
Standards 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
Efficiency Clients’ may be tempted to recommend the product that generates the highest commission
of Financial Investment to the adviser when some of the other products would actually be better suited to the
Markets Goals client’s investment goals. In this conflict of interest, the adviser may inappropriately
Public Clients’ make a decision based on adviser interest and not act in the client’s best interest.
Trust Trust
Obligations of Employees in the Investment Industry 27 28 Chapter 2 ■ Ethics and Investment Professionalism
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. She overheard information at work He overheard information at work
that would cause ABC company’s that would cause ABC company’s
Have you ever faced a conflict of interest in your work? Even if you have not faced stock prices to fall. She called her stock prices to fall. He kept the
one yet, be aware that employees in all parts of the investment industry face potential broker and sold her shares before information to himself and did not
conflicts of interest. Investment professionals and support staff alike must remain the news was made public. act on it.
alert to conflicts that may arise.
Some examples of conflicts of interest are presented in Exhibit 2. In each example, the
individual chose to act in his or her own interest rather than that of the client and/or
employer. As you read these examples, consider how the individual could have more
appropriately responded to the conflict of interest.
tasks of co-workers and the overall success of a team. In a worst-case scenario, the
Exhibit 2 (Continued)
lack of competence and care by one worker can reflect on others and result in the
The following are examples of conflicts of interest involving support staff. 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,
■ When learning about a change in a share recommendation, an individual ethical conduct—including competence, care, and respect towards co-workers—not
in the printing office of a research firm immediately phones family mem- only contributes to the achievement of client and employer goals but can also enhance
bers so they can act on the information prior to the firm’s clients. The your career as you develop social and communication skills and, in some cases, team
individual is not acting in the best interest of his or her employer or the leadership skills.
employer’s clients.
Obligations to co-workers extend beyond competent and careful work. In addition
■ A receptionist at an investment firm hears that a company’s CEO will be to fostering your own professional development, you have an obligation to support
fired. Anticipating downward pressure on the company’s share price, the the professional development of co-workers, which includes helping co-workers
receptionist sells personal shares in the company before the news is made understand, promote, and follow ethical practices as well as encouraging others to
public. adhere to professional obligations, such as the preservation of client confidentiality.
These questions are intended to identify major obligations, but they are not compre- professional association. This adherence helps ensure that common ethical standards
hensive. They can be adapted to identify and consider standards applicable to any are applied across a wide group of people. Engineers, accountants, lawyers, and doctors,
employee’s work environment. 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.
ETHICAL STANDARDS 4 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
Laws and regulations help to ensure that those working in the investment industry
(Code and Standards) on the premise that a fundamental set of ethical principles should
fulfil their obligations. They also help protect the integrity of the financial system and
govern and guide the professional conduct of those participating in the investment
promote fairness and efficiency of financial markets. However, laws and regulations
industry. As a preeminent global association for investment professionals, CFA Institute
alone are not sufficient to protect the financial system. Some of the reasons for this
requires its members and CFA and CIPM (Certificate in Investment Performance
include the following:
Management) 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
■ Laws and regulations may not extend to all areas of finance and can be vague or Code and Standards represent the core values of CFA Institute and its members and
ambiguous, making their interpretation a challenge. have served as a model for ethical standards of investment and other financial pro-
■
fessionals since the 1960s.
Laws and regulations are often slow to catch up with market innovations.
■
The Code and Standards should be viewed and interpreted as an interwoven tapestry
Activities that occur in different jurisdictions can be complicated by inconsis-
of ethical requirements, outlining conduct that constitutes fair and ethical business
tencies in legal obligations in different countries.
practices. Adhering to the ethical principles underlying the Code and Standards will
■ Situations may arise in which no applicable law exists or the existing law is help protect the integrity of financial markets and promote trust in the investment
inconclusive. 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
■ The effectiveness of laws and regulations depends on how market participants code includes ethical principles that can be adapted for use by others working in the
interpret and comply with them. investment industry. These principles are described in Section 4.1.2.
The need for ethical standards is particularly apparent in situations in which vague It is important that individuals working in the investment industry understand how
or ambiguous legal rules provide room for unethical behaviour that could affect the investment professionals should behave because of the potential consequences of any
integrity of the investment industry and result in a loss of clients’ and/or investors’ unethical or unprofessional actions.
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 Exhibit 3 The CFA Institute Code of Ethics
allow them to adapt to a continuously changing investment industry.
Section 4.1 describes why codes of ethics and professional standards exist. As an Members of CFA Institute (including CFA charterholders) and candidates for
illustration, Section 4.1.1 describes the Code of Ethics and Standards of Professional the CFA designation must:
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 ■ Act with integrity, competence, diligence, respect, and in an ethical
to the behaviour of others working in the investment industry. manner with the public, clients, prospective clients, employers, employ-
ees, colleagues in the investment profession, and other participants in the
global capital markets.
4.1 Codes of Ethics and Professional Standards ■ Place the integrity of the investment profession and the interests of clients
The topic of ethics is challenging to discuss because, to a large extent, individuals’ above their own personal interests.
ethical outlooks are personal moral philosophies. These ethical outlooks are related ■ Use reasonable care and exercise independent professional judgment
to upbringing; culture; social, economic, and legal environment; and personal and
when conducting investment analysis, making investment recommen-
professional circumstances. One distinct characteristic of a profession is adherence
dations, taking investment actions, and engaging in other professional
to a code of ethics and standards of professional conduct that are typically set by a
activities.
Ethical Standards 33 34 Chapter 2 ■ Ethics and Investment Professionalism
■ Engage in fair dealing. All clients in similar situations should be treated fairly
Exhibit 3 (Continued)
regardless of whether one client has more assets, pays more fees, or has a closer
■ Practice and encourage others to practice in a professional and ethical relationship. Fair treatment of all stakeholders maintains the confidence of the
manner that will reflect credit on themselves and the profession. investing public in the investment industry.
■ Promote the integrity and viability of the global capital markets for the ■ Protect confidential information. Confidential information of clients, employers,
ultimate benefit of society. counterparties, and other stakeholders must be diligently protected.
■ Maintain and improve their professional competence and strive to main-
The Code and Standards, which are intended to guide the investment professional,
tain and improve the competence of other investment professionals.
can help guide all participants in the investment industry to identify, promote, and
follow high ethical standards.
The CFA Institute Standards of Professional Conduct, contained in the Standards of 4.1.2 How the Code of Ethics May Guide All Employees in the Investment Industry
Practice Handbook, expands on the Code and provides guidance about important issues
The Code of Ethics and the ethical principles embedded in it may seem overwhelming.
relevant to the investment professional.3 Fundamental ethical and professional princi-
Key aspects of potential relevance to you are summarised in Exhibit 4. An explanation
ples that are applicable to the investment industry professional include the following:
of each of the four aspects follows the exhibit.
■ 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 The Code requires investment professionals to act with integrity and to place the
gifts or relationships that may influence their judgment. integrity of the financial markets and the investment profession before personal or
■
employer interests. Integrity also applies to the client relationship. The obligations
Avoid or disclose conflicts of interest. As discussed in Section 3.1, conflicts
to avoid or manage conflicting interests and to prioritize client interests serve this
between client interests and the personal interests of the employee or employer
relationship and promote public trust in the investment industry. It is important that
should be avoided or managed through disclosure so that all relevant stakehold-
all employees in the investment industry act with integrity and act with the primacy
ers are aware of these conflicts and their potential effects on the relationship
of clients’ interests in mind.
with the client. Disclosures must be prominent and made in plain language and
in a manner designed to effectively communicate the information. The Code requires investment professionals to act with competence, diligence, and
■
reasonable care. Because financial markets, investment tools, and related services are
Make full and fair disclosure. Transparency and good communication are key
constantly evolving, employees must continuously strive to maintain and improve their
elements in building trust with investors and allowing clients to make intelli-
knowledge and competence, as well as that of others. Personal education and skill
gent and informed decisions. Those in the investment industry who make false
development will help employees meet these responsibilities competently and diligently.
or misleading statements harm investors and reduce investor confidence in
financial markets. 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.
3 The Standards of Practice Handbook can be accessed at www.cfapubs.org/toc/ccb/2014/2014/4.
Benefits of Ethical Conduct and Consequences of Unethical Conduct 35 36 Chapter 2 ■ Ethics and Investment Professionalism
y
be unaffected by any potential conflict of interest or other circumstance adversely
affecting objectivity and independence. Potential conflicts of interest include, for Liquidity Efficiency
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.
TRUST
BENEFITS OF ETHICAL CONDUCT AND CONSEQUENCES OF
UNETHICAL CONDUCT
5 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.
Unethical behaviour, whether legal or not, can have significant consequences for the
financial system and the economy. Compliance with ethical standards is important to Increased market participation benefits all market participants and stakeholders.
prevent financial crises that can affect economic development and society’s welfare. These benefits include increased liquidity (investors are able to trade assets without
Accordingly, one of the benefits of complying with ethical standards is the increased affecting prices significantly) and increased market efficiency. Increased market par-
stability of the financial system and thus of the entire economy. Importantly, ethical ticipation also promotes public awareness and understanding of the financial system.
standards complement existing legal obligations, professional standards of conduct, This understanding, in turn, leads to additional participation in and efficiency of
and organisational policies and procedures to prevent behaviour that can affect other financial markets.
industries and even the global economy.
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
5.1 Benefits of Ethical Conduct influence the profitability and growth of companies as well as the development of the
The liquidity, profitability, and efficiency of markets and economies are rooted in trust. 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 may enhance employment security and increase certainty in career An example of financial contagion occurred in 2008. As a consequence of unethical
development. Complying with ethical standards may directly and positively affect a behaviour, in the form of aggressive mortgage lending by some market participants,
professional’s position, compensation, and reputation. It may also provide indirect along with other financial events, the US housing and stock markets declined. As a
benefits through the increased reputation and business success of a professional’s result, the US-based global investment firm Lehman Brothers went bankrupt.5 These
team and entire firm, thereby providing long-term career and skill set development events led to a liquidity crisis (a shortage of available funds) in financial markets.
opportunities. Compliance will be further discussed in the Investment Industry The ensuing global financial crisis almost resulted in the bankruptcy of American
Documentation chapter. 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
5.2 Consequences of Unethical Conduct
mortgage lending—by some market participants can lead to the bankruptcy of a
When ethical and professional standards are violated, there can be significant con- company and a negative impact on other interlinked companies, their clients, and
sequences. These consequences include failure to achieve goals on behalf of a client the entire financial system.
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- 5.2.2 Consequences for Clients
ment industry and the economy. 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
5.2.1 Consequences for Industry and Economy wealth and current or future income, and experience personal distress.
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, Unethical behaviour resulting in inappropriate investment advice or services may
they may cease to invest; potential consequences include companies being unable to expose clients to excessive risks, ownership of unsuitable assets, lack of diversifica-
raise capital in financial markets, investment firms losing business or even going out tion, inflated costs of investment management services, and unjustified transaction
of business, and the economy slowing down. Unethical and/or illegal behaviour can and management costs. For example, excessive trading of client assets to maximise
be responsible for these kinds of negative consequences. For example, former US busi- trading commissions will result in clients incurring excessive transaction costs and
nessman Bernard L. Madoff ignored his duty to put his clients’ interests first when he may result in clients owning assets that are not consistent with their objectives and
turned an allegedly legitimate wealth management firm into a Ponzi scheme, in which needs. Because of the central role of trust in a client relationship, the violation of legal
investors were paid with money from other investors as investment returns.4 Madoff and ethical standards generally decreases a client’s trust in investment professionals
thereby acted deceitfully and defrauded clients. The unveiling of this fraud in 2008 and possibly in the investment industry as a whole. Violations related to financial
resulted in Madoff being sentenced to 150 years in prison and caused a widespread market transactions (for example, insider trading) further decrease a client’s trust in
loss of investor trust in investment industry professionals. the integrity of financial markets.
In addition to the immediate consequences of unethical behaviour on companies In all of these cases of unethical behaviour, clients can lose wealth and income. For
in the investment industry and their clients, the transmission of financial shocks example, if a client owns shares in an investment bank and there is a trading scandal,
from one company to another can be dangerous for interconnected companies and, the value of the shares may fall and the client may lose money. The client may also
potentially, for the economy and the financial system. Therefore, the consequences suffer a decrease in current income because of lower dividend payments. In addition,
of unethical behaviour at one company can affect other companies (and their clients) the client’s future income can be reduced if retirement funds have been affected. Faced
despite them not being involved in the unethical behaviour. For example, if a company with financial damage to wealth and income, clients can experience a great level of
goes bankrupt as a result of unethical behaviour, the company’s unfulfilled liabilities personal distress along with severe mistrust in the investment industry, whether that
could result in a widespread crisis for a larger group of related companies, thereby mistrust is justified or misplaced.
potentially damaging the economy. Such spillover or financial contagion may result
in decreased economic output, increased unemployment, and reduced long-term
5.2.3 Consequences for Employers
economic growth expectations.
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
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 5 A 2,200-page, 9-volume report issued 11 March 2010 by the court-appointed examiner of Lehman
investors and/or investors begin to request withdrawals rather than reinvesting their supposed earnings. Brothers identified various questionable, but not necessarily illegal, activities undertaken by the firm.
Benefits of Ethical Conduct and Consequences of Unethical Conduct 39 40 Chapter 2 ■ Ethics and Investment Professionalism
the conduct results in legal scrutiny, including threat of lawsuits, legal charges, and 2007, she settled a civil action suit for insider trading brought by the US Securities
prosecution. Because clients associate a company’s employees with the company’s and Exchange Commission (SEC) by paying a fine of US$195,000 and accepting a
brand, illegal or unethical conduct can result in a loss of company reputation that five-year ban on serving as an officer or director of a public company.
can damage or destroy current and future client relationships.
Consequences of breaches of ethical and professional standards also include disciplinary
In some cases, an employer can face closure because of the unethical and/or illegal action by the employer and/or a professional or regulatory body and disapproval
behaviour of one or more individuals within the company. US energy and commod- from clients, colleagues, and the industry peer group. This discipline can result in the
ity trading company Enron, for instance, collapsed in 2001 as a result of unethical, decreased ability to advance a career because of a loss of reputation, which has personal
aggressive accounting practices, which were later identified to be illegal. As a result, and economic consequences. In particular, the individual can suffer a loss of income
Enron CEO Jeffrey K. Skilling received a 24-year prison sentence. In addition, Arthur as a result of a restricted ability to provide current or future services. The individual
Andersen, Enron’s audit firm, was negatively affected and later dissolved because of could also face the loss of job and career and even alienation of family and friends.
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
6 FRAMEWORK FOR ETHICAL DECISION MAKING
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
Given the potential consequences of unethical behaviour, it is important that indi-
how the unethical behaviour of a few individuals can have detrimental effects on co-
viduals use a framework to help them make ethical decisions. The four-step process
workers and employers.
identified by Alan Meder, CFA (discussed in the Introduction) represents a simple
A loss of reputation can result in a loss of company profits and a loss of shareholder and useful framework. A more detailed framework is shown in Exhibit 5. Note that
value. In cases of illegal conduct, a company in the investment industry may be held even though the points in the framework are numbered, they may be addressed in a
liable for financial losses sustained by customers or other market participants. If prose- different order depending upon the situation. Reviewing the outcome should conclude
cuted, the employer may also be subject to fines and loss of operating licences and may the process and provide feedback for the next time the framework is applied.
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 Exhibit 5 A Framework for Ethical Decision Making
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 1 Identify the Ethical Issue(s) and Relevant Duties/Obligations
resources to administer and provide additional costly analysis and information.
2 Identify Conflicts of Interest
Exhibit 6 illustrates the application of the framework using a scenario that is fictional
Exhibit 6 (Continued)
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 During the orientation, limitations on the use of the company credit
how you would answer the questions posed and go through the framework if you were card were identified.
in the situation. For example, are you able to identify additional alternative actions?
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.
Exhibit 6 Application of a Framework for Ethical Decision Making
● Are there any facts not known that should be known?
Several colleagues and their friends from outside of the office go out after work Carlos would like to know the company policies on allowable client
with Carlos, a newly hired employee. The more experienced employees tell the entertainment expenses and for classifying and documenting someone
“new guy” to charge the meal and drinks to the company credit card. Carlos’s as a potential client. He would like to know if the friends are in fact
colleagues tell him the friends are “prospective clients” and that they have charged prospective clients.
similar outings on the card before, and the boss always approves the charges.
● Other questions that might be asked in fact gathering include, What
Carlos is confused. During orientation, the presenter from human resources resources are available to learn more about the situation? Is there
made it clear that it is against company policy to charge personal expenses on the enough available information to make a decision?
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 In this situation, Carlos does not have the luxury of gathering more
is okay? Use of the framework may help him make an ethically sound decision. information about the policy. Carlos may wonder if the friends actually
represent prospective clients for the company but may find it difficult to
1 Identify the Ethical Issue(s) and Relevant Duties/Obligations 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
● What is the ethical dilemma? company policy and be unethical.
Is it appropriate to use the company credit card to pay for the dinner 4 Identify Applicable Ethical Principles
with colleagues and their friends?
● What are the fundamental ethical principles involved in the situation?
● 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 Carlos is expected to act with integrity in using the resources of his
be affected. employer. He should use reasonable care in determining if the friends
represent prospective clients. He should use independent judgment.
Carlos owes a duty to his employer, which includes displaying loy- He should treat his colleagues with respect, but this does not mean he
alty, following its policies, and acting with integrity. His decision will cannot question their guidance.
potentially affect his relationships with his employer, his boss, and his
colleagues. 5 Identify Factors That Could Be Affecting Judgment
● Are any duties in conflict, and which duty takes precedence? ● What factors are affecting judgment? Outside factors, such as author-
ity figures, a vocal group, and incentives, can affect judgment. Internal
In some situations, duties to multiple parties may exist for the indi- factors, such as overconfidence and rationalization, can also affect
vidual facing the dilemma. In this case, Carlos’s sole duty is to his judgment.
employer.
Carlos may be influenced by his more experienced colleagues. He may
2 Identify Conflicts of Interest rationalise that it is just one dinner and unimportant. He should pause
and think through his decision before acting.
● Are personal interests affecting the decision/action?
6 Identify and Evaluate Alternative Actions
In this case, Carlos may struggle with wanting to fit in with his new
colleagues versus following his understanding of the policies of the ● What are the options? Have creative options been identified?
employer.
Carlos’s options include
3 Get the Relevant Facts
■ complying with his colleagues’ request and charging the dinner to
● What are the relevant facts in the situation? the company card.
(continued)
Framework for Ethical Decision Making 43 44 Chapter 2 ■ Ethics and Investment Professionalism
■ charging the dinner to his personal card and indicating that he will This framework is based on “A Framework for Thinking Ethically” from the Markkula Center for
speak to the boss about it the next day. Applied Ethics at Santa Clara University (www.scu.edu/ethics/practicing/decision/framework.html).
Exhibit 7 (Continued)
■
SUMMARY
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. ■ Trust is essential to the functioning of the investment industry—trust in the
behaviour, actions, and integrity of participants in the financial markets. Trust
■ A research assistant for a pension fund is considering sharing some
depends on participants complying with rules and acting ethically.
investment research and economic forecasts received by the fund with the
advisory board of the endowment for his church. ■ 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
■ A long-time assistant is asked by a senior manager, who is being let go, to
behaviour.
copy several company files for the manager’s job search. The files con-
tain research reports that the manager wrote, marketing presentations ■ Ethical reasoning and decision making become more important as increased
containing the manager’s performance record, and spreadsheets that the opportunities for ethical dilemmas arise in increasingly complex expanding and
manager created. globally interconnected financial markets.
■ An employee in the operations department of an investment firm respon- ■ A culture of integrity, at a business or personal level, can be built using a four-
sible for negotiating cell phone service for company employees is consid- step process:
ering renewing the contract with the firm’s existing carrier without any
further investigation. He is familiar with their service, comfortable with 1 Set high standards and put them in writing
the customer service representative of the carrier, and very busy with the
2 Get adequate and ongoing professional and ethics training
pending move of the firm’s offices.
■
3 Assess the integrity of individuals and groups encountered
An employee in the accounting department is responsible for processing
expense reports for a senior manager. Because the manager often does 4 Take action when integrity breaches are observed
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 ■ Investment professionals have to meet various obligations to serve their clients’
manager asks the associate to process his latest expense report, which interests and to comply with applicable laws, rules, regulations, and ethical
does not have receipts for larger expenses. When the employee asks for standards. Compliance with ethical standards benefits financial markets, clients,
the receipts, the manager tells him he lost them and to “just override the employers, co-workers, and employees within the investment industry.
system like you usually do.”
■ The CFA Institute Code of Ethics sets ethical standards for investment
■ While attending the sponsor’s exhibit area at an investment industry professionals.
conference, an employee of the compliance department of a large invest-
■ Fundamental ethical and professional principles applicable to the investment
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 industry include the following:
wins an iPad from the vendor. The employee discovers that her firm and ● Make client interests paramount.
the vendor are in the final stages of negotiating a long-term business
relationship. ● Exercise diligence, reasonable care, and prudent judgment.
■ An employee receives a check made out to him from a hotel as reimburse- ● Act with independence and objectivity.
ment for an uncomfortable night at the hotel. The employee’s company
paid for the hotel stay. ● Avoid or disclose conflicts of interest.
■ 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
CHAPTER 3
individuals make ethical decisions:
REGULATION
1 Identify the ethical issue(s) and relevant duties and obligations.
by James J. Angel, PhD, CFA
2 Identify conflicts of interest.
g Describe potential consequences of compliance failure. 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.
4 Ensure fairness. All market participants do not have the same information.
Professional Sellers of financial products might choose not to communicate negative infor-
Ethical Standards 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
Principles
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
An understanding of the regulatory environment and company rules is essential for
unfair advantage.
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- 5 Enhance efficiency. Regulations that standardise documentation or how to trans-
mies have had longer to evolve. Many of these systems have been adjusted over many mit information can enhance economic efficiency by reducing duplication and
years, so they not only protect investors and the financial system but also allow the confusion. An efficient dispute resolution system can reduce costs and increase
investment industry to innovate and prosper. economic efficiency.
financial services industry, which includes the investment industry. Customers may analysis also needs to carefully weigh the costs and benefits of the proposed
lose their life savings when sold unsuitable products or customers could be harmed regulation, even though the benefits are often difficult to quantify. In other
if an investment firm misuses customer assets. Furthermore, the failure of one large words, does the cure cost more than the disease? Regulations impose costs,
company in the financial services industry can lead to a catastrophic chain reaction including the direct costs incurred to hire people and construct systems to
(contagion) that results in the failure of many other companies, causing serious dam- achieve compliance, monitor compliance, and enforce the regulations. These
age to the economy. 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.
4 A TYPICAL REGULATORY PROCESS 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.
The processes by which regulations are developed vary widely from jurisdiction to 4 Public consultation. Regulators often ask for public comment on proposed
jurisdiction and even within jurisdictions. This section describes steps involved in a regulations. This public consultation gives those likely to be affected by the reg-
typical regulatory process and compares different types of regulatory regimes. ulations an opportunity to make suggestions and comments, on such issues as
costs, benefits, and alternatives, to improve the quality of the final regulations.
Exhibit 1 shows steps in a typical regulatory process, from the need for regulation to A regulation may go through several rounds of proposal, consultation, and
its implementation and enforcement. amendment before it is adopted.
punishments also may involve the loss of licences, a ban from working in the of US law that outlaw any type of fraud or manipulation.2 Equally, UK regulation is
investment industry, and even prison terms. The loss of reputation resulting often described as principles-based, yet some regulations—such as those for credit
from regulatory action, even when the individual is not convicted or punished, unions—are very detailed.
can have significant effects on individuals and companies.
Regulatory systems can also be designed as “merit-based” or “disclosure-based”. In
9 Dispute resolution. When disputes arise in a market, a fair, fast, and efficient merit-based regulation, regulators attempt to protect investors by limiting the products
dispute resolution system can improve the market’s reputation for integrity and sold to them. For example, a regulator may decide that a hedge fund product is highly
promote economic efficiency. Mechanisms that provide an alternative to going risky and should only be available to investors that meet certain criteria. Investing
to court to resolve a dispute—often known as alternative dispute resolutions— in hedge funds is usually restricted to investors that have a certain level of resources
have been developed globally. These typically use a third party, such as a tribu- and/or investment expertise. Disclosure-based regulation seeks to ensure not whether
nal, arbitrator, mediator, or ombudsman, to help parties resolve a dispute. Using the investment is appropriate for investors, but only whether all material information
alternative dispute resolutions may be faster and less expensive than going to is disclosed to investors. The philosophy behind disclosure-based regulation is that
court. properly informed investors can make their own determinations regarding whether
the potential return of an investment is worth the risk.
10 Review. Regulations can become obsolete as technology and the investment
industry change. For this reason, a good regulatory system has procedures in Again, the real world regulatory environment is often a hybrid of these two types of
place for regularly reviewing regulations to determine their effectiveness and regulation. For example, although US regulation is mostly disclosure-based, US reg-
whether any changes are necessary. ulators sometimes impose extra burdens of disclosure and restrict access to products
that they think lack merit, are highly risky, or are poorly understood.
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
TYPES OF FINANCIAL MARKET REGULATION 5
and companies should maintain ethical standards higher than the legal minimums.
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.
4.1 Classification of Regulatory Regimes These rules include the following:
The type of regulation that an individual or company encounters will affect how
■ Gatekeeping rules
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, ■ Operations rules
particularly if your company operates at a global level.
■ Disclosure rules
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- ■ Sales practice rules
ment industry is expected to operate. This avoids legal complexity and allows regula-
■ Trading rules
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 ■ Proxy voting rules
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
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.”
58 Chapter 3 ■ Regulation Types of Financial Market Regulation 59
■ Anti-money-laundering rules 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-
■ Business continuity rules 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
5.1 Gatekeeping Rules the entire investment industry.
Gatekeeping rules govern who is allowed to operate as an investment professional as
well as if and how products can be marketed.
5.3 Disclosure Rules
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 In order for markets to function properly, market participants require information,
honest people can do tremendous damage if they are untrained or incompetent. For including information about companies and governments raising funds, information
this reason, regulators in most financial markets require individuals to pass licensing about the specific financial instruments being sold and traded, and information about
exams to make sure that industry personnel have an understanding of the financial the markets for those instruments. Rules specify what information is included and
laws and of financial products in general. how the information is disclosed.
Financial products. Financial products must generally comply with numerous regula- Corporate issuers. Regulators typically require corporate issuers of securities to
tions before they can be sold to the public. In disclosure-based regimes, the regulators disclose detailed information to potential buyers before the offering of securities. This
monitor the accuracy of the disclosures; in merit-based regimes, the regulators pass requirement is to ensure that investors have enough information about what they are
judgement on the merits of the investments. buying to make informed decisions. The disclosures generally include audited financial
statements, information about the general business of the company, the intended use of
Gatekeeping rules are necessary because some financial products are complicated to the proceeds, information about management, and a discussion of important risk factors.
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 banks Market transparency. Information about what other investors are willing to pay for
and brokerage firms sold a total of HK$14.7 billion of Lehman Brothers’ investment a security, or the price they just paid, is valuable to investors because it helps them
products—mainly unlisted notes linked to the credit of various companies—to about assess how much a security is worth. But investors generally do not want to reveal
43,700 individual investors. After Lehman’s bankruptcy in 2008, investors lost most, private information. Regulation requires the dissemination of at least some information
if not all, of the principal amount they had invested. regarding the trading environment for securities.
products and services to investors may be tempted to exaggerate past performance Market manipulation. Regulators attempt to prevent and prosecute market manip-
by displaying only winning time periods or winning strategies. Regulators seek to ulation. Market manipulation involves taking actions intended to move the price of a
counteract this tendency by creating standards for the reporting of past performance. stock to generate a short-term profit.
Fees. Regulators may impose price controls to limit the commissions that can be Insider trading. A market in which some participants have an unfair advantage over
charged on the sale of various financial products as well as to limit the mark-ups and other participants lacks legitimacy and thus deters investors. For this reason, most
mark-downs that occur when investment firms trade securities with their customers jurisdictions have rules designed to prevent insider trading. Because material non-
out of their own inventories. public information flows through companies in the financial services industry about the
financial condition of their clients and their trading, regulators often expect companies
Information barriers. Many large firms in the investment industry offer investment to have policies and procedures in place to restrict access to such information and to
banking services to corporate issuers and, at the same time, publish investment research deter parties with access from trading on this information.
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 Front running. As with insider trading, regulators may ensure that companies have
investment banking business. Similarly, research analysts may be under pressure to procedures in place to deter front running and to monitor employees’ personal trad-
publish favourable research reports on securities in which the firm has large positions in ing. Front running is the act of placing an order ahead of a customer’s order to take
its own inventory. Regulators attempt to resolve conflicts of interest by requiring firms advantage of the price impact that the customer’s order will have. For example, if you
to create barriers—virtual and physical—between investment banking and research. 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.
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- Brokerage practices. In some countries, investment managers may use arrangements
dation should be suitable for the client (consistent with the client’s interests). Some in which brokerage commissions are used to pay for external research. These are referred
participants in the investment industry are held to an even higher standard, frequently to as soft money (soft dollar) arrangements. Rather than paying cash for the research,
called a fiduciary standard. Under this standard, any advice or recommendation must the broker directs transactions to a provider. The payment of commissions on those
be both suitable for the client and in the client’s best interests. In order to advise or transactions, possibly made from client accounts, give the brokerage firm access to the
make recommendations, it is critical to “know your customer”—gather information research produced by the provider. Regulators may have regulations regarding the use
about a client’s circumstances, needs, and attitudes to risk. of such arrangements because client transactions could be directed to gain access to
research rather than being used in clients’ interests.3
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 5.6 Proxy Voting Rules
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 In some countries, brokers are required to distribute voting materials to their cus-
firm’s interests may differ from those of the consumer. The firm wants to charge the tomers, gather voting instructions, and submit them for inclusion in the counting of
highest price to the customer, who wants to pay the lowest price. There can also be votes. In other countries, corporate issuers distribute materials directly to shareholders.
confusion among customers as to whether the firm is acting as a principal (the firm Regulation determines what procedures are used for conducting proxy votes.
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 5.7 Anti-Money-Laundering Rules
of the conflict, or ban self-dealing with customers.
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
5.5 Trading Rules the financial services industry to do so. Regulations may require companies to confirm
Regulations are often designed to set investment industry standards as well as to and record the identity of their clients; to report payments, such as dividends, to tax
prevent abusive trading practices. authorities; and to report various other activities, such as large cash transactions.
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).
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.
62 Chapter 3 ■ Regulation Consequences of Compliance Failure 63
5.8 Business Continuity Planning Rules 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
Given the essential nature of financial services to the economy, regulators may be and of good character. The employee’s initial orientation and training should empha-
concerned about business continuity in the event of disasters, such as fires, floods, sise the importance of compliance with corporate policies and procedures and with
earthquakes, and epidemics. Regulators want to be assured that customer records are relevant regulations.
adequately backed up and that companies have plans in place to recover from a disaster.
It is not enough to train new employees. It is important to also provide continuing
Regulations affect all aspects of the investment industry, from entry into it to exit education to reinforce the mission-critical nature of compliance with corporate
from it. 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.
6 COMPANY POLICIES AND PROCEDURES 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’ of continuing education, is essential to
Companies within the investment industry, like all companies, are expected to have prove compliance and enforcement. The Investment Industry Documentation chapter
policies and procedures (also referred to as corporate policies and procedures) in provides a discussion of documentation in the context of the investment industry.
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 6.2 Compensation Plans
do not have the force of law, they are extremely important for the survival of com-
Companies need to be aware of the potential effects of compensation plans on
panies. Policies and procedures establish desired behaviours, including behaviours
employees’ behaviour. For example, bonuses for reaching target sales levels may moti-
with respect to regulatory compliance. Indeed, companies may be sanctioned or
vate employees to make more sales, but they may also motivate employees to break
even barred from the investment industry for not having policies and procedures in
rules and engage in deception to make those sales. Adherence to good compliance
place that ensure compliance with regulations. Policies and procedures also guide
practices should be a standard part of employees’ performance reviews and a factor
employees with matters outside the scope of regulation. Recall from the Ethics and
in determining bonuses.
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 6.3 Procedures for Handling Violations
procedures. Typically, corporate policies and procedures respond to a perceived need.
Companies establish systems to make employees aware of new policies and procedures, No matter how honest and well-meaning employees are, sooner or later, there will
to monitor compliance, and to act on failures to comply. It is important to document be some rule violations. A culture of cover-up is dangerous for a company because
policies and procedures so that the company can prove it is in compliance when once unethical employees discover that it is possible to hide problems, they will be
inspected by regulators. It is also important to document that the company follows tempted to take advantage of that. Companies need to have procedures in place for
and enforces its policies and procedures. employees to report problems without fear of retribution, as well as procedures for
handling problems in an effective manner.
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. CONSEQUENCES OF COMPLIANCE FAILURE 7
6.1 Supervision within Companies Failure to comply with regulations and policies and procedures can have significant
consequences for employees, managers, customers, the company, the investment
Just as it is important for regulators to supervise companies in the investment indus-
industry, and the economy. Companies may fire employees and managers that fail
try, it is also vital that companies supervise their employees. With large amounts of
to comply with regulations and policies and procedures. When a regulatory action
money at stake, a single rogue employee can cause significant harm or even bring
occurs, even if no formal charges are brought, the legal costs to individuals and firms
down a company.
involved in dealing with it can be high.
64 Chapter 3 ■ Regulation Summary 65
Regulators have many ways of disciplining firms and individuals that violate informal ■ A typical regulatory process involves determination of need by a legal authority;
rules. Sanctions for individuals may include fines, imprisonment, loss of licence, and analysis, including costs and benefits; public consultation on proposals; adop-
a lifetime ban from the investment industry. When subordinates violate rules, man- tion and implementation of regulations; monitoring for compliance; enforce-
agers may also face consequences for failure to supervise. Even long after the issue ment, including penalties for violations; dispute resolution; and review of the
is resolved, the regulatory sanctions remain a matter of public record that can haunt effectiveness of regulation.
the individuals involved for the rest of their lives. The economic damage from loss of
■ Regulation may be principles-based or rules-based and merit-based or
reputation can be huge.
disclosure-based.
Companies also face sanctions including fines, loss of licences, and forced closure.
■ The types of regulations that have been developed in response to perceived
A company may be forced to spend significant resources in corrective actions, such
as hiring outside consultants, to demonstrate compliance. Companies interact with needs include rules on gatekeeping, operations, disclosure, sales practice, trad-
regulators on an ongoing basis, so running afoul of a regulator’s opinion in one area ing, proxy voting, anti-money-laundering, and business continuity planning.
can lead to problems in other areas. ■ Corporate policies and procedures are rules established by companies to ensure
Compliance failures affect more than just the company and its employees. Customers compliance with applicable laws and regulations, to establish processes and
and counterparties can be harmed and trust in the investment industry and financial desired behaviours, and to guide employees.
markets damaged. Customers may lose their life savings and counterparties may suf- ■ Documentation is important for demonstrating regulatory compliance.
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 ■ Employees’ activities can have negative consequences for managers (supervi-
of many other companies, causing serious damage to the economy. 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.
SUMMARY ■ 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.
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.
■ 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.
a Define economics;
g Describe and interpret price and income elasticities of demand and their
effects on quantity and revenue;
i Describe production levels and costs, including fixed and variable costs,
and describe the effect of fixed costs on profitability;
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
INTRODUCTION 1 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
Would you prefer to buy a new car, to have more leisure time, or to be able to retire a company and its value as an investment.
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 2 DEMAND AND SUPPLY
industrial facilities. Alternatively, the city could try to increase its share of resources
by increasing taxes or borrowing money.
Buyers demand a product, and sellers supply the product. Consumers buy products,
Individuals and organisations have numerous wants and must prioritise them. In The such as cars, books, and furniture, from manufacturers and retailers, who sell them in
Investment Industry: A Top-Down View chapter, we learned that resources to meet markets. These markets can take the form of physical structures, such as supermarkets
these wants are often limited or scarce—such resources as labour, real assets, financial or shops, or they can be virtual, internet-based markets, such as eBay or Amazon.
capital, and so on are not unlimited. Thus, individuals and organisations have to make Properly functioning markets are essential to capitalism because the interaction of
decisions regarding the allocation of these scarce resources. buyers and sellers determines the price and quantity of a product or service traded.
Economics is the study of production, distribution, and consumption or the study The organisation of markets is important in microeconomics. In some markets, there
of choices in the presence of scarce resources, and it is divided into two broad areas: is a single provider of a product or service, whereas in other markets, there are many
microeconomics and macroeconomics. Microeconomics is the study of how individuals companies providing the same or similar products or services. For example, there
and companies make decisions to allocate scarce resources, which helps in under- may be only one regional power company supplying electricity, but there may be
standing how individuals and companies prioritise their wants. Macroeconomics is many companies providing home insurance. How markets are organised can affect
the study of an economy as a whole. For example, macroeconomics examines factors how the companies operating in these markets set prices and is discussed further in
that affect a country’s economic growth. Macroeconomics is discussed further in the Sections 5 and 6.
next chapter.
Although economic terminology often refers to supply first and demand second, we
This chapter focuses on factors that influence the supply and demand of products will start by defining demand and discussing factors that affect the demand for prod-
and services. Many of the explanations and examples focus on products, but they are ucts and services. Then we will discuss factors that affect the supply of products and
equally applicable to services. Supply refers to the quantity of a product or service services. We will also describe how the interaction of supply and demand determines
sellers are willing to sell, whereas demand refers to the quantity of a product or service the equilibrium price, which is the price at which the quantity demanded equals the
buyers desire to buy. The interaction of supply and demand is a driving force behind quantity supplied.
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, for example when considering 2.1 Demand
such issues as how much to charge for their products and services and what reaction When economists refer to demand, they mean the desire for a product or service cou-
they may see from competitors. Microeconomics helps investment analysts assess pled with the ability and willingness to pay a given price for it. Consumers will demand
the profitability of a company under different scenarios. For example, the analyst may and pay for a product as long as the perceived benefit is greater than its cost or price.
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 2.1.1 The Law of Demand
in the company’s market environment. 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
1 A term from Adam Smith’s 1776 book, An Inquiry into the Nature and Causes of the Wealth of Nations, the choices they make regarding scarce resources. Economists term this satisfaction
in which the invisible hand refers to the role of the markets in allocating scarce resources. of want as utility; utility is a measure of relative satisfaction. For example, consumers
© 2014 CFA Institute. All rights reserved.
Demand and Supply 71 72 Chapter 4 ■ Microeconomics
derive utility or satisfaction from eating pizza. According to the law of diminishing
Exhibit 2 Hypothetical Demand Curve for Pizza
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 D
amount eaten increases. As demonstrated in Exhibit 1, a consumer may enjoy eating 3.0
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. 2.8
2.6
Price
Exhibit 1 Diminishing Marginal Utility
2.4
2.2
2.0
1 2 3 4 5
Quantity Demanded
High Some Low The demand curve in Exhibit 2 shows the quantities of pizza that the individual is
Satisfaction Satisfaction Satisfaction willing to buy at various prices over a given period, if all other factors 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.
2.1.2 The Demand Curve If the price of pizza changes, there is a change in the quantity demanded, which is
The law of demand can be represented on a graph, with quantity demanded on the represented by a move along the demand curve. So, as shown in Exhibit 2, at a price
horizontal axis and price of the product on the vertical axis. The curve that shows of 3.0 the individual demands two slices of pizza. But for three slices of pizza, the
the quantity demanded at different prices is the demand curve. Exhibit 2 shows a individual is only willing to pay the lower price of 2.5. Effectively, the individual is only
consumer’s hypothetical demand curve for pizza.2 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 change, the overall level of demand for
the product may change. That is, the demand curve itself may shift, so the quantity
demanded at each price will change. For example, 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
2 For simplicity, we assume in this exhibit and the following discussion that the demand curve is based on shifts the demand curve to the right from D to D1.
an individual’s demand. In reality, the demand curve reflects what economists call aggregate demand—that
is, the sum of all the individuals’ demands.
Demand and Supply 73 74 Chapter 4 ■ Microeconomics
A change in a consumer’s income may shift a product’s demand curve. For most If the price of Coke decreases, there is likely to be an increase in demand for
products—called normal products—if income increases, demand increases too. Meat Coke and a decrease in demand for Pepsi. If a bottle of Coke and Pepsi each
is an example of a normal product in most emerging economies. However, for infe- sell for $1, people will have no preference based on price. But if the Coca-Cola
rior products, the relationship works in the opposite direction. That is, demand for Company decides to try to increase its market share, it might cut—perhaps just
inferior products decreases as income increases. Grain is often considered an inferior temporarily—the price of a bottle of Coke to 90 cents. Although there will still
product. So, when incomes are higher, people consume more meat relative to grain. 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
Recessions offer an example of when demand for inferior products increases. During a
some of these people then develop a preference for Coke over Pepsi and become
period of decline in economic activity, consumers tend to switch to lower-cost brands
loyal Coke drinkers. So, if Coca-Cola subsequently returns its price to $1, it
and shop more at discount stores than at department stores. So, during recessions,
hopes that it has a larger loyal customer base that will choose Coke over Pepsi.
investors may focus on companies that sell inferior products to identify stocks that
may perform better.
pizzas, to decrease. The reason is because many people use cars to go to work, school, Factors other than the product’s price that may lead to a shift in the supply curve
or shopping and will have to pay more to put fuel in their cars if the price of oil rises. include production costs, technology, and taxes. Higher production costs and taxes
As a result, they will have less money to buy other products. 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
Psychology is often involved in a consumer’s decision-making process, which makes smaller quantity at the same prices. Lower production costs, which may be the result
it difficult to quantify exactly the effect of a change in other products’ prices on the of improvements in technology, and lower taxes will result in increased supply for a
demand for a particular product. For example, because people often buy oil-related given price and the supply curve will shift to the right.
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 Changes in the supply curve are of considerable interest to investors and analysts. A
product that will have a greater effect on the household budget—may not lead to a shift in the supply curve caused by higher or lower costs can affect the profits gen-
reduction in demand. The reason is because consumers tend to pay less attention to erated by a company. For example, a car manufacturer that faces higher steel prices
price changes of products that are purchased infrequently. Evaluating these types of may be willing to produce fewer cars at a given price level, which changes the supply
psychological factors helps investors understand whether, for instance, a pizza com- curve. Whether a company can pass on any cost increases to customers helps investors
pany may see a decrease in sales when oil prices increase. 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
2.2 Supply factors affecting the supply curve as temporary and be willing to continue operations
The supply curve represents the quantity supplied at different prices. The law of supply despite short-term losses. But if the mismatch between revenues and costs persists
states that when the price of a product increases, the quantity supplied increases too. for longer periods, it can cause companies to file for bankruptcy or shut down. Many
Thus, the supply curve is upward sloping from left to right. The law of supply and the airlines have encountered this problem when their production costs, such as the cost
supply curve are illustrated in Exhibit 4. S and S1 are supply curves. 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.
Exhibit 4 Supply Curve
As illustrated in Exhibit 5, the interaction between the demand and supply curves
Price
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.
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. If a change in a factor makes the product more attractive, supply
will shift to the right, meaning that suppliers will offer a larger quantity at any given
price. Alternatively, if a change in a factor makes the product less attractive, supply
will shift to the left, as shown in the move from S to S1 in Exhibit 4. This shift means
that suppliers will offer a smaller quantity at any given price. 3 In this discussion, the assumption is that there are many potential consumers and suppliers, which is
the reality for most markets and most products.
Demand and Supply 77 78 Chapter 4 ■ Microeconomics
Exhibit 5 Interaction of Demand and Supply Curves Exhibit 6 Shift in the Demand Curve to the Right with the Supply Curve
Unchanged
D S
D D1 S
Price
Price
EP EP 1
EP
Quantity
Quantity
At any price above the equilibrium price (EP) in Exhibit 5, suppliers are willing to pro-
duce more of a product than consumers are willing to buy. A price that is higher than The supply curve can shift while the demand curve remains unchanged. An increase
the equilibrium price may result in increasing inventories, which could lead to suppliers in taxes could lead to a shift in the supply curve to the left, as could any increase in
later cutting prices to reduce their inventories. Prices will thus move back toward the production costs, such as wages or energy costs. A decrease in these costs would
equilibrium price. Conversely, if the price is below the equilibrium price, consumers have the opposite effect and shift the supply curve to the right, leading to increased
will demand more of a product than suppliers find it profitable to produce. To meet production at each price. For example, if the government decreases the taxes com-
consumers’ higher demand, suppliers’ inventories may be depleted. Once inventories panies have to pay for their workers’ salaries, companies may hire more people and
are depleted, suppliers may be able to raise prices and increase production. Prices increase production as a result. Companies’ costs will be lower, so they will be will-
will thus move back toward the equilibrium price. The only price at which suppliers ing to produce more of a given product at the current price. This strategy was used
and consumers are both content, with no desire to change the quantity produced or in India and Ireland after the global financial crisis that started in 2008. The Indian
bought, is at the equilibrium price. and Irish governments cut taxes in an effort to stimulate their economies, resulting
in companies increasing output (quantity produced) and hiring workers because the
What factors—other than the price of the product—affect the market equilibrium costs of doing so were lower.
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, So, looking at the supply and demand curves is useful when analysing factors driving
which is shown in Exhibit 6. A shift in the demand curve to the right, from D to D1, company, industry, and consumer behaviour.
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.
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.
to identify the companies and industries that will grow the quickest as the economy disproportionally larger change in demand. Conversely, if price elasticity is between –1
grows. Elasticity of demand thus has relevance to anticipate which companies and and 0, the price elasticity is low, or inelastic. Changes in prices for inelastic products
industries will be successful in the future. 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.
3.1 Price Elasticity of Demand
Price elasticity of demand allows for the comparison of the responsiveness of quantity Products for which demand increases as price increases have positive own price elas-
demanded with changes in prices. Two widely used measures are own price elasticity ticities. This result usually indicates that the product is a luxury product. For luxury
of demand and cross-price elasticity of demand. products, such as expensive cars, watches, and jewellery, an increase in price may
lead to an increase in quantity demanded.
3.1.1 Own Price Elasticity of Demand Exhibit 7 summarises what the sign and magnitude of own price elasticity mean.
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- Exhibit 7 Sign and Magnitude of Own Price Elasticity
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
Sign and Magnitude Description
of measure. So price elasticity is unit free, as are other elasticity concepts.
Less than –1 Negatively, highly elastic: For a given percentage
Examples of own price elasticity of demand are provided in Example 2. 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
EXAMPLE 2. OWN PRICE ELASTICITY OF DEMAND
same percentage.
Greater than –1 to 0 Inelastic: For a given percentage increase in price, the
The own price elasticity of demand for a product is
quantity demanded will decrease by a lesser percentage
Percent change in the quantity demanded of the product than the increase in price.
Perceent change in the price of the product Greater than 0 but less Inelastic: For a given percentage increase in price, the
than 1 quantity demanded will increase by a lesser percentage
If a 10% decrease in the price of cars leads to a 15% increase in the quantity than the increase in price.
demanded, then the own price elasticity of demand for cars is
+1 Positively unit elastic: For a given percentage increase
+15% in price, the quantity demanded will increase by the
= −1.5. same percentage.
−10%
Greater than +1 Positively, highly elastic: For a given percentage
If a 10% increase in the price of hotel rooms leads to a 20% decrease in the
increase in price, the quantity demanded will increase
quantity demanded, then the own price elasticity of demand for hotel rooms is by a greater percentage than the increase in price.
−20%
= −2.
