International Introduction to Securities & Investment PDF (CISI, Edition 16, June 2023)

Investment Operations Certificate International Introduction to Securities & Investment Edition 16, June 2023 This workbook relates to syllabus version 16.0 and will cover exams from 10 September 2023 to 9 September 2024 Welcome to the Chartered Institute for Securities & Investment’s International Introduction to Securities & Investment study material. This workbook has been written to prepare you for the Chartered Institute for Securities & Investment’s International Introduction to Securities & Investment examination. Published by: Chartered Institute for Securities & Investment © Chartered Institute for Securities & Investment 2023 20 Fenchurch Street, London EC3M 3BY, United Kingdom Tel: +44 20 7645 0600 Email: [email protected] Fax: +44 20 7645 0601 www.cisi.org/qualifications Author: Dianne Ramdeen, MSc, FCCA, CFA, MCSI Reviewers: JB Beckett, Chartered MCSI Kevin Rothwell, FCSI This is an educational workbook only and the Chartered Institute for Securities & Investment accepts no responsibility for persons undertaking trading or investments in whatever form. While every effort has been made to ensure its accuracy, no responsibility for loss occasioned to any person acting or refraining from action as a result of any material in this publication can be accepted by the publisher or authors. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording or otherwise without the prior permission of the copyright owner. Warning: any unauthorised act in relation to all or any part of the material in this publication may result in both a civil claim for damages and criminal prosecution. Candidates should be aware that the laws mentioned in this workbook may not always apply to Scotland. A learning map, which contains the full syllabus, appears at the end of this workbook. The syllabus can also be viewed on cisi.org and is also available by contacting the Customer Support Centre on +44 20 7645 0777. Please note that the examination is based upon the syllabus. Candidates are reminded to check the Candidate Update area details (cisi.org/candidateupdate) on a regular basis for updates as a result of industry change(s) that could affect their examination. The questions contained in this workbook are designed as an aid to revision of different areas of the syllabus and to help you consolidate your learning chapter by chapter. Please note that, as part of exam security, hand-held calculators are not allowed in CISI exam venues. Candidates must use the onscreen calculator for all CISI CBT exams in all languages in the UK and internationally. Workbook version: 16.1 (June 2023) II Important – Keep Informed on Changes to this Workbook and Examination Dates Changes in industry practice, economic conditions, legislation/regulations, technology and various other factors mean that practitioners must ensure that their knowledge is up to date. At the time of publication, the content of this workbook is approved as suitable for examinations taken during the period specified. However, changes affecting the industry may either prompt or postpone the publication of an updated version. It should be noted that the current version of a workbook will always supersede the content of those issued previously. Keep informed on the publication of new workbooks and any changes to examination dates by regularly checking the CISI’s website: cisi.org/candidateupdate Learning and Professional Development with the CISI The Chartered Institute for Securities & Investment is the leading professional body for those who work in, or aspire to work in, the investment sector, and we are passionately committed to enhancing knowledge, skills and integrity – the three pillars of professionalism at the heart of our Chartered body. CISI examinations are used extensively by firms to meet the requirements of government regulators. Besides the regulators in the UK, where the CISI head office is based, CISI examinations are recognised by a wide range of governments and their regulators, from Singapore to Dubai and the US. Around 50,000 examinations are taken each year, and it is compulsory for candidates to use CISI learning workbooks to prepare for CISI examinations so that they have the best chance of success. Our workbooks are normally revised every year by experts who themselves work in the industry and also by our Accredited Training Partners, who offer training and elearning to help prepare candidates for the examinations. Information for candidates is also posted on a special area of our website: cisi.org/candidateupdate. This workbook not only provides a thorough preparation for the examination it refers to, it is also a valuable desktop reference for practitioners, and studying from it counts towards your Continuing Professional Development (CPD). Mock examination papers, for most of our titles, will be made available on our website, as an additional revision tool. CISI examination candidates are automatically registered, without additional charge, as student members for one year (should they not be members of the CISI already), and this enables you to use a vast range of online resources, including CISI TV, free of any additional charge. The CISI has more than 40,000 members, and nearly half of them have already completed relevant qualifications and transferred to a core membership grade. You will find more information about the next steps for this at the end of this workbook. III IV 1 1 Introduction: The Financial Services Sector................. The Economic Environment........................... 25 2 The workbook commences with an introduction to the financial services sector and examines the role of the sector and the main participants that are seen in financial centres around the globe. Equities/Stocks................................... 47 3 An appreciation of some key aspects of macroeconomics is essential to an understanding of the environment in which investment services are delivered. This chapter looks at some key measures of economic data and the role of central banks in management of the economy. Bonds........................................ 79 4 The workbook then moves on to examine some of the main asset classes in detail, starting with equities. It begins with the features, benefits and risks of owning shares or stocks, looks at corporate actions and some of the main world stock markets and indices, and outlines the methods by which shares are traded and settled. Other Markets and Investments........................ 103 5 A review of bonds follows which includes looking at the key characteristics and types of government and corporate bonds and the risks and returns associated with them. 119 6 Derivatives..................................... 135 7 This chapter starts the review of financial assets and markets by looking at the characteristics of cash deposits, the money markets, property and the foreign exchange markets. Next there is a brief review of derivatives to provide an understanding of the key features of futures, options and swaps and the terminology associated with them. Investment Funds................................. The workbook then turns to the major area of investment funds or mutual funds/ collective investment schemes. The chapter looks at open-ended and closed-ended funds, exchange-traded funds and hedge funds, and how they are traded. V 8 Regulation and Ethics................................. 155 An understanding of regulation is essential in today’s investment industry. This chapter provides an overview of international regulation and looks at specific areas such as money laundering, insider trading and bribery as well as a section on professional integrity and ethics. 9 Other Financial Products.............................. 171 The workbook concludes with a review of the other types of financial products, including loans, mortgages and protection products, including life assurance. 10 Financial Advice.................................... 189 The workbook concludes with a look at the main areas of financial advice, the financial advice process and the legal concepts. Glossary......................................... 215 Multiple Choice Questions.............................. 223 Syllabus Learning Map................................ It is estimated that this workbook will require approximately 80 hours of study time. What next? See the back of this book for details of CISI membership. Need more support to pass your exam? See our section on Accredited Training Partners. Want to leave feedback? Please email your comments to [email protected] VI 239 Before you open Chapter 1 We love a book!...but don’t forget you have been sent a link to an ebook, which gives you a range of tools to help you study for this qualification Depending on the individual subject being studied and your device, your ebook may include features such as: A A Watch video clips related to your syllabus Highlight, bookmark and make annotations digitally* Read aloud function* Images, tables and animated graphs Adjustable text size allows you to read comfortably on any device* Links to relevant websites Pop-up definitions End of chapter questions and interactive multiple choice questions * These features are device dependent. Please consult your manufacturers guidelines for compatibility Find out more at cisi.org/ebooks ebook bw 18.indd 1 The use of online videos and voice functions allowed me to study at home and on the go, which helped me make more use of my time. I would recommend this as a study aid as it accommodates a variety of learning styles. Billy Snowdon, Team Leader, Brewin Dolphin 02/10/2018 12:01:33 1 Chapter One Introduction: The Financial Services Sector 1. Financial Services Sector 3 2. Financial Markets 5 3. Participants 11 4. Investment Distribution Channels 19 5. Technological Advances and Other Developments 21 This syllabus area will provide approximately 3 of the 50 examination questions 2 1. Financial Services Sector In this chapter, we will look at the role that the financial services sector undertakes within both the local and the global economy. The world is becoming increasingly integrated and interdependent, as trade and investment flows are global in nature. With this background, therefore, it is important to understand the core role that the financial services sector performs within the economy and some of the key features of the global financial services sector. The financial services sector plays a critical role in advanced and developing economies, and the services it provides can be broken down into three core functions: The investment chain – through the investment chain, savers and borrowers are brought together. Savers provide financing to businesses, and businesses that wish to grow offer opportunities for savers to take part in the growth and resulting potential returns. The efficiency of this chain is critical to allocating what would otherwise be uninvested capital to businesses that can use it to grow their enterprises, as well as the savings pools of the investors. This chain, therefore, raises productivity and, in turn, improves the competitiveness of those financial markets within the global economy. Risk – in addition to the opportunities that the investment chain provides for pooling investment risks, the financial services sector allows other risks to be managed effectively and efficiently through the use of insurance, and increasingly through the use of sophisticated derivatives. These tools help businesses cope with global uncertainties as diverse as the changing value of currencies, the incidence of major accidents or extreme weather conditions. They also help households protect themselves against everyday contingencies. 