THE INVESTMENT INDUSTRY:

A TOP- DOWN VIEW

by Ian Rossa OReilly, CFA
CHAPTER 1
LEARNING OUTCOMES
After completing this chapter, you should be able to do the following:
a Explain how an economy benefts from the existence of the investment
industry;
b Explain how an individual benefts from the existence of the investment
industry;
c Describe types and functions of participants that collectively comprise
the structure of the investment industry;
d Describe forces that afect the evolution of the investment industry.
Introduction 3
INTRODUCTION
People work to sustain themselves and their dependents. Often, they earn money for
their labor and use that money to purchase goods and services. If they spend less than
they earn, they have savings. If they expect to earn a return on their savings, they
are investing. For example, an individual might lend her savings to a neighbor who is
starting a new business. If she realistically expects to get more money back than she
lent, she is making an investment.
One reason why the fnancial services industry exists is to provide a link between
savers (also called lenders or investors) that have funds to invest and spenders (also
called borrowers) that need funds. After all, not all savers have savvy neighbors who
are starting promising businesses. As a result, they have to look elsewhere for oppor-
tunities to earn a return on their money.
Lenders invest their savings in a wide range of assets. Assets are items that have value
and include real assets and fnancial assets. Real assets are physical assets, such as
land, buildings, cattle, and gold. In contrast, financial assets are claims on real assets.
For example, a share of stock represents ownership in a company. Tis share gives its
owner, called a shareholder (or stockholder), rights to some of the companys assets
and earnings.
Financial assets that can be traded are called securities. Te two largest categories
of securities are debt and equity securities:
Debt securities are loans that lenders make to borrowers. Lenders expect the
borrowers to repay these loans and to make interest payments until the loans
are repaid. Because interest payments on many loans are fxed, debt securities
are also called fixed- income securities. Tey are also known as bonds, and
investors in bonds are referred to as bondholders. More information about debt
securities is provided in Chapter 10.
Equity securities are also called stocks, shares of stock, or shares. As men-
tioned, shareholders have ownership in the company. Te company has no
obligation to either repay the money the shareholders contributed or to make
regular payments, called dividends. However, investors who buy stocks expect
to earn a return by being able to sell their shares at a higher price than they
bought them and, possibly, by receiving dividends. Equity securities are dis-
cussed further in Chapter 9.
Places where buyers and sellers can trade securities are known as securities markets or
financial markets. A distinction is sometimes made within fnancial markets between
money markets, for securities that have a maturity shorter than a year, and capital
markets, for securities that have a maturity longer than a year. How securities are
issued, bought, and sold is explained in Chapters 13 and 15.
1
Copyright 2012 CFA Institute
Chapter 1 The Investment Industry: A Top- Down View 4
Te primary role of fnancial markets is to channel funds from savers to spenders.
Savers include individuals (households), companies (frms), and governments with
excess money to invest. Note that in this chapter and in the rest of the curriculum,
the terms money, cash, funds, and financial capital (or capital) may be used inter-
changeably. Savers provide capital to spenders.
Spenders include individuals, companies, and governments. For example, individuals
borrow to pay for houses, tuition, and unforeseen expenses. Companies borrow to
invest in real assets, such as land, buildings, or machinery. Tese real assets represent
a companys means (or factors) of production, and they are sometimes referred to as
physical capital. Governments borrow when their current tax receipts are insufcient
to fund their current spending plans.
Savers and spenders sometimes interact through fnancial markets. Te movement
of funds from those who have funds to invest (the savers who become providers of
capital) to those who need funds (the spenders who become users of capital) through
fnancial markets is called direct fnance. Savers and spenders often rely on individuals
in the investment industry to help them navigate fnancial markets. Te investment
industry is a subset of the fnancial services industry. It comprises all the players that
are instrumental in helping savers invest their money and borrowers get the funds they
require. Te major investment industry participants, such as exchanges, investment
brokers (brokers), investment dealers (dealers), fnancial advisers, and investment
analysts (analysts), are introduced in Section 4 of this chapter and discussed further
in Module 5.
Savers and borrowers often rely on fnancial intermediaries to fnd each other and to
channel funds between each other. Tis is indirect fnance. Financial intermediaries
act as middlemen between those who have funds to invest and those who need funds.
Credit institutions, such as banks, are a typical example of fnancial intermediaries.
Tey collect savings from lenders and transform them into loans to borrowers. Tis
transformation process is known as financial intermediation, hence the reason why
banks are called fnancial intermediaries. Other types of fnancial intermediaries are
discussed in Chapter 13.