+10%
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
When looking at elasticities, two elements matter: the sign and the magnitude. 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
The sign of price elasticity of demand provides information about how the quantity elasticity is less than –1 tends to lead to an increase in total revenue. Total revenue
demanded changes relative to a change in price. As illustrated in Example 2, own price is usually measured as price times quantity of products sold. So, when elasticity is
elasticity of demand is usually negative, reflecting the law of demand discussed in highly negative, the decrease in price is more than offset by a greater increase in
Section 2.1.1—that is, the inverse relationship between price and quantity demanded. 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
The magnitude of price elasticity of demand provides information about the strength
percentage decrease in price.
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
Elasticities of Demand 81 82 Chapter 4 ■ Microeconomics
Uniform, non-differentiated products, such as fuel or flour, are typically products with substitute products in many, but not all, cases; it depends on how close of a substitute
highly negative own price elasticities of demand. Companies with many competitors one product is for the other product. For example, coffee and tea are substitutes in the
selling similar products may find that increasing prices leads to a reduction in revenue. 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
Perfectly inelastic demand indicates that quantity demanded will not change at all, considered closer substitutes and have a larger cross-price elasticity of demand. As
even in the face of large price increases or decreases. Perfectly inelastic demand discussed in Section 2.1.6.1, a decrease in the price of Coke may be accompanied by
may occur with products that have no substitutes and are necessities, such as drugs a reduction in the quantity demanded of Pepsi.
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 3.1.3 Interpreting Price Elasticities of Demand
price to maintain sales. 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
Another example of a price inelastic product is one that has a well-defined identity,
own price elasticity will be large and negative—that is, demand is elastic. If a product
such as the Apple iPad. The reason is because, in the mind of many consumers, other
has no immediate substitutes, such as a new drug, or if use of the product is deeply
tablets do not compare with the iPad; there are no perceived substitute products. As a
entrenched by habit, such as tobacco, demand is inelastic.
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. 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
3.1.2 Cross-Price Elasticity of Demand
or decrease as a result of a change in prices, and by how much, helps investors and
Own price elasticity of demand shows the change in the quantity demanded of a analysts understand what drives a company’s profit, which, in turn, affects its stock
product as a result of a price changes in that product. But investors and analysts are valuation.
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 Consider Coke and Pepsi again. Although each has its own brand loyalty among
demand. It is the percentage change in the quantity demanded of a product in response customers who are committed to one or the other, there are plenty of substitutes,
to a percentage change in the price of another product. 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
Examples of cross-price elasticity of demand are provided in Example 3. 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
EXAMPLE 3. COMPLEMENTARY PRODUCTS 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
The cross-price elasticity of demand for a product is
Coca-Cola might gain market share, it becomes a less attractive investment if it is a
Percent change in the quantity demanded of Product 1 less profitable company. Thus, elasticities of demand are often a prime consideration
Percentt change in the price of Product 2 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
If a 5% increase in the price of coffee leads to a 7% decrease in the quantity market share by cutting prices.
demanded of cream, then the cross-price elasticity of demand is
−7%
= −1.4.
+5% 3.2 Income Elasticity of Demand
If a 5% increase in the price of coffee leads to a 7% increase in the quantity Income elasticity of demand is the percentage change in the quantity demanded of a
demanded of tea, then the cross-price elasticity of demand is product divided by the corresponding percentage change in income. It measures the
+7% effect of changes in income on quantity demanded of a product when other factors,
= +1.4. such as the price of the product and the prices of related products, remain the same.
+5%
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,
A negative cross-price elasticity of demand, as in the case of coffee and cream, indicates products with positive income elasticities are called normal products. In contrast, if
complementary products. For complementary products, an increase in the price of consumers purchase less of a product as their income increases, the income elasticity
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
Profit and Costs of Production 83 84 Chapter 4 ■ Microeconomics
is negative and the products are called inferior products. Consumers demand fewer The difference between accounting profit and economic profit is best illustrated by an
inferior products as their income increases and they substitute more expensive and example. Consider the owner of a restaurant in Hong Kong. For a particular period,
desirable products, such as meat instead of potatoes or rice. the restaurant has revenues of HK$5,000,000. The costs of operating the restaurant,
which include renting the premises, paying the salaries of the staff, and buying the raw
Income elasticity of demand also enables investors to distinguish between luxuries and food, is HK$3,000,000. The accounting profit considers only the explicit costs and is,
necessities. A luxury product usually has an income elasticity of greater than one. A in this example, HK$2,000,000 (HK$5,000,000 – HK$3,000,000).
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 Economists, however, take a broader view of costs and also deduct implicit costs from
golf club membership. But what is perceived as a luxury item may change over time revenues and explicit costs to arrive at economic profit. The owner of the restau-
because income elasticities will change as a society’s income improves. So, although rant risks her capital by operating the restaurant. That is, if the restaurant fails, she
a smartphone may be a luxury product at a certain income level, it may become a loses all her money. She could have used her skills and risked her capital differently.
necessity product at another. Assume that the restaurant’s owner could find employment, invest her capital and
earn HK$1,600,000 from receiving a salary and from investing her capital elsewhere.
Exhibit 8 shows graphically the distinction between inferior, necessity, normal, and The amount she would receive from these activities represents what economists call
luxury products based on their income elasticity of demand. 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 HK$1,600,000 by operating the restaurant, the restaurant’s accounting profit
Exhibit 8 Type of Product Based on Income Elasticity of Demand should be at least equal to this. Otherwise, operating the restaurant is an inefficient
allocation of its owner’s resources.
Necessity In this example, the economic profit from operating the restaurant is HK$400,000—that
Product is, the accounting profit of HK$2,000,000 minus the opportunity cost of HK$1,600,000.
Inferior Normal Luxury
Product Product Product 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.
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
t
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.
Fixed Costs
4.1 Accounting Profit vs. Economic Profit
um er nit
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.
Profit and Costs of Production 85 86 Chapter 4 ■ Microeconomics
Fixed costs include costs associated with buildings and machinery, insurance, salaries In the long run, all factors of production can be changed and some costs that are
of full-time employees, and interest on loans. In contrast, costs that fluctuate with the regarded as fixed become variable because, for instance, a company can relocate its
level of output of the company are called variable costs, as illustrated in Exhibit 9B. 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
Exhibit 9B Total Costs 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
sts
l Co average fixed costs and average variable costs, should decrease as output expands.
Tota
t
Variable Costs 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
Fixed Costs 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,
u er nit 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.
For example, raw materials tend to be a variable cost because the more units the com- Economies of scale are cost savings arising from a significant increase in output
pany produces, the more raw materials it needs. The sum of fixed costs and variable without a comparable rise in fixed costs. These cost savings lead to a reduction in
costs gives total costs, illustrated by the green line in Exhibits 9B and 9C. 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.
Exhibit 9C Revenue Costs 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
fit economic principle is known as the law of diminishing returns and is illustrated in
Pro Exhibit 10. For example, suppose a factory has a fixed number of machines and hires
Breakeven additional workers to operate them and make more products. Total output may rise
Point 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
t
sts second area of diminishing marginal returns. Hiring more workers means that they
l Co
Tota
will have to stand in line waiting for their turn at operating the machines. Hiring still
e more workers means that they may get in each other’s way, potentially making the
s nu
Los eve contribution of the additional workers negative—the area of negative marginal return.
R According to the law of diminishing returns, adding ever more variable inputs, such
as workers, is self-defeating.
u er nit
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.
Profit and Costs of Production 87 88 Chapter 4 ■ Microeconomics
As total costs per unit of a product decrease, profitability should improve, assuming
Exhibit 10 Law of Diminishing Returns
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.
utput
3
tal
1
2
5 PRICING
u er r er 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.
1 Increasing marginal returns: Total output increases rapidly. We will discuss competition and how it affects pricing decisions more thoroughly in
Section 6.
Diminishing marginal returns: Total output increases but at
2 a decreasing rate. 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
3 Negative marginal returns: Total output decreases. 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.
4.3 Effect of Fixed Costs on Profitability 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
The relative level of fixed and variable costs has a significant effect on profitability. bottle of water may be very similar to another in terms of taste and chemical composi-
Imagine the investment needed to construct a steel mill (a factory or plant that pro- tion, but experience indicates that consumers perceive that there is a difference. Some
duces steel). If production levels are very low, the fixed costs are massive relative to the marketers of bottled water have achieved substantial product differentiation and are
revenues, and the steel mill will make a low profit or even suffer a loss. As production able to charge a higher price for their water. Although most people think of pricing
increases, variable costs will increase as a result of using additional inputs to the steel- as a product’s production cost plus a mark-up chosen by the producer, the mark-up
making process, such as purchasing raw materials and using additional electricity. But is in fact determined by the product’s uniqueness and substitutability.
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 In addition, if demand for a product is greater than the amount supplied, competing
rises and its fixed costs are spread over more units. products will benefit. Suppliers of similar products will be able to raise their prices
and achieve a higher mark-up or profit.
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- Income levels and elasticity also influence the pricing of products. Producers within an
able costs, such as the steel mill, have high operating leverage. For these companies, industry, such as mobile communications, may have more pricing power as a group as
higher output leads to lower total costs per unit until the full capacity is reached or disposable income increases. But which companies benefit the most depends on the
breakdowns happen, at which point costs increase. existence of close substitutes and consumer perceptions. The perceived superiority of
the Apple iPhone, for example, may give Apple greater pricing power than companies
Companies and industries with high fixed costs thus have greater potential for increased that manufacture similar phones that are regarded as inferior in quality.
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- Prices also increase when supply is limited. If the supply of oil is interrupted by a war,
building facility. Companies may add capacity by incurring additional fixed costs. For for example, buyers frantically chase the limited supplies and bid up prices. Fuel and
example, an airline can buy an additional aircraft and landing rights, or a retailer may heating oil prices will be affected because the underlying cost of the product—the raw
open a new store. In these cases, economies of scale occur as fixed costs are spread material oil—is more expensive. Oil is unique in that consumers and companies cannot
over more passengers or retail customers. 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 89 90 Chapter 4 ■ Microeconomics
Because such companies as utility companies provide essential services, many monop-
olies are regulated and the government approves their prices, sometimes called rates.
MARKET ENVIRONMENT 6 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.
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 A monopolistic company has an advantage in its ability to command higher prices
extreme, where there is a high degree of competition, a market is said to be perfectly and generate relatively larger profits. But a potential benefit to consumers is that the
competitive. At the other extreme, where there is no competition, a market is said to monopolistic company may conduct considerable research and development in order
be a monopoly. Most markets lie between these two extremes. 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.
6.1 Perfect Competition Often, the large scale of their operations also enables monopolistic companies to
exploit economies of scale that may lower costs to consumers. However, compared
A perfectly competitive market consists of buyers and sellers trading a uniform
with companies operating in a perfectly competitive market, a monopolistic company
product—for example, trading wheat or rice. No single buyer or seller can affect the
is likely to charge higher prices and have a lower total volume of products and services.
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. 6.3 Monopolistic Competition
In a perfectly competitive market, marketing, research and development, advertis- Monopolistic competition is distinct from a monopolistic company. Monopolistic com-
ing, and sales promotions play little or no role in driving demand and setting prices. petition characterises a market where there are many buyers and sellers who are able
Companies usually earn normal profits, which compensate the owners of the companies to differentiate their products to buyers. Thus, products trade over a range of prices
for their opportunity cost. Although it is possible in a perfectly competitive market rather than at a single market price. There are typically no major barriers to entry.
for a company that creates a new product to earn abnormal profits—that is, profits Each company may have a limited monopoly because of the differentiation of its
in excess of the opportunity cost—it usually only lasts for a short time. product. Examples of companies in this type of market include restaurants, clothing
Barriers to entry are obstacles, such as licences, brand loyalty, or control of natural shops, hotels, and consumer service businesses. For example, there may be a number
resources, that prevent competitors from entering the market. Barriers to entry in a of clothing shops in a shopping centre, but there may be only one that sells a particular
perfectly competitive market are low to non-existent, meaning that other companies fashion brand. That particular fashion brand may compete with other fashion brands,
can easily enter the market. The entry of other companies causes an increase in the but for people who desire only that brand, only one shop will satisfy their demand. That
market supply and in the long run, abnormal profits are eliminated and only normal shop is a monopoly market for this customer. But customers who have no preference
profits are earned. 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.
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.
6.4 Oligopoly
An oligopoly is a market dominated by a small number of large companies because
6.2 Pure Monopoly the barriers to entry are high. As a consequence, companies are able to make abnor-
Consider an industry with a single company that produces a product for which there mal profits for long periods. Oligopolies exist in the oil industry, telecommunications
are no close substitutes. There are significant barriers to entry that prevent other industry, and in some countries, the banking industry.
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- Because of the large size of each company in the market, one company’s actions
puters. Although it is not a pure monopoly, Microsoft is close to being one. Utility affect other companies significantly. A company that cuts prices will need to con-
companies, such as electricity, water, and natural gas, tend to be natural monopolies. 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
Natural monopolies exist when competition is not possible for various reasons. oligopolies. Collusion in this setting is often an agreement between competitors to
Consider, for instance, the large amount of capital that is needed to set up a competing try to raise prices. This practice is usually illegal or prohibited by regulators because
nuclear power plant. A potential competitor may not want to or may not be able to competition is a necessary ingredient for functioning capitalism; unfair advantages
enter the market because of the huge amount of capital required.
Summary 91 92 Chapter 4 ■ Microeconomics
caused by collusion make markets less efficient and are detrimental to consumers, ■ According to the income effect, if consumers have more purchasing power, the
who are forced to pay prices that may be excessive. However, laws and regulations quantity of products purchased may increase. Increases in income lead to an
cannot prevent occasional cases of competitors colluding by limiting production or increase in demand for normal products and a decrease in demand for inferior
setting high prices. products.
A cartel is a special case of oligopoly in which a group jointly controls the supply ■ If consumers expect that the price of a product will increase in the future, the
and pricing of products or services produced by the group. An example of a cartel current quantity demanded may increase as consumers accumulate the product
is the Organization of the Petroleum Exporting Countries (OPEC), which sets the to avoid paying a higher price in the future.
production and pricing of oil.
■ 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
SUMMARY cheaper products for relatively more expensive ones.
income elasticities are called normal products, whereas products with negative ■ In monopolistic competition, there are many buyers and sellers who are able
income elasticities are called inferior products. Income elasticity of demand to differentiate their products to buyers. Each company may have a limited
also enables investors to distinguish between luxuries, which have income monopoly because of the differentiation of its products. Thus, products trade
elasticity greater than one, and necessities, which have an income elasticity of over a range of prices rather than a single market price. There are typically no
approximately zero. major barriers to entry.
■ Profit is the difference between the revenue generated from selling products ■ An oligopoly is a market dominated by a small number of large companies
and services and the cost of producing them. Accounting profit considers only because the barriers to entry are high. As a consequence, companies are able to
the explicit costs, whereas economic profit takes into account both explicit make abnormal profits for long periods. A cartel is a special case of oligopoly.
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.
■ 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.
■ 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.
LEARNING OUTCOMES
by Michael J. Buckle, PhD, James Seaton, PhD, and Stephen Thomas, PhD d Describe economic growth and factors that affect it;
GROSS DOMESTIC PRODUCT AND THE BUSINESS CYCLE 2 ■ By using an expenditure (spending) approach
In 2010, the world had a total GDP of $63.3 trillion and an average GDP per capita Using the expenditures approach, GDP is estimated with the following equation:
of $9,200. Exhibit 1 shows the five countries with the highest total GDP and the five GDP = C + I + G + (X – M)
countries with the highest GDP per capita in 2010. The United States had the high-
est total GDP in 2010, followed by China, Japan, Germany, and France. In per capita The equation shows that GDP is the sum of the following components:
terms, however, a very different picture emerges. Monaco, Liechtenstein, Luxembourg,
Bermuda, and Norway had the highest GDP per capita. ■ consumer (or household) spending (C)
■ government spending (G) 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-
■ exports (or foreign spending on domestic products and services) (X) ical output, are a better measure of economic growth than changes in nominal GDP.
■ imports (or domestic spending on foreign products and services) (M) 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
The term (X – M) represents net exports. Exports result in spending by other countries’ nominal and real data. Exhibit 3 shows the growth in real GDP per capita in the United
residents on domestically produced products and services, whereas imports involve States from 1981 to 2010. Over the period, GDP per capita, adjusted for changes in
domestic residents spending money on foreign-produced products and services. So, price level, generally exhibited a steady increase. It appears that living standards, as
exports are included as spending on domestic output and are added to GDP, whereas measured by real GDP per capita, rose over the time period.
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 2 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 Exhibit 3 Real GDP per Capita for the United States, 1981–2010
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. 50,000
45,000
40,000
80 30,000
70 25,000
68%
60 20,000
Percent of GDP
59%
50 15,000
40 10,000
30 5,000
20 21% 0
20% 20%
14% 1981 1986 1991 1996 2001 2006 2011
10 1%
–3%
0 Source: Based on data from the World Bank.
–10 Consumer Gross Government Exports Minus
Spending Investment Spending Imports
■ productivity gains, which represent growth in output per unit of labour; and
Exhibit 4 (Continued)
■ availability of capital, which represents inputs other than labour necessary for
United States 2.9
production.
Canada 2.9
Brazil 4.0
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. India 5.4
If that increase is applied across the economy, the economy will grow more rapidly, China 9.1
provided that there is a market for the additional products and services produced. World 3.2
Productivity is a function of the efficiency of a worker and also the availability of Source: Based on data from the World Bank.
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
Some developed countries, such as Japan, are experiencing a decline in population.
cell phones per hour. That is, the worker is more efficient. But with a technological
Such declines will require increases in productivity or a technological revolution if GDP
advance, a worker may be able to produce three cell phones per hour.
is to remain at the long-term trend rate. Demographic change is another reason why
The increase in productivity is because of increased worker efficiency and the availability GDP per capita may be a more useful measure than GDP for evaluating the economic
of new technology. There are many real-world examples of this relationship. Decades well-being of a country’s citizens. If GDP grows at a faster rate than the population
ago, for instance, typesetting allowed the mass production of printed material and growth rate or if GDP shrinks at a lower rate than the population shrinkage rate, it
factories increased productivity in the textile industry through the use of machines. will result in higher GDP per capita.
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, 2.2 The Business (or Economic) Cycle
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, Analysts and economists spend a great deal of energy trying to predict real GDP,
other occupations have been rendered irrelevant. Productivity gains can result in a which is affected by business cycles. Economy-wide fluctuations in economic activ-
lower demand for labour and increased unemployment unless the productivity gains ity are called business cycles. Although we refer to the fluctuations as cycles, they
are offset by increases in demand for products and services. 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-
We will now discuss the effects of growth in the labour force and productivity gains tions in output, but a true business cycle is a fluctuation that affects a large segment
on GDP. Developed countries typically have ageing populations and low birth rates, of the economy over a longer time period.
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 Phases of an economic cycle may include the following:
gains. Exhibit 4 shows the annual GDP growth rate for a sample of countries from
1971 to 2010. 1 Expansion
The growth rate in the developed countries shown—Germany to Canada—was in the 2 Peak
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 3 Contraction
time, as economies grow and make the transition from emerging to developed, the
4 Trough
GDP growth rates are expected to move toward the 2.0%–3.0% range.
5 Recovery
Exhibit 4 Annual GDP Growth Rates at Market Prices There is no universal agreement on what the phases of business cycles are and when
Based on Local Currency, 1971–2010 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 5
shows a stylised representation of a business cycle. The level of national economic
Germany 2.0%
activity is measured by the GDP growth rate.
United Kingdom 2.2
France 2.3
Japan 2.6
(continued)
Gross Domestic Product and the Business Cycle 103 104 Chapter 5 ■ Macroeconomics
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
Peak 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,
GDP Growth Rate
n
DP Gro
io
nd in G
ns
Co
ntr Tre
pa
Ex
ac Trough and recovery. A trough marks the end of the contraction phase and the
tio
n Recovery beginning of recovery. In a trough, the rate of economic growth stabilises and there is
Trough 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
Time growth rate begins to improve and the economy enters a recovery phase.
Aspects of the expansion, peak, contraction, trough, and recovery phases are described 2.3 Causes of Business Cycles
in the following paragraphs.
Why does GDP move through cycles rather than rising in a straight line? To answer
that, recall the four basic components of GDP:
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.
■ Consumer spending
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 ■ Business spending
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 ■ Government spending
emerges and unemployment tends to fall; the increased demand for both products and
■ Net exports (exports minus imports).
services and labour can create inflationary pressures.
Peak. At a peak, economic growth reaches a maximum level and begins to slow, or A contraction in any of these components can cause a reduction in the economic
contract. Each country has a central bank that serves as the banker for the government growth rate. Furthermore, the effect of a change in one component is often amplified
and other banks. Central banks may implement policies to slow the economy and con- because the components are interrelated. Example 1 describes how some of these
trol inflation. These policies are discussed in Section 4.1. Other factors contributing components may be affected by changes in the housing sector.
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 EXAMPLE 1. THE HOUSING SECTOR AND THE BUSINESS CYCLE
also contribute to the end of an expansion.
When consumer confidence is high, consumer spending increases, including
Contraction. During a contraction, the rate of economic growth slows. If economic spending on housing. Because of increased demand, housing prices increase.
activity, as gauged by total real GDP or some other measure, declines (negative growth), This increases wealth and further consumer (household) spending and invest-
a recession may occur. In a contraction, inflation and interest rates tend to fall because ing takes place. As consumer spending increases, business spending increases
of market forces and central bank actions, whereas unemployment tends to increase. too because of the increased demand for products and services and increased
In this scenario, central banks often implement policies to try to stimulate economic availability of capital due to increased consumer investing. The economy expands
growth. On some occasions, federal governments may seek to stimulate the economy and advances toward a peak. If the demand for housing stabilises or declines and
through direct spending programmes to combat economic weakness. Government and consumers begin to think that home prices are too high, the price of homes may
central bank policies are discussed in Section 4. 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
Gross Domestic Product and the Business Cycle 105 106 Chapter 5 ■ Macroeconomics
2
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, 0
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 –2
sector can be very dramatic; an extreme decline is often described as a bubble bursting.
United +2.0 Q3 +4.1 +1.8 +2.7 +3.7 Dec +1.5 Dec +1.7 +1.5 6.7 Dec
Sentiment surveys attempt to measure the confidence that economic entities, such States
as manufacturers and consumers, have in the economy and their intended levels of China +7.7 Q4 +7.4 +7.7 +7.3 +9.7 Dec +2.5 Dec +2.5 +2.6 4.0 Q3§
activity. Sentiment surveys may be useful as predictors of spending plans, but they
Japan +2.4 Q3 +1.1 +1.7 +1.5 +4.8 Nov +1.6 Nov –0.2 +0.2 4.0 Nov
have limitations:
Germany +0.6 Q3 +1.3 +0.5 +1.7 +3.5 Nov +1.4 Dec +2.0 +1.5 6.9 Dec
■ They measure only general attitudes about economic conditions rather than France +0.2 Q3 –0.5 +0.2 +0.8 +1.5 Nov +0.7 Dec +1.3 +1.0 10.8 Nov
actual spending or output.
*% change on previous quarter, annual rate.
†The Economist poll or Economist Intelligence Unit estimate/forecast.
■ The sample may not be representative. For example, only large companies may §Not seasonally adjusted.
be sampled, or the sample of consumers may be pedestrians at a single street Source: “Economic Indicators”, The Economist, January 25th–31st, 2014. The Economist is citing data from Haver Analytics.
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.
3 INFLATION
Economic indicators are often categorised as lagging, coincident, or leading, based
on whether they signal or indicate that changes in economic activity have already Have you noticed that your food costs tend to increase every year? Food that cost on
happened, are currently underway, or are likely to happen in the future. average $100 a week last year, may cost on average $110 a week this year.
Lagging indicators signal a change in economic activity after output has already Inflation is a general rise in prices for products and services. Changing inflation has
changed. An example of a lagging indicator is the employment rate, which tends to implications for economic activity and national competitiveness. Companies must
fall after economic activity has already declined. 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
Coincident indicators reveal current economic conditions, but do not have predictive
to make their buying decisions. So, accurate measurement of inflation is important.
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- 3.1 Measuring Inflation
sidered useful for economic prediction and policy formulation. Examples of leading
indicators include money supply (the amount of money in circulation) and broad stock There are many different measures of inflation based on different price indices. A price
market indices, such as the S&P 500 Index, the FTSE Index, and the Hang Seng Index. 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
A number of organisations publish indices of leading economic indicators. An index is the percentage change in an index from one period to another.
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 Consumer price index. A consumer price index (CPI) is used to measure the change
a monthly index of leading economic indicators. In Europe, similar indices are also in price of a basket of goods typically purchased by a consumer or household over
published. 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
Exhibit 7 shows economic indicators provided by the Economist magazine at the end
measuring the price of the basket of goods in subsequent years.
of each issue. The Economist includes them for a number of countries, but Exhibit 7
shows them only for the five largest economies identified in Exhibit1.
Inflation 109 110 Chapter 5 ■ Macroeconomics
Exhibit 8 Inflation Rates in the United States and the United Kingdom,
1989–2010
10
–2
Weights in this index can be altered when long-term consumer trends change. For –4
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. –6
Today their weighting in a basket of goods may be relatively high. Inflation measured 1989 1994 1999 2004 2009
by a CPI may overstate or understate inflation for a particular consumer or household UK RPI UK CPI US CPI
depending on how their spending patterns compare with the basket of goods.
US Core CPI US PPI
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 Source: Based on data from the Federal Reserve Bank of St. Louis and the Office of National
index (RPI) based on a basket of goods that includes housing costs, and a CPI with Statistics.
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- The relationship between CPIs and PPIs is sometimes used to determine the degree
rary volatility in commodity (including food and energy) prices. Policymakers, such as to which producers’ costs are passed on to consumers. If consumer prices (or costs
governments and central banks, find these indices useful. The reported core inflation to consumers) are static and producer prices (or costs to producers) are rising, then
can differ from what households and companies are experiencing. 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.
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- Implicit GDP deflator. Another way of measuring inflation is to estimate what would
ously narrower in that they do not include services. PPIs can be reported by individual happen if the weight of each good in the index is changed each year to reflect actual
industries, commodity classifications, or stage of processing of products, such as raw spending on that good. Such a measure is known as an implicit deflator and is widely
material and finished products. 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.
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 8,
which shows inflation rates based on different price indices for the United Kingdom and 3.2 The Effects of Inflation on Consumers, Businesses, and
the United States, inflation rates over the same period can vary noticeably depending Investments
on the price index used.
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 111 112 Chapter 5 ■ Macroeconomics
Consumers. If consumers expect prices to increase, they may buy now rather than save. production and labour, and unemployment increases. Encouraging consumption and
Or they may choose to borrow to increase spending. Borrowers benefit from inflation breaking this vicious cycle is very difficult. Japan, for instance, has experienced deflation
because they repay loans with money that is worth less (has lower purchasing power). for much of the past 20 years.
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
4 MONETARY AND FISCAL POLICIES
prices increase. A more detailed discussion of bonds, shares, and other investments
will be covered in the Investment Instruments module. 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.
3.3 Other Changes in the Level of Prices Governments use fiscal policy.
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 4.1 Monetary Policy
problematic for consumers, companies, policymakers in central banks and govern- Monetary policy refers to central bank activities that are directed toward influencing
ments, and economies. 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
Deflation. A persistent and pronounced decrease in prices across most products and ultimate goal is to influence key macroeconomic targets:
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 ■ Output or GDP
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
Monetary and Fiscal Policies 113 114 Chapter 5 ■ Macroeconomics
■ Price stability
QUANTITATIVE EASING
■ Employment
The policy of quantitative easing (QE), used in a number of countries after the
Most central banks have a mandate of maintaining price stability (controlling inflation financial crisis of 2008, is similar to open market operations, but on a much
while avoiding deflation), which has indirect effects on other macroeconomic targets, larger scale and it involves the purchase of instruments other than short-term
such as employment and output. Many central banks have additional responsibili- government instruments. In the United States, QE differed from open mar-
ties to sustain employment levels and to stimulate or slow down economic growth. ket operations in that it involved the purchase of mortgage bonds as well as
Focussing on these only may result in lack of price stability; increased employment large-scale purchases of longer-term US Treasury securities. The intent was
and high economic growth is often accompanied by inflation. to decrease longer-term interest rates for bonds and across a variety of credit
products, induce bank lending, and thereby increase real economic activity.
Consumers and companies should, in theory, be encouraged by lower interest rates It has proven difficult to evaluate the effectiveness of QE because there were
to borrow and spend more and thus stimulate the economy. As interest rates fall, other simultaneous stimulus programmes in the wake of the financial crisis.
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
Additionally, policymakers are concerned about financial contagion because of the
economy. So, reducing interest rates may increase output and employment, thereby
interconnectedness of global financial markets. Financial contagion can occur when
meeting two of the key macroeconomic targets of policymakers. Similarly, increased
financial shocks spread from their place of origin to other locales—in essence, a
interest rates may slow the economy.
declining sector or economy infects other healthier sectors and economies. For this
The tools used for monetary policy include the following: reason, sometimes policymakers from different countries co-ordinate their open
market operations.
■ Open market operations
■ Changes in the central bank lending rate 4.1.2 Central Bank Lending Rates
An obvious expression of a central bank’s intentions is the interest rate it charges
■ Changes in reserve requirements for commercial banks 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
4.1.1 Open Market Operations belief is that changes in interest rates can influence economic activity and affect infla-
Open market operations involve the purchase and sale of government notes and bonds. tion and economic growth. When a central bank wants to stimulate the economy, it
If a central bank wants to increase the supply of money and credit in order to stim- may reduce its lending rate. When a central bank wants to slow the economy, it may
ulate the economy, it can do so by purchasing financial assets, generally short-term increase its lending rate.
government instruments, held by commercial banks. The banks give up short-term
If a central bank announces an increase in its lending rate, then commercial banks
government instruments for cash from the central bank, which puts more money in
will normally increase their lending base rates at the same time. Through its lending
circulation. The injection of money allows banks to lower interest rates and make more
rate and its money market operations, a central bank can influence the availability
loans because they now have more cash reserves at the central bank. Note that the
and cost of credit. Generally, the higher the central bank lending rate, the higher the
central bank does not set the interest rates, but rather uses open market operations
rate that banks, if they run short of funds, will have to pay to not only the central
to influence the interest rates.
bank but to other banks that loan to them as well. The higher the central bank lending
To reduce the supply of money and credit in circulation in order to slow an economy, rate, the more likely banks are to reduce lending and thus decrease the money supply.
the central bank sells these instruments to the commercial banks. The commercial So, higher central bank lending rates are expected to slow down economic activity.
banks now have lower balances at the central bank and more short-term government Similarly, lower central bank lending rates are expected to stimulate economic activity.
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
4.1.3 Reserve Requirements
of credit.
Central banks can affect the amount of money available for borrowing in an economy
By conducting open market operations, the central bank creates a shortage or surplus by changing bank reserve requirements. The reserve requirement is the proportion of
of money. Effectively, the central bank is compelling commercial banks to change deposits that must be held by a bank rather than be lent to borrowers. By increasing
their lending rates. 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 115 116 Chapter 5 ■ Macroeconomics
stimulating the economy but at the same time increasing inflation. However, the time ■ Economic growth is the annual percentage change in real output. It is also
lag for monetary policy may be shorter because central banks may be able to act more sometimes expressed in per capita terms.
quickly than governments.
■ Economic activity and growth rates tend to fluctuate over time. These fluc-
Economists are generally divided into two camps regarding the effectiveness of mon- tuations are referred to as business cycles. Phases of a business cycle include
etary and fiscal policies. Keynesians, named after British economist John Maynard expansion, peak, contraction, trough, and recovery.
Keynes (pronounced “canes”), believe that fiscal policy can have powerful effects on
■ Changes in the business cycle can be driven by many factors, such as housing,
aggregate demand, output, and employment when there is substantial spare capacity
in an economy. Some economists believe that changes in monetary variables under the stock market, and the financial services sector.
the control of central banks can only affect monetary targets, such as inflation, and ■ With the growth of international trade, mobility of labour, and more closely
will not lead to changes in output or employment. This is a subject of intense debate
connected financial markets, movements in the business cycles of countries
between economists.
have become more closely aligned with each other.
Monetarists believe that fiscal policy has only a temporary effect on aggregate demand ■ Economic indicators—measures of economic activity—are regularly reported
and that monetary policy is a more effective tool for affecting economic activity.
and analysed. These measures may be leading, lagging, or coincident indicators.
Monetarists advocate the use of monetary policy instead of fiscal policy to control
the cycles in real GDP, inflation, and employment. ■ Inflation is a general rise in the prices of products and services. Measures of
inflation include consumer price indices, producer price indices, and implicit
In practice, both governments and central banks are likely to act in response to eco-
GDP deflators.
nomic conditions. This is particularly true when economic conditions are extremely
worrisome—for example, when a recession is identified or when either inflation or ■ Changes in price levels can affect economic growth because consumers, com-
unemployment is high. The modern economy is a complex system of human behaviour panies, and governments may change the timing of their purchases, the amount
and interactions. To encourage growth in real GDP requires considerable insight into of their spending, and their saving and spending decisions based on anticipated
the effects of interest rate or tax changes on decisions by consumers and companies. changes in prices.
After all, the economy represents the collective action of many millions of consumers,
companies, and governments around the globe. ■ Three additional price level changes investors also consider are deflation, stag-
flation, and hyperinflation.
■ 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
Investment professionals consider macroeconomic factors when evaluating companies’
output, price stability, and employment.
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 ■ Fiscal policy involves the use of government spending and tax policies to influ-
of macroeconomic factors with any degree of certainty. ence the level of aggregate demand in an economy and thus the level of eco-
nomic activity.
Some important points to remember about macroeconomics include the following:
■ Both fiscal and monetary policies have limitations: they are affected by time lags
■ Gross domestic product is the total value of all final products and services and the responses to and consequences of each may not be as expected.
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 per capita is equal to GDP divided by the population. It allows compari-
sons of GDP between countries or within a country.
LEARNING OUTCOMES
a Define imports and exports and describe the need for and trends in
ECONOMICS OF INTERNATIONAL TRADE c Describe the balance of payments and explain the relationship between
the current account and the capital and financial account;
by Michael J. Buckle, PhD, James Seaton, PhD, and Stephen Thomas, PhD
d Describe why a country runs a current account deficit and describe the
effect of a current account deficit on the country’s currency;
When you walk into a supermarket where you can buy Scottish salmon, Kenyan veg- Countries have been trading with each other for centuries, and the primary mode
etables, Thai rice, South African wine, and Colombian coffee, you are experiencing of international trade is imports and exports. Imports refer to products and services
the benefits of international trade. Without international trade, consumers’ needs that are produced outside a country’s borders and then brought into the country.
may not be fulfilled because people would only have access to products and services For example, many countries in the European Union import natural gas from Russia.
produced domestically. Certain products and services may be missing—perhaps food, Exports refer to products and services that are produced within a country’s borders
vaccines, or insurance products. and then transported to another country. For example, Japan exports consumer elec-
tronics to the rest of the world.
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 Imports and exports represent the flow of products and services in international
2011,1 can be viewed as both a cause and consequence of globalisation, one of the trade. They are important components of a country’s balance of payments, which is
four key forces driving the investment industry discussed in the Investment Industry: discussed in Section 4.
A Top-Down View chapter.
Today, the factors driving supply and demand, and thus prices, are global. An under- ■ Improve quality and/or reduce the prices of products and services
standing of how international trade and foreign exchange rate fluctuations affect econ-
omies, companies, and investments is important. We discussed in the Microeconomics A common reason for international trade is to gain access to resources for which there
chapter how companies and individuals make decisions to allocate scarce resources. is no or insufficient supply domestically. For example, Japanese manufacturers need
In the Macroeconomics chapter, we discussed the factors that affect economies, such access to such resources as metals and minerals, machinery and equipment, and fuel
as economic growth, inflation, and unemployment. We now bring into the discussion to produce the cars and consumer electronics that they then export to the rest of the
the international dimension of economics, which investment professionals must also world. Imports are a way for Japanese manufacturers to gain access to those resources
take into account before deciding which assets to invest in. for which there is no or insufficient supply domestically. Japanese manufacturers
may import metals and minerals from Australia, Canada, and China; machinery and
This chapter will give you a better understanding of how international trade and for- equipment from Germany; and fuel from the Middle East.
eign exchange rate fluctuations affect both your daily life and the work of investment
professionals. 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
1 Data are from www.wto.org/english/res_e/booksp_e/anrep_e/wtr12-1_e.pdf (accessed 12 September 2012). may also enable consumers to access products and services that better suit their needs.
2 Information is from http://www.nestle.com/aboutus/annual-report (accessed 24 March 2014).
© 2014 CFA Institute. All rights reserved.
Imports and Exports 123 124 Chapter 6 ■ Economics of International Trade
Imported products and services may be less expensive and/or of better quality than Improvements in transportation and communications have also helped international
domestically produced ones. By increasing competition between suppliers of products trade. Large shipping containers allow manufacturers to transport non-perishable
and services, international trade promotes greater efficiency, which helps keep prices products more easily on ships, trains, and trucks, while jumbo jets transport perish-
down. International trade also stimulates innovation, which generates better-quality able products quickly around the globe. The ability to communicate digitally has also
products and services. contributed to the increase in the trade of services.
Trade barriers are restrictions, typically imposed by governments, on the free exchange
of products and services. These restrictions can take different forms. Common trade Rather than producing everything themselves, countries often specialise in products
barriers include the following: 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
Tariffs: Taxes (duties) levied on imported products and services. They allow
for other products and services that another country can produce more efficiently.
governments not only to establish trade barriers, often to protect domestic
According to the theory of comparative advantage, countries export products and
suppliers, but also to raise revenue.
services in which they have a comparative advantage and they import products and
■ Quotas: Limits placed on the quantity of products that can be imported. services in which they do not have a comparative advantage. The combination of
specialisation and international trade ultimately benefits all countries, leading to a
■ Non-tariff barriers: These barriers include a range of measures, such as cer- better allocation of resources and increased wealth.
tification, licensing, sanctions, or embargoes, that make it more difficult and
expensive for foreign producers to compete with domestic producers. 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.
No Barrier to Trade Trade Barrier Example 1 illustrates how and why comparative advantage works.
Growland for Kettles, Makeland for Shoes Analysing a country’s balance of payments helps in understanding the country’s
According to the theory of comparative advantage, however, both countries will macroeconomic environment. Questions that can be answered by analysing a coun-
be better off if Growland produces kettles, Makeland produces shoes, and then try’s balance of payments include, “How much does the country consume and invest
they trade with each other. In Growland, it takes the same number of units of compared with how much it saves?” and “Does the country depend on foreign capital
labour to produce shoes and kettles. So making an additional kettle requires to fund its consumption and investments?”
giving up the production of one pair of shoes. In Makeland, by contrast, it takes The balance of payments includes two accounts:
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
■ The current account indicates how much the country consumes and invests
shoes. The opportunity cost of producing an additional kettle is less in Growland
(outflows) compared with how much it receives (inflows). It is primarily driven
(one pair of shoes) than in Makeland (two pairs of shoes), which indicates that
by the trade of products and services with the rest of the world—that is, exports
Growland is more efficient than Makeland at producing an additional kettle.
and imports.
Thus, Growland has what is called a comparative advantage in producing kettles
compared with Makeland. ■ The capital and financial account records the ownership of assets. In particular,
it reflects investments by domestic entities in foreign entities and investments
Similarly, the opportunity cost of producing a pair of shoes is one kettle in
by foreign entities in domestic entities. These investments can be acquisitions of
Growland and half a kettle in Makeland. Thus, Makeland has a comparative
production facilities or purchases and sales of financial securities, such as debt
advantage in producing shoes compared with Growland.
and equity securities.
■ Current transfers
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).
Balance of Payments 127 128 Chapter 6 ■ Economics of International Trade
The current transfers account includes unilateral transfers, such as gifts or workers’
Exhibit 1 Components of the Current Account
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
Current Account 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-
Goods and Services
fers account gives the current account balance. A positive current account balance
Exports − Imports = Net exports is called a current account surplus, whereas a negative current account balance is
= Balance of trade 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
Income current account surplus. In contrast, countries that have a trade deficit because they
Salaries + Income on financial import more than they export tend to have a current account deficit.
investments
4.1.2 Importance of the Current Account
Current Transfers Exhibit 2 lists the five countries with the largest estimated current account surpluses
Unilateral transfers, such as and the five countries with the largest estimated current account deficits in 2013.
gifts or workers’ remittance
The income account reflects the flow of money in and out of the country from salaries Brazil 191 –77.6
and from income on financial investments. For example, if a domestic company has United Kingdom 192 –93.6
a debt or equity investment in a foreign company, any income—such as interest pay- United States 193 –360.7
ments on debt or dividend payments on equity—received by the domestic company
Source: Based on data from https://www.cia.gov/library/publications/the-world-factbook/ran-
is included in income in the country’s current account. In this example, the interest
korder/2187rank.html (accessed 6 March 2014).
or dividend payments are reported as inflows because they represent money coming
into the country from other countries.
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
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.
Balance of Payments 129 130 Chapter 6 ■ Economics of International Trade
a current account deficit spends more than it earns so it needs to borrow or receive to the financial account in the United Kingdom because it is money coming in
investments from other countries. As indicated in Exhibit 2, the United States, the from other countries. The same transaction will be reported as an outflow from
United Kingdom, Brazil, India and Canada had current account deficits in 2013. the financial account in China 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.
4.2 Capital and Financial Account
■ Other investments are largely made up of loans and deposits between domestic
The current account indicates whether a country has a surplus or a deficit. The fol-
entities and foreign entities.
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 ■ The reserve account shows the transactions made by the monetary authorities
questions are answered by analysing the capital and financial account. of a country, typically the central bank.
As the name suggests, the capital and financial account refers to the combination of
two accounts:
4.3 Relationship between the Current Account and the Capital
■ The capital account, which primarily reports capital transfers between domes-
tic entities and foreign entities, such as debt forgiveness or the transfer of assets
and Financial Account
by migrants entering or leaving the country. 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
■ The financial account, which reflects the investments domestic entities make in and the capital and financial account balance should in theory be equal to zero. If a
foreign entities and the investments foreign entities make in domestic entities. 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
Exhibit 3 Components of the Capital and Financial Account country is a net borrower from the rest of the world.
In practice, however, the capital and financial account balance does not exactly offset
Capital and Financial Account 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
Capital 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 transfers between
capital inflows and outflows. Some of the inputs are based on sampling techniques,
domestic and foreign entities
so the resulting figures are estimates.
sum of the current account balances of all countries is, by definition, equal to zero.
Exhibit 4 (Continued)
In other words, an inflow for one country is an outflow for another country. So, it is
Accounts Amount (€ billions)
impossible for all countries to have a current account surplus.
Supplementary trade items –27.3 Second, a current account deficit must be put in context before drawing conclusions. A
Net exports of services –3.1 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
Trade surplus +157.8
services) to help its economy evolve. As the initial period of heavy investment ends
Income +64.4 and the economy gets stronger, the developing country may experience a decrease in
Current transfers –36.8 imports and an increase in exports, progressively reducing or even eliminating the
Current account surplus +185.4 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
Capital and financial account
current account deficit may only be temporary. Alternatively, a mature economy may
Capital account surplus +0.0 run a current account deficit because its consumption far exceeds its production and
Direct investments –47.0 its ability to export. Thus, when reviewing the economic outlook for a country running
Portfolio investments –65.7 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.
Other investments –120.9
Reserve account –1.3 There is a long-running debate about the risk for a country of running a persistent
Financial account deficit –234.9 current account deficit. As mentioned earlier, a current account deficit means that
Capital and financial account deficit –234.9
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
Errors and omissions +49.5
foreign entities are willing to continue holding the assets and the currency of the coun-
Total 0.0 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
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 the country running a current account deficit?
March 2014).
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
Exhibit 4 shows that in 2012, Germany had a current account surplus of €185.4 billion United States or they can be invested. For example, foreign companies may use their
and was thus a net saver. The current account surplus was primarily driven by a trade US dollars to acquire US companies, or they may invest in debt and equity securities
surplus of €157.8 billion, indicating that Germany exported more than it imported issued by US companies. Other governments may also invest in bonds (debt secu-
during the year. As a consequence of its current account surplus, Germany is a net rities) issued by the US government—these bonds are called US Treasury securities
lender to other countries through a combination of direct, portfolio, and other invest- or US Treasuries.
ments. In 2012, Germany’s capital and financial account deficit was €234.9 billion.
But if other countries decide that they want to reduce their exposure to the United
The difference of €49.5 billion between the current account balance and the capital States, they may start selling US assets, which will have a negative effect on the price
and financial account balance labelled errors and omissions is the plug figure that of these assets. In addition, they may decide to convert their US dollars into other
is needed because of measurement errors. The plug figure is often a large amount, currencies, which will cause a depreciation of the US dollar relative to other curren-
indicating how difficult it is to measure accurately the items reported in the balance cies—that is, the US dollar will get weaker and a unit of the US currency will buy
of payments. 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
4.4 Why Does a Country Run a Current Account Deficit and How 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
Does It Affect Its Currency? financing for individuals, companies, and the government in the United States. So,
We saw in Exhibit 2 that some countries, such as the United States, the United the combination of lower asset prices, a weaker US dollar, and higher interest rates
Kingdom, Brazil, India, and Canada, run large current account deficits. Is running a would likely hurt the US economy, potentially leading to a lower GDP, maybe even a
current account deficit a bad sign, and should all countries aim at maximising their recession, and higher unemployment.
current account balance? The answer to both questions is, not necessarily. First, the
Foreign Exchange Rate Systems 133 134 Chapter 6 ■ Economics of International Trade
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
FOREIGN EXCHANGE RATE SYSTEMS 5 bank to decrease the value of the domestic currency relative to other currencies, an
action that many governments are reluctant to take.
International trade requires payments. These payments involve an exchange of cur- To overcome the disadvantages of a fixed exchange rate system, the Bretton Woods
rencies and are thus affected by foreign exchange rates and foreign exchange rate system was abandoned in 1973 and currency values were left to market forces. Thus,
systems. The rate at which one currency can be exchanged for another is called the since 1973, the major currencies, such as the US dollar, the euro, and the British pound,
foreign exchange rate or exchange rate, and it is expressed as the number of units of have existed under a floating exchange rate system. In a pure floating exchange rate
one currency it takes to convert into the other currency. 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
International trade payments can be made in the country’s domestic currency or in a foreign currencies is only driven by supply and demand for each currency.
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 In a managed floating exchange rate system, a central bank intervenes to stabilise
pounds. The exchange rate between the pound and the euro is usually stated in euros its country’s currency. To do so, it buys its domestic currency using foreign currency
per pound (€/£). An exchange rate of €1.20/£1 means that it takes 1 euro and 20 cents reserves to strengthen the domestic currency or it buys foreign currency using domestic
to convert into 1 pound. If the French supermarket chain has to pay the UK dairy currency to weaken the domestic currency. For example, in the wake of the European
producers £100,000, it will have to convert €120,000 (£100,000 × €1.20/£1). 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
The exchange rates between world currencies, such as the US dollar (US$), euro, Swiss franc started eroding the competitiveness of Swiss exporters and pushed the
British pound, and Japanese yen (¥) are just like prices of products and services. As Swiss National Bank, Switzerland’s central bank, to intervene. To drive the price of
discussed in the Microeconomics chapter, prices change continuously depending on the Swiss franc down, the Swiss National Bank sold its domestic currency and bought
supply and demand. If a lot of people want to buy a particular currency, such as the foreign currencies, such as the euro; the Swiss National Bank did the opposite of what
euro, demand for the euro will increase and the price of the euro will rise. It will take investors were doing. In the process, it accumulated foreign currency reserves. This
more of the other currency to buy a euro. In this case, the euro is said to appreciate example shows that central banks do not usually aim for a completely fixed exchange
(get stronger) relative to other currencies. Alternatively, if a lot of people want to sell rate, but typically try to maintain the value of their country’s currency within a cer-
the euro, demand for the euro will decrease and the price of the euro will fall. It will tain range. Central banks typically intervene infrequently, so generally, such a system
take less of the other currency to buy a euro. In this case, the euro is said to depreciate operates as a floating exchange rate system.