3 1 Introduction: The Financial Services Sector Payment systems – payment and banking services operated by the financial services sector provide the practical mechanisms for money to be managed, transmitted and received quickly and reliably. It is an essential requirement for commercial activities to take place and for participation in international trade and investment. Access to payment systems and banking services is a vital component of financial inclusion for individuals. The financial services sector provides the link between organisations needing capital and those with capital available for investment. For example, an organisation needing capital might be a growing company, and the capital might be provided by individuals saving for their retirement in a pension fund. It is the financial services sector that channels the money invested to those organisations that need it and provides execution, payment, advisory and management services. The Global Financial Centres Index is produced by Z/Yen1 and evaluates the rankings and future competitiveness of 111 major financial centres based on the following five areas of competitiveness: Business environment. Human capital. Infrastructure. Financial sector development. Reputation. The Global Financial Centres Index 30 (GFCI 30), published in 2022, showed that New York retained its number one place in the rankings, with London not far behind. Top Five Global Financial Centres 1 New York 2 London 3 Hong Kong 4 Shanghai 5 Los Angeles This chapter looks at how the financial sector is structured and some of its key participants. 1 4 GFCI 30 Rank – Long Finance (https://www.longfinance.net/programmes/financial-centre-futures/global-financialcentres-index/gfci-31-explore-data/gfci-31-rank/) Introduction: The Financial Services Sector 1 2. Financial Markets Learning Objective 1.1.2 Know the function of and differences between retail and professional/commercial business and who the main customers are in each case Within the financial services sector, there are two distinct areas: the wholesale and retail sectors. The wholesale sector is also sometimes referred to as the professional sector or the institutional sector. The activities that take place in wholesale financial markets are shown below and are expanded on in sections 2.1 to 2.5: Equity markets – the trading of quoted shares. Bond markets – the trading of government, supranational or corporate debt. Foreign exchange – the trading of currencies. Derivatives – the trading of options, swaps, futures and forwards. Insurance markets – major corporate insurance (including professional indemnity), reinsurance, captive insurance and risk-sharing insurance. Other activities that take place in the wholesale sector include: fund management – managing the investment portfolios of collective investment schemes (CISs), pension funds and insurance funds investment banking – banking services tailored to organisations, such as undertaking mergers and acquisitions (M&A), equity trading, fixed-income trading and private equity, and custodian banking – provision of services to asset managers involving the safekeeping of assets, the administration of the underlying investments, settlement, corporate actions and other specialised activities. By contrast, the retail sector focuses on services provided to personal customers: Retail banking – the traditional range of current accounts, deposit accounts, lending and credit cards. Insurance – the provision of a range of life assurance and protection solutions for areas such as medical insurance, critical illness cover, motor insurance, property insurance, income protection and mortgage protection. Pensions – the provision of investment accounts specifically designed to capture savings during a person’s working life and provide benefits on retirement. Investment services – a range of investment products and vehicles ranging from execution-only stockbroking to full wealth management services and private banking. Financial planning and financial advice – helping individuals to understand and plan for their financial future. 5 2.1 Equity Markets Equity markets is the name given to stock markets where the ordinary and preferred shares of companies, such as Amazon, Apple, Facebook and Netflix, are traded. Equity markets are the bestknown of the financial markets and facilitate the trading of shares in quoted or listed companies. The World Federation of Exchanges provides data from global stock exchanges. As illustrated in the following graph, global market capitalisation was over US$100 trillion at the end of 2022 (note that not all stock exchanges provide data to the World Federation of Exchanges so actual figures may well be higher). Global market capitalisation is the total value of shares quoted on the world’s stock exchanges. Market Capitalisation 120 USD Million 100 80 60 40 20 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 2020 2022 Source: World Federation of Exchanges The following are some key statistics on the equity markets as at the end of 2022: 6 The New York Stock Exchange (NYSE) was the largest exchange in the world, with a domestic market capitalisation of over US$24 trillion (domestic market capitalisation is the value of shares listed on an individual exchange). The other major US market, Nasdaq, was ranked as the second largest, with a domestic market capitalisation of around US$16 trillion, meaning that the two New York exchanges account for a significant proportion of all exchange business. The Shanghai Stock Exchange (SSE) is now the world’s third largest exchange, with a domestic capitalisation of over US$6 trillion. The Shenzhen Stock Exchange (SZSE) is the sixth largest exchange, with a domestic market capitalisation of over US$4 trillion. Japan Exchange Group, which includes the Tokyo Stock Exchange (TSE), is the world’s fifth largest market, with a domestic market capitalisation of over US$5 trillion. In Europe, the largest exchanges are the London Stock Exchange (LSE), Euronext, SIX Swiss Exchange and Deutsche Börse AG. In the Middle East, Tadawul – the Saudi Stock Exchange is the largest exchange, with a domestic market capitalisation of over US$2.5 trillion. Rivals to traditional stock exchanges have also arisen with the development of technology and communication networks known as multilateral trading facilities (MTFs). MTFs are systems that bring together multiple parties that are interested in buying and selling financial instruments including shares, bonds and derivatives. These systems are also known as crossing networks or matching engines that are operated by an investment firm or another market operator. We will look at equities and equity markets in more detail in chapter 3. Source: World Federation of Exchanges 2.2 Bond Markets Bond markets allow governments and companies to raise loans or debt finance directly from investors and then facilitate the subsequent secondary trading of the debt securities created. Although less wellknown than equity markets, bond markets are larger both in size and value of trading. However, the volume of bond trading is lower, as most trades tend to be very large when compared to equity market trades. The amounts outstanding on the global bond market now exceed US$128 trillion, according to the International Capital Market Association (ICMA). Sovereign, supranational and agency (SSA) debt accounts for 68% of the global bond market while corporate bonds make up the remaining 32%. The bonds traded range from domestic bonds, issued by companies and governments, to international bonds issued by companies, governments, and supranational agencies such as the World Bank. Although the US has the largest bond market, trading in international bonds is predominantly undertaken in European markets. We will look at bonds in more detail in chapter 4. 2.3 Foreign Exchange (FX) Markets Foreign exchange (FX) markets are the global marketplace that determine the exchange rates for currencies around the world, and where one currency is traded for another. FX markets are the largest of all financial markets, with an average daily turnover of approximately US$7.5 trillion*, a volume 30 times greater than daily global GDP. The rate at which one currency is exchanged for another is determined by supply and demand. For example, if there is strong demand from Japanese investors for US dollars, the US dollar will rise in value relative to the Japanese yen. There is an active FX market that enables governments, companies and individuals to deal with their cash inflows and outflows denominated in overseas currencies. The market is provided mostly by the major banks, with each providing rates of exchange at which they are willing to buy or sell currencies. Historically, most FX deals were arranged over the telephone. Now, however, electronic trading is increasingly prevalent. As FX is an over-the-counter (OTC) market, meaning one where brokers/dealers negotiate directly with one another, there is no central exchange or clearing house. FX trading is concentrated in a small number of financial centres. 7 1 Introduction: The Financial Services Sector The Bank for International Settlements (BIS) releases figures on the composition of the FX market every three years. The latest report, published in 2022, shows that market activity remains concentrated in a handful of global centres. As you can see in the chart below, the main centre for FX trading is the UK reflecting its geographic position in the middle of the US and Asian time zones. Main Locations for FX Trading* Other 21.6% UK 38.1% Japan 4.4% Hong Kong SAR 7.1% Singapore 9.4% US 19.4% The BIS survey also shows that the US dollar retained its status as the most dominant currency, being on one side of 88% of all trades. Additionally, it provided a breakdown of the main types of FX trading which we will consider in a later chapter and showed that FX transactions were on average split as shown in the following table. FX Trading by Type of Instrument Spot transactions US$2.10bn 28% Outright forwards US$1.16bn 16% FX swaps US$3.81bn 50% Currency swaps US$124bn 2% FX options and other products US$304bn 4% We will look at FX in more detail in chapter 3. *Source: BIS Triennial Central Bank Survey of OTC foreign exchange turnover 8 Introduction: The Financial Services Sector Derivatives Markets 1 2.4 Derivatives markets trade a range of complex products based on underlying instruments, including currencies, indices, interest rates, equities, commodities and credit risk. Futures and options are two of the most well-known derivatives. Derivatives based on these underlying elements are available on both the exchange-traded market and the OTC market. An OTC market is where trading takes place directly between parties rather than on an exchange and the trading of derivatives is increasingly moving from OTC to trading on exchange. The largest of the exchange-traded derivatives markets is the Chicago Mercantile Exchange (CME), while Europe dominates trading in the OTC derivatives markets worldwide. Based on the value of the notional amounts outstanding, the OTC derivatives markets worldwide are about four times the size of stock quoted on stock exchanges. Interest rate derivatives contracts account for the vast majority of outstanding derivatives contracts, mostly through interest rate swaps and foreign exchange derivatives. In terms of currencies, the interest rate derivatives market is dominated by the euro and the US dollar, which have accounted for most of the growth in this market since 2001. The growth in the market came about as a reaction to the 2000–02 stock market crash as traders sought to hedge their position against interest rate risk. The next largest segment is FX derivatives, which are used to speculate on currency movements and to hedge the risks of currency positions. Equity-linked contracts, credit derivatives and commodity contracts form the next major segments and these are used to hedge against risk or for speculation. We will look at derivatives in more detail in chapter 6. 