Financial intermediaries and the investment industry play important roles in the
fnancial services industry. Many savers do not have the time or the expertise to iden-
tify and select individuals, companies, and governments to lend to or invest in. Once
savers have lent money, they have to monitor the borrowers behavior and fnancial
health to ensure that they will get their money backa task that is time- consuming
and costly. Matching savers and borrowers and monitoring borrowers are functions
that fnancial intermediaries can perform better and more cheaply than most investors
can do on their own. Te investment industry helps investors evaluate the behavior
and fnancial health of the companies and governments they invest in.
Because savers are assigning responsibilities to fnancial intermediaries and participants
in the investment industry, trust is essential to the proper functioning of the fnancial
services industry. Savers should have confdence that they will earn a return on their
investments and that they will be treated fairly by borrowers, fnancial intermediaries,
and investment industry participants. If trust is lacking, savers will be reluctant to
invest, and the economy will sufer.
How Economies Benefit from the Existence of the Investment Industry 5
Exhibit 1 summarizes graphically how funds can be channeled between savers and
spenders, either directly through fnancial markets or indirectly through fnancial
intermediaries.
Exhibit 1 Overview of the Financial Services Industry
Spenders/
Borrowers/
Users of Capital
Financial Intermediaries
Credit institutions
Other monetary financial
institutions
Other
Financial Markets
Money markets
Capital markets
DIRECT FINANCE
INDIRECT FINANCE
Funds
Funds
Funds Funds
Savers/
Lenders/
Providers of Capital
Funds
Source: Based on data from the European Central Bank (http://www.ecb.int/mopo/eaec/structure/
html/index.en.html).
HOW ECONOMIES BENEFIT FROM THE EXISTENCE OF THE
INVESTMENT INDUSTRY
Economic systems can take many forms, from pure capitalism with free markets to
planned economies with centralized authority. Te goal of all economic systems is the
efcient allocation of scarce resources to their most productive uses.
Resources, such as labor, real assets, and fnancial capital, are necessary to produce
goods and services. People have an unlimited desire for goods and services, but
resources are limited. To illustrate this concept of scarcity, assume that an individual
has a limited budget; his fnancial capital is scarce. Should he spend his money on
buying food, paying his mortgage, purchasing a new car, or going on an expensive
holiday? Similarly, should governments spend money on health care, education,
defense, or infrastructure?
Because resources are scarce, decisions must be made regarding the allocation of these
resources. All economic systems must address three questions: (1) Which goods and
services should be produced? (2) How should the goods and services be produced?
2
Chapter 1 The Investment Industry: A Top- Down View 6
(3) Who should receive the goods and services that are produced? Te allocation of
scarce resources is efcient if the scarce resources are used to produce goods and
services that best satisfy the needs of consumers.
2.1 Market Economies
Capitalism is an economic system that favors private ownership as the means of pro-
duction and markets as the means of allocating scarce resources. Markets are places
where buyers meet sellers to trade. Markets include goods and services markets as
well as fnancial markets.
In a pure, free market, capitalistic economy, there is no central authority, such as a
government, directing economic activity. Instead, individuals and companies make
their own decisions about what goods and services to manufacture and provide, and
they get to keep the profts from their activities. If everything goes according to plan,
scarce resources are deployed in the most efcient manner through the markets and
the economy grows at a healthy rate.
Pure free market capitalism is something that exists only in theory. In the real world,
governments play a role in all economies. In some capitalistic economies, such as in
Western economies, the governments role in business is fairly minimal. In countries
largely based on extraction of natural resources, such as some former Soviet Republics,
some Middle Eastern countries, and some South American countries, the government
maintains signifcant control over key national industries. In transition economies,
which are moving from socialist planned economies to market economies, the govern-
ment plays a signifcant role in the economy and business. Chinas economy is often
described as state capitalism because the Chinese central and local governments have
signifcant ownership of many businesses. In China, however, people can create and
invest in businesses and a great deal of market competition exists.
2.2 Benefits Provided by the Investment Industry
Te investment industry brings several benefts to the economy. It facilitates lending
and borrowing. As mentioned above, the investment industry is instrumental in
channeling funds between savers who have money but no immediate use for it and
spenders who have projects to fnance but insufcient capital to do so.
Te investment industry contributes to the efcient allocation of resources in the
economy. Without the investment industry, suppliers and users of capital would have
to spend signifcant resources fnding each other. Tese resources would be expended
on the search rather than on more productive uses, resulting in less efciency.
Te investment industry plays an important role in providing and processing infor-
mation about investment opportunities. Many investment industry participants help
investors collect and analyze macroeconomic data and information about individuals,
companies, and governments capital needs and asset values. Some of the tools and
inputs these participants use are described in Module 3.
How Individuals Benefit from the Existence of the Investment Industry 7
Investment industry participants package investment opportunities so that they sat-
isfy the needs of lenders and borrowers. Te investment industry ofers a wide range
of products and services that make it easier for savers to invest and for spenders to
access the funds they need. Tese investment products and services are discussed in
Modules 4 and 5.