(get weaker) relative to other currencies.
■
Fixed rate
6 CURRENCY VALUES
Floating rate
■ Managed floating rate This section identifies some major factors that affect the value of a currency and then
describes how to assess the relative value of currencies.
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 6.1 Major Factors That Affect the Value of a Currency
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 Major factors that influence the value of a currency include the country’s
known as a fixed exchange rate system or regime.
■ balance of payments,
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 ■ level of inflation,
rates. In a fixed-rate regime, importers and exporters know with greater certainty
■ level of interest rates,
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 ■ level of government debt, and
economy that becomes uncompetitive will see its current account balance worsen
because its currency becomes overvalued; its exports are too expensive from the ■ political and economic environment.
buyer’s perspective and its imports are too cheap from the seller’s perspective. Under
Currency Values 135 136 Chapter 6 ■ Economics of International Trade
6.1.1 Balance of Payments it was in January. The exchange rate has moved from €1.20/£1 to €1.20/£1.10
As discussed earlier, an important factor that affects the value of a currency is the or €1.09/£1. A pound buys fewer euros, so the pound has depreciated relative
current account balance. In a floating exchange rate system, the exchange rate should to the euro.
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 A country with a consistently high level of inflation will see the value of its currency
should fall, making exports more competitive. At the same time, the relative price of fall compared with a country that has a consistently low level of inflation.
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, 6.1.3 Level of Interest Rates
the domestic currency should appreciate relative to foreign currencies. The domestic Higher interest rates, unless they are driven by inflation, usually increase capital flows
currency’s appreciation should have a negative effect on exports and a positive effect into a country because they make investments in that country more attractive, all other
on imports, reducing the current account surplus. So, a floating exchange rate system factors being equal. Increased investments in the country create a demand for the
tends to be self-adjusting. country’s currency. Thus, higher interest rates push the value of the currency higher.
But, as discussed earlier, the self-adjusting mechanism does not always work in practice As discussed in the Macroeconomics chapter, raising interest rates is a way for central
because there are many factors other than international trade that influence exchange banks to control inflation. When a central bank raises interest rates, it may attract
rates. In addition, the natural correction that should lead to a reduction of the current more foreign investors to buy that currency, making the currency appreciate. The
account deficit or surplus may not occur if the country belongs to a single currency appreciating currency makes imports less expensive and thus helps reduce inflation.
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 In addition, some countries that have balanced economic growth and higher relative
current account deficits. The self-adjusting mechanism should lead to a depreciation interest rates may see an increase in capital flows into their currency. This increase
of the euro and reduce the current account deficits of these countries. But the euro is occurs because many investors see higher interest rates as a way of achieving a higher
also the currency used by Germany, the country running the largest current account yield. But high interest rates can also reduce capital inflows if investors believe they
surplus, as shown in Exhibit 2. Because 18 European countries use the same currency might lead to higher inflation and potential currency depreciation.
but face very different economic environments, it makes it difficult, if not impossible,
for natural corrections to take place.
6.1.4 Level of Government Debt
If it appears that a government is over-indebted and may be unable to make a promised
6.1.2 Level of Inflation payment of interest or principal—that is, it may default on its payments—investors
As discussed in the Macroeconomics chapter, inflation erodes the purchasing power may decide that they no longer want to hold the bonds issued by that government.
of a country’s currency—that is, as prices increase, a unit of domestic currency buys If investors sell the government bonds they hold and take their money out of the
less foreign products and services. Example 2 illustrates the effect of inflation on the country, it will cause a depreciation of the country’s currency.
purchasing power of a country’s currency.
costs $30,000 in the United States but the equivalent of $27,000 [M$270,000/
Exhibit 5 Major Factors Affecting the Value of a Currency
(M$10/$1)] in Mexico. In other words, it is cheaper for a US citizen to buy the
car in Mexico.
Factor Effect on the Value of the Currency
The fact that the same product sells for different prices presents an arbitrage
Balance of payments A current account deficit tends to lead to a depre-
opportunity—that is, an opportunity to take advantage of the price difference
ciation of the domestic currency.
between the two markets. If consumers are able to do this without incurring
Level of inflation High inflation tends to lead to a depreciation of
extra costs, then the following may happen:
the domestic currency.
Level of interest rates High interest rates tend to lead to an appreciation
1 US consumers will demand Mexican pesos to buy cars in Mexico. This
of the domestic currency.
demand will cause the Mexican peso to appreciate relative to the US
Level of government debt High government debt tends to lead to a deprecia-
dollar.
tion of the domestic currency.
Political and economic Political instability and poor economic prospects 2 Demand for the car sold in Mexico will increase, so the price Mexican
environment tend to lead to a depreciation of the domestic retailers charge will also increase.
currency.
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.
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- Eventually, these events should cause the prices in the two countries and the
tities by many governments and financial institutions as part of their foreign exchange exchange rate to change until the price difference vanishes. But the adjustment
reserves. A reserve currency also tends to be the international pricing currency for process may take time.
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 In practice, buying the car in Mexico and bringing it to the United States may not be
outlook alone. Many economists believe that a decline in the demand for US finan- as advantageous as it seems in theory. Anything that limits the free trade of goods will
cial assets and for US dollars may take place over many years as alternative reserve limit the opportunities people have to take advantage of these arbitrage opportunities
currencies emerge. However, major foreign investors holding US financial assets and and will influence currency valuations. The following are examples of three such limits:
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.
■ 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
6.2 Relative Strength of Currencies cars imported from Mexico, then it may no longer be advantageous to buy the
The concept of purchasing power parity has long been used to explain relative cur- car in Mexico instead of in the United States.
rency valuations—that is, whether currencies are fairly valued relative to each other. ■ Transportation costs. The gains from arbitrage are limited if it is expensive to
Purchasing power parity is an economic theory based on the principle that a basket transport products from one market to another. Transportation costs may be
of goods in two different countries should cost the same after taking into account the limited for US consumers going to Mexico to buy a car, but costs would be
exchange rate between the two countries’ currencies. much higher if they had to ship a car from Germany or Japan.
Example 3 illustrates what happens if two identical products have different prices and ■ Perishable products. It may be impractical or difficult to transfer products from
how prices and the exchange rate should adjust. 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.
EXAMPLE 3. ARBITRAGE OPPORTUNITY 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
Assume that the exchange rate is currently 10 Mexican pesos for 1 US dollar in various countries around the world, and then it estimates what the exchange rates
(M$10/$1). In the United States, a particular car sells for $30,000, whereas in should be to make the price of Big Macs the same in all the countries. This exchange
Mexico, the same car sells for M$270,000. Given the exchange rate, the car 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 139 140 Chapter 6 ■ Economics of International Trade
of purchasing power parity exchange rates relative to the US dollar and then compares
Exhibit 6 The Economist’s Big Mac Index
them with the actual exchange rates to help identify whether currencies are under- or
overvalued relative to the US dollar.
India –66.8
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- South Africa –53.3
valued relative to the US dollar.
Malaysia –51.8
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 141 142 Chapter 6 ■ Economics of International Trade
The foreign exchange market is where currencies are traded. It is a very active and Bid Offer
liquid market with an average of $5 trillion traded globally every day. It is not in a
British pound (£) $1.50/£1 $1.60/£1
centralised location but is a highly integrated decentralised network that connects
buyers and sellers via information and computer technology. 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 $1,600 into pounds.
7.1 Foreign Exchange Rate Quotes From the US perspective, the British pound is the foreign currency and the
If you have ever converted money, maybe at the airport when visiting a country that US dollar is the domestic currency. Customer A wants to sell the foreign currency
uses a different currency than your home country, you are aware that the bank or (£) and buy the domestic currency ($), which means that the currency dealer has
currency dealer always displays two exchange rates for a particular currency. 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 × ($1.50/£1) for the £1,000.
■ The bid exchange rate (or bid rate) is the exchange rate at which the bank or Customer B wants to sell the domestic currency ($) and buy the foreign cur-
currency dealer will buy the foreign currency. 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
The offer exchange rate (or offer rate), also called the ask exchange rate (or
will receive £1,000 [$1,600/($1.60/£1)] for the $1,600.
ask rate), is the exchange rate at which the bank or dealer will sell the foreign
currency. 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.
Let us return to the example of the French supermarket chain importing dairy prod- The French supermarket may want to determine today how many euros it will have to
ucts from the United Kingdom that has to pay its UK dairy producers £100,000. If give its bank or currency dealer to get £100,000 in two months when it converts the
the French supermarket needs to make the payment now and convert euros into euros into pounds. By using the forward market today, the French supermarket chain
pounds immediately, the exchange rate at which the conversion takes place is the spot can lock in (fix) the exchange rate at which it will pay the invoice in two months. For
rate. Assuming a spot rate of €1.20/£1, the French supermarket chain has to convert example, if the two-month forward rate for delivery in two months is €1.21/£1, the
€120,000 to pay its invoice today, as shown earlier. 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
In the business world, however, many suppliers give credit to their customers. Assume its UK dairy producers. In doing so, it eliminates the currency risk—no matter how
that the French supermarket chain has two months to pay its UK dairy producers. much the euro fluctuates relative to the pound in the next two months, the French
Because the conversion of euros into pounds is not required now but in two months, supermarket chain has certainty about the amount it will pay its UK dairy suppliers.
the French supermarket chain faces uncertainty about the exchange rate that will prevail Reducing or eliminating risk such as currency risk is often called hedging and is fur-
in two months and thus the amount it will have to give its bank or currency dealer to ther discussed in the Derivatives chapter.
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 Gaining certainty is important for companies because it enables them to ensure that
of the exchange rate between the euro and the pound during the next two months. 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,
Example 6 shows the effect of both an appreciation and a depreciation of the euro rather than focus on the intricacies of buying and selling currencies.
relative to the pound on the amount the French supermarket chain would have to
pay its UK dairy producers.
■ Countries trade with each other by importing products and services that are
Exchange rate changes to Exchange rate changes to
€1.15/£1 €1.25/£1 produced in other countries and by exporting products and services produced
domestically.
It takes 5 cents less to It takes 5 cents more to
buy 1 pound. Thus, the buy 1 pound. Thus, the ■ Companies trade across borders to gain access to resources, to create additional
euro appreciated relative euro depreciated relative
demand for products and services produced domestically, to provide consumers
to the pound. to the pound.
with a greater choice of products and services, and to improve the quality and/
French supermarket French supermarket or reduce the price of products and services.
chain must pay chain must pay
£100,000 × €1.15/£1 = £100,000 × €1.25/£1 = ■ International trade has benefited from the reduction in trade barriers, such
€115,000 €125,000 as tariffs, quotas, and non-tariff barriers, and from better transportation and
Euro appreciation relative Euro depreciation rela- communications.
to the pound is beneficial tive to the pound is det-
for the French importer. rimental for the French ■ Countries tend to specialise in products and services for which they have a
importer. 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 145 146 Chapter 6 ■ Economics of International Trade
■ The balance of payments tracks transactions between residents of one coun- to lead to a depreciation in value of the domestic currency relative to foreign
try and residents of the rest of the world over a period of time, usually a year. currencies; it will take more of the domestic currency to buy a unit of foreign
Analysing a country’s balance of payments helps in understanding the country’s currency.
macroeconomic environment.
■ One of the simplest models for determining the relative strength of currencies
■ The balance of payments includes two accounts: the current account and the is purchasing power parity, which is based on the principle that a basket of
capital and financial account. goods in two different countries should cost the same after taking into account
the exchange rate between the two countries’ currencies. Purchasing power par-
■ The current account reports trades of imported and exported goods and ity has limitations because of the difficulty of identifying a basket of goods for
services as well as income and current transfers. A country where the value comparison between countries and barriers to international trade.
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 ■ Two exchange rates are quoted in the market: the bid rate and the offer rate.
trade deficit. Because the trade balance tends to dominate the current account The bid rate is the rate at which the dealer will buy the foreign currency, and
balance, countries that have a trade surplus tend to have a current account sur- the offer rate is the rate at which the dealer will sell the foreign currency. The
plus, whereas countries that have a trade deficit tend to have a current account bid–offer spread is how the dealer makes money.
deficit.
■ Foreign exchange transactions may take place with immediate delivery via the
■ The capital account primarily reports capital transfers between domestic spot market or with future delivery via the forward market.
entities and foreign entities. The financial account includes direct investments,
■ The forward market allows importers and exporters to eliminate currency risk
portfolio investments, other investments, and the reserve account.
by fixing today the exchange rate at which they will trade in the future.
■ 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
LEARNING OUTCOMES
by Michael J. Buckle, PhD, James Seaton, PhD, and Stephen Thomas, PhD d Describe information provided by the income statement;
h Explain links between the income statement, balance sheet, and cash flow
statement;
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
© 2014 CFA Institute. All rights reserved. unqualified or clean opinion, meaning that the financial statements are prepared in
Financial Statements 151 152 Chapter 7 ■ Financial Statements
accordance with the applicable accounting standards, to an adverse opinion, which ■ its obligations to lenders and other creditors (liabilities or debt), and
indicates that the financial statements do not comply with the accounting standards
■ owner-supplied capital (shareholders’ equity, stockholders’ equity, or owners’
and, therefore, do not provide a fair representation of the company’s performance.
equity).
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. The fundamental relationship underlying the balance sheet, known as the accounting
In other words, an audit opinion is not a judgement on the company’s performance equation, is
but on how well it accounted for its performance.
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
FINANCIAL STATEMENTS 3 indicate how those resources are financed—by creditors (liabilities) or by shareholders
(equity). The value of the assets must be equal to the value of the financing provided
to acquire them. In other words, the balance sheet must balance!
■ The income statement (also called statement of profit or loss, profit and loss
statement, or statement of operations) identifies the profit or loss generated by
Equity
the company during the period covered by the financial statements.
■ The cash flow statement shows the cash received and spent during the period.
To illustrate the basic structure of a balance sheet, Exhibit 1 shows the balance sheet production on hand called stocks in some parts of the world); and accounts receivable
for hypothetical company ABC. Two years of information are displayed to reflect (money owed to the company by customers who purchase on credit, sometimes called
the values of the company’s assets, liabilities, and equity on 31 December 20X1 and debtors), are assets that are expected to be converted into cash, used up, or sold within
20X2. Most companies will report the most recent period’s information in the first the current operating period (usually one year). A company’s operating period is the
column of numbers, but occasionally companies will report the most recent period’s average amount of time elapsed between acquiring inventory and collecting the cash
information in the far-right column. Although it is common practice to use paren- from sales to customers. Non-current assets (sometimes called fixed or long-term
theses or minus signs to indicate subtraction, some companies will assume that the assets) are longer term in nature. Non-current assets include tangible assets, such as
reader knows which numbers are generally subtracted from others and will not use land, buildings, machinery, and equipment, and intangible assets, such as patents.
minus signs or parentheses. 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.
Exhibit 1 ABC Company Statement of Financial Position
When a company purchases a long-term (non-current) asset, it does not immediately
As of 31 December 20X2 20X1 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-
($ millions) ised, long-term asset, the company allocates the cost of that asset over the asset’s
Assets estimated useful life. This process is called depreciation. The amount allocated each
Cash 25 16 year is called the depreciation expense and is reported on the income statement as
Accounts receivable 40 35 an expense. The purchase amount represents the gross value of the asset and remains
Inventories 95 90
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
Other current assets 5 5
is calculated as the gross value of the asset minus accumulated depreciation, where
Total current assets $165 $146 accumulated depreciation is the sum of the reported depreciation expenses for the
Gross property, plant, and equipment 460 370 particular asset. Details about the original costs, depreciation expenses, and accu-
Accumulated depreciation (160) (120) mulated depreciation of property, plant, and equipment can be found in the notes to
Net property, plant, and equipment $300 $250 the financial statements.
Intangible assets 100 100 Other assets that might be included on a company’s balance sheet are long-term
Total non-current assets $400 $350 financial investments, intangible assets (such as patents), and goodwill. Goodwill is
Total assets $565 $496 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.
Liabilities and Equity
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
Accounts payable 54 50
expensing the costs of intangible assets over their useful lives is called amortisation;
Accrued liabilities 36 36 this process is similar to depreciation.
Current portion of long-term debt 10 10
Total current liabilities $100 $96 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
Long-term debt 232 200
is money that has been borrowed and must be repaid at some future date; therefore,
Total non-current liabilities $232 $200 debt is a liability—an obligation for which the company is liable. Equity represents
Total liabilities $332 $296 the shareholders’ (owners’) investment in the company.
Common stock 85 85
Debt can be split into current (short-term) liabilities and long-term debt. Current lia-
Retained earnings 148 115
bilities must be repaid in the next year and include operating debt, such as accounts
Total owners’ equity $233 $200
payable (credit extended by suppliers, sometimes called creditors), short-term bor-
Total liabilities and equity $565 $496 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
Balance sheets typically classify assets as current and non-current. The difference greater than one year.
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
Financial Statements 155 156 Chapter 7 ■ Financial Statements
Shareholders are the residual owners of the company; that is, they own the residual
Exhibit 2 (Continued)
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 Net income $76
to common shareholders, which are direct contributions by owners when they pur-
chase shares of stock; and (2) retained earnings (retained income), which represents
Additional information:
the company’s undistributed income (as opposed to the dividends that represent
distributed income). Retained earnings are an indirect contribution by owners who Dividends paid to shareholders $43
allow the company to retain profits. Number of shares outstanding 50 million
Earnings per share $1.52
Retained earnings represent a link between the company’s income statement and the
Dividend per share $0.86
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
The income statement shows the company’s financial performance during a given
retained earnings and thus its equity; the company becomes less valuable because it
time period, which is one year in Exhibit 2. It includes the revenues earned from
has lost, rather than earned, value.
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:
3.2 The Income Statement
Profit (loss) = Revenues – Expenses
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 Expenses are the cost of company resources—cash, inventories, equipment, and so
company during a given time period, such as a year. Generating profit over time is on—that are used to earn revenues. Expenses can be divided into different categories
essential for a company to continue in business. In practice, the income statement that reflect the role they play in earning revenues. Typical categories include
may be referred to as the “P&L”.
■ Operating expenses, which include the cost of sales (or cost of goods sold); sell-
To illustrate the basic structure of an income statement, Exhibit 2 shows the income ing, general, and administrative expenses; and depreciation expenses
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 ■ Financing costs, such as interest expenses
$33 million, the same amount as the change in retained earnings from 20X1 to 20X2 as
■ Income taxes
shown on the balance sheet in Exhibit 1 ($148 million – $115 million = $33 million).
Operating income is often referred to as earnings before interest and taxes (EBIT).1 occurs later, a common situation when the customer buys on credit. In this case, there
Operating income is the income (earnings) generated by the company before taking is initially revenue without cash. A company acquiring or producing a unique item
into account financing costs (interest) and taxes. 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
Another important measure of income is earnings before interest, taxes, depreciation, can be incurred and accounted for without being paid if a supplier extends credit, or
and amortisation (EBITDA). EBITDA is operating income before depreciation and an expense can be paid for before it is actually incurred (prepaid).
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 On the income statement, profits are measured on an accrual basis, which means
than by operating decisions. EBITDA is useful because it offers a closer approxima- that revenues are recorded when the revenues are earned rather than when they are
tion of operating cash flow than EBIT. It is an indicator of the company’s operating received in cash and that related expenses may be recognised before or after they are
performance and its management’s ability to generate revenues and control expenses paid out in cash. Because of the timing difference between when revenues are earned
that are related to its operations. EBITDA may be a better measure than EBIT of and when customers pay their bills, the cash received during a particular period is
management’s ability to manage the revenues and expenses within its control. This not likely to be the same amount as the revenues earned during that period, unless all
measure does not appear, as such, on a company’s income statement. 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,
EBITDA = EBIT (or operating income) + Depreciation and Amortisation
profits and net cash flow are typically not the same amount.
If the company has borrowed money to help finance its activities, it will have to pay
There are other reasons why the profits measured on the income statement are not
interest. Deducting interest expense from operating income determines the earnings
the same as cash flows. For example, the balance sheet reports long-term assets when
before taxes (or profit before tax).
they are acquired, but there is no “long-term asset” expense shown immediately on the
Earnings before taxes = EBIT (or operating income) – Interest expense 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
The income taxes owed by the company on its earnings are then deducted to arrive does not correspond to a cash flow; the cash flow for the asset acquisition happens
at net income (or net profit or profit after tax). up front, when the asset is acquired.
Net income = EBIT (or operating income) – Interest expense – Tax expense 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
= Earnings before taxes – Tax expense
must be paid for the company to keep operating. The income statement indicates
Net income represents the income that the company has available to retain and how good a company is at creating profit, but it is also critical to see how good the
reinvest in the company (retained earnings) or to distribute to owners in the form of company is at generating cash. A company can be profitable but have negative cash
dividends (disbursements of profit). 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
The company’s owners (shareholders) are interested in knowing how much income high depreciation and amortisation expenses. A company can operate at a loss as long
the company has created per share, which is called earnings per share (EPS). It is as the owners allow it, provided the company can generate cash flows to support its
approximated as net income divided by the number of shares outstanding. Existing survival. But a company cannot survive long with negative cash flows, no matter how
and potential investors are also interested in the amount of dividends the company profitable it seems to be. Negative cash flows may cut off access to resources, such as
pays for each share outstanding, or dividend per share. The importance of earnings material and labour, and can cause a company to become bankrupt.
per share and dividend per share in valuing a company is discussed in the Equity
Securities chapter. 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.
3.3 Profit and Net Cash Flow
The income statement shows a company’s profit, but profit is not the same as net cash 3.4 The Cash Flow Statement
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 The statement of cash flows (or cash flow statement) identifies the sources and
example, whether the products have been shipped to the customer. But the cash flow uses of cash during a period and explains the change in the company’s cash balance
from the transaction—the cash received when the customer pays its bill—usually 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.
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.
Financial Statements 159 160 Chapter 7 ■ Financial Statements
FINANCIAL STATEMENT ANALYSIS 4 How would you characterise the liquidity of ABC based on the information
below?
165
Financial statement analysis involves the use of information provided by financial state- ABC’s current ratio = 1.65
100
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 165 − 95 70
allows analysts to standardise financial information and provides a context for making ABC’s quick ratio = = = 0.70
100 100
meaningful comparisons. In particular, investors can compare companies of different ABC’s current ratio of less than 2 and its quick ratio of less than 1 indicate
sizes as well as the performance of the same company at different points in time. that the company may have difficulties meeting its obligations in the short term.
Ratios help managers of the company or outside creditors and investors answer the But it is not necessarily a source of concern because ABC may have access to
following questions that are important to help determine a company’s potential future resources, such as a line of credit from its bank, that do not appear on the bal-
performance: 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.
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?
4.2 Is the Company Generating Enough Profit from Its Assets?
76
A widely used ratio for measuring a company’s profitability is the net profit margin. ABC’s return on assets = 0.1345 13.45%
565
Net income
Net profit margin 110
Revenues ABC’s basic earning power = 0.1947 19.47%
565
This ratio measures the percentage of revenues that is profit—that is, the percent-
ABC’s ratios are higher than the industry averages so it appears to be gen-
age of revenues left for the shareholders after all expenses have been accounted for.
erating more income from its assets than comparable companies. This result
Generally, the higher the net profit margin, the better.
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.
How would you interpret ABC’s net profit margin based on the information To investigate how the company generates more income from its assets than compa-
below? rable companies, return on assets can be separated into two components:
76 Net income Net income Revenues
ABC’s net profit margin = 0.1169 11.69% Return on assets = ROA = = ×
650 Total assets Revenues Total assets
ABC’s net profit margin of 11.69% means that for every dollar of revenue, Similarly, the basic earning power ratio can be separated into two components:
ABC earns $0.1169 of profit.
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
Another ratio used to assess profitability is return on assets (ROA).
assets and a ratio called operating profit margin in the basic earning power ratio. Net
Net income profit margin and operating profit margin show how good the company is at turning
Return on assets ROA
Total assets 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.
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 second component of return on assets and the basic earning power ratio is a
the better. 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
Some analysts may choose to use operating income rather than net income when
in the business, or how effectively the company uses its assets to generate revenues.
calculating return on assets. Recall from an earlier discussion that operating income is
An increasing ratio may indicate improving performance, but care should be taken
the income generated from a company’s assets excluding how those assets are financed.
in interpreting this figure. An increasing ratio may also indicate static revenues and
When calculated using operating income, a better name for the ratio is operating
decreasing assets attributable to depreciation; in other words, sales are not growing
return on assets or basic earning power. The basic earning power ratio compares
and the company is not reinvesting to keep its plant and machinery up to date. It is
the profit generated from operations with the assets used to generate that income.
important to assess the cause of changes in a ratio.
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.
Take a look at the three ratios for ABC shown below. What might these ratios
tell you about how ABC generates its profits?
Financial Statement Analysis 167 168 Chapter 7 ■ Financial Statements
76 10 + 232 242
ABC’s net profit margin = 0.1169 11.69% ABC’s debt-to-equity ratio = = = 1.04
650 233 233
110 565
ABC’s operating profit margin = 0.1692 16.92% ABC’s equity multiplier = 2.42
650 233
A debt-to-equity ratio close to 1 indicates that debt and equity provide
650
ABC’s asset turnover = 1.15 approximately equal amounts of financing to ABC. An equity multiplier close
565 to 2 shows that ABC’s asset value is more than twice the amount of equity. To
The first two ratios indicate that for each dollar of revenue, the company interpret these leverage ratios, a comparison should be made with other com-
generates $0.1169 of net profit (net income) and $0.1692 of operating profit panies in the same industry. If ABC is found to have a higher proportion of debt
(operating income). The net and operating profit margins should be compared than the industry average, then it may indicate a greater financial risk for ABC.
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 Having a higher proportion of debt is riskier because a company is obligated to service
it has better control of its expenses. 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
ABC’s asset turnover is 1.15 times in the year; in other words, for every $1 a risk that it will not be in a position to meet those obligations or respond as quickly
of assets, $1.15 of revenues is generated. If the asset turnover ratio for similar as its competitors to new opportunities.
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. 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
4.3 How Is the Company Financing Its Assets? that uses a large amount of debt financing—that is, a company that is highly leveraged.
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:
4.4 Is the Company Providing Sufficient Return for Its
Debt
Debt-to-equity ratio Shareholders?
Equity
This ratio measures how much debt the company has relative to equity. Typically, It is important to determine whether the return made by the company is sufficient from
the debt considered is only interest-bearing debt, including short-term borrowing, the perspective of the shareholders. That is, is the return high enough for investors
the portion of long-term debt due within the reporting period, and long-term debt. to still want to own the share? One ratio commonly used to answer this question is
It does not include accounts payable and accrued expenses that do not require an return on equity (ROE).
interest payment. Net income
Return on equity ROE
Equity
Another common ratio is the financial leverage or equity multiplier ratio.
This ratio indicates how much return, as measured by net income, is available to a
Total assets
Financial leverage Equity multiplier monetary unit of equity. This measure can be compared with the return on equity over
Equity time, with the return on equity for other companies, and with the relevant industry
This equity multiplier measures the amount of total assets supported by one monetary average return on equity.
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 Return on equity can be decomposed in three components: net profit margin, asset
is one predominantly financed by equity. 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
Try to assess from the ratios below whether ABC has a high level of debt. What Return on equity = ROE
does this level tell you about the riskiness of ABC? = Net profit margin × Asset turnover × Financial leverage
Financial Statement Analysis 169 170 Chapter 7 ■ Financial Statements
You could simply calculate the return on equity by dividing net income by equity, but 76 650 565
the point here is not the algebra itself but the meaning it reveals. The first two com- =
650 565 233
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 = 11.69% × 1.15 × 2.42 = 32.53%
are financed by debt and equity. A company that has a higher level of debt in its total
Or
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 ABC’s return on equity = Return on assets Financial leverage
(the cost of its debt net of tax). This is why the financial leverage ratio is also known
as the equity multiplier ratio. 76 565
= × = 13.45% × 2.42 = 32.55%
565 233
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 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,
Net income
■ generate profits from revenues, expressed as net profit margin = ; has generated a larger return on equity for shareholders. But as noted earlier,
Revenues the high level of leverage brings greater risks.
Revenues
■ generate revenues from assets, expressed as asset turnover = ; and
Total assets
■ use borrowing to finance its assets, expressed as financial leverage 4.5 Summary of Ratios
Total assets
= . Exhibit 5 shows most of the ratios discussed in Sections 4.1 to 4.4, the formula for
Equity
each ratio, ABC’s value for each ratio for the year ending 31 December 20X2, and the
When any of these ratios increase, all else being equal, the return on equity increases. average value for the relevant industry for 20X2.
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- Exhibit 5 Ratios, Formulas, ABC’s Value, and Industry Value
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 ABC’s 20X2 20X2 Industry
ratio into components) is useful because it allows analysts to better understand why Ratio Formula Value Value
the company’s return on equity is changing and to interpret the sources of that change.
Current assets
Current ratio 1.65 1.92
Although each ratio measures an aspect of performance, gaining insight into a com- Current liabilities
pany’s performance depends on the ability to view the ratios in the larger context of Current assets Inventories
Quick ratio 0.70 0.75
overall competitive and historical performance. Current liabilities
Net income
Return on assets 13.45% 10.00%
Total assets
Operating income
Basic earning power 19.47% 15.00%
Total assets
What does the decomposition of ABC’s return on equity into its three key Net income
components tell you about the company’s overall performance?2 Return on equity Equity
32.62% 27.30%
76 Net income
ABC’s return on equity (ROE) = 0.3262 32.62% Net profit margin
Revenues
11.69% 5.56%
233
Broken into its components Operating profit Operating income
16.92% 8.33%
margin Revenues
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.
Financial Statement Analysis 171 172 Chapter 7 ■ Financial Statements
Total assets The book value of equity primarily reflects historical costs and measures the amount
Financial leverage Equity
2.42 2.73 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
Ratios are used to standardise financial data for comparisons and create a context for is an indication that the company’s managers have destroyed value.
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 SUMMARY
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 Financial statements are important in investors’ decisions about whether to purchase
margins. ABC does not turn over its assets as frequently as the industry average, but securities issued by companies. Careful analysis of a company’s financial statements
it compensates with higher profit margins. ABC uses less debt than the industry aver- can provide useful information about how a company has performed. The financial
age, as reflected in the lower financial leverage ratio, which means it is taking on less statements themselves indicate, for example, how profitable a company is and how
financial risk. In spite of the lower financial risk, ABC has a higher return on equity much cash it is generating. Financial ratios are critical for putting this information
as a result of its higher return on assets. Overall, our ratio analysis suggests that ABC in context by showing performance over time and making comparisons with other
appears to be performing better than the industry average. 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.
4.6 Market Valuations
The points below recap what you have learned in this chapter about financial statements:
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 ■ Financial statements are read and analysed by many people to assess a compa-
performance in terms of creating or destroying value for the company’s shareholders. ny’s past and forecasted performance.
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: ■ Accounting standards guide the gathering, analysis, and presentation of infor-
mation in financial statements.
Market price per share
Price-to-earnings ratio
Earnings per share ■ Regulators support accounting standards by recognising them and enforcing
them.
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 ■ Auditors are independent accountants who express an opinion about the finan-
every $1 of earnings per share. If the price-to-earnings ratio is higher for one com- cial statements’ preparation and presentation. This opinion helps determine
pany compared with another one in the same industry, it may indicate that investors how much reliance to place on the financial statements.
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 ■ The three primary financial statements are the balance sheet, the income state-
undervalued by the market. The use of price-to-earnings ratio in valuing companies ment, and the cash flow statement. They are accompanied by notes that provide
is further discussed in the Equity Securities chapter. information that helps investors understand and assess the financial statements.
The second ratio is the price-to-book ratio. It compares the company’s share price ■ The balance sheet (or statement of financial position or statement of financial
with the company’s book value per share: 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 173 174 Chapter 7 ■ Financial Statements
■ The accounting equation underlying the balance sheet is Total assets = Total
Ratio Formula
liabilities + Total shareholders’ equity.
Net income
■ The income statement (or profit and loss statement or statement of opera- Return on equity Equity
tions) identifies the profit (or loss) generated by a company during a given time
period. Net income
Net profit margin
Revenues
■ The profits reported on the income statement are not the same as net cash
Operating income
flows. Revenues and expenses, which are used to calculate profit, are measured Operating profit margin
Revenues
on an accrual basis rather than when they are received or paid in cash.
Revenues
Asset turnover
■ The statement of cash flows identifies the sources and uses of cash during a Total assets
period and explains the change in the company’s cash balance reported on the Total assets
balance sheet. Financial leverage Equity
■ 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.
Ratio Formula
Current assets
Current ratio
Current liabilities
Net income
Return on assets
Total assets
Operating income
Basic earning power
Total assets
(continued)
LEARNING OUTCOMES
g Explain uses of mean, median, and mode, which are measures of fre-
quency or central tendency;
2.1 Interest
INTRODUCTION 1 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
Knowledge of quantitative (mathematically based) concepts is extremely important to given up money. In the future, the borrower will give up money to pay back the lender;
understanding the world of finance and investing. Quantitative concepts play a role the lender will receive money as repayment from the borrower in the form of interest,
in financial decisions, such as saving and borrowing, and also form the foundation as shown below. The lender will also receive back the money lent to the borrower. The
for valuing investment opportunities and assessing their risks. The time value of money originally borrowed, which interest is calculated on, is called the principal.
money and descriptive statistics are two important quantitative concepts. They are Interest can be defined as payment for the use of borrowed money.
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 Lends Money
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 Pays Interest
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 Lender Borrower
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 Interest is all about timing: someone needs money now while someone else is willing
weather information to make decisions about how to dress and whether to carry an and able to give up money now, but at a price. The borrower pays a price for not being
umbrella or bring rain gear. Summary statistics help you understand and use informa- able to wait to have money and to compensate the lender for giving up potential current
tion in making decisions, including financial decisions. For example, summary infor- consumption or other investment opportunities; that price is interest. Interest is paid
mation about a company’s or market’s performance can help in investment decisions. 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
In short, quantitative concepts are fundamental to the investment industry. For any- have been given up by the lender, including lending to others, investing elsewhere,
one working in the industry, familiarity with the concepts described in this chapter is or simply spending the money. Opportunity cost can also be seen as compensation
critical. As always, you are not responsible for calculations, but the presentation for deferring consumption. Lending delays consumption by the term of the loan (the
of formulae and illustrative calculations may enhance your understanding. 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
TIME VALUE OF MONEY 2 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
Valuing cash flows, which occur over different periods, is an important issue in finance.
repaid as promised. The greater the expected inflation, the higher the level of interest
You may be concerned with how much money you will have in the future (the future
demanded by the lender.
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 From the borrower’s perspective, interest is the cost of having access to money that
future. You may want to know what your expected return is on an investment with they would not otherwise have. An interest rate is determined by two factors: oppor-
specified cash flows at different points in time. These types of problems occur every tunity cost and risk. Even if a loan is viewed as riskless (zero likelihood of default),
day in investments (e.g., in buying a bond), personal finance (e.g., in arranging an there still has to be compensation for the lender’s opportunity cost and for expected
automobile loan or a mortgage), and corporate finance (e.g., in evaluating whether inflation. Exhibit 1 shows examples of borrowers and lenders.
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.
Simple interest is not reinvested and is applied only to the original principal, as shown
Exhibit 1 Examples of Borrowers and Lenders
in Exhibit 2.
Pounds (£)
If you put money into a savings £10
120
Save Money account and earn interest, you £10 End of Previous
are a saver who lends your 110 Year Balance
savings to the bank and the bank £10 (Principal + Interest)
Receive Interest 100
is the borrower.
...
Original Principal
If people invest in a
Invest Money company and earn interest 0
by buying bonds, they are Original Year 1 Year 2 Year 3 Year 4 Year 5
Principal
the lenders and the
Receive Interest
company is the borrower.
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:
2.1.1 Simple Interest
Future value = Original principal × [1 + (Simple interest rate
A simple interest rate is the cost to the borrower or the rate of return to the lender, × Number of periods)]
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 To extend our deposit example: £100 × [1 + (0.10 × 2)] = £100 × (1.20) = £120. The
otherwise. The cost or return is stated as a percentage rate of the original principal so value at the end of two years is £120.
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 2.1.2 Compound Interest
promised return to the lender than a loan with a 3% interest rate. 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
The actual amount of interest earned or paid depends on the simple interest rate, the is assumed to be reinvested so future interest is earned on principal and reinvested
amount of principal lent or borrowed, and the number of periods over which it is lent interest, not just on the original principal.
or borrowed. We can show this mathematically as follows:
If a deposit of £100 is made and earns 10% and the money is reinvested (remains
Simple interest = Simple interest rate × Principal × Number of periods
on deposit), then additional interest is earned in the course of the second year on
If you put money in a bank account and the bank offers a simple interest rate of 10% the £10 of interest earned in the first year. The interest is being compounded. Total
per annum (or annually), then for every £100 you put in, you (as a lender to the bank) interest after two years will now be £21; £10 (= £100 × 0.10) for the first year, plus
will receive £10 in the course of the year (assume at year end to simplify calculations): £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
Interest = 0.10 × £100 × 1 = £10 total interest after two years is £21 rather than £20 as in the case of simple interest
shown in Exhibit 2.
If your money is left in the bank for two years, the interest paid will be £20:
Interest = 0.10 × £100 × 2 = £20
Time Value of Money 181 182 Chapter 8 ■ Quantitative Concepts
Exhibit 3 Compound Interest of 10% on £100 Original Principal Exhibit 4 Effects on Savings of Simple and Compound Interest
160 700
Interest per Year £14.64
150 600
140 £13.31 500
130
Pounds (£)
Balance (£)
£12.10 400
120
£11.00 End of Previous 300
110 Year Balance
£10.00 (Principal + Interest)
100 200
0 0
Original Year 1 Year 2 Year 3 Year 4 Year 5 0 5 10 15 20
Principal Years
Simple Interest Compound Interest
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 2.1.4 Annual Percentage Rate and Effective Annual Rate
Unless stated otherwise, interest rates are stated as annual rates. The rate quoted is
In the deposit example, £100 × (1 + 0.10)2 = £100 × (1.10)2 = £121. With compounding,
often the annual percentage rate (APR), which is a simple interest rate that does not
the value at the end of two years is £121.
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
2.1.3 Comparing Simple Interest and Compound Interest once a year—usually monthly, quarterly, or semi-annually. The following equation
shows how to determine the EAR given the APR.
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 ⎡⎛ Number of periods per year ⎤
APR ⎞
two years will end up with £1 more by reinvesting the interest (£121) than with simple EAR = ⎢⎜1 + ⎟ ⎥ −1
⎢⎝ Number of periods per year ⎠ ⎥
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
Example 1 shows a few types of financial products and their simple interest rates
interest {£100 × [1 + (0.10 × 20)] = £100 × 3 = £300} but £673 with compound interest
(APRs) and their compound rates (EARs).
[£100 × (1 + 0.10)20 = £100 × (1.10)20 = £673]. This concept is illustrated in Exhibit 4.
A saver may want to know how much money is needed today to produce a certain
Simple Interest Rate Compound Interest Rate
sum in the future given the rate of interest, r. In the example in Exhibit 3, today’s value
or APR or EAR
is £100 and the interest rate is 10%, so the future value after two years is £100 × (1 +
⎡⎛ 365 ⎤ 0.10)2 = £121. The present value—the equivalent value today—of £121 in two years,
0.1524 ⎞
Credit card 15.24% 16.46% = ⎢⎜1 + ⎟ ⎥ −1 given that the annual interest rate is 10%, is £100.
⎢⎣⎝ 365 ⎠ ⎥⎦
⎡⎛ 0.024 ⎞ ⎤
12
Bank deposit 2.4% (= 0.2% × 12) 2.43% = ⎢⎜1 + ⎟ ⎥ −1 £100 £121
⎢⎣⎝ 12 ⎠ ⎥
⎦ Present Future
Interest Rate (10%)
Value Value
⎡⎛ 0.06 ⎞
4⎤
Loan 6.0% 6.14% = ⎢⎜1 + ⎟ ⎥ −1
⎢⎣⎝ 4 ⎠ ⎥⎦
Today In 2 Years
£100 £121
As can be seen in Example 1, in general, whenever an interest rate compounds more Present Discount Rate (10%) Future
often than annually, the EAR is greater than the APR. In other words, more frequent Value Value
compounding leads to a higher EAR.
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-
2.2 Present Value and Future Value ments under consideration. The following equations generalise the calculation of
Two basic time value of money problems are finding the value of a set of cash flows future and present values:
now (present value) and the value as of a point of time in the future (future value).
Future value = Present value × (1 + Interest rate)Number of periods
Future value
2.2.1 Present Value and Future Value Present value =
(1 Discount rate) Number of periods
If you are offered £1 today or £1 in a year’s time, which would you choose? Most
Note that the interest and discount rates are the same percentage rates, but the termi-
people say £1 today because it gives them the choice of whether to spend or invest
nology varies based on context. Calculating present values allows investors and analysts
the money today and avoid the risk of never getting it at all. The £1 to be received in
to translate cash flows of different amounts and at different points in the future into
the future is worth less than £1 received today. The £1 to be received in the future is
sums in the present that can be compared with each other. Likewise, the cash flows can
today worth £1 minus the opportunity cost and the risk of being without it for one
be translated into the values they would be equivalent to at a common future point.
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. Example 2 compares two investments with the same initial outflow (investment) but
with different future cash inflows at different points in time.
Present Interest Rate (r%) Future
Value Value
EXAMPLE 2. COMPARING INVESTMENTS
Present Future
Time Time
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
Discount Rate (r%)
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
Time affects the value of money because delay creates opportunity costs and risk. If
out £1,350 five years from now. To choose between the two investments,
you earn a return of r% for waiting one year, £1 × (1 + r%) is the future value after
you must compare the value of each investment at the same point in time.
one year of £1 invested today. Put another way, £1 is the present value of £1 × (1 +
r%) received in a year’s time.
Present value of £1,000 in three years discounted at 9%
£1, 000 £1, 000
= = = £772.18
(1.09)3 1.295
Time Value of Money 185 186 Chapter 8 ■ Quantitative Concepts
1 You place £1,000 on deposit at an annual interest rate of 10% and make
EXAMPLE 3. COMPARING INVESTMENTS USING NET PRESENT VALUE 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 NPV of the investment in Example 2 that is paying £1,350 in five years
(discounted at 15%) if it initially cost £500 is:
Time Value of Money 187 188 Chapter 8 ■ Quantitative Concepts
At the end of the first year, you have £1,000 × (1 + 0.10) = £1,100 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
You withdraw £250 and begin the second year with an amount = £850
priced cheaply, priced fairly, or overpriced.
At the end of the second year, you have £850 × (1 + 0.10) = £935
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
Time value of money can also help determine the value of a financial instrument. It
mortgages, involve regular periodic payments to pay off the loan. Each period, some of
can help you work out the value of an annuity or how long it will take to pay off the
the payment covers the interest on the loan and the rest of the payment pays off some
mortgage on your home.
of the principal (the loaned amount). A pension savings scheme or pension plan may
also involve regular contributions.
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 Most consumer loans result in a final balance of money equal to zero. That is, the
the form of future cash flows. These cash flows can be in the form of income, such loan is paid off. Two time value of money applications that require the final balance
as dividends and interest, from the repayment of an amount lent, or from selling the of money to be zero are annuities and mortgages.
financial product or instrument to someone else. An investor is exchanging a sum of
An annuity involves the initial payment of an amount, usually to an insurance company,
money today for future cash flows, and some of these cash flows are more uncertain
in exchange for a fixed number of future payments of a certain amount. Each period,
than others. The value (amount exchanged) today of a financial product should equal
the insurance company makes payments to the annuity holder; these payments are
the value of its expected future cash flows. This concept is shown in Example 5.
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.
EXAMPLE 5. VALUE OF A LOAN
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
Consider the example of a simple loan that was made three years ago. Two years
amounts are fixed, the portion of each payment that is interest is based on the remain-
from today, the loan will mature and the borrower should repay the principal
ing principal at the beginning of each period. As some of the principal is repaid each
value of the loan, which is £100. The investor who buys (or owns) this loan should
period, the amount of interest decreases over time, and thus the amount of principal
also receive from the borrower two annual interest payments at the originally
repaid increases with each successive payment until the value of the principal is
promised interest rate of 8%. The interest payments will be £8 (= 8% × £100),
reduced to zero. At this point, the loan is said to mature.
with the first interest payment received a year from now and the second two
years from now. 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
How much would an investor pay today to secure these two years of cash flow
annuity and the mortgage each mature in five years and entail a single withdrawal or
if the appropriate discount rate is 10% (i.e. r = 0.10)? Note that the rate used for
payment each of the five years.
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
Time Value of Money 189 190 Chapter 8 ■ Quantitative Concepts
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 As the name suggests, descriptive statistics are used to describe data. Often, you are
company is in effect paying him 6.0% interest on the annuity balance. 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
Withdrawal thinking of changing your route. How could you assess whether the journey really is
Annuity Balance (Payment by getting slower? Suppose you calculated and compared the average daily commute time
at Beginning Balance at End of Year Insurance each month over a year. The first question you need to address is, what is meant by
Year of Year before Withdrawal Company) 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.
1 €10,000 €10,600 (= 10,000 × 1.06) €2,375
2 €8,225 €8,719 (= 8,225 × 1.06) €2,375 In general, descriptive statistics are numbers that summarise essential features of a data
3 €6,344 €6,725 (= 6,344 × 1.06) €2,375 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
4 €4,350 €4,611 (= 4,350 × 1.06) €2,375
values for the variable. For example, if you keep track of your daily commute time
5 €2,236 €2,370 (= 2,236 × 1.06) €2,370 for a year, you will end up with approximately 250 observations. The distribution of
6 €0 a variable is the values a variable can take and the number of observations associated
with each of these values.
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 We will discuss two types of descriptive statistics: those that describe the central ten-
be £13,706. 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
Mortgage the drive to work is getting slower (by comparing monthly averages), you might also
Outstanding Total want to find a way to measure how much variation there is between journey times
at Beginning Mortgage Principal from one day to another (by using standard deviation).
Year of Year Payment Interest Paid Reduced
Similar needs to summarise data arise in business. For example, when comparing the
1 £60,000 £13,706 £2,760 (= 60,000 × 0.046) £10,946 time taken to process two types of trades, a sample of the times required to process
2 £49,054 £13,706 £2,257 (= 49,054 × 0.046) £11,449 each trade would need to be collected. The average time it takes to process each type of
3 £37,605 £13,706 £1,730 (= 37,605 × 0.046) £11,976 trade could be calculated and the average times could then be compared. Descriptive
4 £25,630 £13,706 £1,179 (= 25,630 × 0.046) £12,527 statistics efficiently summarise the information from large quantities of data for the
5 £13,103 £13,706 £603 (= 13,103 × 0.046) £13,103 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
6 £0
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.
As you can see in Example 6, both the annuity and mortgage balances decline to zero
over time.
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
Descriptive Statistics 191 192 Chapter 8 ■ Quantitative Concepts
country X in July from 1961 to 2011 is calculated to be 16.1°C. Over the same period
EXAMPLE 7. ARITHMETIC MEAN
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.
An investment earns the returns shown in Exhibit 5 over a 10-year period.
Common measures of central tendency are
25
■
26.4%
arithmetic mean,
■ geometric mean, 20
Exhibit 5 Ten Years of Annual Returns = (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)
25
26.4%
= 6.3%
20
15
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
10
8.0% 7.2% being especially small or large in numerical value. The arithmetic mean is not very
5.2% representative of the whole set of observations when there are outliers. Example 8
5 3.7% 3.7% 4.2%
2.4% shows the effect of excluding an outlier from the calculation of the arithmetic mean.