2.5 Insurance Markets Insurance markets specialise in the management of personaI risk, corporate risk and protection of life events. Globally, the US, China and Japan are the largest insurance markets. The following table shows the top five largest markets by insurance premiums. Five Largest Markets in 2021 (ranked by total premium volume) Rank Country 1 US 2 China 3 Japan 4 UK 5 France Source: SwissRe 9 The market is led by a number of major players who dominate insurance activity in their sector or region; some of the largest are China Life, Allianz and AXA. Another well-known organisation is Lloyd’s (the world’s specialist insurance market and historically referred to as Lloyd’s of London); with a history dating back over 300 years, it is one of the largest insurance organisations in the world. Lloyd’s is not an insurance company but a marketplace that brings together a range of insurers, both individuals and companies, each of whom accepts insurance risks as a member of one or more underwriting syndicates. A small number of individual members (traditionally known as ‘names’) are liable to the full extent of their private wealth to meet their insurance commitments, while the majority are corporate entities which trade with limited liability. Corporate members include companies, limited liability partnerships and some specialist vehicles. Lloyd’s names join together in syndicates and each syndicate will ‘write insurance’, ie, take on all, or part of, an insurance risk. There are many syndicates, and each name will belong to one or a number of these. Each syndicate hopes that premiums received will exceed claims paid out, in which case, each name will receive a share of the profits (after deducting administration expenses). Lloyd’s insures specialist and complex risks in casualty, property, energy, motor, aviation, marine and reinsurance. It has a reputation for innovation (eg, developing policies for aviation, burglary and cybercrime) and is known across the world as the place to bring unusual, specialist and complicated risks. Less well known to the general public is the reinsurance industry. Just as individuals use insurance to protect against the risk of needing to make a claim, insurers protect themselves by using reinsurance companies. An insurer may seek to hedge some of the risks associated with the insurance policies it has written by laying off some of that risk with a reinsurer. The reinsurance contract can cover an entire insurance portfolio or single risks; it may involve sharing all premiums and losses or just those exceeding a threshold, and it can also cover large one-off risks, such as major construction, satellites or large sporting events. Some of the largest reinsurers in the world are Munich Re, Swiss Re, Hannover Re, Berkshire Hathaway, and Lloyd’s. 10 Introduction: The Financial Services Sector 1 3. Participants Learning Objective 1.1.1 Know the role of the following within the financial services sector: retail/commercial banks; savings institutions; investment banks; private banks; pension funds; insurance companies; fund managers; stockbrokers; custodians; platforms; third-party administrators (TPAs); industry trade and professional bodies; sovereign wealth funds; peer-to-peer/crowdfunding The number of organisations operating in the financial services sector is wide and varied. Each carries out a specialised function, and an understanding of their roles is important in order to understand how the sector is organised and how participants interact. Although each participant is described as a separate organisation in the following sections, the nature of financial conglomerates means that some of the largest global firms may have divisions carrying out each of these activities. 3.1 Investment Banks Investment banks provide advice and arrange finance for companies that want to float on the stock market, raise additional finance by issuing further shares or bonds, or carry out mergers and acquisitions. They also provide services for institutional firms that might want to invest in shares and bonds, in particular pension funds and asset managers. Typically, an investment banking group provides some or all of the following services: Finance-raising and advisory work, both for governments and for companies. For corporate clients, this is normally in connection with new issues of securities to raise capital, as well as giving advice on mergers and acquisitions. Securities-trading in equities, bonds and derivatives and the provision of broking and distribution facilities. Treasury dealing for corporate clients in currencies, including ‘financial engineering’ services to protect them from interest rate and exchange rate fluctuations. Investment management for sizeable investors, such as corporate pension funds, charities and very wealthy private clients. In the larger investment banks, the value of funds under management runs into many billions of dollars. Only a small number of investment banks provide services in all these areas. Most others tend to specialise to some degree and concentrate on only a few product lines. A number of banks have diversified their range of activities by developing businesses such as proprietary trading, servicing hedge funds, or making private equity investments. 11 3.2 Custodians Custodians are banks that specialise in safe custody services, looking after investments such as shares and bonds on behalf of others, such as fund managers, pension funds and insurance companies. Activities they undertake include the following: Holding assets in safekeeping, such as equities and bonds. Arranging settlement of any purchases and sales of securities. Asset servicing – collecting income from assets, namely dividends in the case of equities and interest in the case of bonds, and processing corporate actions. Providing information on the underlying companies and their annual general meetings (AGMs). Managing cash transactions. Performing FX transactions when required. Providing regular reporting on all activities undertaken that affect the holdings in a portfolio, including all trades, corporate actions and other transactions. Cost pressures have driven down the charges that a custodian can make for its traditional custody services and have resulted in consolidation within the industry. The custody business is now dominated by a small number of global custodians who are often divisions of major banks. Among the biggest global custodians are the Bank of New York Mellon and State Street. Generally, they also offer other services to their clients, such as stock lending, measuring the performance of the portfolios of which they have custody and maximising the return on any surplus cash. 12 Introduction: The Financial Services Sector Retail/Commercial Banks 1 3.3 Retail/commercial banks are known by different names in different countries. They are the financial institutions that provide services, such as taking deposits from, and lending funds to, retail customers, as well as providing payment and money transmission services. They may also provide similar services to business customers. Historically, these banks have tended to operate through a network of branches with physical locations, but increasingly they operate through telephone and internet-based services. As well as providing traditional banking services, larger retail banks also offer other financial products, such as investments, pensions and insurance. Banks that offer multiple services such as this are known as ‘financial conglomerates’. The BIS defines a financial conglomerate as: ‘any group of companies under common control whose exclusive or predominant activities consist of providing significant services in at least two different financial sectors (banking, securities, insurance)’. More recently, competition to traditional banks has emerged from ‘challenger’ banks. These are smaller banks, specialising in areas underserved by large, traditional banks, and which distinguish themselves from historic banking by deploying modern financial technology with no community branches. 3.4 Savings Institutions As well as retail banks, most countries also have savings institutions that started off by specialising in offering savings products to retail customers, but now tend to offer a similar range of services to those offered by banks. They are known by different names around the world, such as cajas in Spanish-speaking countries, credit unions in North America and building societies in Australia and the UK. They are typically jointly owned by the individuals that have deposited or borrowed money from them – the members. It is for this reason that such savings organisations are often described as ‘mutual societies’ or ‘mutual savings banks’. Over the years, many savings institutions have merged or been taken over by larger ones. More recently, a number have transformed themselves into banks that are quoted on stock exchanges – a process known as demutualisation. 3.5 Peer-to-Peer (P2P) Lending and Crowdfunding A more recent development in the banking sector has been the emergence of competitors to the traditional role of banks in the form of peer-to-peer lenders and crowdfunding. P2P Lending In the traditional banking model, banks take in deposits on which they pay interest and then lend out at a higher rate; the spread between the two is where they earn their profit. Peer-to-peer (P2P) lending cuts out the banks so that borrowers often receive slightly lower rates, while savers get far improved headline rates, with the P2P firms themselves profiting via a fee. 13 In exchange for accepting greater risk, savers can earn higher returns. Available rates vary depending on the type of borrower that the P2P site lends to and the risk the lender is prepared to accept. The deposit is lent out to individuals and businesses, but it may take time before all of a large deposit is lent and interest is earned. No interest is paid while it is waiting to be lent out. Immediate withdrawals are not always possible and, where they are, may take time and incur a charge or a reduced interest rate. Most of these loans are unsecured, meaning that they are not backed by any collateral in the event of default. Crowdfunding Crowdfunding is the practice of funding a project or venture by raising small amounts of money from a large number of people. Traditionally, financing a business, project or venture involved asking a bank or a few people for large sums of money. Crowdfunding switches this idea around, using the internet to access many potential funders. Crowdfunding can take the following forms: A donation – people simply believe in the cause. Debt crowdfunding – investors essentially lend then receive their money back with interest. Equity crowdfunding – people invest in exchange for equity or shares in the venture. In terms of equity crowdfunding, it usually involves a start-up seeking funding from a large number of people. Some start-ups may even seek to convert its fans and customers into investors in order to enhance brand loyalty. To the founder, one advantage of having a large number of funders instead of one or a few key investors is that large investors may have different ideas and seek to influence how the business is run. Having a diverse source of funding may help to diffuse pressure from such investors. Moreover, small investors can be turned into brand ambassadors for the company. 3.6 Insurance Companies As mentioned above, one of the key functions of the financial services sector is to allow risks to be managed effectively. The insurance industry provides solutions for much more than the standard areas, such as life cover and general insurance cover. Protection planning is a key area of financial advice, and the insurance industry provides a variety of products to meet many potential scenarios. These products range from payment protection policies designed to pay out in the event that an individual is unable to meet repayments on loans and mortgages, to fleet insurance against the risk of an airline’s planes crashing. Insurance companies collect premiums in exchange for the coverage provided. This premium income is invested in equities and bonds and, as a result, the insurance industry is a major investor in both equity and bond markets. Insurance companies will also hold a large amount of cash to be able to satisfy any claims that may arise on the various policies and, if required, will liquidate investment holdings. 14 Introduction: The Financial Services Sector Pension Funds 1 3.7 Retirement schemes (or pension funds) are one of the key methods by which individuals can make provision for their retirement needs. There are a variety of retirement schemes available, ranging from ones provided by employers, to self-directed schemes. Traditionally, company pension schemes provided an amount based on the employee’s final salary and number of years of service. Nowadays, many companies find this too expensive and risky a commitment, given rising life expectancy and volatile stock market returns. Most companies offer new staff defined contribution (DC) schemes in which the firm and, in most cases, the employee contribute to an investment pot. At retirement, the accumulated fund is used to provide a pension. Many individuals are not members of company schemes and instead provide for their retirement through their own personal retirement schemes (self-directed schemes). Taken overall, retirement schemes are large, long-term investors in shares, bonds and cash. Some also invest in physical assets like property. To meet their aim of providing a pension on retirement, the sums of money invested in pensions are substantial. 