Te investment industry also provides liquidity. Liquidity refers to the ease of buying
or selling an asset without afecting its price. Some assets, such as real estate, are
inherently illiquid. For example, if you wish to sell a house, it will likely take some time
to sell even if it is priced fairly compared with other houses in the market. If you want
to sell a house quickly, you may have to sell it at a lower price than you think is fair.
Other assets are more liquid, such as shares that trade actively. However, an investor
may hold such a large position (i.e., so many shares) that the sale of her position may
alter the price in the market. For example, if an investor owns 100 shares in a com-
pany with actively traded shares, she will likely be able to sell her shares quickly and
without afecting the stock price. However, if she owns 100,000 shares, she may not
be able to sell those shares quickly without afecting the price in the market. Liquidity
is a very important aspect of well- functioning fnancial markets because highly liquid
markets allow investors to complete a transaction quickly (and to reverse it quickly if
they change their minds) and to have confdence that they are getting the best price
at that particular moment.
All these benefts increase the willingness of suppliers of capital to provide funds
to those who need them. Capital put to better use fosters growth, which ultimately
benefts the economy.
HOW INDIVIDUALS BENEFIT FROM THE EXISTENCE OF THE
INVESTMENT INDUSTRY
In a well- functioning investment industry, investors are treated fairly and honestly.
As a result, they have confdence to commit their savings to investments. Investment
industry participants compete fairly for investors business, and they are competent
and trustworthy in managing investment products and portfolios, executing invest-
ment transactions, and advising on investment matters.
3.1 Benefits Provided by the Investment Industry
Below are some of the most important features that defne a well- functioning invest-
ment industry and, in turn, beneft investors.
Te frst important feature that characterizes a well- functioning investment industry
is the availability of a broad range of investment products and services that meet
investors needs. Investment products are not limited to the debt and equity securities
already presented. Other investment instruments, such as derivatives and alternative
investments, are described in Chapters 11 and 12, respectively.
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Chapter 1 The Investment Industry: A Top- Down View 8
Investment industry participants may also buy and sell various real and fnancial
assets and then package them to create new investment products (frequently referred
to as investment vehicles) and structures that suit the needs of investors better than
the original assets. Mortgage- backed securities provide an example. Tey represent
a claim on the cash fows that are expected to materialize not from a single mortgage
but from a large number of mortgages that have been grouped together in a process
called securitization. Other examples of investment vehicles and structures are pro-
vided in Chapter 14.
In addition to being able to choose from a broad range of investment products, inves-
tors beneft when they have access to a broad range of investment services that help
them make better decisions and implement those decisions. Te investment industry
ofers fnancial advisory, information, and trading services that are valuable to inves-
tors. How investment industry participants assess and serve the needs of investors is
discussed further in Module 7.
Investors beneft when fnancial markets are competitive. Markets in general and
fnancial markets in particular are competitive if a large number of players compete
with one another without any one of them having an undue infuence on supply or
demand. Supply refers to the quantity of a good or service sellers are willing and able
to sell, whereas demand refers to the quantity of a good or service buyers desire to buy.
More information about supply and demand and how the interaction of supply and
demand afects prices of goods and services is presented in Chapter 6. Competitive
markets promote higher production efciency and help keep prices of goods and
services, including investment products and services, down.
Investors also beneft when fnancial markets are liquid and transaction costs are low.
As mentioned earlier, liquidity ensures that investors can quickly buy or sell an asset
without afecting its price. Transaction costs are the costs associated with trading.
Because transaction costs reduce the return savers make on their investments, the
lower the transaction costs, the better. Te combination of liquidity and low trans-
action costs ensures that investors can trade as much (or as little) as they wish under
the best possible conditions.
To make reasonable judgments about their investments, investors need information
about the companies and governments to which they provide or may provide capital.
Terefore, access to relevant and reliable fnancial information is important. By helping
collect and process fnancial information, investment industry participants provide
benefts to investors. Timely access to this information is also critical because securities
prices may change quickly in response to new, relevant information. For example, the
stock price of an oil company that announces it has discovered a large new oil feld
will likely increase at the prospect of higher revenues and proft.
Another important feature that characterizes a well- functioning investment industry
is the ability to transform and transfer risk. Risk is defned as the efect of uncertain
future events on an organization or on the outcomes the organization achieves; risk
is discussed in greater detail in Chapter 17. Risk is an inherent element of investing,
and investors should always consider both return and risk when they make investment
decisions. For example, the individual who lent her savings to her neighbor faces the
risk that her neighbors business fails and she never gets her money back. Although
the prospect of investing in the next Apple, Google, or Microsoft may be appealing,
the investor may fnally decide not to lend her money to her neighbor if losing her
entire savings would have a devastating efect on her lifestyle. Te investment industry
How Individuals Benefit from the Existence of the Investment Industry 9
ofers those who want to reduce risk the opportunity to do so. For example, products
that represent some form of insurance may be available for purchase. Tose who are
willing to take on risk may sell insurance or ofer investments that allow others to
reduce their risks.