1.3% 0.8%
1 2 3 4 5 6 7 8 9 10
Year EXAMPLE 8. EFFECT OF OUTLIER ON ARITHMETIC MEAN
25
three years. So, the second step requires moving from three years to one by raising
26.4% the accumulation to the power of “one over the number of periods held,” three in this
Outlier particular case; this calculation can also be described as taking “the number of peri-
20 ods held” root of the value (1.19031/3 ≈ 1.060). This value of 1.060 includes both the
Annual Returns (%)
original investment and the average yearly return on the investment each year (1 plus
15 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
10 total accumulation over the three years (1.060 – 1 ≈ 0.060 or 6.0%). The geometric
8.0% 7.2% mean return is 6.0%, which in this case is the same as the arithmetic mean return.
4.2% 5.2% Geometric mean is frequently the preferred measure for the investment industry.
5 Mean without Outlier
1.3% 0.8% 3.7% 3.7% The following formula is used to arrive at the geometric mean return:
2.4%
1/ t
1 2 3 4 5 6 7 8 9 10 Geometric mean return = ⎡⎣(1 + r1) × ! (1 + rt )⎤⎦ −1
Year
where
(1.3 + 2.4 + 0.8 + 3.7 + 8.0 + 3.7 + 7.2 + 4.2 + 5.2) ri = the return in period i expressed using decimals
= 4.1% Mean
9
t = the number of periods
The arithmetic mean excluding the outlier is 4.1%. Example 9 shows the calculation of the geometric mean return for the investment
of Exhibit 5.
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 EXAMPLE 9. GEOMETRIC MEAN RETURN
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 If 1 currency unit was invested, you would have 1.8 currency units at the end
said to be right skewed (or positively skewed). Other measures of central tendency of the 10 years.
may better accommodate outliers.
Total accumulation after 10 years
3.1.2 Geometric Mean = [(1 + 1.3%) × (1 + 2.4%) × (1 + 0.8%) × (1 + 3.7%) × (1 + 8.0%) × (1 +
An alternative average to the arithmetic mean is the geometric average or geometric 3.7%) × (1 + 7.2%) × (1 + 26.4%) × (1 + 4.2%) × (1 + 5.2%)]
mean. Applied to investment returns, the geometric mean return is the average return = [(1.013) × (1.024) × (1.008) × (1.037) × (1.08) × (1.037) × (1.072) ×
assuming that returns are compounding. To illustrate how the geometric mean is (1.264) × (1.042) × (1.052)]
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. = 1.8
Average accumulation per year = 10th root of 1.8 = (1.8)1/10 = 1.061
8% 3% 7% Geometric mean annual return = 1.061 – 1 = 0.061 = 6.1%
This can also be done as one calculation:
Geometric mean annual return
Present Year 1 Year 2 Year 3
= {[(1 + 1.3%) × (1 + 2.4%) × (1 + 0.8%) × (1 + 3.7%) × (1 + 8.0%) × (1 +
[(1 + 8%) × (1 + 3%) × (1 + 7%)] 1/3 – 1 6.0% 3.7%) × (1 + 7.2%) × (1 + 26.4%) × (1 + 4.2%) × (1 + 5.2%)](1/10)} – 1
= 6.1%
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- The geometric mean annual return is 6.1%. One currency unit invested for 10
lated at the end of the three years per currency unit of investment: [(1 + 8%) × (1 + years and earning 6.1% per year would accumulate to approximately 1.8 units.
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
Descriptive Statistics 195 196 Chapter 8 ■ Quantitative Concepts
An important aspect to notice is that the geometric mean is lower than the arithmetic An advantage of the median over the mean is that it is not sensitive to outliers. In the
mean even though the annual returns over the 10-year holding period are identical. case of the annual returns shown in Exhibit 5, the median of close to 4.0% is more
This result is because the returns are compounded when calculating the geometric representative of the data’s central tendency. This 4.0% median return is close to the
mean return. Recall that compounding will result in a higher value over time, so a 4.1% arithmetic mean return when the outlier is excluded. The median is usually a
lower rate of return is required to reach the same amount. In fact, if the same set of better measure of central tendency than the mean when the data are skewed.
numbers is used to calculate both means, the geometric mean return is never greater
than the arithmetic mean return and is normally lower.
3.1.4 Mode
The mode is the most frequently occurring value in a data set. Example 11 shows how
3.1.3 Median the mode is determined for the investment of Exhibit 5.
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) EXAMPLE 11. MODE
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. 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% 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
(3.7 + 4.2) to group the answers into categories, such as car, bus, train, bicycle, and walking. The
≈ 4.0% Median
2 category with the highest number would be the mode.
25
26.4% 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,
20
there is no agreed method to choose the representative value. The mode may also
Annual Returns (%)
be difficult to compute if the data are continuous. Continuous data are data that can
15 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,
10 discrete data show observations only as distinct values—for example, the number
8.0% 7.2% of people employed at different companies. The number of people employed will be
4.2% 5.2% a whole number. For continuous data, it is less likely that any observation will occur
5 Median
more frequently than once, so the mode is generally not used for identifying central
1.3% 0.8% 3.7% 3.7%
2.4% tendency for continuous data.
1 2 3 4 5 6 7 8 9 10
Another problem with the mode is that the most frequently occurring observation may
Year be far away from the rest of the observations and does not meaningfully represent them.
140
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%
120
26.4% − 0.8% = 25.6% Range
100
If the extreme value at the upper end of the range is excluded, the next highest
Salary ($ thousands)
value, 8.0%, is used to estimate the range, and the range is reduced significantly.
80
Annual Returns Ordered Low to High
60 Average
Annual Salary 0.8% 1.3% 2.4% 3.7% 3.7% 4.2% 5.2% 7.2% 8.0% 26.4%
20
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.
0
Company A Company B 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
Another reason why measures of dispersion are important in finance is that invest- 50th percentile is the median and divides the observations so that 50% are higher and
ment risk is often measured using some measure of variability. When investors are 50% are lower than the median. The 20th percentile is the value below which 20% of
considering investing in a security, they are interested in the likely (expected) return observations in the series fall. So, the dispersion of the observations can be described
on that investment as well as in the risk that the return could differ from the expected in terms of percentiles. Observations can be divided into other equal-sized intervals.
return (its variability). A risk-averse investor considering two investments that have Commonly used intervals are quartiles (the observations are divided into four equal-
similar expected returns but very different measures of variability (risk) around those sized intervals) and deciles (the observations are divided into 10 equal-sized intervals)
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 3.2.2 Standard Deviation
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.
Descriptive Statistics 199 200 Chapter 8 ■ Quantitative Concepts
Example 13 shows the calculation of the standard deviation for the investment in
Standard deviation =
[X1 − E ( X )]2 + [X 2 − E ( X )]2 + ... + [X n − E ( X )]
2
Exhibit 5.
n
where
n = number of observations of X The arithmetic mean annual return, as calculated in Example 7, is 6.3%.
E(X) = the mean (average) value of X or the expected value of X Standard deviation
[Xi – E(X)] = difference between value of observation Xi and the mean value of = square root of {[(0.013 – 0.063)2 + (0.024 – 0.063)2 + (0.008 – 0.063)2
X + (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}
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 = square root of [(0.0025 + 0.0015 + 0.0030 + 0.0007 + 0.0003 +
the differences are squared, what matters is the size of the difference not the sign of 0.0007 + 0.0001 + .0404 + 0.0004 + 0.0001) ÷ 10]
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. = square root of 0.00497
The value before the square root is taken is known as the variance, which is another = 0.0705, rounded to the nearest 10th percent = 7.1% (this value is used
measure of dispersion. The standard deviation is the square root of the variance. The in Example 14).
standard deviation and the variance capture the same thing—how far away from
The standard deviation is 7.1%.
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 Larger values of standard deviation relative to the mean indicate greater variation in
deviation an easier measure to use and compare with the mean. 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
To illustrate the calculation of the standard deviation, let us return to the example of compares the returns of the investment shown in Exhibit 5 and the returns on another
a three-year investment that returns 8% or 0.08 the first year, 3% or 0.03 the second investment over the same period using mean and standard deviation.
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%.
Number of Employees
consider the distribution of salaries earned by employees in two companies as shown 20
in Exhibit 6. The observations in these distributions are grouped into different salary
ranges. 15
10
Number of Employees 0
15–20 20–25 25–30 30–35 35–40 40–45 45–50 50–55 55–60
Salary ($) Company X Company Y Salary Range ($ thousands)
15,000–20,000 5 1
20,001–25,000 8 1
Note that the two distributions are not symmetrical. A symmetrical distribution
25,001–30,000 20 3
would have observations falling off fairly evenly on either side of the centre of the
30,001–35,000 30 8 range of salaries ($35,001–$40,000). Instead, in each of these distributions, the bulk
35,001–40,000 22 10 of the observations are stacked towards one end of the range and tail off gradually
40,001–45,000 12 15 towards the other end. The two distributions are different in that each is stacked
45,001–50,000 6 20 towards a different end. Such distributions are considered skewed; the distribution
50,001–55,000 2 9
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
55,001–60,000 1 7
negatively skewed (left skewed).
Although the range of the observations is the same in each case, the mean for each
Sometimes it is helpful to look at a picture of the distribution to understand it. The is very different. Company X’s mean is approximately $35,000, whereas Company Y’s
shape of the distribution has a bearing on how you interpret the summary measures mean is approximately $44,000.
of the distribution. This data can be shown pictorially using a histogram—a bar
For a perfectly symmetrical distribution, such as a normal distribution (see Exhibit 8),
chart with bars that are proportional to the frequency of occurrence of each group
the mean, median, and mode will be identical. If the distribution is skewed, these three
of observations—as shown in Exhibits 7A and 7B.
measures of central tendency will differ. Looking again at Company X’s salary data, for
instance, we do not have enough detailed information to identify a mode. The mean
is larger than the median because the mean is more affected by extreme values than
Exhibit 7A Salaries of Employees at Company X the median. The distribution is skewed to the right, so the mean is dragged towards
the extreme positive values. The reverse is true for distributions that are negatively
skewed, such as in Company Y’s salary data. In this case, the mean is smaller than the
35
Number of Employees
median because the mean is pulled left in the direction of the skew.
30
25 A normal distribution is represented in a graph by a bell curve; an example of a bell-
20 shaped curve is shown in Exhibit 8. The shape of the curve is symmetrical with a
single central peak at the mean of the data and the graph falling off evenly on either
15
side of the mean; 50% of the distribution lies to the left of the mean, and 50% lies to
10
the right of the mean. The shape of a normal distribution depends on the mean and
5 the standard deviation. The mean of the distribution determines the location of the
0 centre of the curve, and the standard deviation determines the height and width of
15–20 20–25 25–30 30–35 35–40 40–45 45–50 50–55 55–60 the curve. When the standard deviation is large, the curve is short and wide; when
Salary Range ($ thousands) the standard deviation is small, the curve is tall and narrow.
Descriptive Statistics 203 204 Chapter 8 ■ Quantitative Concepts
A normal distribution has special importance in statistics because many variables have small. The chance of the return being in the left tail more than two standard deviations
the approximate shape of a normal distribution—for example, height, blood pressure, from the mean (which would be an extreme loss under typical circumstances) is just
and lengths of objects produced by machines. This distribution is often useful as a 2.5%. In other words, out of 200 days, 5 days are expected to have observations that
description of data when there are a large number of observations. 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
A normal distribution is a distribution of a continuous random variable (i.e., a variable 25 standard deviations below the mean.
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 To put this in perspective, if returns are normally distributed, a return that is 7.26
shown earlier, the vertical axis was frequency of occurrence. The mean (and median) standard deviations below the mean would be expected to occur once every 13.7 billion
is the centre of the distribution and has the highest probability of occurrence. Half years. That is approximately the age of the universe. The frequency of extreme events
of the observations lie on one side of the mean and half on the other. Approximately during the financial crisis of 2008 was, therefore, much higher than predicted by the
two-thirds of the observations are within one standard deviation of the mean, and normal distribution. This inconsistency is often referred to as the distribution having
95% of observations are within two standard deviations of the mean. Exhibit 8 shows “fat tails”, meaning that the probability of observing extreme outcomes is higher than
a normal distribution. that predicted by a 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 Normal Distribution Distribution with Fat Tails
68% of the observations fall between –1 and +1, and 32% of the observations are more Distribution with Thin Tails
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, In Exhibit 9, the curve with the solid line represents the normal distribution. The curve
and 5% of the observations are more than two standard deviations from the mean. The with the dotted line is an example of distribution with thinner tails than the normal
area under the curve that is within three standard deviations of the mean represents distribution, indicating a reduced probability of extreme outcomes. By contrast, the
about 99% of the observations. Given a mean of 0 and a standard deviation of 1, about curve with the dashed line is an example of a distribution with fatter tails than the
99% of the observations fall between –3 and +3, and less than 1% of the observations normal distribution, indicating increased likelihood of extreme outcomes.
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
Descriptive Statistics 205 206 Chapter 8 ■ Quantitative Concepts
3.3 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
Another way of using and understanding data is identifying connections between it is not likely that all the securities will perform poorly at the same time.
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 The practice of combining securities in a portfolio to reduce risk is known as diver-
correlation. Essentially, two variables are correlated when a change in one variable sification. An extreme example of an undiversified portfolio is one holding only one
helps predict change in another variable. 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
When both variables change in the same direction, the variables are positively cor- portfolio of 20 different securities to go down by a large amount, even if they are
related. If we take the example of traders at an investment bank, salary and age are selected at random. If the securities are selected from a variety of sectors, industries,
positively correlated if salaries increase as age increases. If the variables move in the company sizes, asset classes, and markets, it is even less likely. One caveat is that the
opposite direction, then they are negatively correlated. For example, the size of a benefits of diversification are much reduced in periods of financial crisis. In such
transaction and the fees expressed as a percentage of the transaction are negatively periods, the correlation between returns on different securities (and different asset
correlated if the larger the transaction, the smaller the associated fees. When there is no classes) tends to increase towards +1.
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. SUMMARY
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 The better your understanding of quantitative concepts, the easier it will be for you
of +1. When the two variables move exactly in step in opposite directions, they are to make sense of the financial world. Knowledge of quantitative concepts, such as
perfectly negatively correlated and the correlation coefficient is –1. Variables with no time value of money and descriptive statistics, is important to the understanding of
relationship to each other will have a correlation coefficient close to 0. many of the key products in the financial industry. Understanding the time value of
Correlation measures both the direction of the relationship between two variables money allows you to interpret cash flows and thus value them. Meanwhile, knowledge
(negative or positive) and the strength of that relationship (the closer to +1 or –1, the of statistical concepts will help in identifying the important information in a large
stronger the relationship). In practice, it is unusual to find variables that are perfectly amount of data, as well as in understanding what statistical measures reported by
positively or perfectly negatively correlated. The stronger the relationship between two others mean. It is easy to misinterpret or be misled by statistics, such as mean and
variables—the higher the degree of correlation—the more confidently one variable can correlation, so an understanding of their uses and limitations is crucial.
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 ■ Interest is return earned by a lender that compensates for opportunity cost and
economic growth in the future is expected to be high then returns on the stock market risk. For the borrower, it is the cost of borrowing.
index are likely to be high too.
■ The simple interest rate is the cost to the borrower or the rate of return to the
It is important, however, to realise that correlation does not imply causation. For lender, per period, on the original principal borrowed. A commonly quoted
example, historically in the United States, stock market returns and snowfall are both simple interest rate is the annual percentage rate (APR).
higher in January, and from that you may assume a correlation. But obviously snowfall
■ Compound interest is the return to the lender or the cost to the borrower when
does not cause an increase in stock market returns, and an increase in stock market
interest is reinvested and added to the original principal.
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 ■ The effective annual rate (EAR) of interest is calculated by annualising a rate
between power production and job growth. It may follow that the more workers there that is compounded more than once a year. The EAR is equal to or greater than
are, the more power is consumed, but it does not necessarily follow that an increase the annual percentage rate.
in power generation will create jobs.
■ The present value of a future sum of money is found by discounting the future
Correlation is important in investing because the rise or fall in value of a variable may sum by an appropriate discount rate. (The present value of multiple cash flows
help predict the rise or fall in value of another variable. It is also important because is the sum of the present value of each cash flow.)
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 ■ Three elements must be considered when comparing investments: the cash
deviation of returns). As long as the returns on the securities do not have a correlation 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.
Summary 207 208 Chapter 8 ■ Quantitative Concepts
■ All else being equal (in other words, only one of the three elements differs): ■ 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.
● the higher the cash flows, the higher the present and future values.
■ Standard deviation measures the variability of a data set around the mean of the
● the earlier the cash flows, the higher the present and future values. data set. It is in the same unit of measurement as the mean.
● the lower the discount rate, the higher the present value. ■ A distribution is simply the values that a variable can take, showing its observed
●
or theoretical frequency of occurrence.
the higher the interest rate, the higher the future value.
■ For a perfectly symmetrical distribution, the mean, median, and mode will be
■ The net present value is the present value of future cash flows net of the invest-
identical.
ment required to obtain them. It is useful when comparing alternatives that
require different initial investments. ■ A common symmetrical distribution is the normal distribution, a bell-shaped
■
curve that is represented by its mean and standard deviation. In a normal
Financial instruments can be valued as the present value of their expected
distribution, 68% of all the observations lie within one standard deviation of the
future cash flows.
mean and about 95% of the observations are within two standard deviations.
■ An annuity involves an initial payment (outflow) in exchange for a fixed number
■ The strength of a relationship between two variables can be measured by using
of future receipts (inflows), each of an equal amount. Mortgages are amortising
correlation.
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 ■ Correlation is measured by the correlation coefficient on a scale from –1 to
the principal. Over time, the portion of the payment that reduces the principal +1. When two variables move exactly in tandem with each other, the variables
increases. are said to be perfectly positively correlated and the correlation coefficient is
■
+1. When two variables move exactly in opposite directions, they are perfectly
The role of descriptive statistics is to summarise the information given in large
negatively correlated and the correlation coefficient is –1. Variables with no
quantities of data for the purpose of making comparisons, predicting future
relationship to each other will have a correlation coefficient close to 0.
values, and better understanding the data.
■ It is important to realise that correlation does not imply causation.
■ 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.
LEARNING OUTCOMES
j Explain the relationship between a bond’s price and its yield to maturity;
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.
INTRODUCTION 1 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.
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 A typical bond includes the following three features: par value (also called principal
over time, the company needed more money to continue to grow. The company could value or face value), coupon rate, and maturity date. These features define the prom-
get a loan from a bank or it could turn to investors, other than family and friends, to ised cash flows of the bond and the timing of these flows.
provide additional money.
Par value. The par (principal) value is the amount that will be paid by the issuer to
Companies and governments raise external capital to finance their operations. Both the bondholders at maturity to retire the bonds.
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 Coupon rate. The coupon rate is the promised interest rate on the bond.
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 term “coupon rate” is used because, historically, bonds were printed with
the lenders and the coupons attached. There was one coupon for each date an interest payment
Receive interest was owed, and each coupon indicated the amount owed (coupon payment).
company is the borrower.
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
The illustration has been simplified to show a company borrowing from individuals.
between the interest rate promised by the bond issuer and interest rates in the
In reality, the borrower may be a company or a government, and the investors may be
market.
individuals, companies, or governments. Companies may also raise capital by issuing
(selling) equity securities, as discussed in the Equity Securities chapter.
Coupon payments are linked to the bond’s par value and the bond’s coupon rate. The
annual interest owed to bondholders is calculated by multiplying the bond’s coupon
rate by its par value. For example, if a bond’s coupon rate is 6% and its par value
is £100, the coupon payment will be £6. Many bonds, such as government bonds
3 SENIORITY RANKING
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, The bond contract gives bondholders the right to take legal action if the issuer fails to
payable every six months. Taking the previous example, bondholders would receive make the promised payments or fails to satisfy other terms specified in the contract. If
two coupon payments of £3. Coupon payments may also be paid annually, quarterly, the bond issuer fails to make the promised payments, which is referred to as default,
or monthly. The bond contract will specify the frequency and timing of payments. 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
Maturity date. Debt securities are issued over a wide range of maturities, from as short of claims, or seniority ranking. This priority of claims can affect the amount that an
as one day to as long as 100 years or more. In fact, some bonds are perpetual, with no investor receives upon liquidation.
pre-specified maturity date at all. But it is rare for new bond issues to have a maturity
The par value (principal) of a bond plus missed interest payments represents the
of longer than 30 years. The life of the bond ends on its maturity date, assuming that
maximum amount a bondholder is entitled to receive upon liquidation of a company,
all promised payments have been made.
assuming there are sufficient assets to cover the claim. Because debt represents a
Example 1 describes the interaction of the three main features of a bond and shows contractual liability of the company, debtholders have a higher claim on a company’s
the payments that the bond issuer will make to a bondholder over the life of the bond. 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.
EXAMPLE 1. MAIN FEATURES OF A BOND 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
A bond has a par value of £100, a coupon rate of 6% (paid annually), and a property, plant, or equipment, that the borrower pledges to the bondholders to secure
maturity date of three years. These characteristics mean the investor receives the loan. In the event of default, the bondholders are legally entitled to take possession
a coupon payment of £6 for each of the three years it is held. At the end of the of the pledged assets. In essence, the collateral reduces the risk that bondholders will
three years, the investor receives back the £100 par value of the bond. 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).
Par Value = £100
Coupon Rate = 6% Unsecured. Unsecured debt securities are not backed by collateral. Consequently,
Maturity = 3 Years bondholders will typically demand a higher coupon rate on unsecured debt securities
Coupon Payment = £6.00
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
£100 payment only after higher-priority debt claims are paid in full. Subordinated debt may
+ also be ranked according to priority, from senior to junior.
£6.00 £6.00 £6.00
Exhibit 1 shows an example of the seniority ranking of debt securities.
£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.
Types of Bonds 215 216 Chapter 9 ■ Debt Securities
Market. At issuance, investors buy bonds directly from an issuer in the primary mar-
Exhibit 1 Seniority Ranking of Debt Securities
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
1. Secured Debt market. In the secondary market, investors trade with other investors. When investors
Unsecured Debt 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.
2. Senior Unsecured Debt
Coupon rates. Bonds are often categorised by their coupon rates: fixed-rate bonds,
3. Senior Subordinated Debt floating-rate bonds, and zero-coupon bonds. These categories of bonds are described
further in the following sections.
4. Junior Subordinated Debt
quarterly coupon payment. The coupon rate is reset every quarter. The following
5-year, 10-year, 30-year,
table shows the Libor rate at the beginning of each quarter and the total coupon
1.35% Bonds 2.75% Bonds 4.375% Bonds
payment made each quarter by the company.
Semiannual cou- $6.75 $13.75 $21.875
pon payment per
bond Floating rate = Reference rate + Spread
Maturity date 16 August 2016 16 August 2021 16 August 2041
120 bps
4.2 Floating-Rate Bonds 31 March
1.20%
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 100 bps (0.0120 + 0.0140)
30 June × £2,000,000 = £13,000
bonds changes over time. The coupon rate of a floating-rate bond is usually linked 1.00% 4
to a reference rate. The London Interbank Offered Rate (Libor) is a widely used ref-
erence rate.
30 September 112 bps (0.0100 + 0.0140)
× £2,000,000 = £12,000
1.12% 4
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- 31 December
(0.0112 + 0.0140)
× £2,000,000 = £12,600 £2 million
thiness and the bond’s features. The percentage paid above the reference rate is called 4
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. 4.2.1 Inflation-Linked Bonds
An inflation-linked bond is a particular type of floating-rate bond. Inflation-linked
Floating rate = Reference rate + Spread 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.
In bond markets, the practice is to refer to percentages in terms of basis points. One
Changes to the par value reduce the effect of inflation on the investor’s purchasing
hundred basis points (or bps, pronounced bips) equal 1.0%, and one basis point is equal
power from bond cash flows. For most inflation-linked bonds, the par value—not
to 0.01%, or 0.0001. Therefore, rather than stating a floating rate as Libor plus 0.75%,
the coupon rate—of the bond is adjusted at each payment date to reflect changes in
the floating rate would be stated as Libor plus 75 bps. A floating-rate bond’s coupon
inflation (which is usually measured via a consumer price index). The bond’s coupon
rate will change, or reset, at each payment date, typically every quarter. Floating-rate
payments are adjusted for inflation because the fixed coupon rate is multiplied by
coupon payments are paid in arrears—that is, at the end of the period on the basis of
the inflation-adjusted par value. Examples of inflation-linked bonds are Treasury
the level of the reference rate set at the beginning of the period. On a payment date,
Inflation-Protected Securities (TIPS) in the United States, index-linked gilts in the
the coupon rate is set for the next period to reflect the current level of the reference
United Kingdom, and iBonds in Hong Kong.
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 Because of the inflation protection offered by inflation-linked bonds, the coupon rate
the effect of changes in a reference rate on coupon rates and coupon payments. on an inflation-linked bond is lower than the coupon rate on a similar fixed-rate bond.
Zero-coupon bonds are issued at a discount to the bond’s par value—that is, at an issue 8.0%
price that is lower than the par value. The difference between the issue price and the Required Rate of Return
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- 1 December 2008 1 December 2009 1 December 2028
coupon debt securities. For example, Treasury bills issued by the US government Investor pays Investor sells, receives
are issued as zero-coupon securities. Companies and governments sometimes issue €268.31 €231.71
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. 5 BONDS WITH EMBEDDED PROVISIONS
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. 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.
EXAMPLE 4. ZERO-COUPON BOND Call, put, and conversion provisions are options, a type of derivative instrument
discussed in the Derivatives chapter. The following sections describe call, put, and
On 1 December 2008, Vodafone Group, a UK company, issued zero-coupon conversion provisions and callable, putable, and convertible bonds.
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.
5.1 Callable Bonds
1 If an investor bought the note on 1 December 2008, holds it to matu- A call provision gives the issuer the right to buy back the bond issue prior to the
rity, and receives €1,000, the annual return over the life of the bond to maturity date. Bonds that contain a call provision are referred to as callable bonds.
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% A callable bond gives the issuer with the right to buy back (retire or call) the bond
represents the investor’s required rate of return. 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
6.80% call provision so that if interest rates fall after a bond has been issued, they can call
Required Rate of Return 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
No Coupon Payments the bonds are issued, interest rates are much lower. The inclusion of the call provi-
1 December 2008 1 December 2028 sion allows the company to buy back the bonds, presumably using proceeds from the
Investor pays Investor receives
issuance of new bonds at a lower interest rate.
€268.31 €1000 Par Value
It is important to note that the call provision is a benefit to the issuer and is an adverse
2 To illustrate the sensitivity of zero-coupon bonds to changes in required provision from the perspective of bondholders. In other words, the call provision
rate of return, assume that an original buyer decides to sell the Vodafone is an advantage to the issuer and a disadvantage to the bondholder. Consequently,
note one year after issue. Furthermore, assume that at that time, given the coupon rate on a callable bond will generally be higher than a comparable bond
market conditions and the creditworthiness of Vodafone, the required without an embedded call provision to compensate the bondholder for the risk that
rate of return on the note is 8.0%. Under these circumstances, the original the bond may be retired early. This risk is referred to as call risk.
buyer would receive €231.71 for every €1,000 of par value.
Bonds with Embedded Provisions 221 222 Chapter 9 ■ Debt Securities
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
6 ASSET-BACKED SECURITIES
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 Securitisation refers to the creation and issuance of new debt securities, called asset-
the call price may change over time. Under a typical call schedule, the call price tends backed securities, that are backed by a pool of other debt securities. The most common
to decline and move toward the par value over time. 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.
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
VALUATION OF DEBT SECURITIES 7 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
Valuing debt securities is relatively straightforward compared with, say, valuing equity bonds with higher credit risk should be discounted at relatively higher discount rates,
securities (see the Equity Securities chapter) because bonds typically have a finite life which results in lower estimates of value.
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 Although you are not responsible for calculating a bond’s value, Example 5 illustrates
approach that takes into account the time value of money. Recall from the discussion how to do so and the effect of using different discount rates. This example also serves
of the time value of money in the Quantitative Concepts chapter that the timing of to illustrate the effect of a change in discount rates on a bond. A change in discount
a cash flow affects the cash flow’s value. The DCF valuation approach estimates the rates may be the result of a change in interest rates in the market or a change in credit
value of a security as the present value of all future cash flows that the investor expects risk of the bond issuer.
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 EXAMPLE 5. BOND VALUATION USING DIFFERENT DISCOUNT RATES
payments and the final principal payment expected from the bond. This valuation
approach relies on an analysis of the investment fundamentals and characteristics of Consider a three-year fixed-rate bond with a par value of $1,000 and a coupon
the issuer. The analysis includes an estimate of the probability of receiving the promised rate of 6%, with coupon payments made semiannually. The bond will make
cash flows and an establishment of the appropriate discount rate. Once an estimate six coupon payments of $30 (one coupon payment every six months over the
of the value of a bond is calculated, it can be compared with the current price of the life of the bond) and a final principal payment of $1,000 on the maturity date.
bond to determine whether the bond is overvalued, undervalued, or fairly valued. 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
7.1 Current Yield is $973.36, calculated as
A bond’s current yield is calculated as the annual coupon payment divided by the $30 $30 $30 $30 $30 $1, 030
current market price. This measure is simple to calculate and is often quoted. A V0 = + + + + +
bond’s current yield provides bondholders with an estimate of the annualised return (1.035)1 (1.035)2 (1.035)3 (1.035)4 (1.035)5 (1.035)6
from coupon income only, without concern for the effect of any capital gain or loss V0 = $973.36.
resulting from changes in the bond’s value over time. The current yield should not be
For the same bond, if an investor determines that a discount rate of 8% per
confused with the discount rate used to calculate the value of the bond.
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
7.2 Valuation of Fixed-Rate and Zero-Coupon Bonds V0 = + + + + +
For fixed-rate bonds and zero-coupon bonds, the timing and promised amount of
(1.040)1 (1.040)2 (1.040)3 (1.040)4 (1.040)5 (1.040)6
the interest payments and final principal payment are known. Thus, the value of a V0 = $947.58.
fixed-rate bond or zero-coupon bond can be expressed as For the same bond, if an investor determines that a discount rate of 6% per
CF1 CF2 CF3 CFn year, or 3.0% semiannually, is appropriate for this bond given its risk, the value
V0 = + + +!+ of the bond is $1,000.00, calculated as
(1 + r)1 (1 + r)2 (1 + r)3 (1 + r)n
$30 $30 $30 $30 $30 $1, 030
where V0 is the current value of the bond, CFt is the bond’s cash flow (coupon payments V0 = + + + + +
and/or par value) at time t, r is the discount rate, and n is the number of periods until (1.030)1 (1.030)2 (1.030)3 (1.030)4 (1.030)5 (1.030)6
the maturity date. The bond’s cash flows and the timing of the cash flows are defined V0 = $1, 000.00.
in the bond contract, but the discount rate reflects market conditions as well as the
For the same bond, if an investor determines that a discount rate of 5% per
riskiness of the borrower. As always, you are not responsible for calculations, but the
year, or 2.5% semiannually, is appropriate for this bond given its risk, the value
presentation of formulas and illustrative calculations may enhance your understanding.
of the bond is $1,027.54, calculated as
Valuation of Debt Securities 225 226 Chapter 9 ■ Debt Securities
$30 $30 $30 $30 $30 $1, 030 EXAMPLE 6. YIELD TO MATURITY
V0 = + + + + +
(1.025)1 (1.025)2 (1.025)3 (1.025)4 (1.025)5 (1.025)6
V0 = $1, 027.54. 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:
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. $20 $20 $20 $1, 020
$914.70 = + + +!+ .
To explain this relationship further,
(1 + rytm ) (1 + rytm ) (1 + rytm ) (1 + rytm )
1 2 3 10
■ if the bond’s coupon rate and the required rate of return are the same, the The bond’s yield to maturity is the discount rate that makes the present value
bond’s value is its par value. Thus, the bond should trade at par 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
■ if the bond’s coupon rate is lower than the required rate of return, the bond’s months and a final principal payment of $1,000 on the maturity date in 5 years,
value is less than its par value. Thus, the bond should trade at a discount (trade or 10 semiannual periods. In this case, r ytm is 3% on a semiannual basis, or 6%
at less than par value). annualised. Thus, at a price of $914.70, the bond’s yield to maturity is 6%.
■ if the bond’s coupon rate is higher than the required rate of return, the bond’s The current yield is calculated as $40/$914.70 = 4.37%. You can see that the
value is greater than its par value. Thus, the bond should trade at a premium current yield and the yield to maturity differ.
(trade at more than par value).
In the case of a zero-coupon bond, the only promised payment is the par value on
It is important to understand that bond prices and bond yields to maturity are inversely
the maturity date. To estimate the value of a zero-coupon bond, the single promised
related. That is, as bond prices fall, their yields to maturity increase, and as bond prices
payment equal to the bond’s par value is discounted to its present value by using an
rise, their yields to maturity decrease.
appropriate discount rate that reflects the riskiness of the bond.
where P0 represents the current market price of the bond, and r ytm represents the A yield curve applied by investors to US debt securities is the US Treasury yield curve,
bond’s yield to maturity. 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
Many investors use a bond’s yield to maturity to approximate the annualised return sloping, indicating that longer-maturity bonds offer higher yields to maturity than
from buying the bond at the current market price and holding it until maturity, shorter-maturity bonds. For example, the yield to maturity on a 30-year Treasury bond
assuming that all promised payments are made on time and in full. When a bond’s is 3.50%, but the yield to maturity on a 1-year Treasury bill is only 0.11%.
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.
Risks of Investing in Debt Securities 227 228 Chapter 9 ■ Debt Securities
It is important to note that credit risk can affect bondholders even when the company
2.0 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
1.0 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.
0
1Mo 3Mo 6Mo 1Yr 2Yr 3Yr 5Yr 7Yr 10Yr 20Yr 30Yr
8.1.1 Credit Rating
Maturity
Investors may be able to assess the credit risk of a bond by reviewing its credit rating.
Source: Based on data from the US Department of the Treasury (www.treasury.gov). 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.
Although an upward-sloping curve is the norm, there are times when the yield curve
may be flat, meaning that the yield to maturity of US Treasury bonds is the same no Bonds are classified based on credit risk as investment-grade bonds (those in the
matter what the maturity date is. There are also times when the yield curve is down- shaded area of Exhibit 3) or non-investment-grade bonds (those in the non-shaded
ward sloping, or inverted, which can happen if interest rates are expected to decline area of Exhibit 3). The term investment-grade bonds comes from the fact that regu-
in the future. 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
The term structure for government bonds, such as Treasury bonds, provides investors creditworthiness (low risk of default).
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 Non-investment-grade bonds are commonly referred to as high-yield bonds or junk
higher yields to maturity to compensate investors for the higher credit or default risk. 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
RISKS OF INVESTING IN DEBT SECURITIES 8 interest demanded by the lender.
Exhibit 3 Rating Systems Used by Major Credit Rating Agencies EXAMPLE 7. CREDIT SPREADS
Standard & Caterpillar, a US company, has a bond outstanding with a maturity date of 27
Poor’s Moody’s Fitch May 2041. The bond’s coupon rate is 5.2%. On 13 April 2012, the bond was
AAA Aaa AAA trading at a price of $1,185.32, representing a yield to maturity of 4.10%. The
AA+ Aa1 AA+ bond has approximately 29 years remaining until maturity as of 13 April 2012.
AA Aa2 AA On that same date, 30-year Treasury bonds are yielding 3.22%.
AA– Aa3 AA–
Investment A+ A1 A+ The bond’s credit spread over a 30-year Treasury is 4.10% – 3.22% = 0.88%,
Grade A A2 A or 88 bps. The extra yield, or credit spread, being offered by the Caterpillar
A– A3 A– bond serves as compensation to the investor for taking a higher risk relative to
BBB+ Baa1 BBB+ the Treasury bond.
BBB Baa2 BBB
BBB– Baa3 BBB–
Creditworthiness
BB+ Ba1 BB+
Higher-risk bonds, such as junk bonds, trade at wider credit spreads because of their
BB Ba2 BB
higher default risk. Similarly, lower-risk bonds trade at narrower credit spreads rela-
BB– Ba3 BB–
tive to high-risk bonds. Credit spreads enable investors to compare yield differences
B+ B1 B+
across bonds of different credit quality. If a bond is perceived to have become more
B B2 B
risky, its price will fall and its yield will rise, which will likely result in a widening
B– B3 B–
of the bond’s credit spread relative to a government bond with the same maturity.
Non-Investment CCC+ Caa1 CCC
Grade
Similarly, a bond perceived to have experienced an improvement in credit quality will
CCC Caa2
see its price rise and its yield fall, likely resulting in a narrower credit spread relative
CCC– Caa3
to a comparable government bond.
Ca
C
DDD
DD 8.2 Interest Rate Risk
D D 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
Credit rating agencies assign a bond rating at the time of issue, but they also review bonds. Bond prices and interest rates are inversely related; that is, bond prices increase
the rating and may change a bond’s credit rating over time depending on the issuer’s as interest rates decrease and bond prices decrease as interest rates increase. Example 4,
perceived creditworthiness. An improvement in credit rating is referred to as an in the zero-coupon bond section, illustrates the effect of an interest rate change on
upgrade, and a reduction in credit rating is referred to as a downgrade. A high credit a zero-coupon bond.
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 Prices of zero-coupon and fixed-rate bonds can decline significantly in an environ-
of investors will include institutional investors that must hold significant portions of ment of rising interest rates. However, because coupon rates on floating-rate bonds
their investment assets in investment-grade 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
8.1.2 Credit Spreads because bondholders receive less coupon income when the bond’s coupon rate is
US Treasuries and government bonds of some developed and emerging countries are reset to a lower rate.
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 8.3 Inflation Risk
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 Nearly all debt securities expose investors to inflation risk because the promised
investing in a bond that has a higher probability of default. Example 7 shows the credit interest payments and final principal payment from most debt securities are nominal
spread for a bond issue by Caterpillar Inc. 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.
Risks of Investing in Debt Securities 231 232 Chapter 9 ■ Debt Securities
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 SUMMARY
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
As the Canadian entrepreneur found out, debt securities are an alternative to bank
coupon payment also changes with inflation.
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
8.4 Other Risks debt securities. The financial consequences of not doing so can be substantial.
In addition to credit risk, interest rate risk, and inflation risk, investors in debt secu- The following points recap what you have learned in this chapter about debt securities:
rities also face a number of other risks, including liquidity risk, reinvestment risk,
and call risk.
■ Debt security or bond issuers are typically companies and governments.
Liquidity risk refers to the risk of being unable to sell a bond prior to the maturity
■ A typical debt security is characterised by three features: par value, coupon rate,
date without having to accept a significant discount to market value. Bonds that do
and maturity date.
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 ■ Coupon and principal payments must be made on scheduled dates. If the issuer
more frequently. 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.
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 ■ Debt securities are classified as either secured debt securities (secured by collat-
from a bond that is called early must be reinvested at a lower interest rate than the eral) or unsecured debt securities (not secured by collateral). Debtholders have
bond’s original coupon rate. If market interest rates fall after a bond is issued, bond- a higher priority claim than equityholders if a company liquidates, but priority
holders will most likely have to reinvest the income received on the bond (the coupon of claims or seniority ranking can vary among debtholders.
payment) at the current lower interest rates.
■ Bonds may pay fixed-rate, floating-rate, or zero coupon payments.
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 ■ Fixed-rate bonds are the most common bonds. They offer fixed coupon pay-
of a call provision. If interest rates fall, issuers may exercise the call provision, so ments based on an interest (or coupon) rate that does not change over time.
bondholders will have to reinvest the proceeds in bonds offering lower coupon rates. These coupon payments are typically paid semiannually.
Callable bonds, and most mortgage-backed securities based on loans that allow the
■ Floating-rate bonds typically offer coupon payments based on a reference rate
borrowers to make loan prepayments in advance of their maturity date, are subject
to prepayment risk. that changes over time plus a fixed spread; the reference interest rate is reset on
each coupon payment date to reflect current market rates.
How do the risks of a bond affect its price in the market? The yield to maturity on
■ The only cash flow offered by a zero-coupon bond is a single payment equal to
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 the bond’s par value to be paid on the bond’s maturity date.
maturity. For example, two five-year bonds with the same liquidity and a BBB rating ■ Many bonds come with embedded provisions that provide the issuer or the
will trade at approximately equal yields to maturity.
bondholder with particular rights, such as to call, put, or convert the bond.
Low-risk bonds, such as many government bonds, trade at relatively lower yields to ■ Securitisation is a process that creates new debt securities backed by a pool of
maturity, which imply relatively higher prices. Similarly, high-risk bonds, such as junk
other debt securities. These new debt securities are called asset-backed securi-
bonds, trade at relatively higher yields to maturity, which imply relatively lower prices.
ties. Most asset-backed securities generate monthly payments that include both
Relative to secured debt, subordinated debt securities offer higher yields to maturity,
interest and principal components.
which reflect their higher default risk.
■ 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.
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.
CHAPTER 10
■ The primary risks of investing in debt securities are credit or default risk, inter- EQUITY SECURITIES
est rate risk, inflation risk, liquidity risk, reinvestment risk, and call risk.
by Lee M. Dunham, PhD, CFA, and Vijay Singal, PhD, CFA
■ 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.
Introduction 237
Borrows Money,
Issues Bonds Issues Shares
Debt Equity
Securities Securities
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.
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.
© 2014 CFA Institute. All rights reserved.
238 Chapter 10 ■ Equity Securities Types of Equity Securities 239
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. 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
2 FEATURES OF EQUITY SECURITIES 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.
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. 3.1 Common Stock
Each of these types is discussed more extensively in the next section. Each type of
Common stock (also known as common shares, ordinary shares, or voting shares) is
equity security has different features attached to it. These features affect a security’s
the main type of equity security issued by companies. A common share represents an
expected return, risk, and value.
ownership interest in a company. Common shares have an infinite life; in other words,
There are four features that characterise and vary among equity securities: 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
■ Life 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
■ Par value 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.
■ Voting rights
Common shares represent the largest proportion of equity securities by market value.
■ Cash flow rights 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
Life. Many equity securities are issued with an infinite life. In other words, they are
trading of shares between buyers and sellers. Private companies are typically much
issued without maturity dates. Some equity securities are issued with a maturity date.
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
Par Value. Equity securities may or may not be issued with a par value. The par value shareholders the ability to trade when they want to trade and at a fair price.
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. 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
Voting Rights. Some shares give their holders the right to vote on certain matters. have the right to vote on certain matters. Companies often pay out a portion of their
Shareholders do not typically participate in the day-to-day business decisions of large profits each year to their shareholders as dividends; the rights to such distributions
companies. Instead, shareholders with voting rights collectively elect a group of people, are the shareholders’ cash flow rights. Dividends are typically declared by the board
called the board of directors, whose job it is to monitor the company’s business activ- of directors and vary according to the company’s performance, its reinvestment
ities on behalf of its shareholders. The board of directors is responsible for appointing needs, and the management’s view on paying dividends. As owners of the underlying
the company’s senior management (e.g., chief executive officer and chief operating company, common shareholders participate in the performance of the company and
officer), who manage the company’s day-to-day business operations. But decisions of have a residual claim on the company’s liquidated assets after all liabilities (debts) and
high importance, such as the decision to acquire another company, usually require the other claims with higher seniority have been paid.
approval of shareholders with voting rights.
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
Cash Flow Rights. Cash flow rights are the rights of shareholders to distributions, that provide different cash flow and voting rights. In general, an arrangement in which
such as dividends, made by the company. In the event of the company being liquidated, a company offers two classes of common stock (e.g., Class A and Class B) typically
assets are distributed following a priority of claims, or seniority ranking. This priority provides one class of shareholders with superior voting and/or cash flow rights.
of claims can affect the amount that an investor will receive upon liquidation.
Example 1 describes the two classes of common stock of Berkshire Hathaway and
their cash flow and voting rights.
240 Chapter 10 ■ Equity Securities Types of Equity Securities 241
Preferred shares differ with respect to the policy on missed dividends, depending on
EXAMPLE 1. DIFFERENT SHARE CLASSES
whether the preferred stock is cumulative or non-cumulative. Cumulative preferred
stock requires that the company pay in full any missed dividends (dividends prom-
As of May 2012, Berkshire Hathaway, a US company, has two classes of common
ised, but not paid) before paying dividends to common shareholders. In comparison,
stock: Class A (NYSE: BRK.A)3 and Class B (NYSE: BRK.B). In terms of cash
non-cumulative preferred stock does not require that missed dividends be paid before
flow rights, one Class A share is equivalent to 1,500 Class B shares. But the ratio
dividends are paid to common shareholders. In a liquidation, preferred shareholder
of the voting rights of Class A shares to the voting rights of Class B shares is
may have a claim for any unpaid dividends before distributions are made to common
not 1,500:1. Voting rights for 1 Class A share are equivalent to the voting rights
shareholders.
of 10,000 Class B shares.
Example 2 provides a variety of the features that can characterise a preferred share
BRK.A BRK.B issue. It shows the features of two different issues of Canadian preferred stock.
Par Value
The reason for having multiple share classes is usually that the company’s original Cumulative/ (Canadian
owner wants to maintain control, as measured by voting power, while still offering Issue Non-Cumulative dollars) Annual Dividend Rate Redeemable
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 Royal Bank of Non-cumulative C$25.00 6.25%, reset after five years Yes, redeemable on or after
may not be important to shareholders. 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
3.2 Preferred Stock Canadian Cumulative C$25.00 4.90% Yes, redeemable after 1
Companies may also issue preferred stock (also known as preferred shares or pref- Utilities Limited, September 2017, redemption
Series AA price begins at C$26.00 and
erence shares). These shares are called preferred because owners of preferred stock
declines over time to C$25.00
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 Some companies have more than a single issue of preferred stock. Multiple preferred
have no ownership or residual claim on the company. 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,
Preferred shares are typically issued with an assigned par value. Along with a stated and may differ with respect to other features as well.
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
3.3 Convertible Bonds
price equals the par value for a preferred share. The par value of a preferred share To raise capital, companies may issue convertible bonds. A convertible bond is a
also typically represents the amount the shareholder would be entitled to receive in bond issued by a company that offers the bondholder the right to convert the bond
a liquidation, as long as there are sufficient assets to cover the claim. 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
Preferred shareholders usually receive a fixed dividend, although it is not a legal obli- shares makes its value somewhat dependant on the price of common shares. Thus,
gation of the company. The preferred dividend will not increase if the company does convertible bonds are known as hybrid securities. Hybrid securities have features of
well. If the company is performing poorly, the board of directors is often reluctant to and relationships with both equity and debt securities.
reduce preferred dividends.
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,
3 These are ticker symbols, which are used to identify a particular stock, share class, or issue on a par- the bonds are retired (cease to exist) and common shares are issued.
ticular stock exchange.
242 Chapter 10 ■ Equity Securities Types of Equity Securities 243
Because the conversion feature is a benefit to the bondholder, a convertible bond 3.4 Warrants
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 warrant is an equity-like security that entitles the holder to buy a pre-specified
a maturity date. If the bonds are not converted to common stock prior to maturity, amount of common stock of the issuing company at a pre-specified per share price
they will be paid off like any other bond and retired at the maturity date. (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
When a convertible bond is issued, the conversion ratio is set so that its value as a of compensation. The holders of warrants may choose to exercise the rights prior to
straight bond (i.e., the value of the bond if it were not convertible) is higher than the expiration date. A warrant holder will exercise the right only when the exercise
its conversion value. If the share price of the company significantly increases, the price is equal to or lower than the price of a common share. Otherwise, it would be
conversion value of the bond will rise and may become greater than the value of the cheaper to buy the stock in the market. When a warrant holder exercises the right,
convertible bond as a straight bond. If this happens, converting the bond becomes the company issues the pre-specified number of new shares and sells them to the
attractive. In general, if the conversion value is low relative to the straight bond value, warrant holder at the exercise price.