3.8 Fund Managers Fund managers, also known as investment managers, portfolio managers or asset managers, run portfolios of investments for others. They invest money held by institutions, such as pension funds and insurance companies, as well as individuals. Some are organisations that focus solely on this activity; others are divisions of larger entities, such as insurance companies or banks. Fund management is also known as asset management. The global asset management industry has more than doubled in size since 2000, with the Organisation for Economic Co-operation and Development (OECD) and the International Monetary Fund (IMF) estimating that there are over US$90 trillion of funds under management. Investment managers will buy and sell shares, bonds and other assets in order to increase the value of their clients’ portfolios. They can be subdivided into institutional and private client fund managers. Institutional fund managers work on behalf of institutions, for example, investing money for a company’s pension fund or an insurance company’s fund, or managing the investments of a mutual fund. Private client managers invest the money of individuals. Obviously, institutional portfolios tend to be larger than those of regular private clients. Fund managers charge their clients for managing their money. Their charges are often based on a small percentage of the value of the fund being managed and may also have charges linked to the performance achieved. Generally, brokerage costs tend to be reduced for larger volume trades. Other areas of asset management include running so-called hedge funds and the provision of investment management services to institutional entities, such as charities and local government authorities. 15 3.9 Stockbrokers and Wealth Managers Stockbrokers arrange stock market trades on behalf of their clients, who are investment institutions, fund managers or private investors. They may advise investors about which shares, funds or bonds they should buy or, alternatively, they may offer execution-only services, when the broker executes a trade on a client’s instruction without providing advice. Many stockbrokers now offer wealth management services to their clients and so are also referred to as wealth managers. The services offered by stockbrokers and wealth managers can be divided into four main categories: Execution-only stockbrokers – these offer telephone or internet-based trade execution and settlement for retail clients. No advice is offered and commission is charged per trade. They are aimed at day traders and investors who are confident in making their own investment decisions and, typically, investors with small portfolios. Robo-advisers – a recent innovation, a robo-adviser is an online wealth management service that provides automated, algorithm-based portfolio management advice without the use of human financial planners. The robo-adviser typically charges a monthly or annual fee based on the size of the portfolio (amount of assets under management). Advisory and discretionary wealth managers – these offer a wealth management service to private investors – either advice only or a fully managed (discretionary) service. Their target market ranges from mass affluent to high net worth clients with large portfolios and they charge fees for management of the portfolio based on the value of the portfolio. Institutional brokers – these are stockbrokers who arrange trades on behalf of large institutions. Their skill lies in their ability to execute what are typically large trades in the market, without having a significant adverse effect on the share price. This may involve breaking up a large order into smaller trades and executing them through a variety of different trading venues so as to minimise their impact on the market. Institutional brokers usually charge basis point fees per trade. Like fund managers, stockbrokers and wealth managers can also look after client assets and charge custody and portfolio management fees. Stockbrokers also advise investors about which shares, bonds or funds they should buy. As a result, the traditional distinction between the two has blurred and is rapidly disappearing. These wealth management firms can be independent companies, but some are divisions of larger entities, such as investment or commercial banks. They earn their profits by charging fees for their advice and commissions on transactions. Also, as with fund managers, they may look after client assets and charge custody and portfolio management fees. 3.10 Platforms Platforms, sometimes known as fund supermarkets, are online services used by intermediaries, such as independent financial advisers (IFAs), to view and administer their clients’ investment portfolios. They offer a range of tools which allow advisers to see and analyse a client’s overall portfolio and to choose products for them. As well as providing facilities for investments to be bought and sold, platforms generally arrange custody for clients’ assets. Examples of platforms include those offered by Cofunds and Hargreaves Lansdown. 16 Platforms tend to offer wide ranges of mutual funds, but also ‘wraps’ such as pension plans and insurance bonds. Wrap accounts enable advisers to take a holistic view of the various assets that a client has in a variety of accounts. Advisers also benefit from using wrap accounts to simplify and bring some level of automation to their back office using internet technology. Platform providers also make their services available directly to investors, and platforms earn their income by charging for their services. The advantage of platforms for fund management groups is the ability of the platform to distribute their products to financial advisers. 3.11 Private Banks Private banks provide a wide range of services for their clients, including wealth management, estate planning, tax planning, insurance, lending and lines of credit. Their services are normally targeted at clients with a certain minimum sum of investable cash, or minimum net worth. These clients are generally referred to as high net worth individuals (HNWIs). Private banking is offered both by domestic banks and by those operating ‘offshore’. In this context, offshore banking means banking in a jurisdiction different from the client’s home country – usually one with a favourable tax regime. Competition in private banking has expanded in recent years as the number of banks providing private banking services has increased dramatically. The private banking market is relatively fragmented, with many medium-sized and small players. The distinction between private and retail banks is gradually diminishing as private banks reduce their investment thresholds in order to compete for this market. Meanwhile, many high street banks are also expanding their services to attract the ‘mass affluent’ and HNWIs. 3.12 Sovereign Wealth Funds (SWFs) A sovereign wealth fund (SWF) is a state-owned investment fund that holds financial assets such as equities, bonds, real estate, or other financial instruments. Examples of SWFs include the Norway Government Pension Fund, Abu Dhabi Investment Authority, SAMA Foreign Holdings of Saudi Arabia and China Investment Corporation. SWFs are defined as special purpose investment funds or arrangements owned by a government. Their key characteristics are as follows: They hold, manage, or administer assets to achieve financial objectives. They employ a set of investment strategies which include investing in foreign financial assets. The assets of an SWF are commonly established out of balance of payments surpluses, official foreign currency operations, the proceeds of privatisations, fiscal surpluses, and receipts resulting from commodity exports. 17 1 Introduction: The Financial Services Sector SWFs have emerged as major investors in the global markets over the last ten years, but they date back at least five decades to the surpluses built up by oil-producing countries and, more recently, to the trade surpluses that countries such as China have enjoyed. SWFs have colossal funds under management and are predicted to grow beyond the US$10 trillion mark within a few years. They are private investment vehicles that have varied and undisclosed investment objectives. Typically, their primary focus is on well-above-average returns from investments made abroad. Their size and global diversification allows them to participate in the best opportunities, spread their risks and, by diverting their funds overseas, stabilise their local economies. They may also use part of their wealth as reserve capital for when their countries’ natural resources are depleted. For some of the wealthiest SWFs, it should be noted that the term ‘sovereign’ is not synonymous with public ownership. SWFs are becoming increasingly important in the international monetary and financial system, attracting growing attention. This growth has also raised several issues: Official and private commentators have expressed concerns about the transparency of SWFs, including their size and their investment strategies, and that SWF investments may be affected by political objectives. There are also concerns about how their investments might affect recipient countries, leading to talk about protectionist restrictions on their investments, which could hamper the international flow of capital. In response to these concerns, the International Forum of Sovereign Wealth Funds has been formed and has published a set of 24 voluntary principles, the Generally Accepted Principles and Practices for Sovereign Wealth Funds, known as the Santiago Principles. This is leading to increasing transparency, with a number of countries now publishing annual reports and disclosing their assets under management. 3.13 Industry Trade and Professional Bodies The investment industry is a dynamic, rapidly changing business, and one that requires cooperation between firms; this ensures that the views of various industry sections are represented, especially to governments and regulators, and that cross-firm developments can take place to create an efficient market in which those firms can operate. This is the role of the numerous trade bodies that exist across the world’s financial markets. Examples of these that operate globally are the International Capital Market Association (ICMA), which concentrates on international bond dealing, and the International Swaps and Derivatives Association (ISDA), which produces standards that firms that operate in OTC derivatives follow when dealing with each other. 18 Introduction: The Financial Services Sector 1 3.14 Third-Party Administrators (TPAs) Third-party administrators (TPAs) undertake investment administration on behalf of other firms, and specialise in this area of the investment industry. The number of firms, and the scale of their operations, has grown with the increasing use of outsourcing by firms. The rationale behind outsourcing has been that it enables a firm to focus on the core areas of its business (for example, investment management and stock selection, or the provision of appropriate financial planning) and leave another firm to carry on the administrative functions which it can process more efficiently. Note that ultimate responsibility remains with the outsourcing firm. 4. Investment Distribution Channels Learning Objective 1.1.3 Know the role of investment distribution channels including: independent and restricted advice; execution only; robo-advice 4.1 Financial Planning Financial planning is a professional service available to individuals, their families and businesses, who need objective assistance in organising their financial affairs to achieve their financial and life style objectives more easily. Financial planning is clearly about financial matters, so it deals with money and assets that have monetary value. Invariably this will involve looking at the current value of clients’ bank balances, any loans, investments and other assets. It is also about planning, ie, defining, quantifying and qualifying goals and objectives and then working out how those goals and objectives can be achieved. In order to do this, it is vital that a client’s current financial status is known in detail. Financial planning is ultimately about meeting a client’s financial and life style objectives, not the adviser’s objectives. Any advice should be relevant to the goals and objectives agreed. Financial planning plays a significant role in helping individuals get the most out of their money. Careful planning can help individuals define their goals and objectives, and work out how these may be achieved in the future using the available resources. Financial planning can look at all aspects of an individual’s financial situation and may include tax planning, both during their lifetime and on death, asset management, debt management, retirement planning and personal risk management – protecting income and capital in the event of illness and providing for dependants on death. The Chartered Institute for Securities & Investment (CISI) offers qualifications and related products at all levels for those working in, or looking for a career in, financial planning. Further details can be found on the CISI’s website (www.cisi.org). 