3.2 Laws, Regulations, and Trust
Laws and regulations are necessary to ensure that investors are treated fairly and
honestly. Usually, laws are passed by a legislative body, such as Congress in the United
States, Parliament in the United Kingdom, or the Diet in Japan. Regulations are created
by agencies, such as the Canadian Securities Administrators in Canada, the Autorit
des Marchs Financiers in France, or the Securities & Futures Commission in Hong
Kong. Both laws and regulations are enforceable, and enforcement is critical for laws
and regulations to be efective.
Te form and extent of laws and regulations vary between countries and change
over time, but there are some general principles that apply consistently. Laws and
regulations are designed to
prevent fraud;
protect investment industry participants, in particular investors; and
promote and maintain the integrity, transparency, and fairness of fnancial
markets.
For example, trading based on nonpublic information that could afect a securitys
price, called insider trading, is generally forbidden across most jurisdictions. An analyst
who learns during a private meeting with a companys management that the company
is about to acquire a competitor is not allowed to buy or sell shares in the company
or its competitor until the company has ofcially announced the acquisition. If the
analyst were to trade before this information is available to all market participants, he
could gain from his inside information and the integrity and fairness of the fnancial
market would be compromised.
Although the investment industry is subject to laws and regulations, these laws and
regulations cannot cover every situation and cannot prevent fraud or market abuse
from happening. Tis is why it is important that
individuals who work in the investment industry behave ethically, in accordance
with a set of moral principles, and act professionally; and
organizations that employ these individuals promote cultures of integrity.
Ethical behavior on the part of investment industry participants is paramount to
protecting the reputation of the industry and to maintaining trust in the industry.
Without trust, savers may be less likely to make investments, which would ultimately
be detrimental to the economy.
We return to the discussion of ethics and regulation in Chapters 2 and 3, respectively.
Chapter 17 also addresses the issue of compliance with laws and regulations.
Chapter 1 The Investment Industry: A Top- Down View 10
INVESTMENT INDUSTRY PARTICIPANTS
Tere are many investment industry participants who help savers invest their funds
and help lenders get the funds they require. Anybody working in the investment
industry or using services provided by the investment industry is bound to come in
contact with several of these players.
4.1 Major Players
To introduce some of the major players, consider the example of a Canadian company
that needs funds to support its growth. Te company may generate funds from its
current operations, but if the funds are not enough to support its growth plans, it will
have to turn to providers of capital. Te investment industry can help the company
raise the funds it needs and allow investors to participate in the companys growth.
We frst discuss investment industry participants that may help the Canadian company
to raise funds. Ten we discuss investors and investment industry participants that
may help them to invest funds.
4.1.1 Raising Funds and Investment Industry Participants
Te Canadian company wants to issue shares to raise additional equity capital. Until
now, it has been private; it has not raised funds by issuing shares publicly. It wants to
take the equity issuance opportunity to become a public company and have its stock
listed on the Toronto Stock Exchange. Stock exchanges are organized and regulated
fnancial markets that allow buyers and sellers to trade shares with each other.
Te company contacts an investment bank. Investment banks have expertise in helping
companies and governments raise funds globally. Te investment bank will organize
the companys frst equity issuance, called an initial public offering (IPO). Chapter 9
provides more details about IPOs and equity issuances in general.
Te investment bank will help determine the price at which the new shares will be
issued. To do so, it not only has to assess the companys value, but it also has to gauge
investor interest in purchasing shares of the company. Te investment banks ana-
lystsoften called sell- side analysts because they work for the organization selling
the securitieswill collect and analyze information about the company and prepare
detailed reports that can be shared with potential investors.
Once the investment bank has determined the price of the new shares, the IPO will
take place in the primary marketthat is, the market where new securities, IPOs,
and subsequent oferings are issued and sold to investors. In exchange for providing
money to the company, investors will receive shares in the company. Companies get
funds when they issue new securities in primary markets. After the IPO, the companys
shares will be traded in the secondary marketthat is, the market where investors buy
and sell securities to each other. Te Canadian company will not receive any capital
from the trading of its shares in the secondary market.
4
Investment Industry Participants 11
Now that the Canadian company is a public company, it will have to comply with the
rules set forth by the Toronto Stock Exchange and with relevant Canadian laws and
regulations. One typical rule is related to fnancial reporting; the Canadian company
will have to fle quarterly fnancial statements and audited annual fnancial state-
ments. Auditors, who evaluate a companys accounting and internal controls, play
a very important role. Tey ensure that investors receive reliable information, a key
feature of a well- functioning investment industry. More information about fnancial
statements is provided in Chapter 4.