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 Warrants typically have expiration dates several years into the future. In some cases,
trade at a value closer to its conversion value. 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,
Because a convertible bond should not trade below its conversion value, bondhold- warrants are known as sweeteners because the inclusion of the warrants typically
ers may choose not to convert into common shares even if the conversion value is allows the issuer to offer a lower coupon rate (interest rate) on a bond issue or a lower
higher than the par (principal) value of the bond. Often, a convertible bond includes annual fixed dividend on a preferred stock issue.
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- Companies may also issue warrants to employees as a form of compensation, in
specified redemption price and only after a certain amount of time. Convertible bond which case they are referred to as employee stock options. When warrants are used
issues typically include redemption options so that the issuing company can force as employee compensation, the goal is to align the objectives of the employees with
conversion into common shares. those of the shareholders. Many companies compensate their senior management with
salaries and some form of equity-based compensation, which may include employee
Example 3 describes a convertible bond issue of Navistar International Corp. The stock options.
Navistar bond issue illustrates the typical features of a convertible bond.
Example 4 describes the use of warrants to make a deal more attractive to an investor.
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.
244 Chapter 10 ■ Equity Securities Risk and Return of Equity and Debt Securities 245
Now we will consider how depositary receipts are created and work, using the example Common stock Right to dividends if declared by the Proportional
of Sony and Mexican investors. Mexican investors may want to invest in the stock of board of directors to ownership
Sony, a Japanese company, but Sony’s stock is not listed on the Mexican Stock Exchange. Preferred stock Right to promised dividends if declared None
Buying Sony stock on the Tokyo Stock Exchange is expensive and inconvenient for by the board of directors; board does
Mexican investors. To make this process easier, a financial institution in Mexico, such not have a legal obligation to declare the
as a bank, can buy Sony’s stock on the Tokyo Stock Exchange and make it available dividends
to Mexican investors. Rather than making the shares directly available for trading on Debt security Legal right to promised cash flows None
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
The return potential for both debt securities and preferred stock is limited because
stock of a domestic company on the Mexican Stock Exchange in the local currency
the cash flows (interest, dividends, and repayment of par value) do not increase if
(Mexican peso).
the company performs well. The return potential to common shareholders is higher
Depositary receipts, like the shares they are based on, have no maturity date (i.e., they because the share price rises if the company performs well. Relative to holders of debt
have an infinite life). Depositary receipts typically do not offer their owners any voting securities and preferred stock, common shareholders expect a higher return but must
rights even though they essentially represent common stock ownership; the custodian accept greater risk. The voting rights of common shareholders may give them some
financial institution usually retains the voting rights associated with the stock. influence over the company’s business decisions and thereby somewhat reduce risk.
Example 5 describes the depositary receipt of Vodafone Group in the United States. 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
EXAMPLE 5. DEPOSITARY RECEIPTS 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
The ordinary shares (common stock) of Vodafone, a UK company, trade on the ranks last with respect to the payment of dividends and distribution of net assets if
London Stock Exchange. The company’s stock trades on the NASDAQ exchange the company is liquidated.
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 In the event of the company being liquidated, assets are distributed following a prior-
the ordinary shares in custody and issues ADRs of Vodafone against the ordinary ity of claims, or seniority ranking. This priority of claims can affect the amount that
shares of Vodafone held in custody. The ADRs of Vodafone are available for US an investor will receive upon liquidation. Exhibit 2 illustrates the priority of claims.
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.
246 Chapter 10 ■ Equity Securities Risk and Return of Equity and Debt Securities 247
Given the fact that equity securities are riskier than debt securities, shareholders
Exhibit 2 Priority of Claims
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-
1. Secured Debt ties. However, although debt is safer than equity for a given entity, debt securities are
Unsecured Debt not risk-free; they are subject to many risk factors, which are discussed in the Debt
Securities chapter.
2. Senior Unsecured Debt
Exhibit 3 shows annualised historical return and risk data on various equity and debt
3. Senior Subordinated 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
4. Junior Subordinated Debt six equity indices. The non-shaded rows present return and risk data for three bond
indices.
Equity Securities
5. Preferred Stock
Exhibit 3 Historical Annual Returns on Equity and Debt Securities, 1980–
6. Common Stock 2010
Standard
Debt capital is borrowed money and represents a contractual liability of the company. Deviation of
Debt investors thus have a higher claim on the company’s assets than equity investors.4 Index Annual Return Returns
After the claims of debt investors have been satisfied, preferred stock investors are S&P 500 10.80% 15.60%
next in line to receive what they are due. Common shareholders are last in line and Russell 2000 10.35 19.94
known as the residual claimants in a company. Common shareholders share propor- MSCI Europe 10.81 17.80
Equity
tionately in the remaining assets after all other claims have been satisfied. If funds are MSCI Pacific Basin 7.89 21.13
insufficient to pay off all claims, equity investors will likely receive only a fraction of FTSE All World 7.26 15.98
their investment back or may even lose their entire investment. Accordingly, investing MSCI EAFE 7.09 17.71
in equity securities is riskier than investing in corporate debt securities. Lehman Brothers Corporate Bond 8.82 7.23
Barclays Capital Government Bond 8.15 5.51 Debt
Equity investors are at least protected by limited liability, which means that higher Merrill Lynch World Government Bond 7.88 7.04
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 Source: Frank K. Reilly and Keith C. Brown, Investment Analysis and Portfolio Management, 10th
ed. (Mason, OH: South-Western Cengage Learning, 2012).
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. 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
It is important to note that limited liability of shareholders can actually increase the equity returns (first three shaded indices) were higher than annual bond returns
losses of debt investors as the company approaches bankruptcy. As a company moves (non-shaded indices). Annual equity returns exhibited higher risk than annual debt
closer to a bankruptcy filing, shareholders do not have any incentive to maintain or returns. Note that for the three indices that include emerging economies (the last
upgrade the assets of the company because doing so might require additional capital, three shaded indices), however, annual equity returns were marginally lower than
which they might be unwilling to invest. The consequent deterioration in asset quality annual bond returns but more risky.
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 Exhibit 4 presents annual real returns (returns adjusted for inflation) on equity securities
the company operates in accordance with the debt contract. 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%
4 The priority of claims of debtholders is discussed in the Debt Securities chapter. (that is, they failed to cover inflation) to +3%. On average, government bonds have
5 An exception is cases of fraud and wilful negligence; in such situations, management and the board of
directors may be held personally liable.
248 Chapter 10 ■ Equity Securities Valuation of Common Shares 249
beaten inflation, earning a modest positive real return per year. But in some countries, 5.1 Discounted Cash Flow Valuation
the return to bondholders was not sufficient to cover inflation, so bondholders lost
purchasing power. 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
Exhibit 4 Real Annualised Returns on Equities vs. Bonds Internationally, 1900–2010 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
8 business environment.
6 Common shareholders expect to receive two types of cash flows from investing in
Real Annualised Return (%)
equity securities: dividends and the proceeds from selling their shares. Example 6
4 illustrates the application of the DCF approach, using estimates of dividends and
selling price, for a common share of Volkswagen.
2
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
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
Equities Bonds
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
Source: E. Dimson, P. Marsh, and M. Staunton, Credit Suisse Global Investment Returns Sourcebook 2011 (Zurich: Credit Suisse Research
Institute, 2011).
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
5 VALUATION OF COMMON SHARES Value =
(1 + 0.14)1
+
(1 + 0.14)2
+
(1 + 0.14)3
+
(1 + 0.14)3
= €111.02
5.2 Relative Valuation 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
The relative valuation approach estimates the value of a common share as the multiple market prices when investors are optimistic and at lower multiples and prices when
of some measure, such as earnings per share (EPS) or revenue per share. The multiple investors are pessimistic.
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, 5.3 Asset-Based Valuation
publicly traded companies or an industry average. 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
One multiple commonly used in relative valuation is the price-to-earnings ratio liabilities. In other words, the asset-based valuation approach estimates the value of
(P/E), which is the ratio of a company’s stock price to its EPS. For instance, a publicly common equity by calculating a company’s net asset value. The asset-based valuation
traded company that generates annual earnings per share of $1.00 and is trading at approach implicitly assumes that the company is liquidated, sells all its assets, and
$12 per share has a P/E (or price-to-earnings multiple) of 12. Example 7 illustrates then pays off all its liabilities. The residual value after paying off all liabilities is the
two applications of the relative valuation approach. 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
EXAMPLE 7. RELATIVE VALUATION
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,
1 An investor is estimating the value of an airline’s common stock on a per the value of land on a company’s balance sheet, typically carried at historical cost,
share basis. The airline in question generates annual EPS of €2.00. The may be quite different from its current market value. As a result, estimating the value
investor finds that the average price-to-earnings multiple or P/E for the of the equity of a company using asset values taken directly from the balance sheet
industry is 9. Using relative valuation, the investor estimates that the value may provide a misleading estimate. To improve the accuracy of the value estimate,
of the airline’s stock, on a per share basis, is €18.00 (= €2.00 × 9). current market values can be estimated instead.
2 An investor is estimating the value of the common stock of Ford Motor Also, some assets may not be included on the balance sheet because of financial
Company, a US automobile manufacturing company, on a per share basis. reporting rules. For instance, some internally developed intangible assets, such as a
Analysts estimate that Ford will generate EPS of $1.60 next year. The brand or reputation, are not listed in the financial reports. It is important that analysts
investor gathers information, shown in the second and third columns using asset-based valuation estimate reasonable values for all of a company’s assets,
of the following table, on three competing automobile makers: General which can be very challenging to do.
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].
252 Chapter 10 ■ Equity Securities Company Actions That Affect Equity Outstanding 253
5.4 Implicit Assumptions of Valuation Approaches 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
The DCF valuation approach relies solely on estimates of a company’s future cash growth opportunities. It also helps attract talented staff, raise brand awareness, and
flows and implicitly assumes that the company will continue to operate forever. In gain credibility with trading partners. In addition, it provides greater liquidity for
contrast, the asset-based valuation approach implicitly assumes that the company will shareholders who want to sell their shares or buy additional shares. At or after the
stop operating and essentially provides a liquidation value. IPO, some of the original shareholders may choose to sell some of their shares. The
The relative valuation approach does not estimate future cash flows but instead uses fact that the shares now trade in a public market makes the shares more liquid and
price multiples of other comparable, publicly traded companies to arrive at an estimate thus easier to sell.
of equity value. These price multiples rely on performance measures, such as EPS or A disadvantage to becoming a public company is increased regulatory and disclosure
revenue per share, to estimate value. The relative valuation approach implicitly assumes requirements. IPOs are also expensive; their cost can be as much as 10% of the pro-
that common shares of companies with similar risk and return characteristics should ceeds. Example 8 gives an example of how costly an IPO can be.
have similar price multiples.
6 COMPANY ACTIONS THAT AFFECT EQUITY OUTSTANDING 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 and the Hong Kong Stock
Companies undertake major changes as they grow, evolve, mature, or merge with Exchange. The company raised $7,896 million, but had to pay transaction costs
another company. Some of these changes result in changes to the number of common of $566 million (about 7% of the entire proceeds of the IPO).
shares outstanding—the number of common shares currently held by shareholders.
Various corporate actions can affect equity outstanding:
■
$566 Million
Selling shares to the public for the first time (when a private company becomes (7%)
a public company), referred to as an initial public offering (IPO)
Money Raised after Costs
■ 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
Transaction Costs
■ Buying back existing shares from shareholders, referred to as a share repur- $7,330 Million
chase or share buyback
× $50 = $1,000,000), assuming that the company can buy the shares at their
EXAMPLE 9. SEASONED EQUITY OFFERING
current market value. After the repurchase, the number of shares outstanding
would decrease to 1.98 million (2 million – 20,000).
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 6.4 Stock Splits and Stock Dividends
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 Companies may, on occasion, conduct stock splits or issue stock dividends. A stock
costs for this seasoned offering are much lower than the costs of the IPO in split is when a company replaces one existing common share with a specified number
Example 8. 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.
$183 Million
(‹2%) 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
Net Proceeds after Costs shareholders based on their current ownership percentages. The overall value of
Issuance Costs 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
$11,823 Million
of shares, and total shareholder value.
A company’s management may conduct a spinoff in an effort to create value for its ■ A depositary receipt is a security representing an interest in a foreign company
shareholders by splitting the company into two separate businesses. The rationale that trades like a common share on a domestic stock exchange. It is not issued
behind a spinoff is that the market may assign a higher valuation to two separate but by the foreign company.
more specialised companies compared with the value assigned to these entities when
■ In the event of liquidation, priority of claims states that debt investors rank
they were part of the parent company.
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.
SUMMARY
■ 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.
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 ■ Common approaches used to value common shares include discounted cash
potential returns. However, equities are riskier than debt securities and must be flow valuation, relative valuation, and asset-based valuation approaches.
analysed with care and skill.
■ The discounted cash flow approach estimates the value of a security as the pres-
The following points recap what you have learned in this chapter about equity securities: ent value of its expected future cash flows to its holder.
■ The relative valuation approach estimates the value of a common share as the
■ Companies often issue different types or classes of equity securities. The types
of equity securities, or equity-like securities, that companies may issue include multiple of some measure, such as earnings per share. This approach implicitly
common shares, preferred shares, convertible bonds, and warrants. assumes that common shares of companies with similar risk and return charac-
teristics should have similar price multiples.
■ Equity securities are typically characterised by four main features: specified life
■ The asset-backed valuation approach estimates the value of common stock of a
(infinite or with a maturity date), par value, voting rights, and cash flow rights.
company as the difference between the value of its total assets and liabilities, in
■ Debt securities include contractual obligations to pay a return to the debt pro- other words, as its net asset value.
viders. Equity securities, however, contain no such contractual obligations. A
■ Some corporate actions result in changes to the number of common shares out-
company does not have to repay the amounts contributed by the shareholders
or pay a dividend. standing. Such actions include initial public offerings, seasoned equity offerings,
share repurchases, stock splits, stock dividends, acquisitions, and spinoffs.
■ 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.
■ 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.
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
INTRODUCTION 1 that reduces uncertainty or risk.
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 Underlying
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 But what if the farmer cannot find someone who actually needs the wheat? The farmer
in context, the combined value of every exchange-listed company in the United States might still find a counterparty that is willing to enter into a contract to buy the wheat
is around $23 trillion.1 Given their sheer volume, derivatives are very important to in the future at an agreed on price. This counterparty may anticipate being able to sell
financial markets and the work of investment professionals. 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
USES OF DERIVATIVES CONTRACTS 2 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,
Derivatives can be created on any asset, event, or outcome, which is called the under-
such as weather. They also allow investors to gain exposure to underlying assets while
lying. The underlying can be a real asset, such as wheat or gold, or a financial asset,
committing much less capital and incurring lower transaction costs than if they had
such as the share of a company. The underlying can also be a broad market index,
invested directly in the assets.
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
3 KEY TERMS OF DERIVATIVES CONTRACTS
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. There are four main types of derivatives contracts: forward contracts (forwards), futures
The farmer has no way of knowing what the market price of wheat will be in six months. contracts (futures), option contracts (options), and swap contracts (swaps). Each of
The farmer finds a cereal producer that needs wheat and is willing to contract to buy 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.
1 Information from “Centrally Cleared Derivatives: Clear and Present Danger”, Economist (4 April 2012).
© 2014 CFA Institute. All rights reserved.
Key Terms of Derivatives Contracts 265 266 Chapter 11 ■ Derivatives
3.1 Underlying 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.
Derivatives are constructed based on an underlying, which is specified in the contract. In practice, most derivatives contracts are settled in cash.
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)
■ Natural resources (such as crude oil, natural gas, gold, silver, and timber) 4.1 Forwards
■ Weather-related outcomes (such as heating or cooling days) 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
■ Other products (such as electricity or fertilisers) 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
A derivative’s underlying must be clearly defined because quality can vary. For example, of an underlying and to gain certainty about future financial outcomes. Example 1
crude oil is classified by specific attributes, such as its American Petroleum Institute continues the story of the farmer and describes a forward contract between the farmer
(API) gravity, specific gravity, and sulphur content; Brent crude oil, light sweet crude and a cereal producer.
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.
EXAMPLE 1. FORWARD CONTRACT BETWEEN FARMER AND CEREAL
PRODUCER
3.2 Size and Price The contract between the farmer and cereal producer for 50,000 bushels of
The contract must also specify size and price. The size is the amount of the underly- wheat in mid-September, six months from now, at $8.50 per bushel is a forward
ing to be exchanged. The price is what the underlying will be purchased or sold for contract. The underlying is wheat, the size is 50,000 bushels, the exercise price
under the terms of the contract. The price specified in the contract may be called the is $8.50 per bushel, the expiration date is mid-September, and settlement will
exercise price or the strike price. Note that the price specified in the contract is not be with physical delivery. In September, the farmer will deliver the wheat to the
the current or spot price for the underlying but a price that is good for future delivery. cereal producer and receive $8.50 per bushel.
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
Forwards and Futures 267 268 Chapter 11 ■ Derivatives
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.
By entering into the forward contract, the farmer knows the wheat will sell But if at expiration of the forward contract, the price in the market for a
and has eliminated uncertainty about how much money will be received for the bushel of wheat is $9.00 per bushel, the farmer loses $0.50 per bushel relative to
wheat. The cereal producer knows that wheat will be available and has eliminated the spot price. In other words, the farmer could have sold the wheat for $9.00
uncertainty about how much the wheat will cost. 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.
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
Given the possibility of losing money relative to the future spot price, why settled at the end of every business day, which has the effect of resetting the contract
do the farmer and cereal producer enter into the forward contract? Because price and cash flows to buyers and sellers. At the end of each day, the exchange estab-
each is more concerned about eliminating the uncertainty related to the sale lishes a settlement price based on the closing trades and determines the difference
price and purchase price of wheat in six months, which is valuable in making between the current settlement price and the previous day’s settlement price. The
investment and production decisions. This certainty is more important to them buyer’s and seller’s margin accounts are adjusted to reflect the change in settlement
than winning or losing relative to the future spot price. 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
4.2 Futures 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
What if the farmer could not identify a party that wanted to be on the other side of
with adjustments in price. In addition, the contract specifies the delivery locations
the contract? Futures markets may provide the solution. A futures contract is similar
and the period within which delivery must be made. The size of a futures contract is
to a forward contract in that it is an agreement that obligates the seller, at a specified
set by the exchange to ensure a tradable quantity of adequate value.
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, The other terms may vary across the different contracts. Futures typically expire every
and the seller of the contract is obligated to deliver the underlying, although settle- quarter, usually on the third Wednesday of March, June, September, and December. In
ment may be with cash. The main difference is that futures contracts are standardised addition, many end-of-month futures are available. Standardised contracts may exist
contracts that trade on exchanges. The buyers and sellers do not necessarily know who that only differ on the specified price. A contract’s net initial value to each party should
is on the other side of the contract. Because the contracts are traded on exchanges, be zero; cash may be paid by one of the parties to enter into the contract depending
they are liquid and it is possible for a buyer or seller to close out a position by taking on how the exercise price compares with the current settlement price.
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. 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-
The presence of an exchange as an intermediary between buyers and sellers helps market process. For simplicity, the price of wheat changes only twice over the life
reduce counterparty risk. Counterparty risk cannot be eliminated completely, how- of the contract and at expiration. In reality, the price is likely to change daily, with
ever, because there is always a remote chance that the exchange fails to fulfil its own resulting changes to the accounts of the farmer and cereal producer.
Forwards and Futures 271 272 Chapter 11 ■ Derivatives
The farmer and the cereal producer are each in the same position as they
EXAMPLE 3. FUTURES CONTRACTS ON WHEAT
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-
Futures contracts trade on a number of exchanges globally, including the Chicago
tle the futures contract. The farmer has a net receipt of 850.0 cents per bushel.
Mercantile Exchange. The standard terms of a futures contract on wheat on the
Similarly, the cereal producer can buy the wheat in the spot market for 910.0
Chicago Mercantile Exchange include the following:
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.
■ 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) 4.3 Distinctions between Forwards and Futures
■ Settlement: cash settlement 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.
■ Pricing unit: cents per unit
■ Expiration: March (H), May (K), July (N), September (U), and December Trading and Flexibility of Terms. Forward contracts transact in the over-the-counter
(Z) 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
The farmer and the cereal producer find contracts that expire in September that trade on it. Futures contracts are standardised regardless of buyers’ and sellers’
with exercise prices ranging from 550.0 cents to 1100.00 cents. The farmer specific needs. As a result, the expiration date or contract size may not match that
decides to sell 10 contracts with an exercise price of 850.0 cents. This means the desired by the buyer or seller of the futures contract.
farmer has a contract for the delivery of 50,000 bushels of wheat or their cash For hedgers that are trying to reduce or eliminate risk, standardisation makes it dif-
settlement equivalent. The cereal producer decides to buy 10 contracts with an ficult to precisely hedge a position. For non-hedging investors who are entering into
exercise price of 850.0 cents. contracts expecting compensation for taking the opposite side of a hedge or who are
The farmer and the cereal producer do not transact directly with each other, taking a position based on expectations about future performance of an underlying,
but through an exchange. The current spot price of wheat is 900.0 cents per standardisation of the contracts is not problematic.
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 Liquidity. Forward contracts trade in the over-the-counter market and are illiquid.
50.0 cents into the cereal producer’s account. The effective receipt to the farmer Futures contracts are relatively liquid; they trade on exchanges and can be bought and
and cost to the cereal producer is 850.0 cents per bushel if the contract expires sold at times other than initiation. An investor can close out (cancel) a position using
today. In addition, each is required to deposit an additional amount as collateral futures contracts relatively easily.
with the exchange to protect the exchange, which takes on the counterparty
risk to the contract. 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.
The price of wheat remains unchanged for two months and then changes Futures contracts have lower counterparty risk. The presence of an exchange or a clear-
to 875.0 cents per bushel, a decrease of 25.0 cents from the initial spot price of ing house as the intermediary for all buyers and all sellers helps reduce counterparty
900.0 cents. The farmer’s account is increased by 25.0 cents per bushel and the risk. Counterparty risk cannot be eliminated completely, however, because there is
cereal producer’s account is reduced by 25.0 cents per bushel. After another two always a remote chance that the exchange fails to fulfil its own contractual obligations.
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
Transaction Costs. There can be significant costs to arrange a forward contract.
reduced by 50.0 cents per bushel and the cereal producer’s account is increased
Transaction costs usually are embedded in forward contracts and are not easily visible
by 50.0 cents per bushel.
to the customer. Futures contracts, however, are traded on exchanges through broker-
At expiration, the price per bushel is 910.0 cents per bushel, a decrease in age firms or brokers (agents authorised to trade directly with the exchange), and the
price of 15.0 cents from the previous spot price of 925.0 cents. The farmer’s transaction costs are visible. So, there is more transparency in the futures markets. A
account is increased by 15.0 cents per bushel and the cereal producer’s account broker typically earns the difference between the bid and ask prices as a commission
is reduced by 15.0 cents per bushel. The farmer has settled over time by paying to arrange the trade.3 Because futures contracts are standardised, transaction costs
in net 60 cents (= –50.0 + 25.0 – 50.0 + 15.0). The cereal producer has received are relatively low.
over time net 60 cents. Each will receive back the additional amount deposited
to protect the exchange.
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 273 274 Chapter 11 ■ Derivatives
Timing of Cash Flows. Forward contracts have no cash flows except at maturity. unilateral contracts because only one party to the contract (the seller) has a future
Futures contracts are marked to market daily. It is important to note that if forward commitment that, if broken, represents a breach of contract. Unilateral contracts
and futures contracts with identical terms are held to maturity, the final outcome is the expose only the buyer to the risk that the seller will not fulfil the contractual agreement.
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 The buyer of the contract will exercise the right or option if conditions are favourable
account on an ongoing basis. 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
Settlement. Forward contracts may settle with physical delivery or cash settlement.
buyer decides not to exercise the option, it expires without any action by the seller.
Futures contracts are typically settled with cash.
Options may trade in the over-the-counter market, but they trade predominantly on
Exhibit 1 provides a comparison of forward and futures contracts.
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
Exhibit 1 Comparison of Forward and Futures Contracts
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
Similarities Differences
available for other months as well.
■ 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- A buyer chooses whether to exercise an option based on the underlying’s price
bonds, agricultural products, and kets, whereas futures are standardised compared with the exercise price. A buyer will exercise the option only when doing
precious and industrial metals, among contracts that trade on exchanges. so is advantageous compared with trading in the market, which puts the seller at a
others. disadvantage. Because of the unilateral future obligation (only the seller has an obli-
■ Counterparty risk is high with forward gation), options have positive value for the buyer at the inception of the contract. The
■ For both types of contracts, both the contracts, but limited with futures option buyer pays this value, or option premium, to the option seller at the time of
buyer and seller have obligations. contracts. Requirements imposed by the initial contract. The premium paid by the option buyer compensates the option
exchanges, such as initial and main- seller for the risk taken; the option seller is the only party with a future obligation.
■ Both types of contracts allow locking in tenance margins and daily marking to The maximum benefit to the option seller is the premium. The option seller hopes
a price today for a transaction that will market, reduce the counterparty risk the option will not be exercised.
occur in the future. associated with futures contracts.
■ An investor who buys a put option has the right (but not the obligation) to sell
OPTION CONTRACTS 5 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,
What if the farmer does not want to lock in the price because the farmer thinks the to buy wheat at the exercise price. The farmer may buy a put option to secure the
price of wheat is going to increase? But the farmer does want to make sure that at right, but not the obligation, to sell wheat at the exercise price. Note that the cereal
least a certain amount is received for the wheat. Similarly, the cereal producer thinks producer and farmer enter into totally different option contracts to manage their risks.
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. Example 4 describes how a call option works in practice.
Options give one party (the buyer) to the contract the right to extract 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
Option Contracts 275 276 Chapter 11 ■ Derivatives
■ A put option is “out of the money” if the market price is greater than the exer-
EXAMPLE 4. ILLUSTRATION OF A CALL OPTION
cise price. In this case, the option would not be exercised.
Consider a call option in which the underlying is 1,000 shares of hypothetical ■ A put option is “at the money” if the market price and exercise price are the
Company A trading on the London Stock Exchange (LSE).4 The call option’s same. In this case, the option may be exercised.
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 An option’s in- or out-of-the-money designation, also known as “moneyness”, reflects
of Company A’s share price in the market. Note that the buyer will exercise this whether it would be profitable for the buyer to exercise the option at the current time.
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 5.2 Factors that Affect Option Premiums
transaction costs, such as the premium paid for the call option and trading Option premiums are expected to compensate option sellers for their risk. The option
costs). The seller of the call option is obligated to sell the shares at £6.00 per premium represents the maximum profit that the option seller can make. If an option
share to the call option buyer, even though the market price is £7.00 per share, seller underestimates the risk associated with the option, the premiums may be far
incurring a loss of £1,000 (ignoring the premium received for the call option). less than the losses incurred if the option is exercised.
If Company A’s share price is less than £6.00 per share, the call option buyer The lower the exercise price for a call option relative to the current spot price, the
has no incentive to exercise the option; it would not make sense to voluntarily higher the premium because the likelihood that it will be exercised is greater. The
pay more than the market price. In this case, the buyer will let the option expire. higher the exercise price for a put option relative to the current spot price, the higher
Because an option buyer is not forced to exercise an option, an option’s value the premium because the likelihood that it will be exercised is greater.
cannot be negative.
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
Example 4 illustrates that, ignoring the premium paid, an option buyer’s payoff is
higher the option premium because the likelihood is greater that the underlying will
never negative. Option buyers pay premiums to option sellers to compensate option
change in favour of the option buyer and that it will be exercised.
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. 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
Call options protect the buyer by establishing a maximum price the option buyer will
the effects on an option’s premium for a call option and a put option of an increase
have to pay to buy the underlying; the maximum price is the exercise price.
in each factor.
■ 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.
Exhibit 2 Effects on Premiums for a Call Option and a Put Option of an
■ A call option is “out of the money” if the market price is less than the exercise Increase in a Factor
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 Factor Increasing Call Option Premium Put Option Premium
same. In this case, the option may be exercised. Underlying’s price Increases Decreases
Exercise price Decreases Increases
Put options protect the buyer by establishing a minimum price the option buyer will Time to expiration Increases Increases
receive when selling the underlying; the minimum price is the exercise price.
Underlying’s volatility Increases Increases
■ 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.
Swap Contracts 277 278 Chapter 11 ■ Derivatives
SUMMARY
SWAP CONTRACTS 6
Derivatives have grown remarkably since their introduction because they help to
Swaps are typically derivatives in which two parties exchange (swap) cash flows or
provide innovative investment products and to manage risk at a considerably lower
other financial instruments over multiple periods (months or years) for mutual benefit,
cost. For example, by using options, investors can gain exposure to stock or bond
usually to manage risk.
markets with a fraction of the capital needed to invest directly in stocks or bonds.
Swaps of this type involve obligations in the future on the part of both parties to the Also, the transaction costs of trading derivatives are considerably smaller compared
contract. These swaps, like forwards and futures, are forward commitments or bilateral with direct investments. Derivatives thus can effectively substitute for direct invest-
contracts because both parties have a commitment in the future. Similar to forwards ments in underlying assets.
and futures, a contract’s net initial value to each party should be zero and as one side
Derivatives also provide ways to manage future risk. For example, an airline company
of the swap contract gains the other side loses by the same amount.
cannot hedge the risk of volatile jet fuel prices in a cost-effective manner except through
Swaps in which two parties exchange cash flows include interest rate and currency derivatives. Theoretically, it is possible to buy and store millions of gallons of jet fuel for
swaps. An interest rate swap, the most common type, allows companies to swap next year’s operations. But the capital investment and storage costs required for such
their interest rate obligations (usually a fixed rate for a floating rate) to manage inter- an undertaking would be formidable. In addition to hedging the risk of movements
est rate risk, to better match their streams of cash inflows and outflows, or to lower in raw material prices, derivatives can be used to hedge other kinds of risk, including
their borrowing costs. A currency swap enables borrowers to exchange debt service currency risk, product price risk, and economic risk.
obligations denominated in one currency for equivalent debt service obligations
Finally, exchange-traded derivatives improve financial market efficiency. They help
denominated in another currency. By swapping future cash flow obligations, the two
market prices become better indicators of value, which improves resource allocation,
parties can manage currency risk.
an important benefit provided by the financial services industry and discussed in The
As an example of a currency swap, Company C, a US firm, wants to do business in Investment Industry: A Top-Down View chapter. For example, if a particular share is
Europe. At the same time, Company D, a European firm, wants to do business in undervalued in the stock market relative to the futures market, an investor can buy
the United States. The US firm needs euros and the European firm needs dollars, it in the stock market and sell the related futures contract. Futures and spot market
so the companies enter into a five-year currency swap for $50 million. Assume that prices will adjust and become better indicators of value.
the exchange rate is $1.25 per euro. On this basis, Company C pays Company D
The following points recap what you have learned in this chapter about derivatives:
$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
■ Derivatives are contracts (agreements to do something in the future) that derive
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 their value from the performance of an underlying asset, event, or outcome.
and the contract ends. ■ Derivatives are used to manage risks of various types, to earn compensation for
Credit default swaps (CDS) are not truly swaps. Like options, credit default swaps taking the opposite side of a hedge, and to potentially benefit an investor based
are contingent claims and unilateral contracts. One party buys a CDS to protect itself on expectations about the future performance of an underlying.
against a loss of value in a debt security or index of debt securities; the loss of value ■ There are four main types of derivatives contracts: forwards, futures, options,
is primarily the result of a change in credit risk. The seller is providing protection to
and swaps.
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 ■ Derivatives are characterised by certain common features, including the (1)
risk of the contract. The contract will specify under what conditions the seller has to underlying, (2) maturity, (3) size and price, and (4) settlement.
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 ■ Forwards, futures, and most swaps involve obligations in the future on the part
payments received to enter into the contracts. of both parties to the contract. These contracts are sometimes termed forward
commitments or bilateral contracts because both parties have a commitment in
The use of swaps has grown because they allow investors to manage many kinds of the future.
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 ■ Options and credit default swaps are unilateral contracts and provide contin-
exchange barriers, and manage exposure to underlying assets. 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 279
■ 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. CHAPTER 12
■ 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 ALTERNATIVE INVESTMENTS
spot and exercise prices for the underlying, the time to expiration, and volatility
by Sean W. Gill, CFA
of the underlying. The effect of an increase in each on an option premium is
shown in the following table.
■ 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 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.
Introduction 283
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, 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.
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
2 WHY INVEST IN ALTERNATIVES? 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
The different types of alternative investments often look completely unrelated to each 2008, many investors suffered losses on their private equity and real estate investments
other. But they have potential common advantages: they may help enhance returns and and some of these losses were worse than those on traditional investments, such as
reduce risk by providing diversification benefits. They also share similar limitations: publicly traded equity.
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 2 Historical Returns for Various Asset Classes between 1990 and
Exhibit 1 shows the results of a global survey of institutional investors regarding their 2009
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 12
average, 22.4% of the respondents’ portfolios are invested in alternative investments,
6 7.2
6.2
Exhibit 1 Global Survey of Institutional Investors’ Holdings 4 4.5
2
Percentage of Average Percentage of
Respondents Holding the Portfolio Invested in 0
Equity Debt Private Real Commodities
Type of Asset This Type of Asset This Type of Asset Equity Estate
Equity 98% 41.0% Asset Class
Fixed income (debt) 99 33.2
Source: T. Duhon, G. Spentzos, and S. Stewart, “Introduction to Alternative Investments”, in CFA
Cash 61 3.2 Program, Level 1, Volume 6 (CFA Institute, 2012):177.
Alternatives (total) 94 22.4
Private equity 64 5.1
Private real estate 66 4.7 Reducing Risk. Investors rarely allocate all their money to one type of asset or security.
Public real estate 32 1.3 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
Commodities 22 1.0
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
Source: Based on data from Russell Research, “Russell Investment’s 2012 Global Survey on perfectly positively correlated), then combining these two assets or securities in a
Alternative Investing”, (19 June 2012): http://www.russell.com/Public/pdfs/publication/communi- portfolio provides diversification benefits and thus reduces the risk in the portfolio.
que_october_2012/global_survey_on_alternative_investing.pdf.
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
2.1 Advantages of Alternative Investments Quantitative Concepts chapter, during periods of financial crisis, returns on different
Investors add alternative investments to their portfolios for two main reasons: investments may become more correlated and the benefits of diversification may be
reduced.
■ to enhance returns and
2.2 Limitations of Alternative Investments 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
Although alternative investments have the potential to enhance returns and reduce her business.
risk, they also have limitations. Typically, alternative investments are
Private equity firms invest in private companies that are not publicly traded on a stock
■ less regulated and less transparent than traditional investments, exchange. Although people commonly refer to private “equity”, investments include
both equity and debt securities. Debt investments, however, are less common than
■ illiquid, and equity investments.
■ difficult to value.
Because alternative investments are less regulated and less transparent than tradi- 3.1 Private Equity Strategies
tional investments, such as equity and debt securities, individual investors are less Private equity encompasses several strategies that may help provide money to com-
likely to invest in them. Institutional investors may view this as an opportunity to panies at different stages of their development. The most widely used strategies
take advantage of market inefficiencies. This is discussed further in the Investment are venture capital, growth equity, buyouts, and distressed. Another private equity
Management chapter. investment strategy, which is unrelated to the stage of a company’s development, is
called secondaries.
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 3.1.1 Venture Capital
piece of land, or a building. Some institutional investors, depending on their cash As mentioned in the example provided in the introduction, venture capital is a private
flow needs, may be willing and able to hold investments for long periods, so liquidity equity investment strategy that consists of financing the early stage of companies that
may be less important for them than for individuals or institutional investors that have an innovative business idea. Venture capitalists frequently invest in “start-up”
have liquidity constraints. companies that exist merely as an idea or a business plan. The company may have
Alternative investments are also difficult to value because data availability to assess how only a few employees, have little or no revenue, and still be developing its product
much they are worth is limited. Purchases and sales of start-up companies, land, or or business model. Entrepreneurs are often looking not only for capital to start their
buildings are infrequent, so valuation is challenging and is often based on an appraisal. business but also for advice and expertise about how to establish and run their company.
An appraisal is an assessment or estimation of the value of an asset and is subject to Venture capital is considered the riskiest type of private equity investment strategy
certain assumptions, which may not always be realistic. For example, a property may because many more companies fail than succeed. It can take many years before a
be estimated to be worth £100,000 based on its location, its square footage, and the company becomes successful, and most venture capital–funded companies have years
price per square foot paid in similar transactions. But if the property market slows of unprofitable activity before they reach the point of making money. So, venture
down, the assumption about the price per square foot may prove overly optimistic capital investing requires patience. However, those companies that do succeed tend
and the value of the property could be worth less than estimated. to greatly reward their investors.
Google, and Facebook, is an opportunity for founders and existing shareholders to 3.2 Structure and Mechanics of Private Equity Partnerships
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 As mentioned in the previous section, private equity investments are usually organised
offerings may be valuable for founders and existing shareholders. in funds managed by partnerships. A private equity partnership usually includes two
types of partners:
3.1.3 Buyouts ■ The general partner is typically a private equity firm that sets up the part-
Buyouts are a private equity investment strategy that consists of financing established nership. It is responsible for raising capital, finding suitable investments, and
companies that require money to restructure and facilitate a change of ownership. making decisions. General partners have unlimited personal liability for all the
Buyout transactions sometimes involve making a publicly traded company private. debts of the partnership—that is, general partners could lose more than their
For example, such companies as UK-based Alliance Boots or US-based Hertz and investment in the partnership because if necessary, their personal assets could
Hilton Hotels were once public companies, but they underwent buyouts and are now be used to pay the partnership’s debts.
privately owned companies.
■ Limited partners are investors who contribute capital to the partnership. They
Buyouts for which the financing of the transaction involves a high proportion of debt are not involved in the selection and management of the investments. Limited
are often called leveraged buyouts (LBOs)—recall from the Debt Securities chapter partners have limited personal liability—that is, limited partners cannot lose
that financial leverage refers to the proportion of debt relative to equity in a compa- more than the amount of capital they contributed to the partnership.
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 A private equity firm may create different private equity funds for different types of
strong and sustainable cash flows. So, they are often well-established companies investments. The investments are usually not managed by the general partner itself,
with good competitive positioning in their industry. Buyout investors often target but by professional fund managers who are hired by the general partner. Each private
companies that have recently underperformed but that offer opportunities to grow equity fund may have its own fund manager who is responsible for the day-to-day
revenues and margins. management of the investments in the funds.
regardless of how much capital the private equity firm has already invested.
EXAMPLE 1. STRUCTURE AND MECHANICS OF A PRIVATE EQUITY
Thus, in the early years of the private equity fund’s life, the limited partners may
PARTNERSHIP
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
Fund Manager 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
Fixed Fees on the investment in Company W is $600,000—that is, the difference between
Limited Capital Calls Incentive Fees
Partner Company the selling price of $1,000,000 and the initial investment of $400,000. So the
Management Fees W
A Carried Interest Investments 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
Limited the limited partners is $510,000 ($600,000 – $90,000). Thus, each limited part-
Partner Company
B X ner receives a cash distribution of $227,500—that is, $100,000 of capital plus
Private Equity Firm/ $127,500 of profit, which represents a return on investment of 128% [($227,500
General Partner – $100,000)/$100,000], ignoring management fees.
Limited
Partner Company
C Y This return on investment is high, but remember that venture capital is
Cash Realisations risky. Assume that Company X encounters financial trouble and that the private
Limited Distributions equity firm wants to sell its ownership interest in Company X. Another private
Partner Company
D Z 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
Assume that a private equity firm has created a $4 million private equity investment in Company X turns out to be a loss of $500,000 (the selling price of
fund to invest in start-up companies. As discussed in Section 3.1.1, this private $100,000 minus the initial investment of $600,000) so there is no carried interest.
equity investment strategy is called venture capital. The private equity firm is Each limited partner receives a cash distribution of $25,000, which represents
the general partner and its first task is to raise capital from investors. Suppose a return on investment of –83% [($25,000 – $150,000)/$150,000], ignoring
that it identifies four investors who are willing and able to contribute $1 million management fees. As mentioned earlier, limited partners are not exempt from
each. These investors are the limited partners—A, B, C, and D in the figure. The paying management fees on their total commitment, including the $150,000
limited partners do not transfer $1 million each to the general private equity contribution to Company X, even if the investment is underperforming or fails.
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.
As illustrated in Example 1, each limited partner’s capital of $1 million is drawn down
When the private equity firm has secured the $4 million, it can start invest-
gradually over the commitment term of the private equity fund’s life. In the early
ing. Assume that it finds a suitable investment in Company W for $400,000.
years of the fund, the limited partners face negative cash flows because they receive
The private equity firm contacts the limited partners and makes a capital call of
several capital calls to fund investments and they must pay management fees on the
$100,000 per limited partner—capital calls often happen on short notice. Limited
committed capital. Later on, when investments pay dividends or are sold, the private
partners A, B, C, and D transfer $100,000 each to the private equity firm, which
equity firm makes cash distributions to the limited partners. When cash distributions
invests the $400,000 in Company W. A few months later, the private equity firm
net of carried interest exceed capital calls and management fees, the limited partners
identifies another suitable investment in Company X for $600,000. It makes
experience positive cash flows.
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. 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
As shown in the figure, the private equity firm makes investments in four
with a life of 10 years. It is assumed that the private equity firm makes investments in
companies. These investments are typically managed by a professional fund
10 companies between Year 1 and Year 6, these investments start paying dividends in
manager who charges the private equity firm fees for his or her services, usually
Year 4, and they get sold between Year 6 and Year 10. The blue bars show the sum of
a combination of a fixed fee plus an incentive fee. In turn, the private equity firm
the capital calls and management fees, which are assumed to be 1.5% of the committed
charges the limited partners management fees to cover the fund manager fees
capital. The green bars reflect the cash distributions, ignoring carried interest. The
and other administrative fees. For example, assume that the annual management
line is the cumulative net cash flow to the limited partner—that is, the sum of the
fee is 1.5% of the committed capital. So, each limited partner who committed
cash distributions minus the sum of the capital calls and management fees. This line
$1 million must pay the private equity firm an annual management fee of $15,000
is known as a J curve because its shape resembles the letter J.
292 Chapter 12 ■ Alternative Investments Real Estate 293
Many investors focus their real estate investments on what is commonly referred to
Exhibit 3 The J Curve
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
800 in a small number of countries. With the exception of China, this concentration is
skewed toward developed countries.
600
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 REAL ESTATE
Generally, residential real estate transactions involve owner-occupiers (that is, people
4.1.1 Land
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 Undeveloped, or raw, land can be highly speculative because there are no cash
residential real estate for investment-related purposes, such as renting out holiday inflows from tenants or occupants, only cash outflows in the form of real estate taxes
homes. 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.
294 Chapter 12 ■ Alternative Investments Real Estate 295
Investing in undeveloped land is risky because values can decrease rapidly when 4.2 How To Invest in Real Estate?
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 Investors who have sufficient funds can buy real estate directly. Otherwise, they can
acres of undeveloped land outside Los Angeles lose more than 90% of its value in the gain exposure to real estate through either the private or public market.
aftermath of the 2008 global financial crisis.1
4.2.1 Private Market Investments
4.1.2 Offices In the private market, the primary way of investing in real estate is through real estate
Offices represent one of the largest segments of commercial real estate. They are usu- limited partnerships and real estate equity funds.
ally owned by real estate investment companies that lease space to tenants in varying Real estate limited partnerships are partnerships that specialise in real estate invest-
terms, from short-term monthly leases to longer multiyear leases. Because tenants are ments. Their structure and mechanics are similar to those of the private equity partner-
responsible for paying their leases whether they occupy the space or not, the income ships discussed in Section 3.2. The partnership is often set by a real estate development
associated with office rents is relatively predictable over the life of the lease. In addition, firm that becomes the general partner. The general partner then raises capital from
office rents typically adjust for inflation, which makes offices an attractive investment investors, who become the real estate limited partnership’s limited partners. The capital
for those seeking to protect their real estate income against inflation. 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
4.1.3 Multifamily Residential Dwellings 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
Also known as apartments or flats, multifamily residential dwellings represent a sig-
must pay the general partner management fees on the committed capital and carried
nificant portion of the investable commercial real estate market. They are commercial
interest on the profit made on the real estate assets.
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 Similar to investments in private equity partnerships, investments in real estate limited
year or less, so the multifamily residential dwellings segment is sensitive to supply partnerships are illiquid. In addition, the limited partners may face years of negative
and demand dynamics in the local marketplace. 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.
4.1.4 Retail Properties Real estate equity funds typically hold investments in hundreds of commercial prop-
The retail segment includes such assets as shopping malls, commercial shopping erties. These properties are diversified by geography, property type, and vintage year
centres, and other buildings designated for retail purposes. The owner, or investor, (that is, the year the purchase was made). Real estate equity funds are often open-end
leases the space to a retailer with lease terms varying from weeks to years. 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
4.1.5 Industrial Properties out of the real estate equity funds’ cash flows, such as the income received from rents
The industrial segment includes such properties as manufacturing facilities, research and the sale of properties. So, real estate equity funds are, in theory, more liquid than
and development space, and warehouse/distribution space. Again, lease terms vary real estate limited partnerships. However, there is no guarantee that the cash flows
in length. will be sufficient to meet investors’ redemption requests.
1 Michael Corkery, “Calpers Confronts Huge Housing Losses”, Wall Street Journal (13 November 2008).
296 Chapter 12 ■ Alternative Investments Summary 297
■ Alternative investments are diverse and include private equity, real estate, and
commodities.
5 COMMODITIES
■ Investors add alternative investments to their portfolios to potentially
help enhance returns and reduce risk by obtaining diversification benefits.
Commodities, such as precious and base metals, energy products, and agricultural Diversification benefits occur because there is a relatively low correlation
products, tend to rise in price with inflation. So, they can provide inflation protection between different types of alternative investments and also between alterna-
in a portfolio. tive investments and other asset classes. The benefits of diversification may be
reduced in periods of financial crisis when returns on different investments may
There are several ways for investors to gain exposure to commodities. They can buy become more correlated.
Purchase of commodity derivatives. As mentioned in the Derivatives chapter, inves- ■ Commercial real estate segments include land, offices, multifamily residential
tors can buy derivatives in which the underlying asset is a commodity or a commodity dwellings, retail and industrial properties, and hotels.
index. Typical commodity derivatives are forwards, futures, options, and swaps. Recall
■ Investors can buy real estate directly or gain exposure to real estate through the
that futures and some types of options are traded on exchanges, whereas forwards,
private market via real estate limited partnerships and real estate equity funds,
swaps, and other types of options are privately negotiated agreements.
or through the public market via real estate investment trusts.
The following points recap what you have learned in this chapter about alternative
investments:
■ hold, manage, and account for securities and assets during the periods of the
investments.
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 ■ evaluate the performance of their investments.
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 These activities generally require information, expertise, and systems that few individual
as travel and charitable gifts, and to pass wealth on to the next generation. Companies and institutional investors have. Investors obtain assistance with these activities from
save to invest in future projects and to pay future salaries, taxes, and other expenses. investment professionals, either directly by hiring investment professionals or indirectly
Governments save when they collect tax revenues in advance or in excess of spending by investing in investment vehicles that the investment industry creates and oversees.
requirements or receive the money from bond sales before this money is spent.