19 4.2 Independent versus Restricted Advice Investment firms describe their services as either independent advice or restricted advice. Firms that describe their advice as independent must ensure that they genuinely do make their recommendations based on comprehensive and fair analysis of all products available in the market, and provide unbiased, unrestricted advice. If a firm chooses to only give advice on its own range of products – restricted advice – this must be made clear to customers. 4.3 Execution Only A firm carries out transactions on an execution-only basis if the customer asks it to buy or sell a specific named investment product without having been prompted or advised by the firm. In such instances, customers are responsible for their own decision about a product’s suitability. The practice of execution-only sales is long-established. To ensure that firms operate within regulatory guidelines, they need to record and retain evidence, in writing, that the firm: gave no advice, and made it clear, at the time of the sale, that it was not responsible for assessing the product’s suitability. 4.4 Robo-Advice Robo-advice is the application of technology to the process of providing financial advice, but without the involvement of a financial adviser. A prospective investor enters data and financial information about themselves, and the system then uses an algorithm to score the information and decide what investments should be chosen. The system then presents the investment strategy, which is usually passively focused around index funds or exchange-traded funds (ETFs), and allows easy implementation. 20 Robo-advice can be fully automated or provide guidance and tools to enable investors to choose their own solutions. The approach uses an asset-and-risk model, as well as the construction of risk-targeted portfolios or funds to achieve a client’s objectives, and then the ongoing monitoring and rebalancing against those objectives. Robo-advice is already established in the US, with some of the industry’s largest players involved. 5. Technological Advances and Other Developments Learning Objective 1.1.4 Know about the following themes: Fintech; environmental, social and governance (ESG) 5.1 Technological Advances Technology and the demand for greener solutions are changing the way that the financial services sector operates. Technology is embedded in everything we do, changing the way we live, work, and experience the world. Advances in technology have radically altered how we use the internet and communicate which, in turn, are disrupting traditional industries. Financial technology, known as Fintech, is impacting on the traditional banking and wealth management industry and, therefore, requires the development of new digital services and platforms across a range of financial institutions. People are becoming more digitally proficient, and they desire constant access to sophisticated tools and services, with clients of financial services firms being no different. We have already looked at how challenger banks, P2P lending and robo-advice are challenging the long-established provision of banking and investment services. Technological developments in communications are also changing the face of the industry. Today, as the use of apps and artificial intelligence (AI) recommendations from providers is increasing, customers are demanding the same range of digital capabilities that they have become used to for other products and services. As an example, China’s fund management industry has gone from fledgling asset management to global pioneer in a short number of years in terms of how fund purchases take place. In 2012, only a handful of investors made fund purchases online but, according to a survey by the Asset Management Association of China, more than two-thirds of investors now subscribe to funds via mobile phone apps. 21 1 Introduction: The Financial Services Sector 5.2 Environmental, Social and Governance (ESG) Investing The emergence of a more conscious investor has contributed to the development of the latest theme within the financial sector. ESG factors are used by these investors to determine if an investment suits their objectives: Environmental factors and concerns include sustainability and climate change. Social factors and concerns include consumer protection and diversity. Governance factors and concerns include employee relations and management structures. In the investment industry, the expressions ‘ethical investment’, ‘environmental investment’, ‘green investment’, ‘responsible investment’ and ‘socially responsible investment’ are often used interchangeably and so can be quite confusing. Together, these strands are often brought together under the label of environmental, social and governance (ESG), which includes a range of approaches that includes various issues; it may also be referred to as ‘responsible investing’. Broadly speaking, ‘responsible investing’ reflects the ethical, moral, religious or socially responsible beliefs of the client, and can heavily influence their choice of investments. Also included in this group is the growing number of Shariah investments, which meet the rules of Islamic finance. A key trend in recent years has been the increasing debate on environmental and social issues and the scale of concern about environmental change is being reflected in the asset management industry. Green finance and sustainable finance are becoming increasingly important topics in the financial services sector. Sustainable finance refers to the process of taking due account of environmental and social considerations in investment decision-making, leading to increased investments in longer term and sustainable activities. Climate finance is an emerging form of green finance available for projects in developing countries that helps reduce emissions or adapt to climate change. This is achieved either via increasing the revenues available to public and private development projects (such as tariff support or carbon finance) or by improving project capital structure; for example, by reducing the costs of debt and equity. Research suggests that, by 2025, 50% of investment funds will have an investment mandate requiring them to invest in accordance with ESG principles. 22 Introduction: The Financial Services Sector 1 End of Chapter Questions Think of an answer for each question and refer to the appropriate section for confirmation. 1. 2. Name four main activities undertaken by the professional financial services sector and five by the retail sector. Answer Reference: Section 2 What are the main types of services provided by investment banks? Answer Reference: Section 3.1 3. What services does a custodian offer? Answer Reference: Section 3.2 4. How does a ‘mutual savings’ institution differ from a retail bank? Answer Reference: Sections 3.3 and 3.4 5. What is protection planning and what scenarios might necessitate the use of protection policies? Answer Reference: Section 3.6 6. What sectors of the financial services sector do the International Capital Market Association (ICMA) and the International Swaps and Derivatives Association (ISDA) represent? Answer Reference: Section 3.13 7. What is the role of a third-party administrator? Answer Reference: Section 3.14 8. 9. What are the two types of financial adviser, and how does the range of products they advise on differ? Answer Reference: Section 4.2 What records should be kept when a transaction is undertaken on an execution-only basis? Answer Reference: Section 4.3 23 24 Chapter Two The Economic Environment 1. Introduction 27 2. Factors Determining Economic Activity 27 3. The Economic Cycle and Economic Policy 30 4. Central Banks 33 5. Key Economic Indicators 36 This syllabus area will provide approximately 4 of the 50 examination questions 26 The Economic Environment In this chapter, we turn to the broader economic environment in which the financial services sector operates. First, we will look at how economic activity is determined in various economic and political systems, and the stages of the economic cycle. We will then look at the role of government in determining economic policy as well as the role of governments and central banks in the management of those economic activities. Finally, the chapter concludes with an explanation of some of the key economic measures that provide an indication of the state of an economy. 2. Factors Determining Economic Activity Learning Objective 2.1.1 Know the factors which determine the level of economic activity: state-controlled economies; market economies; mixed economies; open economies Every country has a set of characteristics, such as natural resources and a skilled workforce, which can influence their ability to grow their economy. While it is not just economic factors that influence economic development, they are important for understanding the capacity or the ability of an economy to develop on its own. There are several factors affecting economic growth, and it is helpful to split them into demand-side factors (eg, consumer spending) and supply-side factors (eg, productive capacity). Each of these factors influences the available economic resources and growth opportunities within a country. 27 2 1. Introduction Economic systems are the means by which countries determine how they will use these resources to resolve the basic problem of what, how much, how, and for whom, to produce. The main types of economic systems are a planned economy, a market economy and a mixed economy, while an open economy refers to a country’s economic relationship with the rest of the world. Each of these are considered below. 2.1 State-Controlled Economies A state-controlled economy is one in which the state (in the form of the government) decides what is produced and how it is distributed; they are also known as planned economies or command economies. The best-known example of a state-controlled economy was the Soviet Union throughout most of the 20th century. Sometimes, these economies are referred to as ‘planned economies’, because the production and allocation of resources is planned in advance rather than being allowed to respond to market forces. The perceived advantage of a planned economy is suggested to be low levels of inequality and unemployment, with the common good replacing profit as the primary incentive of production. However, this may not be the case and large inequalities can arise, as seen in countries such as Russia and Venezuela. The need for careful planning and control can bring about excessive layers of bureaucracy, and state control inevitably removes a great deal of individual choice. These latter factors have contributed to the reform of many planned economies and the introduction of a more mixed economy (covered in more detail in section 2.3). 