begins by introducing fundamental concepts of demand and supply analysis for individual consumers and firms.

We cover various market structures (perfect competition, oligopoly, monopoly) in which firms operate.

We cover Key macroeconomic concepts and principles, including aggregate output and income measurement, aggregate demand and supply analysis, and analysis of economic growth factors.

The study session concludes with coverage of the business cycle and its effect on economic activity.

I. WHY WERE THE GIPS STANDARDS CREATED?

Institutions and individuals are constantly scrutinizing past investment performance returns in search of the best manager to achieve their investment objectives.

In the past, the investment community had great difficulty making meaningful comparisons on the basis of accurate investment performance data. Several performance measurement practices hindered the comparability of performance returns from one firm to another, while others called into question the accuracy and credibility of performance reporting overall. Misleading practices included:

• Representative Accounts: Selecting a top-performing portfolio to represent the firm’s overall investment results for a specific mandate.

• Survivorship Bias: Presenting an “average” performance history that excludes portfolios whose poor performance was weak enough to result in termination of the firm.

• Varying Time Periods: Presenting performance for a selected time period during which the mandate produced excellent returns or out-performed its benchmark—making comparison with other firms’ results difficult or impossible.

Making a valid comparison of investment performance among even the most ethical investment management firms was problematic. For example, a pension fund seeking to hire an investment management firm might receive proposals from several firms, all using different methodologies for calculating their results.

The GIPS standards are a practitioner-driven set of ethical principles that establish a standardized, industry-wide approach for investment firms to follow in calculating and presenting their historical investment results to prospective clients. The GIPS standards ensure fair representation and full disclosure of investment performance. In other words, the GIPS standards lead investment management firms to avoid misrepresentations of performance and to communicate all relevant information that prospective clients should know in order to evaluate past results.

In this reading we explain why the portfolio approach is important to all types of investors in achieving their financial goals. We compare the financial needs of different types of individual and institutional investors. After we outline the steps in the portfolio management process, we compare and contrast the types of investment management products that are available to investors and how they apply to the portfolio approach.

One of the biggest challenges faced by individuals and institutions is to decide how to invest for future needs. For individuals, the goal might be to fund retirement needs. For such institutions as insurance companies, the goal is to fund future liabilities in the form of insurance claims, whereas endowments seek to provide income to meet the ongoing needs of such institutions as universities. Regardless of the ultimate goal, all face the same set of challenges that extend beyond just the choice of what asset classes to invest in. They ultimately center on formulating basic principles that determine how to think about investing. One important question is: Should we invest in individual securities, evaluating each in isolation, or should we take a portfolio approach? By “portfolio approach,” we mean evaluating individual securities in relation to their contribution to the investment characteristics of the whole portfolio. In the following section, we illustrate a number of reasons why a diversified portfolio perspective is important.

Agricultural societies experience good harvest times and bad ones. Weather is a main factor that influences crop production, but other factors, such as plant and animal diseases, also influence the harvest. Modern diversified economies are less influenced by weather and diseases but, as with crops, there are fluctuations in economic output, with good times and bad times.

This reading addresses changes in economic activity and factors that affect it. Some of the factors that influence short-term economic movements—such as changes in population, technology, and capital—are the same as those that affect long-term sustainable economic growth. Other factors, such as money supply and inflation, are more specific to short-term economic fluctuations.

All investment decisions are made in an environment of risk. The tools that allow us to make decisions with consistency and logic in this setting come under the heading of probability. This reading presents the essential probability tools needed to frame and address many real-world problems involving risk. We illustrate how these tools apply to such issues as predicting investment manager performance, forecasting financial variables, and pricing bonds so that they fairly compensate bondholders for default risk.

We explore in detail the concepts that are most important to investment research and practice. One such concept is independence, as it relates to the predictability of returns and financial variables. Another is expectation, as analysts continually look to the future in their analyses and decisions. Analysts and investors must also cope with variability. We present variance, or dispersion around expectation, as a risk concept important in investments. The reader will acquire specific skills in using portfolio expected return and variance.

Section 2 Sets out the basic tools of probability, including expected value and variance

Section 3 introduces covariance and correlation (measures of relatedness between random quantities) and the principles for calculating portfolio expected return and variance.

Two topics end the reading: Bayes’ formula and outcome counting.

Bayes’ formula is a procedure for updating beliefs based on new information.

The reading ends with a discussion of principles and shortcuts for counting. In several areas, including a widely used option-pricing model, the calculation of probabilities involves defining and counting outcomes.