Some investment firms and professionals working in the investment industry specialise
The investment industry provides many services to facilitate successful saving and in providing a single service. Others provide a broad spectrum of investment services.
investing. This chapter discusses how investment professionals organise their efforts For the sake of clarity, this discussion considers each service separately, even though
to help their clients meet their financial goals. It also describes how these efforts help most investment firms and professionals provide multiple services.
ensure that only the individuals, companies, and governments with the best value-
enhancing plans for using capital receive funding.
Investment Investment
Financial
Planning
Management Information Trading
Custodial
3 FINANCIAL PLANNING SERVICES
Investment clients often need advice to set their financial goals and determine how
Savers much money they should save for future expenses. Some clients also need advice
(Providers of Capital) 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
Institutional Investors Individual Investors 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
HOW THE INVESTMENT INDUSTRY PROMOTES SUCCESSFUL
INVESTING
2 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.
The investment industry provides services to those who have money to invest—indi- Many pension funds employ financial planners to help pension beneficiaries make
vidual and institutional investors who become providers of capital. Investing involves better savings decisions. Some employers also contract with financial planning con-
many activities that most individual and institutional investors cannot do themselves. sultants to make financial planning services available to their employees and retirees.
Investors must Increasingly, financial planners provide financial planning advice over the internet to
retail investors.1
■ 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.
Various organisations require financial planning services to help them meet their as into foreign and domestic. To determine the appropriate allocation to each of the
investment objectives. For example, foundations and endowment funds—which are various asset classes, investment managers must assess the risk and return charac-
not-for-profit institutions with long-term investment objectives—sometimes hire teristics of many potential investments.
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. Investment analysis involves estimating the fundamental value of potential invest-
The payout policies depend on the assumptions the financial planners make about ments and identifying attractive securities and assets. An investment’s fundamental
future expected investment returns. Assuming high future expected returns allows value, also called intrinsic value, indicates the price that investors would pay for the
for higher current spending. But if these assumptions prove to be overly optimistic, investment if they had a complete understanding of the investment’s characteristics.
payouts will exceed the returns generated by the investments and the spending of the A widely used approach to estimating the fundamental value of an investment is to
foundation or endowment fund will have to decrease over time. 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
INVESTMENT MANAGEMENT SERVICES 4 its estimated fundamental value.
Active investment managers collect and analyse as much relevant information and data Most research reports are largely based on publicly available information. These reports
as they can reasonably obtain to predict which securities and assets will outperform summarise information from lengthy disclosures, saving investors considerable time.
or underperform their peers in the future. They often need the help of investment Many reports also present financial analyses that estimate the fundamental value of
information service providers to gather the required information and data. 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
4.2 Services for Retail Clients clients to better serve them, to attract new clients, and to encourage their clients to
Retail investors do not typically have access to the same level of service as high-net- trade. Investors may also purchase reports directly from independent research firms,
worth and institutional investors. Many retail clients obtain assistance and advice on or they may obtain reports from research firms that issuers pay to produce reports
investment management activities, including asset allocation, investment analysis, about their securities.
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
Macro-
Economic
funds and life insurance policies for the trades and contracts they recommend. Others
Data
are fee-only professionals who accept payments only from their clients. Unlike brokers Industry
and agents, who are paid commissions on the trades and contracts they recommend, Data
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
Firm
funds, that are professionally managed. Types and characteristics of pooled investment Data
vehicles are discussed in the Investment Vehicles chapter. Retail investors may also
need investment information to implement their investment plans.
their ratings. Such a situation would have a negative effect not only on credit rating The widespread availability of investment data has greatly changed the investment
agencies but also on the economy in general and the investment industry in particular industry landscape; whereas access to data used to be a key driver of investment
because flows of capital would be reduced. profits, now investment profits increasingly depend on the ability to analyse data.
Exhibit 1 shows examples of historical data that may be of interest to investors and Brokers, dealers, clearing houses, settlement agents, custodians, and depositories
how investors may use these data to make decisions. 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.
Access to investment data was once very expensive and thus restricted to investment Brokers often also ensure that their clients settle their trades. Such assurances are
firms and institutional investors. The growth of information technologies, particularly essential when exchanges arrange trades between strangers who do not have credit
those involving the internet, has substantially reduced the cost of accessing data, so arrangements with each other. For such trades, brokers guarantee the settlement of
more investment data are now available to the general public. In many countries, some their clients’ trades.
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.
Trading Services 309 310 Chapter 13 ■ Structure of the Investment Industry
Individual brokers may work for large brokerage firms or the brokerage arms of Broker/dealers face a conflict of interest with respect to how they fill their clients’
investment banks or at exchanges. Some brokers match clients personally. Others orders. When acting as brokers, they must seek the best price for their clients’ orders.
use specialised computer systems to identify potential trades and help their clients When acting as dealers, however, they profit most when they sell to their clients at
fill their orders. Many simply route their clients’ orders to exchanges or to dealers. 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
Block brokers help investors who want to trade large blocks of securities. Large block with other traders or to fill them internally. Consequently, when trading with broker/
trades are hard to arrange because finding a counterparty willing to buy or sell a large dealers, some clients may specify that they do not want their orders to be internalised.
number of securities is often quite difficult. Investors who want to trade a large block Or they may choose to trade only via brokers who do not also act as dealers.
often have to offer price concessions to encourage other investors to trade with them.
Often, buying a large number of securities requires paying a premium on the current Primary dealers are dealers with which central banks trade when conducting monetary
market price, and selling a large number of shares requires offering a discount on the policy. Recall from the Macroeconomics chapter that monetary policy refers to cen-
current market price. 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
Prime brokerage refers to a bundle of services that brokers provide to some of their money supply. The primary dealers then sell the bonds to their clients. Central banks
clients, usually investment professionals engaged in trading. In addition to the typical buy bonds from primary dealers to increase the money supply, the primary dealers
brokerage services mentioned, a prime broker helps these professionals finance their buy bonds from their clients and sell them back to the central banks.
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.
6.3 Clearing Houses and Settlement Agents
Clearing houses and settlement agents settle trades after they have been arranged.
6.2 Dealers 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.
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. Settlement Clearing
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 Buyer’s Seller’s
they sell but before they can repurchase. Broker Broker
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 Clearing House
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 Clearing houses arrange for the final settlement of trades. The members of a clearing
and place. Dealers are often called market makers because they are willing to make house are the only traders for whom the clearing house will settle trades. Thus, bro-
a market (that is, trade on demand) in specified securities at their bid and ask prices. 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.
Dealers may organise their operations within investment banks, hedge funds, or sole
proprietorships. Almost all investment banks have dealing operations ready to buy Reliable settlement of all trades promotes liquidity because it reassures investors that
and sell currencies, bonds, stocks, and derivatives if no other counterparty can be their trades will be settled and thus allows strangers to confidently contract with each
found. Some dealers rely on individuals to make trading decisions; others primarily other without worrying much about settlement risk, which is the risk that counter-
use computers. 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.
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.
Trading Services 311 312 Chapter 13 ■ Structure of 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.
purchase these investment products and services from sell-side firms. For example, The back office houses the administrative and support functions necessary to run
such institutional investors as pension plans, endowment funds, foundations, and the firm. These functions include accounting, human resources, payroll, and opera-
sovereign wealth funds, as well as insurance companies, are all considered buy-side tions. For brokerage firms and banks that provide custodial services, the accounting
participants. Buy-side firms include firms that manage portfolios for clients and/or department is especially important because it is responsible for clearing and settling
themselves. Practitioners also sometimes use the term buy side to refer to consultants trades and for keeping track of who owns what.
who provide services only to buy-side firms. For example, many buy-side consultants
help buy-side institutional investors evaluate investment performance.
Clients
Funds
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
However, the buy-side/sell-side classification does not apply to all firms in the invest- and executing trades. confirming trades. settling trades, as well as
providing accounting and
ment industry. For example, it is not relevant for the investment information services Trades Trades
financial support.
presented in Section 5. In addition, the buy-side/sell-side classification is somewhat • Sales • Risk Management
• Marketing • Information Technology • Accounting
arbitrary and not easily applied to many large, integrated firms. For example, many • Customer Service • Corporate Finance • Human Resources
investment banks have divisions or wholly owned subsidiaries that provide investment • Portfolio Management • Payroll
management services, which are buy side. These functions are on the buy side, even • Research • Operations
though investment banks are sell-side firms.
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
7.2 Front, Middle, and Back Offices department ensures that the firm and its clients comply with the many laws and
regulations that govern the investment industry.
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 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
The front office consists of client-facing activities that provide direct revenue genera- management firms are similar to those of sell-side firms. These departments include
tion. The sales, marketing, and customer service departments are the most important sales and client relations, investment research and portfolio management, trading,
front-office activities. Some practitioners consider the trading department to be a compliance, accounting, and administration.
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- 7.3 Leadership Titles and Responsibilities
mation technology (IT), corporate finance, portfolio management, and research are Exhibit 2 provides an example of major leadership titles and responsibilities in the
generally considered middle-office activities, especially if these departments do not investment industry. Titles used by different firms may vary.
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.
Organisation of Firms in the Investment Industry 315 316 Chapter 13 ■ Structure of the Investment Industry
■ Research assistants assist research analysts with the collection and analysis of
Exhibit 2 Leadership Titles and Responsibilities
investment information.
Title Responsibility ■ Buy-side traders interact with sell-side firms to trade orders created by their
portfolio managers.
Chief executive officer (CEO) Manages the firm.
Chief financial officer (CFO) Responsible for financing the firm and for financial ■ Sales traders at sell-side firms help arrange trades for their buy-side clients.
reporting.
■ Sales managers manage sales for regions, products, or customer types.
Chief operating officer Responsible for the day-to-day management of the
(COO) firm.
■ Salespeople identify potential clients and sell them the firm’s products and
Chief investment officer Responsible for any investment advice that the firm services.
(CIO) provides to its clients and for the investment deci-
sions that the firm makes for itself and on behalf of its ■ Sales assistants provide administrative support to the salespeople.
clients.
Head trader Responsible for all trading operations. At firms that ■ Client service agents and their assistants answer client questions and help cli-
engage in proprietary trading, the head trader is ents open, close, and manage their accounts.
responsible for all positions, risks, and profits.
Chief accountant (also Responsible for the accounting and financial systems. Investment professionals who interact with clients may also be known as account
known as finance controller) executives and account managers at many firms.
Treasurer Responsible for cash management, including the
investment of receipts and payment of invoices. Research assistant is often the entry-level position for investment professionals inter-
ested in becoming portfolio managers. Assistants who acquire strong expertise in a
Chief risk officer Responsible for identifying and managing the risks to
which the firm and its clients are exposed.
particular area and who can write well may be promoted to research analysts. Those
analysts who demonstrate excellent investment judgment often become portfolio
Chief compliance officer Responsible for ensuring that the firm complies with
managers. Likewise, sales assistants and account services assistants are entry-level
all constraints placed on it by laws, regulations, and
clients.
positions for investment professionals interested in sales or account services.
Chief audit executive Leads the internal audit department, which is respon- Companies that provide investment management services also employ many other
sible for providing independent assessments of the types of professionals besides investment professionals. These include professionals
firm’s operational systems as well as suggestions for working in accounting, information services, marketing, and legal services.
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.
SUMMARY
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. 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
7.4 Investment Staff to remember include the following:
Firms in the investment industry employ many types of investment professionals.
Examples include the following: ■ The investment industry provides many services to facilitate successful saving
and investing.
■ Portfolio managers at buy-side firms make investment decisions for one or
■ Investing involves many activities that most individual and institutional inves-
more portfolios.
tors cannot do themselves. Investors obtain assistance with these activities
■ Buy-side, sell-side, and independent research analysts produce the investment either directly or indirectly.
research that portfolio managers use to make decisions.
Summary 317
■ 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.
■ 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.
■ 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,
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.
c Describe security market indices including their construction and valua- Investment vehicles are assets offered by the investment industry to help investors
tion, and identify types of indices; 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;
d Describe index funds, including their purposes and construction; real assets, such as gold; and real estate. Many investment vehicles are entities that
e Describe hedge funds; own other investment vehicles. For example, an equity mutual fund is an investment
vehicle that owns shares.
f Describe funds of funds;
This chapter introduces the most important investment vehicles and explains how
g Describe managed accounts; they are structured and how those structures serve investors. Understanding these
products and how they benefit clients will help you support investment professionals
h Describe tax-advantaged accounts and describe the use of taxable and contribute to the value creation process.
accounts to manage tax liabilities.
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:
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.
Direct Investment estate investment trusts compared with real estate limited partnerships or real
estate equity funds. Although the assets in which traded investment vehicles
invest may be difficult to buy and sell, ownership shares in these vehicles can
trade in liquid markets.
$ Commodities
¥€ Direct investments also present some advantages to investors compared with indirect
investments.
Real Estate
■ Investors exercise more control over direct investments than over indirect
Stocks & Bonds
investments. Investors who hold indirect investments generally must accept all
decisions made by the investment managers, and they can rarely provide input
Indirect Investment into those decisions.
■ Indirect investments are professionally managed. Professional management is So, is direct or indirect investment more advantageous for investors? The answer is: it
particularly important when direct investments are hard to find and must be depends. Each investor and each investment firm must decide on the best approach
managed. given their specific needs and circumstances.
■ 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
324 Chapter 14 ■ Investment Vehicles Pooled Investments 325
■ Investment managers who receive commissions on trades that they recom- Pooled investment vehicles are overseen by a board of directors, a board of trust-
mend may execute too many trades. Some managers have been known to ees, a general partner, or a single trustee; the governance structure depends on the
sell and replace their entire portfolios once or more over the course of a year. form of legal organisation. In some countries, directors must be independent of the
Practitioners commonly call this practice churning. 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,
■ Investment managers may favour themselves or their preferred clients over employees or directors of the sponsor may also serve as directors of its associated
other clients when allocating trades that have been, or are expected to be, prof- investment vehicles.
itable. For instance, a manager might offer shares in an initial public offering
that is expected to do well only to preferred clients. The directors appoint a professional investment management firm, which is almost
always an affiliate of the sponsor. The investment manager works on a contractual
To successfully use the services of professional investment managers, investors must basis in exchange for a management fee paid by the investment vehicle from its
control potential investment management problems. Investors who cannot easily assets. The investment manager chooses the securities and other assets held by the
deal with these problems often prefer indirect investment vehicles, such as public investment vehicle.
mutual funds, for which a board of directors (or trustees) has primary responsibility
All pooled investment vehicles disclose their investment policies, deposit and redemp-
for monitoring the performance of the managers. Unfortunately, although board
tion procedures, fees and expenses, and past performance statistics in an official offering
members generally work conscientiously on behalf of their shareholders, some may
document called a prospectus. Investors use this information to evaluate potential
be more loyal to the managers that they monitor than to the shareholders that they
investments. Investment vehicles may disclose additional information through other
represent. Regardless, the managers of public mutual funds generally work hard for
mandated regulatory filings, on their websites, or in marketing materials.
their investors because they usually are paid in proportion to their total assets under
management. Because good performance tends to attract additional investments, The three main types of pooled investment vehicles are open-end mutual funds,
mutual fund managers generally work to produce investment returns that attract new closed-end funds, and exchange-traded funds. An important distinction between
investments and thus increase their fees. 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
In contrast, large institutional investors are often direct investors who hire and over-
common stocks. In contrast, open-end mutual funds are not exchange traded.
see investment managers. These institutional investors can often devote substantial
resources to monitoring and evaluating their managers. 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
3 POOLED INVESTMENTS 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.
Most retail investors choose to save through pooled investment vehicles managed by
Sections 3.2 to 3.4 discuss more thoroughly the characteristics of open-end mutual
investment firms. The sole purpose of these investment vehicles is to own securities
funds, closed-end funds, and exchange-traded funds. Section 3.5 compares the three
and other assets. The investment vehicles, in turn, are owned by their investors, who
types of pooled investment vehicles and concludes with a summary table.
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 3.2 Open-End Mutual Funds
investment vehicle’s securities and assets, but not their legal owners.
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-
3.1 How Pooled Investment Vehicles Work 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
Banks, insurance companies, and investment management firms organise most pooled
redeems the investors’ shares and pays them cash. So from the fund’s point of view,
investment vehicles. The organiser is often called the sponsor. Sponsors can organ-
investor purchases and sales are deposits and redemptions, respectively.
ise investment vehicles as business trusts, limited partnerships, or limited liability
companies. Depending on the form of the organisation, ownership shares are known The manager of an open-end mutual fund determines the prices at which deposits
as shares, units, or partnership interests. Large sponsors can organise hundreds of and redemptions occur. No-load funds, which do not charge deposit or redemption
investment vehicles. 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
326 Chapter 14 ■ Investment Vehicles Pooled Investments 327
dividing the total net value of the fund (the value of all assets minus the value of all Listed closed-end funds sell shares to the public in initial public offerings (IPOs), as
liabilities) by the fund’s current total number of shares outstanding. Managers compute described in the Equity Securities chapter. They then use the proceeds from the IPO
the fund’s NAV each day following the normal close of exchange market trading. They to purchase securities and other assets. After the IPO, investors who want to buy or
use last reported trade prices to value their portfolio securities and usually publish sell a listed closed-end fund do so through exchanges and dealers. The closed-end
the NAVs a few hours after the market closes. 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
Investors may have to pay sales loads to the fund distributor, who markets the fund, obtain in the market.
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 Listed closed-end funds are actively managed and generally trade at prices different
sales loads are fees that investors may have to pay when they sell shares in a fund that from their NAV. A fund is said to trade at a discount if the trading price is lower than
they have not held for more than some pre-specified period, typically a year or more. the fund’s NAV or at a premium if the trading price is greater than its NAV. Discounts
Sales loads are calculated as a percentage of the sales price. The percentage is usually are more common than premiums because many closed-end fund investment managers
around 3%, but can be as high as 9%. Typically, the fund distributor receives the fee have been unable to add more value to their funds than the funds lose through their
and pays part of it to the investment manager and part of it to anybody who helped various operational costs. The investment management fee typically is the largest of
arrange the sale, except where legally restricted from doing so. these costs. Other costs include portfolio transaction costs and fees for accounting
and other administrative services.
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 3.4 Exchange-Traded Funds
primarily consist of the costs of trading portfolio securities incurred when buying Exchange-traded funds (ETFs) are pooled investment vehicles that are typically pas-
securities to invest the cash received from investors or when selling securities to raise sively managed to track a particular index or sector, although an increasing number of
cash for redemptions. ETFs are actively managed. ETFs are generally managed by investment professionals
who provide investment, managerial, and administrative services. The fees for these
As mentioned earlier, open-end mutual funds may be passively or actively managed.
services and trading costs are low, particularly for ETFs that are passively 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, 3.5 Comparison of Pooled Investment Vehicles
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, We already mentioned that two important differences between pooled investment
a euro per share in the eurozone) if they meet certain conditions. In particular, they vehicles is whether they are exchange traded and whether they are passively or actively
may only hold money market securities—that is, generally very short-term, low-risk managed. Other differences involve risks, management accountability, costs, and taxes.
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, 3.5.1 Risks
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. 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
Money market funds are vulnerable to a run on assets. In particular, if investors expect its portfolio. These risks vary much more by the investment approach than by how
that the value of their money market funds will decline in the near future, they may the investment vehicle is organised. In general, passively managed funds are less risky
rush to redeem their shares before the NAV falls. These actions can be destabilising than actively managed funds that invest in the same asset class because investors in
because they force funds to sell portfolio securities when the market is falling. 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
3.3 Closed-End Funds discounts and occasional premiums at which closed-end funds trade relative to their
Unlike open-end funds, closed-end funds have a fixed number of shares; they do not NAVs vary over time. Variation of these discounts and premiums increases the risk
issue or redeem shares on demand. They may issue additional shares in secondary of holding closed-end funds. ETFs also sometimes trade at discounts and premiums
offerings or through rights offerings or they may repurchase shares, but these events to their NAVs, but these variations tend to be small.
are uncommon. Accordingly, the total number of shares outstanding for most closed-
end funds rarely changes.
328 Chapter 14 ■ Investment Vehicles Index Funds 329
3.5.2 Management Accountability 3.5.5 Summary of Differences Between Pooled Investment Vehicles
Investors in indirect investment vehicles cannot choose who will manage their invest- Exhibit 1 offers a summary table of characteristics of open-end mutual funds, closed-
ments. But they can choose the funds in which they invest and seek to invest in funds end funds, and ETFs.
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 Exhibit 1 Comparison of Open-End Mutual Funds, Closed-End Funds, and ETFs
funds that use passive investing strategies because their managers have little influence
on portfolio performance. Open-End Mutual Funds,
including
Investors are more concerned about the accountability of managers of actively managed Money Market Funds Closed-End Funds Exchange-Traded Funds
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 Managed Yes, actively or passively Yes, primarily actively Yes, primarily passively
under management and the fee paid to the manager. Exchange traded No Yes, but not traded Yes, traded continuously
continuously
In contrast, managers of closed-end funds are largely insulated from their shareholders. If exchange traded, size of Can be large, usually trade Small, usually trade at close
Shareholders can sell their shares to new investors, but the assets under management the gap between the price at a discount to the NAV to the NAV
remain the same. and the net asset value
Redeemable Yes No Yes
3.5.3 Costs Risky Yes Yes Yes
The costs incurred by pooled investment vehicles are deducted from their assets, Management accountability Few issues, particularly Management not particu- Few issues, particularly if
reducing their investment performance. if funds are passively larly responsive to share- funds are passively managed
managed holders’ concerns
The biggest costs are those associated with management, distribution, and account Management fees High if actively managed, High because actively Low if passively managed
maintenance. The level of management fees depends primarily on the style of asset low if passively managed managed
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
INDEX FUNDS 4
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. 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
Investors who trade listed closed-end funds and exchange-traded funds generally know popular because they provide broad exposure to an asset class and are cheap relative
the prices at which their trades can take place because market prices are available. to many other products. In order to understand index funds, it is necessary to have
They usually use brokers to arrange their trades and must pay commissions to them. an understanding of security market indices.
A security market index is a group of securities representing a given security market, Index includes more than 6,000 stocks in 24 developed markets. Note that the list of
market segment, or asset class. The security market indices just mentioned are widely securities included in an index may change from time to time. The process of adding
published equity market indices. Practitioners have also created many other indices. 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
4.1.1 The Index Universe index: price-weighted, capitalisation-weighted, or equal-weighted.
The investment industry has created indices to measure the values of almost every
A price-weighted index is an index in which the weight assigned to each security is
existing market, asset class, country, and sector:
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
■ Broad market indices cover an entire asset class—for example, stocks or more of an effect on the value of the index than low-priced stocks. The DJIA in the
bonds—generally within a single country or region. United States and the Nikkei 225 in Japan are examples of price-weighted indices.
■ Multi-market indices cover an asset class across many countries or regions. Many indices are capitalisation-weighted indices (also known as cap-weighted indi-
■
ces, market-weighted indices, or value-weighted indices). The weight assigned to each
Industry indices cover single industries.
security depends on the security’s market capitalisation. The market capitalisation or
■ Sector indices cover broad economic sectors—sets of industries related by capitalisation of a security is the market price of the security multiplied by the number
common products or common customers, such as healthcare, energy, or of shares outstanding of the security. For example, as of November 2013, Apple’s stock
transportation. price was $524 per share and there are about 900 million shares. Thus, Apple’s market
capitalisation was about $472 billion. Securities included in capitalisation-weighted
■ Style indices provide benchmarks for common styles of investment manage- indices are given weights in the proportion of their market capitalisations. In other
ment. Examples of equity-style indices include indices of value and growth words, securities of bigger companies get higher weights. The Hang Seng in Hong
stocks; of small-, mid-, and large-capitalisation stocks; and of combinations of Kong, the FTSE 100 in the United Kingdom, and the S&P 500 Market Weight Index
these classifications, such as small-cap growth. are examples of capitalisation-weighted indices.
■ Fixed-income indices cover debt securities and vary by characteristics of the Equal-weighted indices show what returns would be made if an equal value were
underlying securities and by characteristics of the issuers. For example, sepa- invested in each security included in the index. The prices of these securities change
rate indices are available for securities issued by governments (sovereign) and continuously. Thus, to maintain the equal weights between securities, regular index
companies (corporate); short-, mid- (intermediate-), and long-term bonds; rebalancing is necessary. That is, the weights given to securities whose prices have risen
investment-grade and high-yield bonds; inflation-protected and convertible must be decreased, and the weights given to securities whose prices have fallen must be
bonds; and asset-backed securities. increased. The S&P 500 Equal Weight Index is an example of an equal-weighted index.
■ Other indices track the performance of alternative investments, such as hedge The fact that different indices include different securities and use different approaches
funds, real estate investment trusts (REITs), and commodities. As discussed to assign weights to the securities explains why the changes in values of indices
in the Alternative Investments chapter, real estate investment trusts are public vary, even when focussing on the same national market or sector. For example, as of
companies that mainly own, and in most cases operate, income-producing real November 2013, Apple is the largest company by market capitalisation. Apple stock
estate. is not included in the DJIA but 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
4.1.2 How to Compute the Value of Indices 500 Equal Weight Index. Because the S&P 500 Market Weight Index assigns to each
The value of an index is computed from the prices of the securities that compose the stock a weight that reflects the company’s market capitalisation, Apple represents
index. Two important elements affect the value of an index: 3.0% of the S&P 500 Market Weight Index. A change in the price of Apple’s stock will
not affect the DJIA, will have a small effect on the S&P 500 Equal Weighted Index,
■
and will have a much larger effect on the S&P 500 Market Weight Index. Knowing
the securities included in the index and
which securities are included in an index and how much weight is assigned to each
■ the weight assigned to each security in the index. is important information for people using the index.
The percentage change in the value of an index over some time interval is the index
Some indices include a small number of securities from one national market or one return. Analysts focus more on index returns than on index values because index
particular sector. For example, the Dow Jones Industrial Average (DJIA) includes only values are arbitrary. For example, the value of the FTSE 100 was arbitrarily set to
30 large US company stocks and the Dow Jones Utilities includes only 15 large US a base value of 1,000 on 3 January 1984 when the Financial Times and the London
company stocks from the utility sector. Other indices try to capture a larger share of Stock Exchange created the index.
the securities market and include hundreds or thousands of securities from around
the world. For example, the Morgan Stanley Capital International (MSCI) World
332 Chapter 14 ■ Investment Vehicles Hedge Funds 333
Some index fund managers invest in every security in the benchmark index, a strat- They can also be distinguished by their use of strategies beyond the scope of most
egy known as full replication. Other index funds find it difficult to buy and hold all traditional closed-end funds and open-end mutual funds that are actively managed.
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 5.1.1 Availability
fund managers might invest in only a representative sample of the index securities, Hedge funds are usually available only to some investors who meet various wealth,
a strategy called sampling replication. Managers of small funds, which track indices income, and investment knowledge criteria that regulators set. The criteria are
with many securities, often use the sampling replication strategy to reduce costs. designed to ensure that these investment vehicles are suitable for their investors.
Most money invested in hedge funds comes from large institutional investors, such
Once set up, index funds only trade if the weightings need to be adjusted. Adjustments as pension funds, university endowment funds, and sovereign wealth funds, as well
are necessary in the case of index reconstitution—that is, when securities are added as from high-net-worth individuals.
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. 5.1.2 Lock-Up Agreements
The capitalisation-weighted index fund only needs to rebalance if corporate actions, Most hedge funds lock up their investors’ capital for various periods, the length of
such as mergers and acquisitions, affect weightings. 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
Index funds sometimes buy securities to invest cash when cash inflows are received.
strategies generally have shorter lock-up periods than funds that engage in strategies
Cash inflows include receipt of dividends and/or interest. They also include additional
that may take much more time to realise the expected returns, such as strategies that
net cash inflows from investors—that is, additional investments from investors that
involve reforming corporate governance.
exceed withdrawal (redemption) requests by investors. Index funds may have to sell
securities if withdrawal requests from investors exceed additional investment from
investors. 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
5 HEDGE FUNDS
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.
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.
334 Chapter 14 ■ Investment Vehicles Hedge Funds 335
For example, assume that the assets under management are £1 million, that High-Water Mark
Some managers terminate their funds and start over when they have significant losses
12% excess 20% × 12% × £1,000,000 = £24,000 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
17% return always solve their problem: managers who have performed poorly often have difficulty
raising new funds from investors.
5% hurdle
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.
Total compensation = £44,000
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.
336 Chapter 14 ■ Investment Vehicles Tax-Advantaged Accounts and Managing Tax Liabilities 337
5.3 Legal Structure and Taxes 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
The legal structure and legal domicile of hedge funds generally depend on their manag- well-diversified fund of hedge funds, investment gains in some funds are often offset
ers’ and investors’ tax situations. For example, most hedge funds serving US investors by losses in the other funds. The fund of hedge funds pays performance fees to the
are organised as domestic limited partnerships in which the manager is the general winning hedge fund managers and thus shares its gains in these funds with those
partner and the investors are the limited partners. This structure, which is similar to managers. But losing hedge fund managers do not share in the losses of their hedge
the structure of private equity funds described in the Alternative Investments chapter, funds. If the gains and losses are of equal size, fund-of-hedge-funds investors will not
allows for some of the fees to be treated as capital gains rather than ordinary income. profit overall, but will still pay substantial performance fees to the winning managers.
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.
MANAGED ACCOUNTS 7
Many investors contract with investment professionals to help manage their invest-
6 FUNDS OF FUNDS 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
Funds of funds are investment vehicles that invest in other funds. They can be actively ensure that these professionals will not profit from recommending excessive trading.
managed or passively managed. 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
Fund services, such as brokerage, investment advice, financial planning, and investment
$€ 1 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.
Fund Investment managers can hold their institutional clients’ investments in separate
$ $ Fund accounts or in commingled accounts. In a commingled account, the capital of two or
¥€ of
Funds
¥€ 2 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.
¥€
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
TAX-ADVANTAGED ACCOUNTS AND MANAGING TAX
LIABILITIES
8
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 To promote savings for retirement income, educational expenses, and health expenses,
risk of their funds. many countries give tax advantages to certain investment accounts.
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.
338 Chapter 14 ■ Investment Vehicles Summary 339
Some countries allow all distributions from certain tax-advantaged accounts to be tax Whether investors should defer taxable income depends on the tax regime, their
free if the money is used for higher education or for health care. Distributions from expectations of future tax rates (including estate tax rates, which are imposed on the
retirement accounts are generally taxed as ordinary income. 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.
Governments usually prohibit early withdrawals or withdrawals for unauthorised Some investment professionals can help investors work through these issues.
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- SUMMARY
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 Companies in the investment industry offer many investment vehicles that help indi-
expenses are not taxable. vidual and institutional investors meet their investment needs. Investors use these
investment vehicles to reduce the cost of investing, control their risk exposure, and
Some tax-advantaged accounts allow the deferral of tax. Whether deferral is advanta-
improve their returns. By pooling their money in investment vehicles, investors can
geous depends on the tax rates at which the principal and investment income would
gain access to skilled professional investment managers, reduce risk through diversi-
otherwise be taxed and on the tax rates at which the deferred income will be taxed.
fication, and benefit from economies of scale.
If future tax rates are expected to be lower or the same as current tax rates, deferral
is advantageous. 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
Deferring taxes may not be beneficial if tax rates are expected to be higher in the
of investment vehicles designed to satisfy investors whose needs are diverse.
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.
340 Chapter 14 ■ Investment Vehicles Summary 341
This chapter provides an overview of the investment vehicles that investors commonly ■ Separate accounts can be managed for the exclusive benefit of a single investor,
use. Some important points to remember include the following: but they can be expensive to manage. In contrast, commingled accounts provide
investors the benefit of economies of scale in asset management.
■ Investors make direct investments by buying investment securities issued by
■ Tax-advantaged accounts allow investors to avoid or defer paying taxes on
companies and governments and real assets. Direct investors benefit from the
investment income and capital gains. Investors in taxable accounts can also
ability to choose the securities and assets they invest in, time their trades to
often minimise their tax liabilities through timing of investment decisions and
minimise their tax liabilities, and exercise control over their investments.
choice of 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.
■ 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.
LEARNING OUTCOMES
CHAPTER 15 b Explain the role of investment banks in helping issuers raise capital;
FINANCIAL MARKETS d Explain the roles of trading venues, including exchanges and alternative
trading venues;
by Larry Harris, PhD, CFA
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;
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
INTRODUCTION 1 founders and other early investors with a means of converting their investments into
cash, a process known as monetising.
Have you have ever bought shares, bonds, or invested money in a mutual fund? If The selling of new shares by a publicly traded company subsequent to its IPO is
so, you have—whether you realise it or not—been served by financial markets. Many referred to as a secondary, or seasoned, equity offering. Both initial public and sea-
investors use financial markets to implement their investment decisions, as reflected soned offerings occur in the primary market for a particular type of securities—for
by the trillions of financial market transactions each year. 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
Investors buy and trade securities that are issued by companies and governments that the issuer only receives additional capital when it issues new securities in the
that need to raise capital. Markets in which companies and governments sell their primary market. It will not receive any new capital from the trading of its securities
securities to investors are known as primary markets. Each type of security has its in the secondary market.
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.
Issue New Securities Securities (Buyer) or
(IPO) Cash (Seller)
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 Primary Secondary
variety of tasks, which were described in the Structure of the Investment Industry Market Market
Issuer Investor Issuer Exchange/ Investor
chapter. Broker
The issuer receives
Well-functioning financial markets are important for economic welfare. Investment no cash (capital) in
industry participants must understand how financial markets work; this understand- Cash secondary market Cash (Buyer) or
(Capital) transactions. Securities (Seller)
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 Before a public offering, the issuer typically provides detailed information about its
served by these markets, and what characterises well-functioning financial markets. 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
PRIMARY SECURITY MARKETS 2 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
Secondary markets are the main focus of this chapter because most investors buy and underwritten offering or a best efforts offering.
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 The most common offering type for initial public and seasoned offerings is an under-
in which issuers sell their securities to investors. In other words, primary markets are written offering. In an underwritten offering, the investment bank acts as an under-
where securities first become available to all investors. Issuers are typically companies writer. In this role, the investment bank buys the securities from the issuer at a price
and governments; selling securities to investors in exchange for cash is a way for these that is negotiated with the issuer, thus guaranteeing that the issuer gets the amount
companies and governments to raise money. The main primary market transactions of capital it requires. The securities are then sold at an agreed-on offering price to
are public offerings, private placements, and rights offerings. 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
2.1 Public Offerings unable to resell all the securities it bought from the issuer.
As discussed in the Equity Securities chapter, a company that sells securities to the
In a process called book building, the investment bank identifies investors who are
public for the first time makes an initial public offering (IPO), sometimes also called a
willing to buy the securities. These investors are known in the industry as subscribers.
placing or placement. Practitioners say that the company is “going public”. The shares
The investment bank tries to build a book of orders from clients or other interested
© 2015 CFA Institute. All rights reserved. buyers to whom they can resell the securities.
Primary Security Markets 347 348 Chapter 15 ■ The Functioning of Financial Markets
In the book building process, the right offering price is particularly important. If
Exhibit 1 Roles of Those Involved in a Public Offering
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
Participant Role
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 Issuer Makes new shares or shares held by the founders and other
all investors get a set proportion of the shares they ordered. early investors available for sale to the public.
Provides detailed information about its business and inherent
In the case of undersubscription, the investment bank will be left with unsold secu- risks as well as the proposed uses for the funds.
rities, which not only commits capital for longer than expected but is also risky. If
Investment bank Identifies investors who are willing to buy the securities and
after the public offering, the price of the securities falls below the offering price, the helps sell the securities to the public.
investment bank may face a loss. So, investment banks have a conflict of interest with
Underwritten offering
respect to the offering price in underwritten offerings. As agents for the issuers, they
Buys the securities from the issuer at a price that is negoti-
should price the issue to raise the most money for the issuer. But as underwriters, ated with the issuer and then resells them to investors at the
they have strong incentives to choose a lower price because it reduces the risk of offering price. This effectively guarantees that the issuer gets
the offering being undersubscribed. Underwriters can also allocate these essentially the amount of capital it expects.
“underpriced” securities to benefit their clients, a process that indirectly benefits the In an initial public offering, it also promises to ensure that
investment bank. the secondary market for the securities will be liquid and to
provide price support for a limited period of time.
First-time issuers may accept lower offering prices because they are concerned about
Best effort offering
the possibility of the issue being undersubscribed. Many believe that an undersub- Only acts as a broker of the offered securities and does not
scribed IPO conveys unfavourable information about a company’s prospects at a time assume the risk associated with buying the securities.
when the company is most vulnerable to public opinion about its future. The issuer
Syndicate Helps the lead underwriter build the book of orders.
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.
Companies sometimes sell new issues of seasoned securities directly to the public over
In an IPO, the underwriter usually promises to ensure that the secondary market for time via shelf registrations. In a shelf registration, the company provides the same
the securities will be liquid. If necessary, the underwriter provides price support for detailed information that it would for a regular public offering. However, in contrast
a limited period of time, typically about a month. During that time, if the price of the to a seasoned offering in which all the shares are sold in a single transaction, a shelf
securities falls below a certain threshold, the underwriter will buy securities to stop registration allows the company to sell the shares directly to investors over a longer
or limit the price fall. Providing price support is costly to investment banks, and it is period of time. Shelf registrations provide companies with flexibility on the timing of
another factor that motivates them to choose a lower offering price so that the secu- raising capital, and they can alleviate the downward pricing pressures often associated
rity’s price in the secondary market rises immediately following the IPO. However, with large secondary offerings.
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.
2.2 Private Placements
Pricing is less challenging in a seasoned offering because the issuer’s securities already Companies sometimes issue their securities to select investors via private placements.
trade in the secondary market. Thus, it is easier to identify an appropriate price for the In a private placement, companies sell securities directly to a small group of inves-
offering. The fees charged for a seasoned offering are lower than for an initial public tors, usually with the assistance of an investment bank that helps identify potential
offering because there is less risk. investors and set the price of the securities.
A single investment bank may not have the distribution network, capital, or risk appe- Investors in private placements are expected to have sufficient knowledge and expe-
tite to organise a large offering, so large offerings are often organised by a syndicate rience to recognise the risks that they assume, so most countries require less disclo-
that includes several investment banks. The syndicate helps the investment bank that sure for private placements than for public offerings. Thus, private placements allow
leads the offering (known as the lead underwriter) to build the book of orders. The quicker access to capital with less regulatory oversight and lower cost of regulatory
issuer pays the investment banks an underwriting fee for all these services. compliance than public offerings.
In a best efforts offering, the investment bank acts only as a broker and does not Issuers can raise money in the primary markets at a lower cost when their securities
assume the risk associated with buying the securities. If the offering is undersubscribed, can be traded in liquid secondary markets. Investors value liquidity because they
the issuer will sell fewer securities and may not be able to raise as much capital as it may need to sell their securities quickly to raise cash. So investors will pay less for
had planned. 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
Exhibit 1 summarises the roles of those involved in a public offering.
Primary Security Markets 349 350 Chapter 15 ■ The Functioning of Financial Markets
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.
3 TRADING VENUES
So far in this chapter, we have described how primary markets operate; the rest of
Sell New or Existing Securities
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
Private want to trade give trading service providers, such as brokers and dealers, who are
Placement discussed in the Structure of the Investment Industry chapter.
Qualified This section discusses exchanges and alternative trading venues and then compares
Issuer Investors
them.
Capital
3.1 Exchanges
Securities exchanges, or exchanges, are where traders can meet to arrange their
2.3 Rights Offerings 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
Companies can also raise capital and issue new shares via rights offerings. In a rights
submit to them electronically. These exchanges essentially act as brokers, blurring the
offering, a company allows existing shareholders to buy shares at a fixed price (called
distinction between exchanges and brokers.
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 The main distinction between exchanges and brokers is their regulatory operations.
right of first refusal on any new equity offerings. Without such rights, the issuing com- Most exchanges regulate their members’ actions when trading on the exchange and
pany’s management could dilute (reduce) the ownership interests of existing investors. sometimes also away from the exchange. Brokers generally regulate trading only in
their brokerage systems.
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 Many exchanges also regulate the issuers that list on the exchange, generally requiring
rights is typically set below the current market price of the shares so that buying shares timely financial reporting and disclosure. Financial analysts use this information to
by exercising the rights is immediately profitable—that is, an existing shareholder can value the securities traded on the exchange. Without such information, valuing secu-
pay the exercise price and get shares that can immediately be sold at a higher market rities would be difficult and market prices might not reflect the fundamental values
price for a profit. Accordingly, most rights are exercised. 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
Existing shareholders who do not want to exercise their rights will be “diluted”—that
they had a complete understanding of the security’s investment characteristics. When
is, their proportional ownership will decrease because they will hold the same number
market prices do not reflect fundamental values, well-informed participants can profit
of shares in a company that now has more shares outstanding. By selling their rights
from less-informed participants. To avoid losses, less-informed participants withdraw
to others who will exercise them, they receive compensation for the decrease in their
from the market, which is detrimental not only to the investment industry but also
proportional ownership. Shareholders generally dislike rights offerings because they
to the wider economy.
must provide additional capital to avoid dilution or sell their rights and experience
dilution of ownership. 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
2.4 Other Primary Market Transactions from concentrating voting rights in the hands of a few shareholders who do not own
a proportionate share of the company’s equity.
The national governments of financially strong countries generally issue their debt
securities in public auctions. These governments may also sell securities to dealers, Exchanges derive their regulatory authority from their national or regional govern-
who then resell them to their clients. Smaller and less financially secure national ments or through voluntary agreements by their members and their issuers. In most
governments often contract with investment banks to help them sell their securities. countries, regulators created by the national government oversee exchanges. Most
countries also have regulators that impose financial disclosure standards on public
issuers.
Trading Venues 351 352 Chapter 15 ■ The Functioning of Financial Markets
Exchanges charge fees for their services. They may charge the buyer, the seller, or quotes and orders. Quotes are prices at which dealers are prepared to buy and sell
both parties a transaction fee, which is essentially a commission for facilitating trades. securities and are discussed in Section 6. Markets are said to be post-trade transparent
Transaction fees and other transaction costs are further discussed in Section 8. if the trading venue publishes trade prices and sizes soon after trades occur.
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
4 TRADING IN SECONDARY MARKETS
intermediation of dealers or brokers, which makes them lower-cost trading venues.
Some alternative trading venues operate electronic (computerised) trading systems Trading in secondary markets is the successful outcome of searches in which buyers
that are similar to those operated by exchanges. Others operate innovative trading look for sellers and sellers look for buyers. A critical key to success is liquidity because
systems that suggest trades to their clients based on information that clients share when markets are liquid, the costs of finding a suitable counterparty to trade with
with them or that they obtain through research into their clients’ preferences. are low.
One type of alternative trading venue is a crossing network, which is an electronic Secondary markets are organised either as call markets or as continuous trading mar-
trading system that matches buyers and sellers who are willing to trade at prices kets. In a call market, participants can arrange trades only when the market is called,
obtained from exchanges or other alternative trading venues. Crossing networks are which is usually once a day. In contrast, in a continuous trading market, participants
popular with investors who want to trade large blocks of securities without risking can arrange and execute trades any time the market is open. Most markets, including
moving the price of those securities by submitting an order to an exchange. alternative trading venues, are continuous.
Some alternative trading venues are known as dark pools because of their lack of Buyers can easily find sellers and vice versa in call markets because all traders interested
transparency. Dark pools do not display orders from clients to other market partici- in trading (or orders representing their interests) are present at the same time and
pants. Large institutional investors may transact in dark pools because market prices place. Trading venues that are call markets have the potential to be very liquid when
often move to their disadvantage when other traders know about their large orders. 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-
3.3 Comparison of Trading Venues driven, and brokered markets.
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 4.1 Quote-Driven Markets
how to match buyers and sellers, vary depending on the trading venue.
Quote-driven markets, also called dealer markets or price-driven markets, are markets
Electronic trading systems have greatly decreased the costs of arranging trades. The in which investors trade with dealers. These markets take their name from the fact
lower costs of trading have increased trading volumes, and investors now use many that investors trade with dealers at the prices quoted by the dealers. Almost all bonds
investment strategies that were previously too expensive to implement. and currencies, and most spot commodities (commodities for immediate delivery),
trade in quote-driven markets.
An important distinction between exchanges and alternative trading venues is the reg-
ulatory authority that exchanges exert over users of their trading systems. Alternative Quote-driven markets are also referred to as over-the-counter (OTC) markets because
trading venues only control the conduct of subscribers who use their trading systems. securities once literally traded over a counter in the dealer’s office. Now most trades
Another distinction among trading venues is related to trade transparency. A market in OTC markets are conducted electronically, by telephone, or sometimes via instant
is said to be pre-trade transparent if the trading venue publishes real-time data about messaging systems.
Positions 353 354 Chapter 15 ■ The Functioning of Financial Markets
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 5.2 Leveraged Positions
assets. Long positions increase in value when prices rise. In contrast, positions that In many markets, investors can buy securities on margin—that is, by borrowing
increase in value when prices fall are called short positions. To take short positions, some of the purchase price. When investors borrow to buy securities, they are said
investors must sell assets or securities that they do not own, a process that involves to leverage (or lever) their positions. A highly leveraged (or levered) position is one
borrowing the assets or securities, selling them, and repurchasing them later to return in which the amount of debt is large relative to the equity that supports it.
them to their owner. Section 5.1 describes this short-selling process more thoroughly,
and Section 5.2 discusses leveraged positions.
Positions 355 356 Chapter 15 ■ The Functioning of Financial Markets
Buying securities on margin increases the potential gains or losses for a given amount Some investors, including hedge funds and investment banks, get into trouble when
of equity in a position because the buyer can buy more securities using borrowed they use leverage. In an attempt to obtain greater profits by borrowing to increase
money. The use of leverage allows buyers to earn greater profits when prices rise. their positions, they often underestimate the risks to which they are exposed. If prices
But, equally, a buyer who has leveraged a position suffers greater losses when prices move against their positions, their losses can put them into financial distress or, in
fall. Buying securities on margin thus increases the risk of investing in the securities. extreme cases, bankruptcy.
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 6 ORDERS
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. 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
The leverage ratio is the ratio of a position’s value to the value of the equity in it. It is a sell, and how much should be bought or sold. In addition, most orders have other
useful measure because it indicates the effect of the return on the equity investment, instructions attached to them, including order execution, exposure, and time-in-force
as illustrated in Example 1. 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
EXAMPLE 1 are called ask prices (or offer prices). The ask prices are invariably higher than the
bid prices.
Leverage Ratio of a Position Dealers may also indicate the quantities that they will trade at their bid and ask prices.
Assume that an investor bought £250,000 of Toyota’s shares on margin. She These quantities are called bid sizes for bids and ask sizes for offers. Depending on
contributed £100,000 of her own money and borrowed £150,000 from her broker. the trading venue, these quotation sizes may or may not be exposed to other traders
The investor’s equity represents 40% of the value of the position: or dealers in that market.
£100,000/£250,000 = 40%. 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-
The leverage ratio is 2.5:
est bid in the market is the best bid and the lowest ask in the market is the best ask.
£250,000/£100,000 = 2.5. 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
A leverage ratio of 2.5 means that if Toyota’s share price rises by 10%, the investor
never be more) because dealers often quote better prices on one side of the market
will experience a 25% return on the equity investment in her leveraged position:
than on the other. Accordingly, the bids and asks that are the best bid and best ask in
2.5 × 10% = 25%. the market often come from different dealers.
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.
6.1 Order Execution Instructions
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. Order execution instructions indicate how to fill an order. Market and limit orders
are the most common execution instructions.
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 ■ A market order instructs the broker or trading venue to obtain the best price
investment by 2.5. These calculations do not count interest on the margin loan immediately available when filling the order.
and commission payments, both of which lower realised returns.