2.2 Market Economies In a market economy, the forces of supply and demand determine how resources are allocated. Businesses produce goods and services to meet the demand from consumers. The interaction of demand from consumers and supply from businesses in the market will result in the market-clearing price – the price that reflects the balance between what consumers will willingly pay for goods and services, and what suppliers will willingly accept for them. If there is oversupply, the price will be low and some producers will leave the market. If there is undersupply, the price will be high, attracting new producers into the market. There is a market not only for goods and services, but also for productive assets, such as capital goods (eg, machinery), labour and money. For the labour market, it is the wage level that is effectively the ‘price’, and for the money market it is the interest rate. People compete for jobs and companies compete for customers in a market economy. Scarce resources, including skilled labour, such as that provided by a software engineer, or a financial asset, such as a share in a successful company, will have a high value. In a market economy, competition means that lesser skilled software engineers and shares in unsuccessful companies will be much cheaper. Ultimately, competition could bring about the collapse of the unsuccessful company, and result in the lesser skilled software engineer seeking an alternative career. 28 The Economic Environment 2.3 Mixed Economies 2 A mixed economy combines a market economy with some element of state control. The vast majority of established markets operate as mixed economies to a lesser or greater extent. While most of us would agree that unsuccessful companies should be allowed to fail, we generally feel that the less able in society should be cushioned from the full force of the market economy. In a mixed economy, the government will provide a welfare system to support the unemployed, the infirm and the elderly, in tandem with the market-driven aspects of the economy. Governments will also spend money running key areas such as defence, education, public transport, health and police services. Governments raise finance for this public expenditure by: collecting taxes directly from wage-earners and companies collecting indirect taxes (eg, sales tax and taxes on petrol, cigarettes and alcohol), and raising money through borrowing in the capital markets. 2.4 Open Economies In an open economy, there are few barriers to trade or controls over foreign exchange. Although most western governments create barriers to protect their citizens against illegal drugs and other dangers, they generally have policies to allow or encourage free trade. From time to time, issues will arise when one country believes another is taking unfair advantage of trade policies and will take some form of retaliatory action, possibly including the imposition of sanctions. For example, trade tensions between the US and other countries have seen the US introduce tariffs on imports to protect their domestic industry; this has led to international concerns about the rise of protectionism. When a country prevents other countries from trading freely with it in order to preserve its domestic market, the practice is usually referred to as protectionism. The World Trade Organization (WTO) exists to promote the growth of free trade between economies. It is, therefore, sometimes called upon to arbitrate when disputes arise. In addition to global agreements on trade under the WTO, there are many regional and bilateral trade agreements that go beyond commitments made in the WTO that aim to increase trade and boost economic growth. It should be noted that both market and mixed economies can also be open economies. 29 3. The Economic Cycle and Economic Policy Learning Objective 2.1.2 Know the stages of the economic cycle and the role of government in determining: economic policy; fiscal policy; monetary policy Traditionally, the role of government has been to manage the economy through taxation, economic and monetary policy, and to ensure a fair society by the state provision of welfare and benefits to those who meet certain criteria. At the same time, business is left relatively free to address any challenges and opportunities that may arise. Governments can use a variety of policies when attempting to reduce the impact of fluctuations in economic activity. Collectively, these measures are known as stabilisation policies and are categorised under the broad headings of fiscal and monetary policy. Fiscal policy involves making adjustments using government spending and taxation, while monetary policy involves making adjustments to interest rates and the money supply. 3.1 Stages of the Normal Economic Cycle Over time, the level of economic activity within an economy tends to fluctuate as GDP increases and decreases. The following diagram illustrates the four typical stages of the economic cycle, ie, peak, contraction, trough and expansion. Level of National Economic Activity Peak Tre Gro wth Exp ansi on Peak Co nt ra ct io n Trough Time 30 nd Peak – GDP is at its highest point. Any growth in output stops. This is the point at which GDP is expected to decline, eg, contraction of the economy is expected. Contraction – this is the period over which GDP declines as economic activity slows. When there are two consecutive quarters of declining GDP or ‘negative growth’, economists refer to this as a ‘recession’. Trough – GDP is now at its lowest point. The contraction phase is over. Expansion – economic activity picks up and GDP begins growing once again. Early expansion is usually characterised by a moderate increase in GDP, whereas with late expansion, the rate of increase is higher. Section 5.2 expands on this cycle. 3.2 Macroeconomic Policy Macroeconomic policy is the management of the economy by the government in such a way as to influence the performance and behaviour of the economy as a whole. The main objectives are as follows: Full employment Economic growth Low inflation Balance of payments equilibrium As far as possible, all factors of production, ie, land, labour capital and enterprise should be fully utilised. Measured by increases in gross domestic product (GDP). Achieving price stability. Typically, a rate of inflation of 2% is set as a target. Deficits in external trade, with imports exceeding exports, might be damaging for the prospect of economic growth. Simultaneous achievement of all four objectives is extremely difficult. For example, the balance of payments tends to deteriorate as economic growth improves. This is because when growth is triggered by an increase in aggregate demand, it often leads to an increase in imports as foreign goods are bought by UK manufacturers and consumers. 3.3 Fiscal Policy Fiscal policy is any action by the government to spend money, or to collect money in taxes, with the purpose of influencing the condition of the economy. The government will use the following tools to influence the level of spending in the economy. The budget – the government budget is a statement of public income and expenditure over a period of one year. There will be a balanced budget where income equals expenditure, a deficit budget where expenditure exceeds income or a surplus budget where income exceeds expenditure. With a budget deficit, for example, where public expenditure is more than public income, the government must borrow to make up the difference. Taxation – taxation can be direct, for example, tax levied on income, or indirect, eg, value-added tax or sales tax charged on goods and services. Through the taxation system, the government can influence the level of spending in the economy. If the government were to reduce taxation and keep 31 2 The Economic Environment its own spending constant, it would mean that firms and households would have more disposable income. This is one method of stimulating demand. On the other hand, the government could reduce demand by raising taxes or reducing its expenditure. Fiscal policy will change depending on the stage of the economic cycle. Expansionary or ‘loose’ fiscal policy is aimed at stimulating the economy and involves increasing government expenditure and/or lowering taxes in order to boost economic activity. Contractionary or ‘tight’ fiscal policy, on the other hand, emphasises cutting government spending and/or raising taxes. 3.3.1 Implications of Fiscal Policy for Business Planning Since fiscal policy influences the level of aggregate demand in the economy, businesses need to take this into account when planning output levels, future employment levels, and also, deciding on investments. Planning will be much easier if government policy is stable. Cost Taxation, especially an employer’s national insurance contributions, will affect total labour costs, hence the ultimate cost for products and services. In addition, if indirect taxes such as VAT rise, the cost would either have to be absorbed by the firm or passed on to the customer. 3.4 Monetary Policy Monetary policy is the regulation of the economy through control of the monetary system by operating on such variables as the money supply, the level of interest rates and the conditions for the availability of credit. Monetary policy is generally concerned with the volume of money in circulation and the price of money or the interest rate. The Money Supply The stock of money in the economy is believed to influence the volume of expenditure in the economy. This, in turn, influences the level of output and prices. Under monetary policy, the government can target the stock of money as an economic tool. Governments may decide to impose a ‘credit squeeze’ and restrict credit lending to control the level of spending and reduce inflation. Alternatively, governments may impose reserve requirements on banks, eg, a minimum cash reserve ratio. Interest Rates Interest represents the price of money or the cost of borrowing. It is, therefore, assumed that there is a direct relationship between the interest rate and the level of spending in the economy. An increase in interest rates is thought to discourage spending in the economy and thereby reduce the level of aggregate spending. Other possible outcomes include the following: 32 Consumers would be encouraged to save with higher interest rates. Mortgage payments would rise, leaving less disposable income for homeowners. The higher cost of credit would deter borrowing and, hence, spending. The Economic Environment The level of corporate investments would decline due to higher borrowing costs. The corporate sector may lose confidence in the economy and become pessimistic about future prospects. It has been argued, however, that a higher level of interest rates will not necessarily achieve the above. The following effects of a high rate of interest also need to be considered. Higher interest means greater interest income for savers. Thus, they may increase their spending. Demands for higher wages could arise out of the need to make higher mortgage payments. Higher interest rates attract capital inflows. This would lead to an appreciation in the exchange rate, making imports cheaper and more attractive. This will contribute to the balance of payments deficit. Lower demand could result in higher unemployment and lower tax income for the government. Unemployment benefits may, therefore, increase. Low investment would now mean poor prospects for future economic growth. As with fiscal policy, monetary policy will vary depending on the stage of the economic cycle. ‘Loose’ monetary policy seeks to expand or grow an economy by lowering interest rates and/or lowering reserve requirements for banks. ‘Tight’ monetary policy, on the other hand, aims to contract a growing economy (to prevent ‘overheating’ and control inflation) by increasing interest rates and /or increasing reserve requirements for banks. 4. Central Banks Rather than following one or another type of policy, most governments now adopt a pragmatic approach to controlling the level of economic activity through a combination of fiscal and monetary policy. In an increasingly integrated world, however, controlling the level of activity in an open economy in isolation is difficult, as financial markets, rather than individual governments and central banks, tend to dictate economic policy. Governments implement their monetary policies using their central bank, and a consideration of their role in this implementation is noted below. Central banks are guided in their activities by the Bank for International Settlements (BIS), which was established in 1930. The BIS has 63 member central banks representing countries from around the world which, together, make up approximately 95% of world gross domestic product (GDP). The mission of the BIS is to serve central banks in their pursuit of monetary and financial stability, to foster international cooperation in those areas and to act as a bank for central banks. 