4.1.2 Investing Funds and Investment Industry Participants
Te Canadian company may have sold its shares to many investors. When investors
want to buy (sell) shares in the secondary market, they need to fnd another investor
who is willing to sell (buy) shares. Brokers and dealers are very important investment
industry participants who facilitate trading between investors. Brokers act as agents.
Tey do not trade directly with market participants; they only help buyers and sellers
fnd one another and trade with each other. In contrast, dealers act as principals.
Tey use their own accounts and their own capital to trade with buyers and sellers in
what is known as proprietary trading. Tey make markets in securities by acting as
buyers when investors want to sell and as sellers when investors want to buy. Brokers
and dealers provide liquidity and help reduce transaction costs; as mentioned earlier,
liquidity and low transaction costs are benefcial to investors.
Tere are also investment industry participants that provide trading support. Tey
include clearing and settlement agents that confrm and settle trades after they
have been arranged. Custodians also provide trading support by holding money and
securities on behalf of their clients.
Tere are diferent categories of investors, which are discussed further in Chapters 13
and 19. Institutional investors are typically organizations that invest for themselves to
advance their mission or invest for others to meet the others needs. For example, pen-
sion funds manage portfolios for the beneft of current and future retirees. Institutional
investors usually rely on their own analysts to review a potential investment. Tese
analysts are called buy- side analysts because they work for the organization buying
the securities. Tey rely on investment information service providers, such as data
vendors and investment research providers, to gather data about the company and
its environment.
Individual investors often do not have the time, the inclination, or the expertise to
perform their own analysis. Some of them, such as wealthy individuals called high-
net- worth investors, may seek the help of investment professionals, such as fnancial
advisers (also called investment advisers). Financial advisers help their clients under-
stand their future fnancial needs and the risks they face when investing as well as
provide advice about investments. High- net- worth investors very often give authority
to their advisers to manage the investments on their behalf. Tese advisers are called
investment managers or asset managers.
Many investors may be willing to invest but lack sufcient fnancial resources to
contract an asset manager to look after their investments. Tese investors, called
retail investors, very often buy investment products created and managed by banks,
insurance companies, or investment management frms. For example, an individual
Chapter 1 The Investment Industry: A Top- Down View 12
who wishes to plan for her retirement may need a convenient and inexpensive way
of investing money regularly. She may buy shares in a mutual fund, a professionally
managed vehicle that has investments in a range of securities.
Exhibit2 summarizes the investment industry participants introduced in this section.
Tey are grouped into categories that are discussed further in Chapter 13. Te rest
of the curriculum provides more information about how these participants operate
and how they interact with one another and with investors.
Exhibit 2 Investment Industry Participants
Funds
Funds
Investment
Information Service
Providers
Investment
research providers,
analysts
Financial Advisory
Service Providers
Financial advisers
Investment
Management
Service Providers
Asset managers
Investment Banks
Savers/
Lenders/
Providers of Capital
Retail, high-net-
worth, and
institutional
investors
Spenders/
Borrowers/
Users of Capital
Individuals,
companies,
governments
Financial
Markets
Custodial Service
Providers
Custodians
Trading Service
Providers
Exchanges,
brokers, dealers,
clearing and
settlement agents
All these players can afect trust in the investment industry through their relationships
with one another and with their clients. Trust in the investment industry is only as
strong as the trust in its weakest link; it is thus critical that all players act with integrity.
Investment Industry Participants 13
4.2 Duty of Care
As presented above, there are diferent types of investment professionals, such as
fnancial advisers and asset managers, who provide advice to investors. Investment
professionals are held to diferent duties of care to their clients. Duty of care refers to
the legal obligations that investment professionals have when acting for or on behalf of
their clients. Te level of care depends not on the title of the investment professional
but on the laws and regulations where the investment professional is based and the
role the investment professional plays when advising his clients.
In the United States, there are two levels of care: a high standard of care, called the
fduciary standard, and a lower standard of care, called the suitability standard. To
diferentiate these two levels of care, consider the example of a fnancial adviser who
has to recommend an investment product to her client. Whether the adviser is held to
a fduciary or suitability standard, she must understand her clients objectives in terms
of risk and return and any constraints her client may have. Te process of identifying
an investors needs and constraints is described in Chapter 19. If the investment adviser
is held to the fduciary standard, she is required to recommend the best investment
product. In contrast, if the investment adviser is held to the suitability standard, she
has to recommend an investment product that meets her clients objectives and con-
straints, but it does not have to be the best investment product. It is sufcient for the
investment product to meet the clients objectives and constraints even if there is a
better alternative available. Te distinction between the fduciary and the suitability
standardis particularly important if the adviser represents certain funds or products.