■ 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 357 358 Chapter 15 ■ The Functioning of Financial Markets
Market orders generally execute immediately if other traders are willing to take the 6.3 Order Time-in-Force Instructions
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 Time-in-force instructions indicate when an order can be filled. The most common
of orders at disadvantageous prices is particularly likely when the order is placed in time-in-force instructions are
a market for a thinly traded security or when the order is large relative to normal
trading activity in the market. ■ immediate or cancel orders, which can be executed only on immediate receipt
by the broker or trading venue;
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 ■ day orders, which can be executed only on the day they are submitted and are
they may not execute. Limit orders do not execute if the limit price on a buy order is cancelled at the end of that day;
too low or if the limit price on a sell order is too high. For example, if an investment
■ good-until-cancelled orders, which can be executed until they are cancelled;
manager submits a limit order to buy at €20 and nobody is willing to sell at or below
some brokers or trading venues may set a maximum numbers of days before the
€20, the order will not be filled.
order is automatically cancelled.
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
7 CLEARING AND SETTLEMENT
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 Brokers and trading venues, especially those that arrange trades among strangers, gen-
above the sell order’s stop price before the order trades, the order remains valid. For erally need intermediaries to help traders clear and settle orders that have been filled.
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 7.1 Clearing
market sell orders if prices are falling with the hope of stopping losses on positions The most important clearing activity is confirmation, which is performed by clearing
that they have established. These stop orders are often called stop-loss orders. 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
Some order execution instructions specify conditions on size. For example, all-or-
day of the trade and is necessary only for manually arranged trades. For electronic
nothing orders can trade only if their entire sizes can be traded. Traders can likewise
trades, confirmation is done automatically.
specify minimum fill sizes.
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
6.2 Order Exposure Instructions 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
Order exposure instructions indicate whether, how, and sometimes, by whom an to ensure that these members do not arrange trades that they cannot settle.
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. 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
Note that there is nothing wrong or unethical about hiding an order. Traders with large clients. The clearing members guarantee settlement of the trades that their clearing
orders use hidden orders when they are afraid that other investors might trade against clients present to them, and clearing houses guarantee settlement of all trades presented
them if they knew that a large order was in the market. In particular, large buyers fear to them by their clearing members. If a clearing member fails to settle a trade, the
that they will scare sellers away if their orders are seen. Sellers generally do not want clearing house settles the trade using its own capital or capital pledged by the other
to be the first to trade with large buyers because large buyers often push prices up. members of the clearing house.
Large buyers are also concerned that other buyers will be able to trade before them The ability to settle trades reliably is important because it allows strangers to confi-
by buying first to profit from any increase in price necessary to fill their large orders. dently contract with each other without worrying about counterparty risk. A secure
This increases the costs of filling large orders by taking buying opportunities away clearing system thus greatly increases liquidity because it vastly expands the number
from the large traders. Large sellers likewise fear that buyers will shy away from their of counterparties with whom a trader can confidently arrange a trade.
exposed orders and that other sellers will trade before them.
Clearing and Settlement 359 360 Chapter 15 ■ The Functioning of Financial Markets
settlement period, the fewer extreme price changes can occur before final settlement. Order
Remains
Open?
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 No
Order Closed Order Settled
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. * 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
Exhibit 2 shows the life of a trade from order to settlement/closure. An order for a occur when there are liquidity issues.
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.
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.
The order is filled and financial settlement takes place. A record of the
transaction is then sent to James Armistead, who works for Big Bank Financial
Services, a custodian bank. It provides safekeeping of assets, such as the shares
purchased by Aus Ltd. Big Bank Financial Services keeps a record of the security
and the price paid, and this record is available—usually online—so that Aus
Ltd. Can prove it owns the shares and can include them in its accounts.
Transaction Costs 361 362 Chapter 15 ■ The Functioning of Financial Markets
■ opportunity costs
Contacts with Submits Stock
Market Order Order Exchange James Armistead
O
Asset Exe rder 8.2.1 Bid–Ask Spread
Broker cut
Manager ed 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
Settles Order risk of buying and selling securities. Bid–ask spreads tend to be wider in opaque
and Keeps Record markets because finding the best available price is harder for dealers in such markets.
Custodian Transparency reduces bid–ask spreads, which benefits investors.
Bank
The commissions compensate brokers for the resources they use to fill orders. Brokers 8.3 Minimising Transaction Costs
must maintain order routing systems, market data systems, accounting systems,
Traders choose their order submission strategies to minimise their transaction costs.
exchange memberships, office space, and personnel to manage the trading process.
Efficient traders ultimately are more successful than those who do not trade well. They
These are all fixed costs. Brokers also pay variable costs, such as exchange, regulatory,
buy at lower prices, sell at higher prices, and less often fail to trade when they want to.
and clearing fees, on behalf of their clients. Traders who do not trade through brokers
pay the fixed and variable costs of trading themselves. 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
8.2 Implicit Trading Costs see their orders and exploit them.
Implicit trading costs are the indirect costs associated with trading. These costs result
from the following:
■ bid–ask spreads
Summary 363 364 Chapter 15 ■ The Functioning of Financial Markets
Most brokers and large institutional traders conduct transaction cost analyses of their ■ Investment banks play an important role in helping issuers raise capital. In
trades to measure the costs of their trading and to determine which trading strate- a public offering, they help the issuer identify potential investors and set the
gies work best for them. In particular, these studies help large institutional investors offering price for the securities.
better understand how their order submission strategies affect the trade-off between
■ In underwritten offerings, the investment bank guarantees the sale of the
transaction costs and opportunity costs.
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.
■
EFFICIENT FINANCIAL MARKETS 9 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
As described in the previous section, low transaction costs are an important char- placements or rights offerings. In a private placement, companies sell securities
acteristic of well-functioning financial markets because they benefit everyone who directly to a small group of investors, usually with the assistance of an invest-
needs to trade. Low transaction costs contribute to making financial markets efficient. ment bank. In a rights offering, companies give existing shareholders the right
Financial market efficiency increases investor confidence, which ultimately lowers the to buy shares in proportion to their holdings at a price that is typically set below
costs that companies pay to raise capital. the current market price of the shares, thus making the exercise of the rights
immediately profitable.
The following are the three types of efficiency that ultimately contribute to efficient
■ Liquid secondary markets reduce the costs of raising capital because investors
financial markets:
value the ability to sell their securities quickly to raise cash.
■ Operational efficiency. Operationally efficient markets have low transaction ■ Secondary markets require a trading venue—either physical or electronic—
costs and they can absorb large orders without substantial price impacts. The where trading among investors can take place. Most secondary market trading
most operationally efficient markets tend to be those in which many people are globally is now done via electronic trading systems.
interested in trading the same securities in the same trading venue.
■ Exchanges are the most common type of trading venue, but alternative trad-
■ Informational efficiency. Informationally efficient prices reflect all available ing venues, which have their own rules, have gained in popularity. The two
information about fundamental values. They are crucial to an economy’s welfare main distinctions between exchanges and alternative trading venues are that
because informationally efficient prices help ensure that the resources available exchanges typically have regulatory authority and more trade transparency than
to the economy, such as labour, capital, materials, and ideas, are used wisely. alternative trading venues.
■ Allocational efficiency. Allocationally efficient economies are economies that ■ Markets vary in how trades are arranged. In quote-driven markets, investors
put resources to use where they are most valuable. Economies that misallocate trade with dealers at the prices quoted by the dealers. Order-driven markets
their resources tend to waste resources and consequently are often relatively arrange trades using rules to match buy orders with sell orders. In brokered
poor. markets, which are usually markets for assets that are unique, brokers arrange
trades among their clients.
■ When investors borrow some of the purchase price to buy securities, they are
Financial markets that function efficiently benefit all investors by keeping transaction
said to buy securities on margin and leverage their positions. Leveraged posi-
costs low and allowing investors to trade financial instruments easily.
tions expose investors to more risk and higher potential gains and losses than
Some important points to remember about financial markets include the following: otherwise identical debt-free positions.
■ Orders are instructions to trade. They always specify what security to trade,
■ Issuers sell their securities and raise capital in primary markets. The securities whether to buy or sell, and how much should be bought or sold. They usually
then trade in secondary markets among investors. provide several other instructions as well, such as execution instructions about
Summary 365
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
CHAPTER 16
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.
INVESTORS AND THEIR NEEDS
by Alistair Byrne, PhD, CFA
■ 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
lowest 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.
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.
invest. Many investment firms make a distinction between their retail clients, more 2.1.1 Retail Investors
affluent clients with larger amounts, and high- and ultra-high-net-worth investors Retail investors are by far the most numerous type of investor. They buy and sell
with the largest amounts of investable assets. relatively small amounts of securities and assets for their personal accounts. They
may select investments themselves or hire advisers to help them make investment
There is no defined standard in the industry to classify individual investors by investable
decisions. They also may invest indirectly by buying pooled investment products, such
assets; each investment firm designates its own categories and values within those
as mutual fund shares or insurance contracts.
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 The investment industry provides mostly standardised services to retail investors
(retail, affluent, wealthy, high net worth, very high net worth, and ultra-affluent). Firms because they generate the least revenue per investor for investment firms. Many
that use the same categories may have different cutoff points. For example, one firm retail investment services are delivered over the internet or through customer service
may classify retail clients as those with investable assets up to €100,000, and another representatives working at call centres.
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 INVESTOR PROFILE: ZHANG LI
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.
Zhang Li is a retail investor whom we met in The
An investment firm that focuses on retail investors has to service the needs of a large Investment Industry: A Top-Down View chapter. She
earns 5,000 Singapore dollars a month and wants to
number of relatively small accounts. Often, this means consolidating the retail inves-
save for a deposit on an apartment in the suburbs of
tors’ assets into a smaller number of funds and having automated processes for the
Singapore. She also wants to save to pay for her son’s
administration of client fund holdings. university education in 10 years’ time. To accumulate
money for the apartment deposit, she can save using
An investment firm or division within an investment firm focussing on high-net-
short-term, low-risk investments. She can save using
worth investors may have fewer clients, but higher average account balances, than longer-term investments, such as mutual funds of shares
one that focuses on retail investors. Investor assets may still be invested in funds, but and bonds, for her son’s education.
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. 2.1.2 High-Net-Worth Investors
Wealthier investors generally receive more personal attention from investment per-
Individual investors vary in their level of investment knowledge and expertise. Some sonnel. Their investment problems often involve tax and estate planning issues that
individual investors have relatively limited investment knowledge and expertise, require special attention. They either pay directly for these services on a fee-for-service
and others are more knowledgeable, perhaps as a result of their education or work basis or indirectly through commissions and other transaction costs.
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 INVESTOR PROFILE: MIKE SMITH
2013, restricts investments in hedge funds to accredited investors, which in the case
of individuals means having a net worth in excess of $1 million and/or an income in Mike Smith is a high-net-worth investor whom we
excess of $200,000. This restriction is presumably based on the logic that wealthier met in The Investment Industry: A Top-Down View
investors are expected to have a higher level of investment knowledge or at least be chapter. He recently sold his technology company and
better able to pay for advice and better able to bear risk. has $10 million to invest. He wants to invest not only
to meet his lifestyle needs but also to plan his estate to
Additional aspects of the personal situations of individual investors—such as age and secure his children’s future and leave a large charitable
family obligations—will also differ and affect their investment needs and decision donation after his death. He has expressed an interest in
making. The expected holding period (time or investment horizon) for investments, investing globally in real estate.
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.
372 Chapter 16 ■ Investors and Their Needs Types and Characteristics of Investors 373
2.1.3 Ultra-High-Net-Worth Investors and Family Offices Money from employer and/or employee contributions is set aside to provide income
Very wealthy individuals usually employ professionals who help them manage their to plan members when they retire. The contributions must be invested until the
investments, future estates, and legal affairs. These professionals often work in a employee retires and receives the retirement benefits.
family office, which is a private company that manages the financial affairs of one or
Pension plans differ by whether they are organised as defined benefit or defined
more members of a family or of multiple families. Many family offices serve the heirs
contribution plans.
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 2.2.1.1 Defined Benefit Plans Defined benefit pension plans promise a defined annual
travel arrangements, and planning social events. 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.
Wealthy families often have substantial real estate holdings and large investment Typically, employees do not have the right to receive benefits until they have worked for
portfolios. The investment professionals who work in family offices generally manage the company or government for a period specified by the pension plan. An employee’s
these investments using the same methods and systems that institutional investors rights are vested (protected by law or contract) once they have worked for that period.
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- Defined benefit pension funds, particularly those of government-sponsored plans,
erations or charitable institutions. 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
2.2 Institutional Investors will decrease over time.
Institutional investors are organisations that hold and manage portfolios of assets for
themselves or others. There are many different types of institutional investors with In a defined benefit pension plan, the sponsoring employer promises its members
varying investment requirements and constraints. Institutional investors may invest (or employees) a defined amount of benefit. For example, it is quite common for the
to advance their mission or they may invest for others to meet the others’ needs. employer to promise an annual pension that is a set proportion of the employee’s
Institutional investors that invest to advance their missions include pension plans, final pre-retirement salary. The pension may be adjusted for inflation over time. The
endowment funds and foundations, trusts, governments and sovereign wealth funds, employer will make contributions to the pension fund to fulfil the promise. Employees
and non-financial companies. Institutional investors that invest to provide financial may also be asked to contribute.
services to their clients include investment companies, banks, and insurance companies.
In a defined benefit plan, the employer bears the risk—in this case, that the invest-
These institutional investors may also provide services to the institutional investors
ments made by the pension fund fail to perform as expected. If the investments fail to
that invest to advance their missions.
perform as expected, the employer may be required to make additional contributions
Some institutional investors manage their investments internally and employ investment to the fund. However, it is possible that pension sponsors will be unable to make the
professionals whose job it is to select the investments. Other institutional investors necessary contributions and that beneficiaries will not receive the benefits expected.
outsource the investment of the portfolio to one or more external investment firms. Defined benefit plans are becoming less common around the globe and are being
The choice between internal and external management will often be driven by the size replaced by defined contribution plans.
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.
INVESTOR PROFILE: EURO PENSION FUND Defined Benefit Plan Defined Contribution Plan
Investments are chosen by a pension fund Investments are chosen by the member.
Euro Pension Fund is the fund for a defined benefit manager(s).
pension plan located in Frankfurt, Germany. The plan
Risk that investments do not perform Risk that investments do not perform
sponsor remits money to the fund based on estimates
as expected is borne by the employer. as expected is borne by the member.
of pension benefit obligations compared with pension
Employer may need to make additional Member may need to adjust lifestyle or
plan assets. Working members of the plan also pay a
contributions. defer retirement.
portion of their wages to the fund. Each month, the
fund pays out money to the retired members of the In the past, most pension plans were defined benefit pension plans. Because these
pension plan. The fund must invest to pay both short- plans promise defined benefits to their beneficiaries, they are expensive obligations
term benefits and benefits that will be payable many for the sponsor (employer) and many sponsors no longer offer them. This change
years from now. It needs a complex blend of invest- explains why defined contribution pension plans are increasingly replacing defined
ments in a wide range of assets to achieve its goals. It
benefit plans in most countries.
has an asset management team that devises the fund’s
strategy and implements it. Anna Huber is a member of
that team. 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
2.2.1.2 Defined Contribution Pension Plans In a defined contribution pension plan, universities, colleges, schools, museums, theatres, opera companies, hospitals, and
the pension sponsor typically contributes an agreed-on amount—the defined contri- clinics. These organisations use their endowment funds to provide some services
bution—to an account set up for each employee. Employees also generally contribute to their students, patrons, and patients. Foundations are grant-making institutions
to their own retirement plan accounts, usually through employee payroll deductions. funded by gifts and by the investment income that they produce. Most foundations do
The contributions are then invested, normally in funds that the employee chooses from not directly provide services. Instead, they fund organisations that provide services in
a list of eligible funds within the plan. The plan provides enough choices of funds to such areas as the arts or charities. Foundations often own endowment funds, which
allow employees to create a broadly diversified portfolio. The sponsor generally limits invest the foundation’s money.
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 Endowment funds and foundations typically have a charitable or philanthropic pur-
reasonable. At retirement, the balance that has accumulated in the account is available pose and receive gifts from donors interested in supporting their activities. In many
for the employee. 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
In defined contribution plans, the member (or employee) bears the risk that the pen- income and capital gains that these organisations receive from investing these funds
sion account’s investments fail to perform as expected. This contrasts with defined may also be tax-exempt.
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 Endowment funds are usually intended to exist in perpetuity and, as such, are regarded
perform poorly. If the retirement fund is less than expected, the employee may have as very long-term investors. But they are also typically required to spend annually
to make do with less retirement income or, possibly, defer retirement. Because saving on the charitable or philanthropic purpose for their existence, so money needs to be
enough and choosing the right investments are very important, defined contribution drawn from their funds. Many endowment funds and foundations establish spending
plan sponsors are increasingly providing financial guidance to their beneficiaries or rules; for example, they may set spending goals of a percentage range of their assets.
arranging for financial planners to help guide members. Often, their challenge lies in balancing long-term growth with shorter-term income
or cash flow requirements.
2.2.1.3 Comparison of Defined Benefit and Defined Contribution Pension Plans 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
Defined Benefit Plan Defined Contribution Plan 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-
Member’s benefit in retirement is defined. Member’s benefit in retirement is not ing. These differences have implications for how the institutional investor’s assets
defined.
are invested. An endowment client that is restricted from fundraising has to meet
Employer’s contributions are not defined. Employer’s contributions are defined. 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.
Non-financial companies invest money that they do not presently require to run their
INVESTOR PROFILE: PHILANTHROPY FOUNDATION
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
Philanthropy Foundation was started in 1950 with a gift typically include cash that the company will need soon to pay salaries and accounts
of $1 million. The foundation invested its money, raised
payable and financial vehicles that are safe and liquid, including demand deposits
no additional money, and now has assets of $250 mil-
(checking accounts), money market funds, and short-term debt securities issued by
lion. The foundation supports various charitable causes
and is committed to donating $5 million every year,
governments or other companies.
although it typically makes donations in excess of this
Long-term investments are usually managed under the direction of the chief financial
amount. Gertrude Ahlbergson is the chief investment
officer or the chief investment officer, if the company has one. Companies often invest
officer for Philanthropy Foundation. She has deter-
mined that because the foundation is designed to exist long-term to finance future research, investments, and acquisitions of companies and
forever, it can have some very long-term investments. It products. Companies may invest long-term directly, or they may hire investment
can afford to take considerable investment risk because managers to invest on their behalf.
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.
INVESTOR PROFILE: UK TECHNOLOGY
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.
INVESTOR PROFILE: CROWN STATE MONEY
Practitioners call these investments “strategic investments.” These types of investments
are common in Asian countries, such as Japan and South Korea, and in European
Crown State Money is a sovereign wealth fund created countries, such as France, Germany, and Italy.
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 2.2.5 Investment Companies
forever, so the fund invests for the long term in order
to sustain the country’s development and benefit future
Investment companies include mutual funds, hedge funds, and private equity funds.
generations if oil revenues fall. Neil Thornmarshal is These companies exist solely to hold investments on behalf of their shareholders,
employed by Crown State Money to manage the money partners, or unitholders (units refer to shares and bonds for equity and debt securities,
it allocates to alternative investments. 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
2.2.4 Non-Financial Companies
firms often organise and market the investment companies that they manage and thus
Analysts often identify companies as either financial companies or non-financial serve as the investment sponsors.
companies. Financial companies include investment companies, banks and other
lenders, and insurance companies. These companies provide financial services to Mutual funds pool the assets of many investors into a single investment vehicle, which
their clients. In contrast, non-financial companies produce goods and non-financial is professionally managed and benefits from economies of scale. There are thousands
services for their customers. of mutual funds managed by investment management firms. Mutual funds are typ-
ically categorised by their investment(s). Investments eligible for inclusion may be
378 Chapter 16 ■ Investors and Their Needs Types and Characteristics of Investors 379
narrowly or broadly defined and based on types of assets, geographic area, and so on. longer-term time horizons and more predictable payouts and, therefore, have more
For example, mutual funds may indicate that they invest in Chinese equities identified latitude to invest in riskier assets. They usually invest their reserve funds, which often
as having growth potential, global equities, long-term investment-grade European are very large, in securities, commodities, real estate, and other real assets.
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. INVESTOR PROFILE: ABC INSURANCE
Hedge funds and private equity funds can similarly be considered institutional investors ABC Insurance is a global insurance company that insures thousands of peo-
that manage private investment pools and as investment vehicles. They are distin- ple’s lives. It takes the monthly premiums its clients pay for their insurance
guished by their use of strategies beyond the scope of most traditional mutual funds. 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.
2.2.6 Insurance Companies
Insurance companies comprise another important category of institutional investor.
Insurance companies collect premiums from the individuals and companies they Isabel Robilio
insure. Premiums are payments that insurance companies require to provide insurance Zhang Li
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 Money to Makes
Be Invested Investment
diversified portfolios of securities and assets that aim to ensure that sufficient funds Premiums Financial
are always available to satisfy all claims. Regulators often set requirements to restrict Markets
the types of investments insurance companies can hold. Insurance companies profit Returns
Insurance
from income that they can earn on the float, which is the amount of money they have Company
available to use after receiving premiums and before paying claims.
Zhang Li, the retail investor described in Section 2.1.1, purchased life insur-
Pays Invests Premiums ance from ABC Insurance to provide money for her family in the event of her
Premium in a Reserve Fund 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.
Insured or Insurance Diversified
Investor Company Portfolio 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.
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
3 FACTORS THAT AFFECT INVESTORS’ NEEDS 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
Each investor—individual or institutional—has different investment objectives. Key risk and able to withstand losses.
factors that are common to all investors but that will vary for each investor include
the following: 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
■ Required return
their investments within the defined contribution plan.
■ Risk tolerance
■ Time horizon
3.2 Risk Tolerance
Investors may also have specific needs in relation to liquidity, tax considerations, Investors typically have limits on how much risk they are willing and able to take with
regulatory requirement, consistency with particular religious or ethical standards, or their investments. As noted earlier, there is a link between risk and return. Typically,
other unique circumstances. Investors’ circumstances and needs change over time, the higher the expected return, the higher the risk associated with that return. Equally,
so it is important to re-evaluate their needs at least annually. 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.
There may be situations in which an investor’s willingness to take risk and his or her An individual may also require that a portion of the portfolio be liquid to meet
ability to take risk differ. In such situations, the investment adviser should counsel the unexpected expenses. In addition, the individual may have known future liquidity
investor on risk and determine the appropriate level of risk to take in the portfolio, requirements, such as a planned future expenditure on children’s education or retire-
taking into account both the investor’s ability and willingness to take risk. The lesser ment income needs.
of the two risk levels should be the risk level assumed.
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
3.3 Time Horizon to the plan) and will need to sell off some portfolio investments to meet those needs.
The investor and adviser must be clear on the time horizon for the investments. Some It needs to hold liquid assets in order to do this.
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
3.5 Regulatory Issues
expects to have to meet claims in the next few years will have a short time horizon, Some types of investors have regulatory requirements that apply to their portfolios.
whereas a sovereign wealth fund that is investing oil revenues for the benefit of future For example, in some countries and for certain types of institutional investors, there
generations will have a long time horizon, possibly decades. 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
In the case of individual investors, for example, someone who is planning on buying are typically extensive. Exhibit 2 shows some restrictions that apply to institutional
a new home or paying for college in two or three years will have a short horizon for pension funds in selected countries as of September 2012. In all the countries shown,
at least a portion of his or her investments. A 20-year-old saving for retirement will restrictions exist on the amount of the pension fund that can be invested in equity.
typically have a long horizon, probably more than 40 years.
Maximum Maximum
Equity Foreign
Country Investment Investment Other
The investment horizon has important implications for how much risk can be taken
United States No limit No limit Restrictions on buying shares or bonds
with the portfolio and the level of liquidity that may be required. Liquidity is the
of sponsor
ease with which the investment can be converted into cash. For example, an illiquid
Switzerland 50% No limit Limit of 30% for real estate
private equity investment with a likely payoff in 10 years would be unsuitable for an
investor with a 5-year horizon. Denmark 70% No limit —
Austria 70% 30% —
Investors with longer time horizons should be able to take more risk because they
Mexico 30% 20% Maximum equity shown is an approxi-
have more time to adapt to their circumstances. For example, they can save more to mation; it varies by fund category.
compensate for any losses or returns that are less than expected. History shows that
Korea 30% No limit Real estate investments are not per-
over time, markets go up more often than they go down, so an investor with a longer
mitted in defined benefit plans.
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 Source: Based on data from www.oecd.org.
poor performance, although recovery cannot be guaranteed.
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
INVESTMENT POLICY STATEMENTS 4
(i.e., dividends from shares).
It is good practice to capture information about the client and the client’s needs in
Individuals may also face different tax circumstances for different parts of their wealth. an investment policy statement (IPS). An IPS—for both individual and institutional
For example, an individual may choose to hold some assets in a pension account if investors—serves as a guide for the investor and investment manager or adviser
income and capital gains on assets held in a pension account are tax-exempt or tax- regarding what is required of and acceptable in the investment portfolio. An IPS also
deferred. The investor may choose to hold assets expected to generate capital gains forms the basis for determining what constitutes success in managing the portfolio.
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 The IPS should capture the investor’s objectives and any constraints that will apply to
and wealth accumulation. 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
3.7 Unique Circumstances opportunity for the investment manager and client to discuss the client’s goals.
Many investors have particular requirements or constraints not captured by the A common format for an IPS is to split it into sections covering objectives and con-
standard categories discussed so far. 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
Some investors have social, religious, or ethical preferences that affect how their 3. The following format is typical:
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. ■ Objectives
Other investors may require investments that are consistent with certain religious
beliefs. For example, some investors may not invest in conventional debt securities ● Return requirement
because they do not believe they comply with Islamic law.
● Risk tolerance
Investors may also have specific requirements that stem from the nature of their broader
■ Constraints
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
● Time horizon
help the employee reduce single-company exposure and gain broader diversification.
Interestingly, many individuals are actually inclined to boost their holdings in their ● Liquidity
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 ● Regulatory constraints
its financial position declines. For example, many employees of Enron Corporation, a
● Taxes
US energy company, not only lost their jobs but also suffered significant investment
losses when Enron went bankrupt. ● Unique circumstances
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 A typical IPS covers objectives and constraints, but many investors, especially insti-
avoid investing in tobacco stocks because it believes encouraging tobacco smoking is tutional investors, will also include procedural and governance issues in the IPS. The
counter to its objectives of improving health. 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.
386 Chapter 16 ■ Investors and Their Needs Summary 387
■ the general objectives (including return objectives) of the investment program ■ The investment industry provides services to individual investors—from those
and their relationship to the mission of the institution of modest means (retail customers) to the very wealthy with a substantial
amount of money to invest. Investment services are also provided to many
■ the risk tolerance of the organisation and its capacity for bearing risk
types of institutional investors, such as pension plans, endowment funds and
■ all economic and operational constraints, such as tax considerations, legal and foundations, governments and sovereign wealth funds, non-financial compa-
regulatory circumstances, and any other special circumstances nies, investment companies, and insurance companies.
■ ■ Needs vary among different investor types. Clients have their own objectives
the time horizon over which funds are to be invested
related to their circumstances and have different constraints that apply to their
■ the relative importance of capital preservation and capital growth portfolios. Key dimensions include
■ the asset classes in which the institution is allowed to invest ● return requirement—before and after tax,
■ a target asset allocation that indicates what proportion of the investment funds ● risk tolerance, and
will be invested in each asset class
● time horizon.
■ whether leverage (use of debt) or short positions are allowed
■ Investors may also have particular requirements related to liquidity, tax, regu-
■ how actively the institution will trade lation, and other unique circumstances, including consistency with particular
religious or ethical standards.
■ how investment decisions will be made
■ It is good practice to capture the needs of an investor in an investment policy
■ the benchmarks against which the institution will measure overall investment statement. The investment policy statement serves as a guide for the investment
returns manager or adviser regarding what is required of and acceptable in the invest-
ment portfolio.
The board of the institution or its senior leadership formally adopts the investment
and payout policies. ■ The investment policy statement should capture the investor’s objectives and
any constraints that will apply to the portfolio. An investment policy statement
The investment leaders decide whether to manage investments in-house or to contract is typically divided into sections that cover objectives and constraints. Each
with one or more investment managers. Institutional investors that manage their invest- section has its own subsections.
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.
LEARNING OUTCOMES
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
SYSTEMATIC RISK, SPECIFIC RISK, AND DIVERSIFICATION 2 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
How well investment risk is managed is a key determinant of the success of invest- over the long term.
ment management. Risk occurs when there is uncertainty—meaning that a variety of Portfolio theory suggests that taking on more specific risk does not necessarily lead
outcomes are possible from a particular situation or action. In investment terms, risk to higher returns on average because specific risk can be diversified away. But some
is the possibility that the actual realised return on an investment will be something investors may try to identify shares that they expect to outperform (to earn higher
other than the return originally expected on the investment. There will be times when returns than expected based on their risk) and invest in them rather than diversifying.
the return fails to meet an investor’s expectations and times when the return exceeds In the process, investors take on specific risk; if they turn out to be correct, they may
expectations. Fluctuations in the prices and values of investments (capital gains and earn a higher return as a result of taking on more risk.
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- 2.2 Diversification
comes and more certainty, all other things being equal. The trade-off between risk
Diversification is one of the most important principles of investing. When assets and/
and return is a fundamental issue in investment management. Typically, the higher
or asset classes with different characteristics are combined in a portfolio, the overall
the risk of an investment, the higher the expected return; the lower the risk, the lower
level of risk is typically reduced.
the expected return.
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
3 ASSET ALLOCATION AND PORTFOLIO CONSTRUCTION
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. 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
Most investors hold more than two securities in their portfolios. Adding more secu- the portfolio is determined. This determination involves decisions regarding which
rities to a portfolio will reduce risk through diversification, although eventually the asset classes are suitable (e.g., global equities, domestic government bonds, commod-
additional benefits begin to lessen. Exhibit 1 shows the levels of risk—total, specific, ities, or domestic real estate investment trusts) and the proportion of the portfolio to
and systematic—for portfolios of shares chosen at random from all of the shares in invest in each asset class. In some cases, the asset allocation decision is documented
the US market. Specific risk is reduced by combining additional shares, but as the as part of the IPS; in other cases, asset allocation is regarded as part of the subsequent
portfolio moves beyond 30 shares, the incremental risk reduction becomes small and implementation of the IPS.
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. 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
Exhibit 1 Portfolio Risk
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.
Specific
Total Risk
Risk
Risk of Market
Portfolio EXAMPLE 1 STRATEGIC ASSET ALLOCATION
Systematic
Risk 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
1 5 10 20 30
yielding 4%, and the committee’s expectation for the long-term return on the
Number of Shares global equity market is 9%.
A portfolio allocation of 40% bonds and 60% equity gives an expected return
Exhibit 1 assumes randomly chosen shares. There is the potential for greater risk of 7%:
reduction when shares with low correlation to each other are chosen.
(0.40 × 0.04) + (0.60 × 0.09) = 0.07 or 7%
Combining different asset classes can also improve diversification and reduce a The committee has to consider the level of risk implied by this asset allocation.
portfolio’s risk by reducing specific risk. For example, an investor might combine If the committee is not comfortable with the risk, the return requirement may
investments in various stock and bond markets with investments in real estate and need to be reduced. The portfolio mix can be adjusted as bond yields change and
commodities to reduce the overall risk of a portfolio. the committee revises its expectations for the return on the global equity market.
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.
Asset Allocation and Portfolio Construction 395 396 Chapter 17 ■ Investment Management
Strategic asset allocation typically requires investment managers to estimate the To illustrate, we will extend the earlier example in which an investor has a strategic
expected risk and return of each asset class. Historical returns can be used as a guide, asset allocation of 60% global equities and 40% European government bonds. The
but estimates need to be forward-looking. Managers also need to determine the cor- investment manager may think the global equity market is overvalued and likely to
relation of returns between the asset classes so they can calculate the diversification produce poor returns in the short term. In response, the manager could adjust the asset
benefits that may be achieved by combining the various assets in a portfolio. 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
Bonds Bonds Bonds allocation within predetermined ranges. For example, an acceptable strategic asset
Equities Equities Equities 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
Maintains the same target asset allocation over time.
allocation decisions. The decisions may be based on
The chosen strategic asset allocation is expected to meet the investor’s long- term risk
■ fundamental analyses of economic and political conditions and their likely
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 effects on market returns,
of the portfolio will likely depart from the original weights chosen as the different ■ market valuation measures relative to past data, or
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 ■ trends and momentum in markets.
a process called rebalancing.
When considering tactically altering a portfolio’s asset allocation, a manager may look
Rebalancing involves selling some of the holdings that have increased as a proportion
at the strength of the economy and likely future trends to gain a perspective on how
of the portfolio and investing the proceeds into the holdings that have decreased as a
the central bank might change interest rates and on what might happen to corporate
proportion of the portfolio. Because there are trading costs associated with rebalanc-
profits. The manager may then look at the level of the price-to-earnings ratio of the
ing, most investors will not rebalance on a continual basis but will instead rebalance
stock market and how it compares with recent decades as a measure of valuation or
at specified intervals or weightings.
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.
3.2 Tactical Asset Allocation 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
Although the chosen strategic asset allocation is expected to meet the investor’s management, which we will discuss in the next section.
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 Beyond deciding on asset allocation, an investor must decide whether to use a passive
or active management approach to asset selection.
Equities Equities Equities
■ Passive managers manage a portfolio designed to match the performance of a
specified benchmark.
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
Performance
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.
For active managers to identify outperforming securities on a consistent basis, they and so on) in a way that equity investments do not. So, most investments in real estate
must either have access to better information than other investors or be able to respond are actively managed to some extent. A similar argument applies to private equity
and use the same information faster or with better models to process the information. and venture capital.
The ability to do this is difficult because so many other investors have access to the
same information and resources. 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
In many markets, corporate disclosure regulations mean that information on company expensive technology. Active management typically also has higher transaction costs
fundamentals must be made available to all investors at the same time. In fact, laws because of more frequent trading in the portfolio. If active management does achieve
typically prohibit selective disclosure of material information on company prospects returns that are higher than the benchmark, the excess return may compensate for
or performance. With many profit-motivated investors digesting corporate informa- the higher employee, technology, and transaction costs and the net returns to the
tion, it is a challenge to interpret the information faster and better than the aggregate investor may be higher.
market view.
Proponents of active management argue that good active managers can more than
Also, for active management to be successful, any mispricing of investments has to cover their costs and thus deliver net benefit to investors. Conversely, proponents of
be substantial enough to cover the costs of exploiting this mispricing. Investing in passive management argue that the difficulty of identifying superior investments means
an undervalued security is only worthwhile if the excess return covers the cost of the it is not worth paying higher costs for that effort and that passive management will
research required to identify the undervaluation and the trading costs involved in deliver higher net-of-costs returns over the longer term. Concerns about the costs, the
investing in the security. 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
Accurately predicting mispricing is difficult because prices generally should already passive investment strategies increasingly popular over time. Despite these concerns,
reflect most publicly available information about fundamental values. It is interesting active management still remains popular.
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. As noted earlier, an investor may decide to use a passive approach in some markets
Much academic and practitioner research has shown that most active managers do and an active approach in other markets based on an assessment of the efficiency of
not consistently outperform the market over long time periods, after accounting for each market.
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.
Is investing passively in an index, such as the Hang Seng Index, the S&P 500 Index,
Active investment managers use various methods to try to identify future performance.
or the FTSE 100 Index, the best way to increase your wealth? Or is hiring an active
Managers using fundamental analysis focus on macroeconomic, industry-specific, and
investment manager with a record of past success a better option? Unfortunately, it is
company-specific factors that make securities and assets valuable. Other managers
never possible to know for sure. But the choice between passive and active management
use technical and behavioural models to identify trends and momentum in the market
is a key issue for investors and the decision must be weighed carefully.
and to predict how trading by other market participants may change future market
Passive management is typically cheaper to implement than active management prices. Some active managers build statistical or quantitative models to try to identify
because successfully replicating or tracking a benchmark requires fewer analytical shares that are likely to outperform or underperform. In practice, many managers use
resources than researching and identifying investments with superior return poten- a blend of the techniques discussed in the following sections. Based on their analysis,
tial. The passive approach requires some skill, such as knowing which investments to active managers purchase assets that are expected to have superior returns and sell
include in the benchmark and their respective values and weights in the benchmark. assets that are expected to underperform.
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. 5.1 Fundamental Analysis
Passive management of equity portfolios is a well-established discipline and replicating Active managers often try to identify and capture market inefficiencies through fun-
an equity market index is quite straightforward. But for some markets, such as real damental analysis. For equity investors, this process means conducting a thorough
estate, in which all properties are unique and trading is done in private transactions analysis of a company’s business model, its prospects, and its financial situation. This
rather than on a public stock exchange, it is less clear how a passive approach can be analysis may involve meeting company management and interviewing them about
used. There may not be a suitable index for passive managers to track. In addition, their strategy and the prospects of the company. Analysts must take care not to violate
real estate assets themselves have to be managed (maintained, rented, refurbished, laws and regulations when gathering information. Their goal is to identify companies
Identifying and Capturing Market Inefficiencies 401 402 Chapter 17 ■ Investment Management
that have better prospects than the stock market price reflects. Typically, an analyst ■ Prospects for disruptive technological innovations, the imposition or removal
or investment manager performs some form of fundamental analysis to arrive at an of significant regulatory constraints, and legal or extra-legal expropriations that
estimated value for a company’s shares. If the share price is significantly below the may affect the company’s viability
estimated value, the manager will increase the weighting of the shares in the portfolio
■ Macroeconomic issues, such as prospects for inflation, national economic
or add the shares to the portfolio.
growth, and unemployment
As explained in the Equity Securities and Debt Securities chapters, the value of a
■ Legal and regulatory environment the company operates within and whether
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 any major changes are planned
by discounting all the dividends they expect to receive while they hold the stock and ■ Corporate governance problems that may allow corporate managers to waste or
adding the proceeds from selling the stock. Value that is estimated this way is called
misuse corporate earnings that otherwise could be distributed to shareholders
the stock’s fundamental value or intrinsic value. Although fundamental values are not
or be retained to pay off debt holders
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 When analysing alternative investments, the issues considered will also differ. For
exceptional returns when they accurately estimate values and make the appropriate example, when analysing real estate investments, managers consider how the value
investments before other market participants. 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
To estimate fundamental values, they must forecast future cash flows and estimate the through redevelopment. Managers using fundamental analysis consider the specific
rates at which these cash flows are discounted. Managers using fundamental analysis factors that are expected to affect the value of the type of asset being analysed.
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), 5.2 Technical and Behavioural Analysis
managers consider borrowers’ ability and willingness to pay their debts—that is, Managers using technical analysis study market information, including price patterns
borrowers’ creditworthiness and trustworthiness. Lenders consider borrowers to be and trading volumes, whereas managers using behavioural analysis focus on indica-
creditworthy if they expect that the borrowers will be able to pay interest, principal, tors of market sentiment, such as manufacturers’ new orders or indices of consumer
and preferred dividends when due. They consider borrowers to be trustworthy if they expectations.
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 Some investment managers use a technical approach, seeking to assess price and
determine whether borrowers are creditworthy and trustworthy. 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
When analysing equities, they pay close attention to an issuer’s future prospects for to invest in shares that have recently been rising in the market, which is based on the
earning money and producing valuable assets. Among many other issues, they con- notion that a rising share will continue to rise. Other managers might look for signs of
sider the following: imbalance between the potential buyers and sellers of a share to try to predict which
direction the share is likely to move.
■ Demand for the company’s products
Recall from the discussion about supply and demand in the Microeconomics chapter
■ Cost of producing those products 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
■ Profit margins of the company and whether the margins are sustainable 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
■ Competitiveness of the company and whether it can remain competitive
in seller interest causes the price of the security to rise, and they try to sell before
■ Quality, stability, and security of the company’s management, workforce, and an increase in seller interest or a decrease in buyer interest causes the price of the
physical and intellectual assets security to fall.
■ Amount of debt the company uses to fund its operations and investments 5.3 Quantitative Analysis
■
Some managers build statistical models to try to identify shares that are likely to
Value of options to suspend or expand operations or to engage in new initiatives
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 403 404 Chapter 17 ■ Investment Management
of the share price to earnings per share, known as P/E) and above-average expected ■ Although the strategic asset allocation should meet the investor’s objectives
earnings growth tend to outperform. This insight can then be used to search for over the longer term, the manager or investor can potentially increase returns
shares that show those characteristics. Managers using this approach are often called by exploiting short-term fluctuations in asset class returns. The process of
“quants”, because of the quantitative models they use. exploiting these short-term fluctuations by adjusting the asset class mix in the
portfolio is known as tactical asset allocation.
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 ■ An informationally efficient market is one in which prices reflect the fundamen-
and the precise variables of interest will differ. tal values and prospects of the assets they represent.
■ Active management attempts to add value to the portfolio through the selection
SUMMARY of investments that are expected to outperform the benchmark and/or through
tactical asset allocations.
■ 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.
LEARNING OUTCOMES
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
INTRODUCTION 1 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-
Risk is part of your daily life, and whether you realise it or not, you often act as a risk nal to the company. But not all outcomes from events are negative. Some events can
manager. Before crossing a busy road, you first assess that it is safe for you to do so; if have a positive effect on the company, creating opportunities for gains. For example,
you take a toddler to the swimming pool, you make sure that she is wearing inflatable a company that takes the risk of investing in a country with tight capital controls (or
armbands before she gets into the water and that she is never left unattended; you controls on flows in financial markets) may benefit if the capital controls are lifted
have probably purchased car, home, and/or health insurance to protect you and your and the company becomes one of the few foreign companies licensed to buy and sell
family against accidents, disasters, or illnesses. Thus, in the course of your life, you are securities in that country. So, the assessment of risk needs to include opportunities
well acquainted with identifying risks, assessing them, and selecting the appropriate as well as threats.
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 2.2 Classification of Risks
important for companies to develop a structured process that helps them recognise Risks are classified according to the source of uncertainty. There is a long list of sources
and prepare for a wide range of risks. Although risk management is sometimes of uncertainty, so there is a correspondingly long list of risks. Relatively well-defined
viewed as a specialist function, a good risk management process will encompass the categories of risk exist, but no standard risk classification system applies to all com-
entire company and filter down from senior management to all employees, giving panies because risks should be classified in a manner that helps managers make better
them guidance in carrying out their roles. Any action that you take as an employee decisions in the context of their particular company and its environment.
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 All companies face the risk of not being able to operate profitably in a given com-
important that you gain a good understanding of the types of risks companies in the petitive environment, typically because of a shift in market conditions. For example,
investment industry face and that you learn how these risks are managed. 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.
Risk
There are three risks to which companies in the investment industry are typically
exposed and that are discussed in this chapter:
M a nage m e n t
■ 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.
DEFINITION AND CLASSIFICATION OF RISKS 2 ■ 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.
Risk can take different forms. Although there is no universal classification of risks, ■ Investment risk, which is the risk associated with investing that arises from
this section identifies typical risks to which companies in the investment industry the fluctuation in the value of investments. Although it is an important risk for
are exposed. 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
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.
1 Investment risks are discussed elsewhere in the curriculum. It was introduced in the Quantitative
© 2014 CFA Institute. All rights reserved. Concepts chapter and discussed further in the Investment Management chapter.
The Risk Management Process 409 410 Chapter 18 ■ Risk Management
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
THE RISK MANAGEMENT PROCESS 3 maintaining confidence among market participants and trust in the financial system.
A good risk management process helps companies reduce the likelihood and severity 3.2 Steps in the Risk Management Process
of adverse events and enhance management’s ability to realise opportunities. The
consequences of inadequate risk management include investment losses and even A structured risk management process generally includes five steps, as illustrated in
bankruptcy. Other costly consequences are also possible, such as sanctions for the Exhibit 1.
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; Exhibit 1 Risk Management Process
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
tive
s IdenDetec
sometimes follow these crises. Well-run companies, however, benefit from people and bjec tify t
O E
an ents
processes that enable forward-looking attention to emerging risks.
t
Se
d
v
3.1 Definition of Risk Management Risk
Management
C o n t ro i t o r
Risk management is a process—that is, a series of actions to achieve a company’s
iti s n d
e Ris k
Process
Mon
objectives.2 These objectives may take different forms, but they are typically driven
io r s s a
l an
by a company’s mission and strategy. A common corporate objective is to create value
Pr s s e
in a business environment that is usually fraught with uncertainty. So, an important
A
objective of the risk management process is to help managers deal with this uncer-
tainty and identify the threats and opportunities their company faces. One of the main S ele
ct a Ris k
functions of risk management is to find the right balance between risk and return. Re s p o n s e
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. 3.2.1 Set Objectives
Setting objectives is an important part of business planning. Risk management enables
The involvement of the board of directors and senior management in risk management
management to identify potential events that could affect the realisation of those
is critical because they set corporate strategy and strategic business objectives. Although
objectives. A company may set strategic objectives, which are typically high-level
directors and senior managers are in charge of setting the appropriate level of risk to
objectives connected to its mission. It may also define objectives that are related to its
support the corporate strategy, risk management should involve all employees. One
operations. Many of these objectives depend on external factors that may be difficult
employee making an inaccurate or fraudulent assessment can damage the reputation
for companies to influence and control, which leads to a high degree of uncertainty.
of his or her company and even lead to its demise. Reputations take years to build but
A strong risk management process helps decision makers ensure that the company
they can be lost in an instant. Markets are increasingly interdependent, and media and
is on track to achieve its objectives.
3.2.2 Detect and Identify Events Depending on their expected level of frequency and severity, risks will receive different
The next step in the risk management process is to detect and identify events that levels of attention:
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 ■ Green. Risks in the green area should not receive much attention because they
can be positive. have a low expected frequency and a low expected severity.
The aim of risk management is to try to capture the full range of risks, including hidden ■ Yellow. Risks coded yellow are either more likely but of low severity, or more
or undetected ones. Therefore, companies should involve employees in many differ- severe but unlikely. They should receive a little more attention than risks in the
ent roles and business areas in order to detect and identify as many risks as possible. green area, but less attention than risks in the orange area.
But there will always be unforeseen hazards. No matter how hard companies try to
■ Orange. Risks in the orange area have a higher expected frequency or higher
identify and reduce threats, they can never be completely identified or eliminated.
The complexity of the business environment makes it impossible to understand and expected severity than risks coded yellow, so they should be monitored more
model the large number of possible outcomes and combinations of outcomes. What actively.
risk management provides is a robust framework to help companies prepare for adverse ■ Red. Risks coded red should receive special attention because they have a rela-
events, identify their occurrence as early as possible if they do materialise, and thus tively high expected frequency and their effect on the company would be severe.
reduce their effect. The process of identifying potential risks can also reveal hidden
value-enhancing opportunities. ■ 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
3.2.3 Assess and Prioritise Risks
persisted until they were discovered in Australia in the 17th century. These risks
No matter what form risk takes, two elements of it are typically considered, in particular are usually not identified until after they occur.
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 In practice, the selection of key risk measures is important for the risk management
can be specified, as illustrated in Exhibit 2. This type of risk matrix can be used to function to be proactive and predictive. Key risk measures should provide a warning
prioritise risks and to select the appropriate risk response for each risk identified. 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
Exhibit 2 Risk Matrix 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
Catastrophic 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.