33 2 4.1 The Role of Central Banks Learning Objective 2.1.3 Know the function of central banks Central banks operate at the very centre of a nation’s financial system. They are usually public bodies but, mainly, they operate independently of government control or political interference. They usually have some or all of the following responsibilities: acting as banker to the banking system by accepting deposits from, and lending to, commercial banks acting as banker to the government managing the national debt regulating the domestic banking system acting as lender of last resort to the banking system in financial crises to prevent the systemic collapse of the banking system setting the official short-term rate of interest controlling the money supply issuing notes and coins holding the nation’s gold and foreign currency reserves influencing the value of a nation’s currency through activities such as intervention in the currency markets, and providing a depositors’ protection scheme for bank deposits. The following table shows details of some of the world’s main central banks. Federal Reserve (the Fed) 34 The Federal Reserve System in the US dates back to 1913. The Fed, as it is known, comprises 12 regional Federal Reserve Banks, each of which monitors the activities of, and provides liquidity to, the banks in its region. The Federal Open Market Committee (FOMC) takes responsibility for decisions, which are directed towards its statutory duty of promoting price stability and sustainable economic growth. The FOMC meets every six weeks or so to examine the latest economic data in order to gauge the health of the economy and determine whether the economically sensitive Fed funds rate should be altered. Very occasionally, it meets in emergency session, if economic circumstances dictate. As lender of last resort to the US banking system, the Fed rescued a number of US financial institutions and markets from collapse during the financial crisis, including the financing of government bailouts of the US auto industry and agency mortgage associations. In doing so, it prevented widespread panic, and prevented systemic risk from spreading throughout the financial system. European Central Bank (ECB) Bank of England (BoE) Bank of Japan (BoJ) The ECB is based in Frankfurt. It assumed its central banking responsibilities upon the creation of the euro, on 1 January 1999. It is principally responsible for setting monetary policy for the entire eurozone, with the objective of maintaining internal price stability. Its objective of keeping inflation, as defined by the harmonised index of consumer prices (HICP), ‘close to, but below, 2% in the medium term’ is achieved by influencing those factors that may influence inflation, such as the external value of the euro and growth in the money supply. The ECB sets its monetary policy through its president and council, the latter of which comprises the governors of each of the eurozone’s national central banks. In 2014, the ECB was given a supervisory role to monitor the financial stability of banks in eurozone states. Its Single Supervisory Mechanism (SSM) for banking supervision aims to ensure the safety and soundness of the European banking system and increase financial integration and stability in Europe. The SSM is an important milestone towards a banking union within the EU. The UK’s central bank, the BoE, was founded in 1694, but it was not until 1997, when the BoE’s Monetary Policy Committee (MPC) was established, that the Bank gained operational independence in setting UK monetary policy, in line with that of most other developed nations. The MPC’s primary focus is to ensure that inflation is kept within a government-set range. It does this by setting the base rate, an officially published short-term interest rate and the MPC’s sole policy instrument. In addition to its short-term interest rate-setting role, the BoE is one of the UK’s regulators, and assumes responsibility for all other traditional central bank activities – with the exception of managing the national debt and providing a depositors’ protection scheme for bank deposits. The BoJ began operating as Japan’s central bank in 1882 and, like the BoE, gained operational independence in 1997. The Bank is responsible for the country’s monetary policy, issuing and managing the external value of the Japanese yen, and acting as lender of last resort to the Japanese banking system. 35 2 The Economic Environment 5. Key Economic Indicators As well as being essential to the management of the economy, indicators can provide investors with a guide to the health of the economy and aid long-term investment decisions. Learning Objective 2.1.4 Understand the impact of the following economic data: gross domestic product (GDP); balance of payments; budget deficit/surplus; level of unemployment; exchange rates; inflation/ deflation 5.1 Inflation/Deflation Inflation is a persistent increase in the general level of prices. There are a number of reasons for prices to increase, such as excess demand in the economy, scarcity of resources and key workers or rapidly increasing government spending. Many governments seek to control inflation at a level of about 2–3% per annum (pa) – not letting it get too high (or too low). High levels of inflation can cause problems: Businesses have to continually update prices to keep pace with inflation. Employees find the real value of their salaries eroded. Those on fixed levels of income, such as pensioners, will suffer as the price increases are not matched by increases in income. Exports may become less competitive. The real value of future pensions and investment income becomes difficult to assess, which might act as a disincentive to save. There are, however, some positive aspects to high levels of inflation: 36 Rising house and asset prices contribute to a ‘feel-good’ factor (although this might contribute to further inflation, as asset owners become more eager to borrow and spend and lead to unsustainable rises in prices and a subsequent crash). Borrowers benefit, because the value of borrowers’ debt falls in real terms – ie, after adjusting for the effect of inflation. Inflation also erodes the real value of a country’s national debt and so can benefit an economy in difficult times. The Economic Environment 2 The following chart shows the inflation rates for the US, the UK and Japan from 1980 to 2000. It highlights how governments managed to take control of inflation and reduce it from the damaging levels of the 1970s and early 1980s. Inflation 1980–2000 % Rate of Inflation 20.00 15.00 10.00 Japan 5.00 UK US 0.00 –5.00 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 Source: International Monetary Fund (IMF) Central banks use interest rates to control inflation. They set an interest rate at which they will lend to financial institutions, and this influences the rates that are available to savers and borrowers. The result is that movements in a central bank’s rate affect spending by companies and their customers and, over time, the rate of inflation. Changes in this short-term official rate can take up to two years to have their full impact on inflation, so the central bank has to look ahead when deciding on the appropriate monetary policy. If inflation looks set to rise above target, then the central bank raises rates to slow spending and reduce inflation. Similarly, if inflation looks set to fall below its target level, it reduces its official rate to boost spending and inflation. As well as experiencing inflation, economies can also face the problems presented by deflation. Deflation is defined as a general fall in price levels. Although not experienced as a worldwide phenomenon since the 1930s, deflation has been seen in an increasing number of countries, including Japan as shown in the following graph, and in eurozone countries, such as Greece and, to a lesser extent, Spain. 37 Japan % Rate of Inflation 2.00 1.50 1.00 0.50 0.00 –0.50 –1.00 –1.50 19 98 19 99 20 00 20 01 20 02 20 03 20 04 20 05 20 06 20 07 20 08 20 09 20 10 20 11 20 12 Source: IMF While it may seem that lower prices are good, deflation can ripple through the economy, such as when it causes high unemployment, and can turn a bad situation, such as a recession, into a worse situation, such as a depression. Deflation can spiral into a vicious circle of reduced spending and a reluctance to borrow as the real burden of debt in an environment of falling prices increases. Deflation can then become a self-reinforcing loop – falling prices create the circumstances for prices to continue falling and lead to a depression. It should be noted that falling prices are not necessarily a destructive force per se and, indeed, can be beneficial if they result from positive supply shocks, such as rising productivity growth and greater price competition caused by the globalisation of the world economy and increased price transparency. 38 The Economic Environment 5.1.1 Inflation Measures 2 There are various measures of inflation, but the most common term encountered is the consumer price index (CPI). CPIs measure changes in prices to estimate how the prices of goods and services are changing over time. Over any given period, the prices of some goods will rise and some will fall, so inflation measures present a picture of what is happening with the average level of prices in the economy. If inflation is rising, then this implies that, overall, the cost of goods and services is also rising and that you can buy less for one unit of that country’s currency. The annual rate of inflation is simply the percentage change in the latest index compared with the value recorded 12 months previously. In each country, a government department or separate agency will be responsible for producing national statistics such as measures of inflation. They are usually produced by national statistical offices such as the Bureau of Labor Statistics in the US, the National Bureau of Statistics in China, the Japanese Statistics Bureau and the Office for National Statistics (ONS) in the UK. Different people buy different things and use different services, so estimates of inflation are based on typical goods and services that a household consumes: A frequently used method to calculate inflation is to collect price data on a typical ‘shopping basket’ of, say, 700 items from month to month. The CPI market basket is developed from detailed expenditure information provided by families and individuals on what they actually bought. The content of the basket is fixed for a period of 12 months and different weights are attached to various items in the basket reflecting their importance in a typical household budget. The content and the weightings attached are reviewed regularly to ensure that they remain up to date. To calculate changes in price, the government agency sets a base year for the total cost of the ‘shopping basket’, which is then converted into an index of 100. On a monthly basis, prices are collected again and the cost of the basket is recalculated resulting in a revised index number. The resulting rate of inflation is a measure of average changes in prices paid by consumers. Because it is based on samples, it will not necessarily reflect the change in prices that an individual might experience if their expenditure pattern differs from the average. International standards for the calculation of the CPI are published by the IMF in conjunction with major international organisations. The procedures used in different countries are not static, but continue to evolve and improve, so it is important to recognise that there are different ways of calculating inflation, and that different measures may give alternative pictures of what is happening in an economy. In addition to inflation measures like the CPI, there are a number of other economic statistics carefully watched by governments and by other market participants as potentially significant indicators of how economies are performing. 