Laws and regulations across Asia vary greatly, but in some places, such as Singapore
and Hong Kong, the legal concept of fduciary duty is based on the British legal system.
Duties of care, similar to the suitability standard described earlier, are usually defned
by laws and regulations that are country specifc.
Duty of care in the European Union is governed by the Markets in Financial Instruments
Directive (MiFID). Te options in the EU are either a suitability standard or an appro-
priateness standard. Te appropriateness standard only requires investment profes-
sionals to assess a clients level of understanding, not to review the clients objectives
and constraints. Te suitability standard is the higher standard and requires the
investment professional to review and consider the clients objectives and constraints.
Investors seeking advice from investment professionals should understand the laws
and regulations that apply to these investment professionals and the duty of care these
investment professionals hold with regard to their clients. Tese issues may infuence
investment professionals advice signifcantly. In particular, investors must assess when
the interests of investment professionals may not be aligned with their own interests,
which is known as a conflict of interest. For example, an investment manager might
have a monetary incentive to invest a clients money in a particular investment product
or to buy and sell assets more actively than is justifed for the client.
Chapter 1 The Investment Industry: A Top- Down View 14
KEY FORCES DRIVING THE INVESTMENT INDUSTRY
Te four key forces that drive the investment industry are competition, computeri-
zation, globalization, and regulation.
Competition in the investment industry is based on innovative investment product
oferings. It is also based on pricing, service, and performance.
Over the years, technological advancements have allowed investment industry par-
ticipants to reduce operating costs. Computerization, in particular, has dramatically
decreased trade processing costs and increased trade processing capacity. It has also
spurred the development and analysis of innovative types of investment products.
Globalization is another force driving the investment industry. Investors look outside
their domestic markets to diversify their investments and generate higher returns.
Emerging markets, in particular, hold the promise for higher rates of growth. For
example, China, Brazil, and India are emerging economies that are growing faster
than developed economies. Furthermore, such countries as China, Saudi Arabia, and
Russia, which have trade surpluses, use those surpluses to invest abroad in a variety
of opportunities. Tese foreign investments contribute to economic development as
well as to the overall profts of the investment industry.
Globally, there has been a growing trend toward greater regulation of the investment
industry. Regulation is needed to protect investors and safeguard their investments.
By promoting disclosure and transparency, it is hoped that regulation will prevent the
kinds of mistakes and frauds that have cost investors signifcant amounts of money over
the years. International cooperation among fnancial regulators has played and should
continue to play an important role in raising global standards of securities regulation.
SUMMARY
Te fnancial services industry exists to provide a link between savers/lenders/
providers of capital that have funds to invest and spenders/borrowers/users of
capital that need funds.
Financial intermediaries help channel fnancial capital efciently between savers
and spenders.
Te investment industry comprises all the players that are instrumental in help-
ing savers invest their money and borrowers get the funds they require.
Capitalism takes diferent forms, but two important characteristics are that it
favors private ownership as the means of production and markets as the means
of allocating resources.
5
Summary 15
Te investment industry provides several benefts to the economy, including
the efcient allocation of scarce resources, better information about investment
opportunities, products and services that are appropriate for suppliers and
users of capital, and liquidity.
Te benefts for investors of a well- functioning investment industry include a
broad range of investment products and services that meet their needs, com-
petitive markets that provide liquidity and keep transaction costs low, timely
and efcient disclosure of information, and the ability to modify their risk
exposures.
Laws and regulations are necessary to protect clients and ensure the integrity,
transparency, and fairness of fnancial markets.
Ethical behavior is critical to protecting the reputation of and maintaining trust
in the investment industry.
Investment industry participants include the following:
Categories Participants Key Characteristics
Investors Retail investors Individual investors with the least
amount of assets
High- net- worth
investors
Individual investors with a higher
amount of assets
Institutional
investors
Organizations that invest to advance
their mission or to provide fnancial
services to their clients
Financial advisory
service providers
Financial advisers Professionals that provide advice
about investments and help clients
understand their needs and the risks
they face
Investment man-
agement service
providers
Asset managers Professionals that manage invest-
ments on behalf of their clients
Investment informa-
tion service providers
Data vendors Organizations that provide informa-
tion resources
Investment research
providers
Organizations that produce informa-
tion reports
Analysts Professionals who produce research
reports
(continued)
Chapter 1 The Investment Industry: A Top- Down View 16
Categories Participants Key Characteristics
Trading service
providers
Exchanges Financial markets that allow investors
to trade
Brokers Professionals and their frms that
facilitate trading between investors,
acting as agents (do not trade with
their clients)
Dealers Professionals and their frms that
facilitate trading between investors,
acting as principals (trade with their
clients)
Clearing and settle-
ment agents
Organizations that confrm and settle
trades
Custodial service
providers
Custodians Organizations that hold money and
securities on behalf of their clients
Investment professionals are held to varying standards of care based on regula-
tory jurisdiction and the investment professionals role. Some are held to a high
level of care (fduciary standard), whereas others are held to a lower level of
care (suitability standard or appropriateness standard).