Expected Severity
Extremely
Harmful
Harmful
Slightly
Harmful
Negligible
Highly Unlikely Possible Likely Highly
Unlikely Likely
Expected Frequency
The Risk Management Process 413 414 Chapter 18 ■ Risk Management
EXAMPLE 1. TWO KEY RISK MEASURES USED BY A SECURITIES EXAMPLE 2. RISK RESPONSE STRATEGIES FOR A BANK
BROKERAGE FIRM
Assume that a bank has expertise in making loans to small companies in its home
Key Risk Source of country. A neighbouring country is opening its economy and experiencing strong
Measure Type of Risk Data Interpretation 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
Client satis- Operational Client A decrease in the client satisfac-
country. At this stage, the bank is willing to tolerate the risks of doing business
faction index risk surveys tion index may be an indication
in a foreign country because the opportunity is potentially significant.
that the quality of client services
is deteriorating, which may have
A few years later, the bank has a large portfolio of loans in the neighbouring
a negative effect on the firm’s
country, but the economic situation there is deteriorating. The bank is concerned
ability to generate revenue and
profit.
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
Number of Compliance Legal or An increase in the number of
decides to treat this credit risk by implementing stricter criteria before granting
fines paid risk compliance fines paid may be an indication
department that the firm does not comply
loans to small companies and by obtaining additional collateral to back each
with the required laws and regu- loan. Recall from the Debt Securities chapter that collateral refers to the assets
lations, which may result in the that secure a loan.
firm losing its ability to operate.
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.
3.2.4 Select a Risk Response
The next step in risk management is to formulate responses to deal with the risks A few months later, the neighbouring country faces a recession, which leads
identified in the previous step. For each risk, management must select an appropriate to social and political unrest. The bank makes the decision that it no longer wants
response and develop actions to align the company’s risk profile with its risk tolerance. 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
It is important to recognise that all companies must take risks in the course of their bank terminates all risks.
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 practice, investment firms set internal risk limits that incorporate the company’s
in the range of investments available.
overall risk tolerance and risk management strategy—for example, by specifying the
Therefore, each company must determine the risks that should be exploited, which are maximum amount of a risky security that can be held or the maximum aggregate
often risks the company has expertise in dealing with and can benefit from. Companies exposure to one asset type or to one counterparty. Defining limits and then controlling
must also determine the risks that should be mitigated or eliminated, which are often and monitoring those limits allows firms to implement risk response strategies.
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
3.2.5 Control and Monitor
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: 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
Tolerate. This strategy involves accepting the risk and its effect. In some cases,
and monitored. Relevant information must be identified, captured, and reported
the risk is well understood and taking it provides opportunities to create value.
accurately to enable people to carry out their responsibilities. Risk management, like
In other cases, the risk must be taken because other risk response strategies are
many processes, should be iterative and subject to regular evaluations and revisions.
unavailable or too costly.
Results must be used to make appropriate adjustments, which leads to a constant
■ Treat. This strategy involves taking action to reduce the risk and its effect. improvement in the risk management process.
■ Transfer. This strategy involves moving the risk and its effect to a third party. 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
■ Terminate. This strategy involves avoiding the risk and its effect by ceasing an (ERM) helps a company manage all its risks together in an integrated way rather than
activity. 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
Example 2 illustrates the use of the four risk response strategies by a bank. the business unit level to the project level.
The Risk Management Process 415 416 Chapter 18 ■ Risk Management
3.3 Risk Management Functions that information technology and accounting systems accurately reflect transactions.
Proactive auditors may also advise managers on how to improve risk management,
If you process transactions, recruit people, manage information technology (IT) controls, and efficiency. Best practice suggests that internal auditors should report
projects, or interact with clients, you are an integral component of your company’s directly to the audit committee of the board of directors to ensure their independence.
operations. Any failure to follow the appropriate policies and procedures may have a Thus, risk and audit committees of the board will often hear presentations from the
negative effect on your company. heads of risk management, compliance, and internal audit.
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 3.4 Benefits and Costs of Risk Management
action. The chief risk officer often reports directly to the board of directors. The
Risk management provides a wide range of benefits to a company. It can help by
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
■ supporting strategic and business planning;
other objectives, such as profitability.
■ incorporating risk considerations in all business decisions to ensure that the
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, company’s risk profile is aligned with its risk tolerance;
they may have an approval function or veto authority. But it is the members of the ■ limiting the amount of risk a company takes, preventing excessive risk taking
business functions, such as portfolio managers or traders, who “own” the risk of their
and potential related losses, and lowering the likelihood of bankruptcy;
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 ■ bringing greater discipline to the company’s operations, which leads to more
relevant risks are identified, but the final judgment on the business decision lies with effective business processes, better controls, and a more efficient allocation of
the decision makers. Therefore, it is important for risk management to be part of the capital;
company’s corporate culture and to be fully integrated with core business activities.
■ recognising responsibility and accountability;
Companies will often use a three-lines-of-defence risk management model, as illus-
trated in Exhibit 3 below. ■ 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
Exhibit 3 Three Lines of Defence communication, increased transparency, and improved awareness and under-
standing of risk; and
■ assisting with the early detection of unlawful and fraudulent activities, thus
Risk
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
ees / Manag
ploy ers dedicated risk management personnel, putting in place procedures, and investing in
Em
gement and Co systems, and intangible costs, such as slower decision making and missed opportunities.
na mp
Ma ernal Audit
l So, allocation of resources to risk management should be based on a cost–benefit anal-
Int
ia
ysis. It is difficult to weigh the costs and benefits of risk management precisely because
k
nc
Ris
it is impossible to observe, let alone measure, the cost of potential catastrophes 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 adequate and effec-
Front-line employees and managers, through their daily responsibilities, form the first tive system for reconciling client orders and trades on a global basis. Such a system
line of defence. The risk management and compliance groups operate as a second could have revealed the losses before they wiped out all of the bank’s equity capital.
line of defence, assisting and advising employees and managers while maintaining a It is estimated that implementing this system would have cost about £10 million, a
certain level of independence. An internal audit function then forms the third line of small price to pay compared with the £827 million loss that brought down Barings.
defence. Internal audit is an independent function. Internal auditors follow risk-based
internal audit programmes, delving into the details of business processes and ensuring
Operational Risk 417 418 Chapter 18 ■ Risk Management
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
OPERATIONAL RISK 4 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)
As mentioned earlier, operational risk is the risk of losses from inadequate or failed because of a human error was hidden in the accounting system (a back office activity),
people, systems, and internal policies and procedures, as well as from external events and subsequent losses accumulated until they exceeded the bank’s equity capital.
that are beyond the control of the company but that affect its operations. Following Barings’ collapse, banks were required to establish a clear separation between
their front and back offices.
Although these precautions may appear to be standard, studies have shown that dis-
Exhibit 4 Examples of Rogue Trading Incidents 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
Year of the
truth was revealed, even if they had performed successfully in their position.
Loss Company Rogue Trader Estimated Loss
1995 Barings Bank Nick Leeson £827 million 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
1995 Daiwa Bank Toshihide Iguchi US$1.1 billion
who expose the company to significant risks, such as traders and investment staff. A
1996 Sumitomo Corporation Yasuo Hamanaka ¥285 billion good compensation system should take into account the level of risk undertaken for
2002 Allied Irish Banks John Rusnak US$691 million a given level of return and should reward those who achieve returns without taking
2004 National Australia Bank Gianni Gray and AU$360 million excessive risks. An example of an incentive that could lead to perverse behaviour is
others rewarding traders for profits regardless of the risks they take. This approach would
2004 China Aviation Oil Chen Jiulin US$550 million give them all the upside for trading gains, but less downside for taking on risks and
2008 Société Générale Jérôme Kerviel €4.9 billion 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
2008 Groupe Caisse d’Epargne Boris Picano-Nacci €751 million
the compensation they previously received. Some authorities are now imposing new
2011 UBS Kweku Adoboli $2.3 billion
compensation structures that include deferred compensation to take into account
Source: Thomas S. Coleman, A Practical Guide to Risk Management (Charlottesville, VA: long-term performance as well as claw-back provisions, whereby employees may have
Research Foundation of CFA Institute, 2011):91–92. to return their bonuses if reported profitable deals result in losses later.
4.2 Managing Systems Compliance and internal audit functions are key to ensuring that employees are actually
following internal policies and procedures.
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- 4.4 Managing the Environment
ations or greatly reduce their efficiency, harming the company’s profitability via lower The type of environment in which a company operates can add layers of uncertainty
revenues, higher costs, or a combination of both. that need to be addressed.
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 4.4.1 Political Risk
employees who do not follow internal policies and, for instance, download unautho-
Political risk is the risk that a change in the ruling political party of a country will lead
rised applications for personal or business use. The dangers of this practice include
to changes in policies that can affect everything from monetary policy (money supply,
malicious viruses and unlicensed, and perhaps incompatible, software getting into
interest rates, and credit) and fiscal policy (taxation) to investment incentives, public
company systems. In addition, IT departments are in a constant battle with hackers
investments, and procurement. Some industries are heavily influenced by governments
who exploit weaknesses to penetrate systems. Key controls to protect systems and
that, for example, control natural resources or set prices of raw material inputs or
business information include the establishment and communication of internal policies
products. In these instances, a change in administration or policies can affect the
for users and IT technical staff, the creation of appropriate security standards and
value of an investment. Political risk is inherent in all countries and should always be
configurations for systems, and the allocation of adequate personnel and technical
considered, even if it is perceived to be relatively remote.
resources to maintain a well-controlled IT environment.
Although there are usually legal means to compel a counterparty to perform its obli- Companies should have internal reporting procedures to encourage employees to
gations, such measures are costly and time-consuming. A counterparty is more likely come forward and report instances in which they suspect someone has violated inter-
to find it difficult to fulfil its obligations during challenging economic times or when nal policies, procedures, laws, or regulations. This process is called whistle-blowing.
bankruptcy is imminent than during profitable times. In the case of bankruptcy, it Whistle-blowing has become an important way for authorities to learn of violations,
may take months or years to receive assets through a bankruptcy resolution proce- and provisions to protect and reward whistle-blowers have been strengthened in the
dure and the proceeds may only be a fraction of the original nominal amount of debt. wake of financial scandals.
5.2.1 Corruption
Corruption, which is defined as the abuse of power for private gain, has received height-
COMPLIANCE RISK 5 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
Compliance risk is the risk that a company fails to comply with all applicable rules, through agents and other third parties should be aware that their responsibility for
laws, and regulations. The risk of non-compliance with laws and regulations is higher preventing corruption extends to the actions of these third parties. Ignoring the
than non-compliance with internal policies and procedures because sanctions can practices of third parties does not constitute a defence in the event of a regulatory
be applied. These sanctions can affect both individuals and companies and may be investigation.
severe. Ensuring compliance with rules and regulations has often been viewed as a
To safeguard against corruption, companies must start by establishing a tone at the
rather mundane chore, but the rapidly changing regulatory environment has recently
top, with senior management communicating an unambiguous policy of zero tolerance
brought compliance to the forefront of business priorities. Many people believe that for unethical business practices and bribery. Risk assessments should identify major
the trend toward less regulation contributed to the global financial crisis that began risk areas and susceptible employees. For instance, employees who deal with govern-
in 2008. The trend has reversed with the re-imposition of greater regulation and
ment officials for licensing or deal with government or state-owned entities should be
oversight. This increased legislation, in turn, has led to more compliance activities given enhanced training and be monitored closely. Controls over corporate gifts and
and more compliance risk. hospitality, especially in payment-processing areas, are crucial for the prevention of
illegal or unethical payments.
5.2.3 Insider Trading Investment risk can take different forms depending on the company’s investments and
There are laws that prohibit the trading of a security when in possession of important operations. Companies in the investment industry typically experience three broad
confidential information pertaining to the security in question. Most markets have types of investment risk:
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 ■ Market risk, which is the risk caused by changes in market conditions affecting
similar to those used in investigations of organised crime cases—including tapping prices.
telephones, using evidence already collected to make peripheral suspects co-operate,
■ Credit risk, which is the risk for a lender that a borrower fails to honour a con-
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 tract and make timely payments of interest and principal.
and that nobody in the company will be in the position to violate them. Investment ■ Liquidity risk, which is the risk that an asset or security cannot be bought or
firms that face a high risk of insider trading, such as investment banks, have “control sold quickly without a significant concession in price.
rooms” to monitor information flowing between teams. They also have virtual walls
or information barriers to restrict and segregate information and to manage other
A common theme for success in all types of investment risk management is the need
conflicts of interest. These virtual walls are sometimes called Chinese walls, which
to understand the risks and price them accurately.
may be in reference to the screens that were common in China to separate large areas
into smaller rooms or in reference to the Great Wall of China.
INVESTMENT RISK 6 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
Risk is a critical element of investment decisions. Investors, for instance, buy equity offer examples of how companies can hedge unwanted risks.
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 6.2 Credit Risk
if commodity or real estate prices fall.
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
Investment Risk 425 426 Chapter 18 ■ Risk Management
and let the bank take possession of the property. This potentially unethical decision 6.3 Liquidity Risk
is rational from a purely financial perspective, apart from the worse credit profile for
future borrowing. 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
The expected loss from credit exposure is a function of three elements: the amount of as bank credit, are plentiful. But during the global financial crisis of 2008, an acute
money lent to a particular borrower, the probability that the borrower defaults, and shortage of liquidity in the financial systems in many countries led to failures. These
the loss that would be incurred if the borrower defaults. The amount that is at risk failures occurred because some companies were unable to maintain access to sufficient
may be reduced if collateral or guarantees from third parties are included. Enforcing money to finance their working capital (inventories and receivables from customers
contract provisions to take possession of collateral, however, can be a time-consuming net of payables from suppliers) and, therefore, to keep their companies going.
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 Firms in the investment industry face a greater level of liquidity risk than, say, man-
of a discount if sold on short notice. Assets for which a steady market demand exists ufacturers. To operate profitably, they need markets that can accommodate their
and that can be moved and easily transferred are more valuable than assets that are trades without significant adverse effects on prices. When markets are illiquid—either
traded less frequently and are less mobile. 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
Various sources of independent information exist on borrower creditworthiness, negative effect on these firms.
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:
7 VALUE AT RISK
■ 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
Companies in the financial services industry expect that the assets and securities they
set for a particular counterparty.
hold will provide them with a positive return. However, they also need to estimate the
■ Require additional collateral and impose covenants. Covenants, discussed in the potential loss on an investment if their forecasts for the asset or security turn out to be
Debt Securities chapter, are terms for loans that specify both what a borrower inaccurate. This potential loss is often measured using a metric known as value at risk.
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 7.1 Use and Advantages of Value at Risk
the restrictive conditions is broken, the lender may recall the loan or demand
some action, such as the assignment of additional collateral. 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
■ Transfer risk by using derivative instruments. Credit default swaps are often Quantitative Concepts chapter. VaR gives an estimate of the minimum loss of value
used when companies want to protect themselves against the risk of a loss that can be expected for a given period with a given level of probability. For example,
in value of a debt security or index of debt securities, as discussed in the an asset management firm may estimate that a portfolio has a VaR of $1 million for one
Derivatives chapter. 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.
Lending to governments or state-owned companies creates another type of credit risk. Put another way, a loss of $1 million or more for this portfolio is expected to occur,
Sovereign risk is the risk that a government will not repay its debt because it does on average, once in 20 trading days (1/0.05).
not have either the ability or the willingness to do so. The unique aspect of sovereign
VaR offers several advantages:
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
■ It is a standard metric that can be applied across different investments, portfo-
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 lios, business units, companies, and markets.
leave the country. ■ 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.
■ 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 reduc-
tion of operational risk requires companies to manage people to reduce human
Summary 429
■ 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. CHAPTER 19
■ Investment risks take different forms depending on the company’s investments
and operations. Investment firms typically experience: market risk, caused by
PERFORMANCE EVALUATION
changes in market conditions affecting prices; credit risk, caused by borrow- by Andrew Clare, PhD
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.
Introduction 433
e Describe reward-to-risk ratios, including the Sharpe and Treynor ratios; But knowing the return achieved by an investment management company or fund
manager is only part of the process of performance evaluation. Investment management
f Describe uses of benchmarks and explain the selection of a benchmark; is a competitive industry. Both investors and investment management companies will
want to know how fund managers have performed relative to familiar and relevant
g Explain measures of relative performance, including tracking error and financial market benchmarks (e.g., a stock index, such as the S&P 500 Index in the
the information ratio; United States or the Hang Seng Index in Hong Kong) and relative to their peers. In
addition, interested parties will want to know how the fund manager achieved the
h Explain the concept of alpha;
performance—for example, whether the performance was the result of skill or luck
i Explain uses of performance attribution. or perhaps the result of excessive risk taking.
The performance evaluation process includes four discrete but related stages:
Attribute performance
Absolute returns are the returns achieved over a certain time period. Absolute Holding Period Return
returns do not consider the risk of the investment or the returns achieved by similar
investments.
£5
dividend
2.1 Holding-Period Returns Return = £15
£10
The performance of a security, such as an equity (stock) or debt (bond) security, over capital gain
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). £100 £100 Original Investment = £100
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 1 January 31 December
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 Holding-period return = Return ÷ Original investment
in price (capital gain or loss) and receipt of interest (income).
= (10 + 5) ÷ 100
Example 1 illustrates how holding-period returns are calculated. As always, you are = .15
not responsible for calculations, but the presentation of formulae and calculations = 15%
may enhance your understanding.
Return (%)
Portfolios, 2010
5
20
0
16
8
Capital Gain Income Total Return
4 Source: Based on data from the Centre for Asset Management Research, Cass Business
School, London.
0
Global United States Europe Emerging Market
Exhibit 1A shows that the total holding-period return of all the equity port-
Capital Gain Income Total Return 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
Source: Based on data from the Centre for Asset Management Research, Cass Business equity portfolio’s total holding-period return was approximately 4% and was
School, London. made up almost entirely of income return.
2.2 Cash Flows and Time-Weighted Rates of Return 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
In the holding-period return calculation in Example 1, the income (the dividend) was approach is to calculate the geometric mean, which does consider compounding and
received at the end of the holding period. This time of receipt, plus the fact that no is usually the preferred approach.
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,
EXAMPLE 3. CALCULATION OF A FUND’S RETURN WHEN THERE IS A
■ funds may consist of hundreds of individual investments that pay income at DEPOSIT
different times throughout the holding period.
Suppose that the fund in Example 2 had received one client cash inflow of
■ clients may make additional investments (cash inflows) in and withdrawals $5 million at the close of business on 30 June. No other cash inflows or outflows
(cash outflows) from a fund throughout the holding period. 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
In other words, there is a constant flow of cash into and out of most investment funds can be divided into two periods of six months. The holding-period return is
and portfolios. Additional investments and withdrawals by clients will affect the cal- calculated as follows:
culation of the performance of the fund. Example 2 illustrates this point.
■ First, calculate the six-month holding-period return for the period from 1
January to 30 June, before the additional deposit.
EXAMPLE 2. EFFECT OF A DEPOSIT ON A FUND’S INVESTMENT ■ Next, calculate the six-month holding-period return for the period from 1
PERFORMANCE July to 31 December, including the cash inflow of $5 million that increased
the value of the fund on 30 June.
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 ■ Finally, calculate the annual holding-period return by combining the two
value of this fund came from changes in the values of the securities held in the six-month holding-period returns.
portfolio and from income received and reinvested during the year. The total
holding-period return on the fund is 10%, calculated as follows: 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
⎛ $110 million − $100 million ⎞
Fund return = ⎜ ⎟ = 0.10 = 10% immediately before the inflow of $5 million. Assume that the fund’s value was
⎝ $100 million ⎠ as follows (the 30 June value does not include the $5 million deposit):
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 Date Fund’s Value
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 1 January $100 million
client money. In other words, a total holding-period return of 10% overstates 30 June $98 million
the fund’s investment performance. 31 December $110 million
The holding-period return over the first six months (1 January to 30 June) is
as follows:
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 ⎛ $98 million − $100 million ⎞
Fund return = ⎜ ⎟ = −0.020 = −2.0%
each time a cash flow occurs—that is, each time money flows into or out of a fund. If ⎝ $100 million ⎠
there is only one cash flow during the holding period, the measurement period will On 30 June, the fund has fallen in value to $98 million. But at this point,
be divided into two shorter holding periods. If there are two cash flows, there will be the fund experiences the positive cash inflow of $5 million. This event means
three holding periods, and so on. In practice, client cash inflows and outflows may that at the start of the second holding period on 1 July, the fund has a value of
occur on a daily basis, in which case an annual holding-period return is divided into $103 million ($98 million + $5 million). On 31 December, the fund has a value
daily holding-period returns. of $110 million. Thus, the holding-period return for the second six months (1
July to 31 December) is as follows:
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. ⎛ $110 million − $103 million ⎞
The first approach is to calculate the arithmetic mean by adding the two six-month Fund return = ⎜ ⎟ = 0.068 = 6.8%
⎝ $103 million ⎠
returns. This approach, however, does not consider compounding; recall from the time
440 Chapter 19 ■ Performance Evaluation Adjust Returns for Risk 441
The clients of the fund may want to know the return achieved by the fund deviation. The standard deviation of returns reflects the variability of returns around
manager over the full calendar year rather than over each six-month period. the mean (or average) return; the higher the standard deviation of returns, the higher
Using our current example, the fund return was –2.0% for the first six months the variability (or volatility) of returns and the higher the risk.
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:
STANDARD DEVIATION OF RETURNS FOR A VARIETY OF PORTFOLIOS
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 Exhibits 2A and 2B show the standard deviation of the annual returns for
is the return achieved by the fund manager on the funds under management 2006–2010 on the four equity, three bond, and two commercial property port-
between 1 January and 31 December. folios introduced in Exhibits 1A and 1B.
Returns calculated in the manner described in Example 3 are known as time-weighted Exhibit 2A Standard Deviation of Returns in Equity Portfolios
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, 50
or day of that year. The timing of each individual cash flow identifies the sub-periods
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.
Exhibit 2B Standard Deviation of Returns in Bond and Commercial 3.2 Downside Deviation
Property Portfolios 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
10 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
Downside deviation is calculated in almost exactly the same way as standard devia-
2 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
0
mean. Downside deviation may also be calculated by focussing on outcomes that are
European European European US UK
Government Corporate High Yield Commercial Commercial 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
Source: Based on data from the Centre for Asset Management Research, Cass Business
investing in a diversified portfolio of UK equities and in a diversified portfolio of UK
School, London.
government bonds.
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 Exhibit 3 Standard Deviation vs. Downside Deviation, 2001–2010
for the equity portfolios exceeded 20%, reaching 41% for the emerging market
equity portfolio. In contrast, Exhibit 2B indicates that the standard deviation 25
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 20
and corporate bond portfolios and less than 10% for the high-yield bond and
the two commercial property portfolios.
Deviation (%)
15
10
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- 5
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
0
will behave like past returns. Second, the variability of returns may affect an inves-
UK Equity UK Bond
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 Standard Deviation Downside Deviation
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 Source: Based on data from the Centre for Asset Management Research, Cass Business School,
could potentially disrupt investors’ plans. If returns are very negative one year, then London.
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. 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.
444 Chapter 19 ■ Performance Evaluation Adjust Returns for Risk 445
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
Each of these ratios can be compared with the same ratios for similar funds or port-
reward is measured as the portfolio’s excess return, which is equal to the difference
folios to evaluate the fund’s or portfolio’s performance. As stated earlier, the higher
between the portfolio’s holding-period return and the return on a “risk-free” investment.
the value of the reward-to-risk ratio, the better the risk-adjusted return—that is, the
Risk-free investment is usually approximated by the return achieved from investing in
higher the return per unit of risk.
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 FOR A VARIETY OF PORTFOLIOS
Sharpe ratio
Return on portfolio − Risk-free return Excess return on portfolio 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.
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 Exhibit 4A Sharpe Ratios for Equity Portfolios, 2006–2010
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 0.5
chapter. The Treynor ratio is calculated as follows:
Treynor ratio 0.4
Return on portfolio − Risk-free return Excess return on portfolio
= =
Sharpe Ratio
Beta of portfolio returns Beta of portfolio returns 0.3
Example 4 illustrates the calculation of the Sharpe and Treynor ratios.
0.2
0.1
0
Global United States Europe Emerging Market
Source: Based on data from the Centre for Asset Management Research, Cass Business
School, London.
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.
446 Chapter 19 ■ Performance Evaluation Measure Relative Returns 447
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
Exhibit 4A shows that the Sharpe ratios of all the equity portfolios were have already seen an application of this use of comparison in the Financial Statements
positive, ranging from 0.10 to 0.40. The emerging market equity portfolio had chapter with ratio analysis.
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 4.1.1 Benchmarks
the commercial property portfolios had negative Sharpe ratios, indicating that Fund managers may not only use a benchmark for assessment, but some, such as index
these funds generated lower returns than the government bond portfolios during fund managers, may also manage their portfolios to a benchmark.3 This means that
2006–2010. That is, they provided a negative reward for the risk taken. But you managers must regularly compare the composition and performance of their portfolios
should not conclude that commercial property portfolios are necessarily poor with the composition of a financial market index, such as the FTSE 100 Index or the
investments. The 2006–2009 period was not typical given that it was marked by S&P 500. For investors, knowing the financial market index that a fund manager uses
a global financial crisis that saw a significant drop in property prices. 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-
The Sharpe ratio, along with other reward-to-risk ratios, is an important metric for cial market benchmark that they intend to use to assess the performance of the fund
understanding the quality of the returns produced by a portfolio. A portfolio with manager. For example, a US equity fund manager may be asked, or mandated, to
high returns but with high risk might be said to have produced lower-quality returns manage a portfolio of US equities for a client and told that they will be “benchmarked
than a portfolio with similarly high returns but with much lower risk. So, in a sense, against” the S&P 500. A fund manager may simple be a passive index fund manager
reward-to-risk ratios, such as the Sharpe ratio, are one of the main quality control using S&P 500 as the reference index. Alternatively, a manager might be given a spe-
checks that investors need to apply to their investments. Such ratios are also helpful cific mandate reflecting specific risk requirements, return targets, or style or sector
for comparing investments. 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.
To help clients meet their objectives, a benchmark should meet certain criteria: 4.1.3 Relative Returns
The wide range of financial market indices available allows investors to set performance
■ Investability. The benchmark should be composed of assets that can be bought targets (passive or active) for their fund managers and enables them to compare the
and sold by the fund manager. For passive fund managers, it would be difficult performance of their fund manager over time against an independent benchmark. In
to mimic the benchmark if it contained assets that they could not buy. For short, a benchmark index allows investors to evaluate relative returns.
active fund managers, not being able to invest in some of the benchmark’s com-
ponents could limit their ability to outperform it. Despite the widespread availability of independently constructed financial market
indices covering nearly every conceivable sector and aspect of the world’s financial
■ Compatibility. The benchmark should have an appropriate composition and markets, some investors prefer to compare their fund managers not with broad bench-
level of risk for the investor. In other words, it should match the investor’s marks constructed by index providers but instead with the fund manager’s peers. For
objectives. For example, investors may not want to invest in assets that carry example, investors may compare the performance of one manager of European equities
credit or default risk and so they may be willing to accept a relatively low return with that of other managers of European equities. Each manager is assigned a perfor-
on their assets. In this case, a financial market index of government bonds mance ranking within his or her particular sector of the financial markets. Managers
might be compatible (based on historical performance) with investor pref- who are in the top 10% of performers among their peers over a specific period are said
erences. A benchmark composed of emerging market equities would not be to be top-decile performers. The performances of individual fund managers may be
compatible. 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
■ Clarity. The rules governing the construction of the benchmark should be clear. managers relative to those of other managers that they could have chosen.
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.
4.2 Tracking Error and Information Ratio
■ Pre-specification. The benchmark should be specified before an investment is
The tracking error of an investment fund reflects how the performance of the invest-
made so that the manager is clear about the client’s objectives and expectations
ment fund deviates from the performance of its benchmark. The tracking error is
and so the manager can construct a portfolio accordingly.
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
4.1.2 Indices error because the manager is seeking to replicate a benchmark. But for an active fund
A number of organisations produce financial market indices that allow investors to manager, the tracking error will be higher.
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 Tracking error can also be used to formulate another widely used reward-to-risk
one index that represents the majority of its stocks. In addition to these broad indices, ratio known as the information ratio. The “reward” part of the information ratio is the
stock indices that measure performance of industrial sectors are also available, both difference between the holding-period return on the portfolio and the return on an
within a particular country and globally. These indices make it possible, for instance, appropriate benchmark over the same period; the “risk” part of the information ratio
for investors to compare the performance of a portfolio of global information tech- is based on the tracking error of the fund—that is, its deviation from the performance
nology (IT) stocks with the performance of a portfolio of Indian IT stocks, as long as of the benchmark. It is calculated as follows:
the indices have been constructed using the same methodology.
Difference in average return between portfolio and benchmarrk
Information ratio =
A number of bond indices exist too. Many leading investment banks, such as Barclays Fund tracking error
Capital and Goldman Sachs, produce bond indices for different types of issuers located Example 5 uses the annual holding-period returns on the UK equity portfolio as seen
in developed or emerging countries. Independent index providers also provide a wide in Exhibit 3 to illustrate the calculations of the tracking error and the information ratio.
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 EXAMPLE 5. TRACKING ERROR AND INFORMATION RATIO
indices for nearly every asset class, including cash, currencies, commercial property,
hedge funds, private equity, and commodities, as well as for bonds and equities. 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.
450 Chapter 19 ■ Performance Evaluation Measure Relative Returns 451
simply attributable to luck. But even when stocks are not chosen randomly, luck can
Exhibit 5 Calculating Tracking Error
play a big part in investment returns, so investors need a way to distinguish between
skill and luck.
UK Equity Portfolio FTSE All-Share Index
Year Total Return Total Return Difference 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
2001 5.00% 5.05% –0.05%
total return—generated by the fund’s manager. All things being equal, a manager who
2002 –15.00 –15.30 0.30
produces a consistently high reward-to-risk ratio could be said to be more skilful
2003 –28.00 –28.56 0.56 than one who consistently produces a lower ratio. Investors who invest in a fund that
2004 32.00 32.96 –0.96 is managed on an active rather than on a passive basis are effectively paying for the
2005 15.00 15.45 –0.45 manager’s investment skill and expertise.
2006 24.00 26.40 –2.40
Fund manager skill is often referred to as alpha. Perhaps the best way to explain the
2007 13.00 14.30 –1.30 concept of alpha is to consider the sources of a fund’s return, which is composed of
2008 –3.00 –3.02 0.02 three elements:
2009 –29.00 –29.15 0.15
2010 36.00 36.36 –0.36 ■ market return
Mean 5.00% 5.45%
■ luck
Difference in Average –0.45%
Return ■ skill
Tracking Error 0.84%
Source: Based on data from the Centre for Asset Management Research, Cass Business
4.3.1 Market return
School, London.
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
The average of the differences in returns is –0.45% per year; in other words, on hold in the appropriate proportions those securities that comprise their benchmark.
average, the equity portfolio underperformed the benchmark by 0.45% each Although this process requires some skill, it is not so much investment skill as effi-
year over the 10-year period. 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
The standard deviation of these differences is 0.84%. The formula used to
passive fund should also fall. Therefore, over time, the fund should produce a return
calculate standard deviation was presented in the Quantitative Concepts chap-
similar to that of the chosen benchmark minus fees.
ter, but you are not required to perform this calculation. This 0.84% represents
the tracking error. 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
The information ratio is, therefore,
fund will come from market movements over which the active fund manager has no
0.45% control. Arguably then, investors in actively managed funds should not pay higher active
Information ratio = = –0.53
0.84% 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
The information ratio is negative because the fund underperformed its benchmark
by investing in passively managed funds.
over the period. If the information ratio had outperformed the benchmark, it
would have been positive.
4.3.2 Luck
Some of the return generated by an investment fund is the result of luck rather than
4.3 Skill vs. Luck judgement. The prices of financial assets held in portfolios are affected by events that
cannot be foreseen by a fund manager.
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 Skilful fund managers may be unlucky on occasion and unskilled fund managers might
are skilful investors? At the same time, other people in the room may see the value enjoy some good luck. Because luck tends to even out over the long term, it is vital that
of their investments fall. Does that mean that they are poor investors? The answer investors are able to distinguish luck from skill. However, it is not always easy to do so.
to both questions is no. The stocks were chosen randomly, so the performance was
452 Chapter 19 ■ Performance Evaluation Attribute Performance 453
4.3.3 Skill Benchmarks can also be used to explore the reasons for the fund manager’s perfor-
A skilful fund manager is able to add value to a portfolio over and above changes to mance. By using appropriate financial market indices, the fund manager’s performance
the portfolio’s value that are driven by market movements and that could have been can be decomposed to reveal the sources of returns. Depending on the nature of the
produced by a passive fund manager. fund, the performance itself might come from the following sources:
Because luck will tend to even out over time, a skilful manager is one who adds this ■ asset allocation
value consistently over time, year after year. This outperformance over the returns
from a relevant market benchmark is generally referred to as alpha. ■ sector selection
■ stock selection
4.3.4 Distinguishing Between Sources of Return
■ currency exposure
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 Knowing how a fund manager’s performance is derived is useful information both for
model (CAPM),4 from which the term alpha comes. This model includes a measure the clients of the fund and for the investment management company. For example,
of systematic risk: beta. Systematic risk (also called market or non-diversifiable risk) if a fund manager is skilled at stock selection but less proficient at sector selection,
is the risk that affects all risky investments and cannot be diversified away. Factor another fund manager may be asked to give advice on the sector selection aspect of the
models, such as the CAPM, separate a fund’s performance into return from market portfolio, allowing the first fund manager to concentrate on stock selection. Knowing
performance (beta), from luck or randomness, or from the investment skills of the the strengths of fund managers can also help investors choose an investment fund.
fund manager (alpha). Determining how much of performance is the result of the selection of asset classes,
Most active managers benchmark their performance against an independently cal- sectors, individual securities, and currencies is known as performance attribution,
culated financial market index. Just as standard deviation is a standardised measure and it is the fourth stage of the performance evaluation process. Example 6 provides
of the deviation of a fund’s return relative to its average return, tracking error is a an illustration of performance attribution.
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 EXAMPLE 6. PERFORMANCE ATTRIBUTION
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
Consider a fund manager who manages a portfolio that has a value of £100 mil-
in the fund management industry. Finally, alpha is calculated by using factor models
lion on 1 January, the start of an annual evaluation period. The benchmark for
in an effort to identify the return from a fund manager’s skill.
this fund comprises three equity market indices:
Benchmarks form the basis of performance measurement, which is an important The mandate specifies that the benchmark will be 60% of the performance
part of performance evaluation. By comparing the performance of a UK equity fund of the FTSE 100, 30% of the S&P 500, and 10% of the Nikkei 225. We can show
manager with the performance of an appropriate UK equity index, the fund manager’s this as
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 Benchmark composition = (60% × FTSE 100) + (30% × S&P 500)
the fund’s tracking error or information ratio. + (10% × Nikkei 225)
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.
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.
454 Chapter 19 ■ Performance Evaluation Attribute Performance 455
It is possible to calculate the returns that the fund manager would have
Exhibit 6 Index and Benchmark Performance over One Year
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
Return the following return:
1 January to 1 July to 1 January to
Index Weight 30 June 31 December 31 December Return from 1 January to 30 June
FTSE 100 60% 6.0% 10.0% 16.0% = (60% × FTSE 100) + (30% × S&P 500) + (10% × Nikkei 225)
S&P 500 30 5.0 8.0 13.0
= (60% × 6%) + (30% × 5%) + (10% × 15%)
Nikkei 225 10 15.0 –10.0 5.0
Benchmark 100% 6.6% 7.4% 14.0% = 6.60%
Source: Andrew Clare and Chris Wagstaff, The Trustee Guide to Investment (London: In the second half of the year, the fund would have achieved the following
Palgrave Macmillan, 2011). return:
Over the full year, the benchmark generated a return of 14%, composed of = (50% × FTSE 100) + (20% × S&P 500) + (30% × Nikkei 225)
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 = (50% × 10%) + (20% × 8%) + (30% × –10%)
these two periods. In particular, the Japanese index was up 15% over the first = 3.60%
half of the year, but down 10% over the second half.
This analysis suggests a return of approximately 10.2% for the full year.
Assume that over the full year, the fund manager achieved a return of 15%. However, the fund manager actually achieved a return of 15%, which means that
The manager thus satisfied the mandate—the return on the fund (15%) is 1% 4.8% (15.0% – 10.2%) of the return came from a source other than broad asset
higher than the benchmark’s return (14%). But where did the performance allocation decisions. In fact, had the manager held the equity funds passively,
come from? To understand this question, an investor needs more information in line with the benchmark proportions, the manager would have achieved a
about the fund manager’s decisions. In particular, an investor needs to know the return of 14% over the year—that is, the return for the full year reported in
proportions of the funds that the manager allocated to UK, US, and Japanese Exhibit 6. This result means that the fund manager’s asset allocation decisions
equities over the course of the year. cost the fund 3.8% (14% – 10.2%).
Exhibit 7 shows the fund manager’s allocation to the three markets. 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
Exhibit 7 Fund Manager Asset Allocation Decisions
exposure, which is the change in the relative value of the currencies involved
(the pound, dollar, and yen).
Fund Allocations
1 January to 1 July to Using the type of techniques outlined here, it would be possible to further
Markets 30 June 31 December 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.
UK equities 60% 50% This attribution analysis is summarised in Exhibit 8.
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.
456 Chapter 19 ■ Performance Evaluation Summary 457
■ Returns need to be measured by taking into account the cash flows into and out
Exhibit 8 Manager’s Performance Attribution Breakdown
of a fund over time.
■ 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,
In Example 6, it was assumed that the return that did not come from the manager’s sectors, or individual securities or currencies.
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.
SUMMARY
■ Absolute returns include two components: a capital gain or loss component and
an income component.
LEARNING OUTCOMES
a Define a document;
Documentation touches every aspect of investing, from internal documents to con- ■ Communicates—conveys ideas, concepts, or information
tracts with external parties. Every time an investment manager places an order and
■ Authorises—provides the basis, and often the authority, for action
purchases a security, for instance, a large number of documents are developed to
record the trade. ■ Formalises—establishes roles, deliverables, and obligations
Documentation provides evidence of how companies operate, interact internally and ■ Organises—ensures thoroughness and consistency of action, allowing the com-
externally, and deliver their services. Documentation varies across the investment pany to function more efficiently and effectively
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- ■ Measures—provides a benchmark for measurement and audit
panies. This chapter explains why documentation is important, provides examples of
■ Records—preserves learning within the company (also known as institutional
different types of documents, and describes how documents are managed.
memory)
Records Communicates
Objectives
2.1 Objectives of Documentation 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 Measures Authorises
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 Organises Formalises
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 From a legal perspective, documents also establish proof: proof of existence, authority,
that the company must take, from start to finish, to achieve that desired outcome. activity, and obligation.
Documentation of policies, procedures, and processes helps to communicate them
and to ensure compliance with rules, laws, and regulations.
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.
© 2015 CFA Institute. All rights reserved.
Objectives and Classification of Documentation 463 464 Chapter 20 ■ Investment Industry Documentation
Origin relates to the source of the document. Documents can be classified by their
EXAMPLE 2. RISK MANAGEMENT POLICY
source as
An employee travels for work and incurs expenses while doing so.
■ The receipt for a taxi or a train ticket is an original document. 3 INTERNAL DOCUMENTATION
■ 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 Internal documents are generally administrative and formalise policies, procedures,
documents—in this case, the taxi or train ticket receipt. 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
■ The company’s travel policy is an associated document. When filling out as important as external documents, such as contracts and regulatory submissions.
the expense claim form, the employee may have to refer to the travel pol-
icy to determine which expenses will be reimbursed. 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
Documents “flow” in different directions. Typically, documents associated with pol- important to document these policies and procedures so that the company can prove
icies and procedures “flow down” through a company. Referring back to Example 1, it is in compliance if it is inspected by regulators. It is also important to document
the travel policy document may flow down from the human resources department that the company follows and enforces its policies and procedures.
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. 3.1 Document Creation
A distinction can be made between standardised and ad hoc documents: 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
■ Standardised documents are pre-established. They are crafted for a range of that most people are familiar with help individuals read and understand these docu-
specific purposes. Some standard contracts are tailored by negotiation, but their ments. They are also easier to use and enable individuals, including board members,
form, content, and purpose are still pre-established. to perform their duties more effectively.
■ Ad hoc documents, such as letters, memos, and e-mails, are typically informal. A standardised template helps maintain version control. Given the level of legislative
The free-form nature of ad hoc documents means that they carry additional risk and regulatory activity affecting most companies, it is rare for policy and procedure
for the company, particularly if the records are subpoenaed in a legal dispute. documents to remain static. Any changes reflected in a policy document need to be
Consequently, companies may implement policies and procedures to impose a similarly reflected in all associated procedure and process documents. Simply stating
process of peer review for ad hoc communication. Peer review should be docu- the document title, the version number, and the date on which the version came into
mented and auditable. 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.
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.
Internal Documentation 465 466 Chapter 20 ■ Investment Industry Documentation
Policies, procedures, and processes are living documents and should be subject to context in which to learn them, understand them, and attribute the proper degree
a regular review and confirmation process as a function of good governance. This of importance to them. Failure to do so increases operational risk, which can have
review and confirmation process should not be merely event driven. Even without a severe consequences, as noted in the Risk Management chapter.
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- 3.2 Policy Documentation
uments containing obligations, past actions, and future or outstanding requirements. Laws and regulations require that companies in the investment industry maintain
Registers of the previous and next review dates should be maintained by a control certain policy documents. Policy documents often describe the company’s mission,
function (generally, the compliance or internal audit function) and scheduled for dis- values, and objectives. These documents should be consistent with the company’s
cussion. A sign-off process is generally also incorporated into the document template. documents and bylaws, which summarise the legal identity, purpose, and activities
of the company.
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, One role of the board of directors is to ensure that the company works within the law
it is better practice to include a sense of why the policy and required documentation and, in doing so, protects and represents the interests of all stakeholders. This over-
are in place and to whom they apply. Examples 3 and 4 show how providing context sight usually results in policy documents that help a company develop and implement
may improve compliance with a travel policy and limit the risk of insider trading. procedures and processes.
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
EXAMPLE 4. LIMITING THE RISK OF INSIDER TRADING 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.
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 The keys to good policy documentation are simplicity and transparency. Policy state-
statement “real” for the employees. It should be explained that the policy has ments do not need to be overly detailed, but they should include a statement of intent
its origin in law and that violation carries penalties for the company and the that explains the purpose and goals of the policy. The statement of intent should cover
individual. It should also be explained that the policy applies to everyone who the circumstances under which the policy is invoked and establish any parameters for
has access to sensitive information that could be considered “inside information”, its use. The policy document should also clearly designate who needs to comply with
which includes not only decision makers but also anyone with access to sensi- the policy and who is responsible for controlling and monitoring activities.
tive information. For example, the boardroom attendant serving refreshments
during board meetings may have access to sensitive information and, therefore,
would require training. 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
The importance of understanding the origins of, reasons for, and implications of doc- level. Policies broadly set the rules, procedures help apply policies, and processes
umentation, for both the company and the individual, should not be underestimated. divide procedures into manageable actions. To ensure that policies are embedded in
People create and implement policies, procedures, and processes, and they need
Internal Documentation 467 468 Chapter 20 ■ Investment Industry Documentation
a company’s culture, various procedures must typically be adopted across different or process and the limitations in place at the time of its creation. Companies must also
business units and functional areas of the company. In addition, a single procedure make sure that all employees receive adequate training regarding existing procedures
could have hundreds of associated processes to be followed. and processes, and that they are kept informed when changes are made.
Example 5 provides an illustration of the relationship between a policy statement and Making changes is never easy, so it is advisable to make processes modular—that
the procedures and some of the processes associated with it for an investment firm is, they should be made up of separate elements that can be reviewed and replaced
operating in different jurisdictions. 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.
EXAMPLE 5. POLICY, PROCEDURE, AND PROCESS DOCUMENTATION
An important consideration when creating or reviewing procedures is risk man-
To ensure stakeholder confidence, and hence support, the firm must demonstrate the 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
Statement
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.
1. Identify the 2. Monitor 3. Identify 4. Train employees As with policies, context is critical in the creation of procedures and processes.
highest compliance. breaches and to mitigate Understanding where inputs come from, where outputs go, and what they will be
Procedures
standards. implement breaches. used for provides that context. All procedure documents follow a similar pattern: an
remedial action. 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
1. Create a register of 1. Check that all 1. Review 1. Conduct when a number of contingent activities take place.
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
comply with them. If any of the parties fail to fulfil their obligations, the law offers the
POLICY: Gifts worth more than $100 require compliance approval other party or parties protection or help. The level of protection or help often varies
Statement to determine potential conflicts of interest. depending on the jurisdiction that applies to the contract.
Policy
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-
PRODECURE 1: Gift Management
Procedures
tion for a new investment product, or a statement about the launch of a new website.
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
External Documentation 471 472 Chapter 20 ■ Investment Industry Documentation
Marketing materials are typically regulated to ensure that companies in the investment
Exhibit 2 Typical Client Interaction Cycle
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
Marketing products to retail investors, who are considered the least sophisticated investor type.
on
i
pt
On
em
4.2 Client On-Boarding
Cliearding
-Bo
Red
nt
Client on-boarding is the process by which a company accepts a new client and inputs
Client the client’s details into its records to enable the company to conduct transactions with
Investment and on behalf of the client. Companies in the investment industry usually have a legal
I n v e s t nts
(KYC) process before commencing a relationship with the potential client. The typical
in g
me
nd
nt
4.3 Funding Once the order has been received, a number of documents record the progress of the
trade until execution. These include:
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
■ A submitted-for-dealing note
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 ■ Confirmation of dealing
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 ■ A contract note once the trade is complete
example, the documentation associated with the investment transaction could be a
share certificate or confirmation of an investment in a mutual fund. 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
Each step in the funding process relies on external documentation to formalise,
be produced by accounting and other departments.
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. 4.5 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
4.4 Trading 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
Documentation is important in trading—to provide a record of which assets were
national newspaper.
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. 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 diagram below shows a simplified version of the trading process, as presented in
the asset, including its fair value per unit and the quantity of units held at a particular
The Functioning of Financial Markets chapter. It illustrates some of the documents
point in time. It may also contain performance information, measured by the change
that may be produced during a trade. Depending on the asset, where it is traded, and
in value over various periods of time—a quarter, a year, or perhaps a longer period.
between which counterparties, the documentation required can vary widely.
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
Documents and performance statements, clients may receive a range of other documents, such
Order Placed
Order Document
as investment reports, annual financial statements, and risk management reports.
■ Bankruptcy. If a company files for bankruptcy or undergoes a reorganisation, possible to capture inputs—including client interactions—from outside the company
the client may be affected, depending on the nature of the underlying trans- by directly accessing a company’s IT systems. In some instances, the need for physical
action or investment. There will be written communication about the legal documentation has completely disappeared. Examples include the use of internet
process, the rights of the parties involved, and any liquidation. banking and online share trading, which eliminate the need for deposit/withdrawal
slips and trade order tickets.
■ Natural disaster. This type of event may affect a real asset or even a financial
asset. 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.
4.7 Redemption 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
At some stage, a client may want to redeem or sell an investment. Depending on the
that relies on dual independent (blind) input with automated reconciliation and release
type of investment, a written request may be required. After verifying the authenticity
reduces the risk of errors and time for review.
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. 5.2 Access, Security, Retention, and Disposal of Documents
Although redemption is the end of a transaction, it does not necessarily mean the end The importance of document management cannot be over-emphasised. Easy access to
of the client relationship. The client may want to invest or conduct other transactions documents is essential for an efficient business operation. Document management also
with the company in the future. The documentation relating to the final transaction enhances security, including confidentiality and protection of client information. Given
will be retained, as discussed in Section 5, should there be any future dispute or dis- the huge amount of data available on every client, it is important that companies take
agreement between the parties. 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
DOCUMENT MANAGEMENT 5 external documents relevant to the company’s business activities.
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:
■ Policy broadly sets the rules, procedures help apply policies, and processes
divide procedures into manageable actions.