39 5.2 Gross Domestic Product (GDP) At the very simplest level, an economy comprises two distinct groups: individuals and firms. Individuals supply firms with the productive resources of the economy in exchange for an income. In turn, these individuals use this income to buy output produced by firms employing these resources. This gives rise to what is known as the circular flow of income. Simplified Model of the Economy Individuals Output National Income Expenditure Firms This economic activity can be measured in one of three ways, namely: 40 by the total income paid by firms to individuals by individuals’ total expenditure on firms’ output, or by the value of total output generated by firms. Land Labour Capital The Economic Environment 2 GDP is the most commonly used measure of a country’s output. It measures economic activity on an expenditure basis and is typically calculated quarterly as follows: Gross Domestic Product consumer spending plus government spending plus investment plus exports less imports equals GDP Economic Growth There are many sources from which economic growth can emanate, but in the long run, the rate of sustainable growth (or trend rate of growth) ultimately depends on: the growth and productivity of the labour force the rate at which an economy efficiently channels its domestic savings and capital attracted from overseas into new and innovative technology and replaces obsolescent capital equipment, and the extent to which an economy’s infrastructure is maintained and developed to cope with growing transport, communication and energy needs. In a mature economy, the labour force typically grows at about 1% pa, though this can vary. Longterm productivity growth is dependent on factors such as education and training and the utilisation of labour-saving new technology. Moreover, productivity gains are more difficult to extract in a postindustrialised economy than in one with a large manufacturing base. Given these factors, the US’s long-term trend rate of economic growth has averaged nearly 3%. In developing economies, however, economic growth rates of up to 10% pa are not uncommon. The fact that actual growth fluctuates and deviates from trend growth in the short term gives rise to the economic cycle, or business cycle as seen in section 3.1. When an economy is growing in excess of its trend growth rate, actual output will exceed potential output, often with inflationary consequences. However, when a country’s output contracts – that is, when its economic growth rate turns negative for at least two consecutive calendar quarters – the economy is said to be in recession, or entering a deflationary period, resulting in spare capacity and unemployment. 41 5.3 Balance of Payments (BoP) and Exchange Rates The balance of payments (BoP) is a summary of all the transactions between a country and the rest of the world. If the country imports more than it exports, there is a balance of payments deficit. If the country exports more than it imports, there is a balance of payments surplus. The main components of the balance of payments are the trade balance, the current account and the capital account. Trade Balance Current Account Capital Account The trade balance comprises: a visible trade balance – the difference between the value of imported and exported goods, such as those arising from the trade of raw materials and manufactured goods, and an invisible trade balance – the difference between the value of imported and exported services, arising from services such as financial services (including banking) and tourism. If a country has a trade deficit in one of these areas or overall, this means that it imports more than it exports, and if it has a trade surplus, it exports more than it imports. The current account is used to calculate the total value of goods and services that flow into and out of a country. The current account comprises the trade balance figures for the visibles and invisibles. To these figures are added other receipts, such as dividends from overseas assets and remittances from nationals working abroad. The capital account records international capital transactions related to investment in business, real estate, bonds and stocks. This includes transactions relating to the ownership of fixed assets and the purchase and sale of domestic and foreign investment assets. These are usually divided into categories such as foreign direct investment, when an overseas firm acquires a new plant or an existing business, portfolio investment which includes trading in stocks and bonds, and other investments, which include transactions in currency and bank deposits. For the balance of payments to balance, the current account must equal the capital account plus or minus a balancing item – used to rectify the many errors in compiling the balance of payments – plus or minus any change in central bank foreign currency reserves. A current account deficit resulting from a country being a net importer of overseas goods and services must be met by a net inflow of capital from overseas, taking account of any measurement errors and any central bank intervention in the foreign currency market. 42 The Economic Environment If the value of its currency rises, then exports will be less competitive, unless producers reduce their prices, and imports will be cheaper and, therefore, more competitive. The result will be either to reduce a trade surplus or worsen a trade deficit. If its value falls against other currencies, then the reverse happens: exports will be cheaper in foreign markets and so more competitive, and imports will be more expensive and therefore less competitive. A trade surplus or deficit will therefore see an improving position. 5.4 Budget Deficits and the National Debt A key function of government is to manage the public finances, therefore, a key economic indicator is the level of public sector debt, or the national debt as it is more frequently referred to. There are a wide number of measures used as key economic indicators, which can be quite confusing. Each measures different sets of data, but essentially, they fall into two main types: Government debt – essentially this is what the government owes. Budget deficit – essentially the shortfall between what the government receives in tax receipts and what it spends. Debt measures are also usually presented as a percentage of GDP, since comparisons over time need to allow for effects such as inflation. Dividing by GDP is the conventional way of doing this. The budget deficit is the difference each year between government expenditure and government income; the latter mainly from taxes. In a buoyant economy, government spending tends to be less than income, with substantial tax revenues generated from corporate profits and high levels of employment. This enables the government to reduce public sector (ie, government) borrowing. In a slowing economy, government spending tends to exceed tax revenues and the government will need to raise borrowing by issuing government bonds. If left unaddressed, high levels of public borrowing and debt, and the associated significant interest payments risk undermining growth and economic stability and could negatively affect the country’s credit rating. As mentioned earlier, excessive government spending, causing a growing budget deficit, has the potential to bring about an increase in the rate of inflation. 5.5 Level of Unemployment The extent to which those seeking employment cannot find work is an important indicator of the health of the economy. There is always likely to be some unemployment in an economy – certain people are in the process of either looking for a new job that better suits them, returning to the workforce after some time off, they could be new immigrants, lacking the right skills, or are living in areas in which it is difficult to find work. Economists refer to this as the ‘natural rate of unemployment’. 43 2 Having the ‘right’ exchange rate is critical to the level of international trade undertaken, to international competitiveness and, therefore, to a country’s economic position. This can be understood by looking at what happens if a country’s exchange rate alters. Higher levels of unemployment indicate low demand in the economy for goods and services produced and sold to consumers and, therefore, low demand for people to provide them. High unemployment levels will have a negative impact on a government’s finances. The government will need to increase social security/welfare payments, and its income will decrease because of the lack of tax revenues from the unemployed. Care needs to be taken when looking at official unemployment figures as the latest trends that use fixed hour contracts of employment in the gig economy can distort these statistics and disguise higher underlying unemployment figures. 5.6 Exchange Rates An exchange rate can be described as the price of one currency in terms of another and is quoted for pairs of currencies. If the exchange rate changes, such that currency A can buy more of currency B, this shows an appreciation of currency A and a depreciation of currency B. For example, in the diagram below, we can see the exchange rate moves such that USD 1 (formerly, equivalent to EUR 0.75) is now equivalent to EUR 0.95. This appreciation of the USD against the EUR has been caused by an increase in demand for the USD. Exchange Rate (EUR) S 0.95 D1 0.75 D Quantity (USD) Note that the mechanics of exchange rates are covered elsewhere (chapter 5, section 4). In this context, we are considering the effect that exchange rates have on an economy. Generally, very volatile exchange rates (ie, rates that are not stable and have large variations), create a great deal of uncertainty and affect economic activity, as well as investment decisions that involve foreign assets. For example, an investor based in the UK may have property in the US, ie, a US dollar-denominated asset. 44 The Economic Environment A significant factor that influences the volatility of exchange rates is the exchange rate regime that the central bank follows. These vary widely, but two extremes are described below: 1. Fixed rate system – the exchange rate is pegged to a particular currency, eg, the US dollar or a basket of currencies. To ensure that the rate stays ‘fixed’, the central bank will intervene in the currency market to offset the natural forces of demand and supply by spending its foreign currency reserves or buying foreign currency. 2. Floating rate system – the exchange rate is determined by the natural forces of demand and supply. There is no intervention in the market by the central bank. This is, sometimes, referred to as a ‘free’ floating rate system. Examples of exchange rate regimes that fall within the two extremes include the following: Target zone – similar to the fixed rate system, however, the exchange rate is managed within a band (with upper and lower limits). This means that the rate can fluctuate, therefore, the central bank will only intervene if the upper or lower limits for the rate are breached. Crawling peg – similar to target zone, but with upper and lower limit bands gradually widening. This system is generally used as a strategy for moving away from a fixed rate system. Managed float – this is also known as a ‘dirty’ float. With this system, the exchange rate is largely a floating rate, but with occasional intervention from the central bank to alter the direction of the rate or the speed with which the rate changes. 45 2 If the US dollar were to depreciate relative to sterling, the investor would experience a decrease in the value of their asset even though property prices in the US may not have changed. End of Chapter Questions Think of an answer for each question and refer to the appropriate section for confirmation. 1. What are the key differences between state-controlled and market economies? Answer Reference: Sections 2.1 and 2.2 2. Which international organisation has the role of reducing trade barriers? Answer Reference: Section 2.4 3. What are the main functions of a central bank? Answer Reference: Section 4.1 4. What are the negative effects of inflation? Answer Reference: Section 5.1 5. What economic measure is used as an indicator of the health of the economy? Answer Reference: Section 5.2 6. What does the balance of payments represent? Answer Reference: Section 5.3 7

International Introduction to Securities & Investment PDF (CISI, Edition 16, June 2023)

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