Te four key forces that drive the investment industry are competition, comput-
erization, globalization, and regulation.
Chapter Review Questions 17
CHAPTER REVIEW QUESTIONS
Test your knowledge of this chapter at cfainstitute.org/claritasstudy.
1 Te fnancial services industry benefts the economy by providing a link
between providers of capital and:
A savers.
B lenders.
C borrowers.
2 Te investment industry benefts the economy by:
A increasing risk.
B decreasing liquidity.
C increasing efciency.
3 Which of the following best describes a beneft of a well- functioning investment
industry from the perspective of an individual investor?
A Risk transformation
B Scarce resource allocation
C Fewer fnancial intermediaries
4 A major beneft of competitive markets for the individual investor is:
A risk transfer.
B lower prices.
C greater integrity.
5 Which of the following would most likely assist high- net- worth individuals in
arranging their fnancial afairs?
A Financial advisers
B Investment dealers
C Investment bankers
Copyright 2012 CFA Institute
Chapter 1 The Investment Industry: A Top- Down View 18
6 Which of the following is least likely to facilitate trading and help reduce trans-
action costs?
A Stock exchanges
B Investment dealers
C Investment analysts
7 Relative to the suitability standard of care for investment professionals, the
fduciary standard of care is:
A lower.
B higher.
C equivalent.
8 Which of the following forces that drive the investment industry promotes
transparency of fnancial markets?
A Competition
B Computerization
C Regulation
9 Globally, regulation of the investment industry has:
A increased.
B decreased.
C remained stable.
Answers 19
ANSWERS
1 C is correct. Te fnancial services industry exists to provide a link between
providers of capital (also called savers, lenders, or investors) that have funds to
invest and users of capital (also called spenders or borrowers) that need funds.
A and B are incorrect because savers and lenders are providers, not users, of
capital.
2 C is correct. Te investment industry helps savers invest their money and helps
borrowers get the funds they require. In doing so, it reduces the resources that
would be expended on the search rather than on productive uses, thus increas-
ing efciency. A is incorrect because the investment industry helps transform
and transfer risk, not increase it. B is incorrect because the investment industry
increases rather than decreases liquidity.
3 A is correct. In a well- functioning investment industry, risks can be trans-
formed and transferred. Individuals who want to reduce risk can do sofor
example, by buying insurance. B is incorrect because the efcient allocation
of scarce resources through a well- functioning investment industry is a pri-
mary beneft for the economy, not the individual. C is incorrect because a
well- functioning investment industry is characterized by competitive markets.
Competitive markets are made up of a large number of fnancial intermedi-
aries (e.g., banks or insurance companies) that compete with one another.
Competitive markets keep prices of investment products and services down.
4 B is correct. Competitive markets promote higher production efciency and
help keep prices of investment products and services down. A is incorrect
because risk transfer, although it is a beneft for the individual investor, deals
with transferring risk from those that want to reduce risk to those that are will-
ing to take on risk; risk transfer does not deal with competition. C is incorrect
because greater integrity is achieved by efective laws and regulations and not
through competition.
5 A is correct. Financial advisers typically provide high- net- worth individuals
with advice about how to manage their investments. B is incorrect because
investment dealers facilitate trading between investors. C is incorrect because
investment bankers help companies and governments raise funds globally.
6 C is correct. Investment analysts are primarily engaged in analyzing investment
opportunities and providing recommendations about the investments they
follow. A is incorrect because stock exchanges facilitate trading of new and
existing securities and, as such, help reduce transaction costs. B is incorrect
because investment dealers facilitate trading by acting as buyers when investors
want to sell and as sellers when investors want to buy. By doing so, they help
reduce transaction costs.
7 B is correct. Investment professionals who have a fduciary responsibility to
their clients must act in their clients best interests. Te fduciary standardis
a higher standard of care than the suitability standard. A and C are incorrect
Chapter 1 The Investment Industry: A Top- Down View 20
because investment professionals who have a fduciary responsibility to their
clients have a higher, not lower or equivalent, standard of care than investment
professionals who must meet the suitability standard of care.
8 C is correct. Regulation promotes transparency. Increased transparency is
designed to prevent mistakes and fraud. A is incorrect because competition,
although one of the four forces, does not promote transparency. B is incorrect
because computerization, although it is one of the four forces, does not pro-
mote transparency. Regulation is the only one of the four forces that promotes
transparency.
9 A is correct. Globally, there has been a growing trend toward greater regulation
of the investment industry. B and C are incorrect because globally, there has
been a growing trend toward increased regulation of the investment industry,
not a trend of decreased or stable regulation.
GLOSSARY
G-1
Analysts Analysts select, evaluate, and interpret information
to arrive at an opinion.
Asset managers See investment managers.
Assets Resources that a company controls as a result of past
events and that are expected to provide future economic
benefts.
Auditors An external auditor is an independent accountant
that examines fnancial statements and provides a writ-
ten opinion on them. An internal auditor is employed by
the company and evaluates a companys accounting and
internal controls.
Bond A formal contract that represents a loan from an investor
(bondholder) to an issuer. Te contract describes the key
terms of the debt obligation such as the interest rate and
the maturity.
Brokers Agents who execute orders to buy or sell securities
for their clients and provide trading services in exchange
for a commission.
Capital markets Financial markets for securities that have a
maturity longer than a year.
Capitalism An economic system that favors private ownership
as the means of production and markets as the means of
allocating scarce resources.
Clearing and settlement agents Investment industry partici-
pants that confrm and settle trades after they have been
arranged.
Conflict of interest When either the employees personal inter-
ests or the employers interests confict with the interests
of the client (conficts of interest can also arise when
employees and employers interests confict).
Custodians Entities that hold money and securities on behalf
of their customers, help arrange trade settlements, and
collect interest and dividends for their customers.
Dealers Financial intermediaries that allow their clients to
trade when they want to trade by standing ready to buy
(sell) when their clients want to sell (buy) by acting as
principals in trades.
Demand Te desire for a good or service coupled with the ability
and willingness to pay for the desired product.
Duty of care Te legal and professional obligations that invest-
ment professionals have when acting for or on behalf of
their clients.
Financial advisers Investment professionals who provide both
fnancial planning and investment advisory services to
their clients.
Financial assets Claims on other assets and on future cash
fows; for example, a share of common (ordinary) stock
represents ownership in a company or a claim on the
residual value of the company.
Financial capital Funds provided to corporations and govern-
ments that allow them to purchase physical capital, to hire
labor, and to acquire other inputs necessary to produce
goods and services.
Financial intermediaries Financial institutionssuch as banks,
securitizers, and insurance companiesthat channel funds
from savers to spenders; they transform deposits made by
savers into loans to borrowers.
Financial intermediation Process of collecting savings from
lenders in one form, such as deposits, and transforming
them into another form, such as loans, for borrowers.
Financial markets Places where buyers and sellers can trade
securities; also called securities markets.
Fixed- income securities Loans that lenders make to borrowers;
also called debt securities and bonds.
High- net- worth investors Individual investors who have inves-
table assets over a certain amount (e.g., USD1million or
CNY10million) and who are often, but not always, more
sophisticated investors.
Initial public offering Te frst issuance of common shares to
the public by a formerly private corporation.
Insider trading Trading while in possession of material non-
public information.
Institutional investors Companies, trusts, and governments
that invest to advance their missions or to provide fnancial
services to their clients.
Investment banks Financial intermediaries that typically
provide capital raising and strategic advisory services,
brokerage and dealing services, and research services to
companies and governments.
Investment industry All the players that are instrumental
in helping savers invest their money and lenders get the
funds they require.
Laws Rules passed by a legislative body, such as Congress in
the United States, Parliament in the United Kingdom, or
the Diet in Japan.
Liquidity Measure of the ease of buying or selling an asset
without afecting its price.
Money markets Financial markets for securities that have a
maturity shorter than a year.
G-2 Glossary G-2 Glossary
Mutual fund Investment company that holds portfolios of
investment securities and assets.
Pension funds Institutional investors who hold investment
portfolios for the beneft of future and current retirees.
Physical capital Te means of production; tangible goods such
as equipment, tools, and buildings.
Primary market Te market where new securities, IPOs, and
subsequent oferings are issued and sold to investors.
Proprietary trading When dealers trade using their own
accounts and their own capital with buyers and sellers.
Real assets Physical assets such as land, buildings, cattle,
and gold.
Regulations Rules that set standards for conduct and that
carry the force of law.
Retail investors Individual investors who have the least amount
of investable assets and who are often, but not always, less
sophisticated investors than institutional investors.
Risk Te efect of uncertain future events on an organization
or on the outcomes the organization achieves.
Secondary market Market in which traders of a security trade
with each other but not with the original security issuer;
market in which investors buy and sell securities with
each other.
Securities Financial assets that can be traded.
Stock exchanges Organized and regulated fnancial markets
that allow buyers and sellers to trade securities with each
other.
Stocks Ownership in a company; also called equity securities,
shares of stock, or shares.
Supply Te quantity of a good or service sellers are willing and
able to sell at a given price.
Transaction costs Costs that accrue from brokerage com-
missions, bidask spreads, and market impact; the costs
associated with trading.
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