The scope of working capital management includes transactions, relations, analyses, and focus:

• Transactions include payments for trade, financing, and investment.

• Relations with financial institutions and trading partners must be maintained to ensure that the transactions work effectively.

• Analyses of working capital management activities are required so that appropriate strategies can be formulated and implemented.

• Focus requires that organizations of all sizes today must have a global viewpoint with strong emphasis on liquidity.

This reading is organized as follows:

Section 2 discusses the costs that are included in inventory and the costs that are recognised as expenses in the period in which they are incurred.

Section 3 describes inventory valuation methods and compares the measurement of ending inventory, cost of sales and gross profit under each method, and when using periodic versus perpetual inventory systems.

Section 4 describes the LIFO method, LIFO reserve, and effects of LIFO liquidations, and demonstrates the adjustments required to compare a company that uses LIFO with one that uses FIFO.

Section 5 describes the financial statement effects of a change in inventory valuation method.

Section 6 discusses the measurement and reporting of inventory when its value changes.

Section 7 describes the presentation of inventories on the financial statements and related disclosures, discusses inventory ratios and their interpretation, and shows examples of financial analysis with respect to inventories.

General meetings.

1. The right to participate in general shareholder meetings is a fundamental shareholder right. Shareholders, especially minority shareholders, should have the opportunity to ask questions of the board, to place items on the agenda and to propose resolutions, to vote on major corporate matters and transactions, and to participate in key corporate governance decisions, such as the nomination and election of board members.
2. Shareholders should be able to vote in person or in absentia, and equal consideration should be given to votes cast in person or in absentia.

A board of directors , which serves as a link between shareholders and managers, acts as the shareholders' monitoring tool within the company.

Related-party transactions involve buying, selling, and other transactions with board members, managers, employees, family members, and so on. They can create an inherent conflict of interest. Policies should be established to disclose, mitigate, and manage such transactions.

Composition of the Board of Directors A board of directors is the central pillar of the governance structure, serves as the link between shareholders and managers, and acts as the shareholders' internal monitoring tool within the company. The structure and composition of a board of directors vary across countries and companies. The number of directors may vary, and the board typically includes a mix of expertise levels, backgrounds, and competencies. Board members must have extensive experience in business, education, the professions and/or public service so they can make informed decisions about the company's future. If directors lack the skills, knowledge and expertise to conduct a meaningful review of the company's activities, and are unable to conduct in-depth evaluations of the issues affecting the company's business, they are more likely to defer to management when making decisions. Executive (internal) directors are employed by the company and are typically members of senior management. Non-executive (external) directors have limited involvement in daily operations but serve an important oversight role. In a classified or staggered board, directors are typically elected in two or more classes, serving terms greater than one year. Proponents argue that by staggering the election of directors, a certain level of continuity and skill is maintained. However, staggered terms make it more difficult for shareholders to make fundamental changes to the composition and behavior of the board and could result in a permanent impairment of long-term shareholder value. Functions and Responsibilities of the Board Two primary duties of a board of directors are duty of care and duty of loyalty. Among other responsibilities, the board is to:

• establish long-term strategic objectives for the company with a goal of ensuring that the best interests of shareholders come first and that the company's obligations to others are met in a timely and complete manner.

• establish clear lines of responsibility and a strong system of accountability and performance measurement in all phases of a company's operations.

• hire the chief executive officer, determine the compensation package, and periodically evaluate the officer's performance.

• ensure that management has supplied the board with sufficient information for it to be fully informed and prepared to make the decision that are its responsibility, and to be able to adequately monitor and oversee the company's management.

Board of Directors Committees

A company's board of directors typically has several committees that are responsible for specific functions and report to the board.

• The audit committee plays a critical role in ensuring the corporation's financial integrity and consideration of legal and compliance issues. The primary objective is to ensure that the financial information reported by the company to shareholders is complete, accurate, reliable, relevant, and timely.

• The governance committee tries to ensure that the company adopts good corporate governance practices.

• The remuneration (compensation) committee develops and implements executive compensation policies. Incentives should be provided for actions that boost long-term share profitability and value.

• The nomination committee searches for and nominates board director candidates, and establishes the nomination policies and procedures.

• Other common committees include those responsible for overseeing management's activities in certain areas

...

Composition of the Board of Directors A board of directors is the central pillar of the governance structure, serves as the link between shareholders and managers, and acts as the shareholders' internal monitoring tool within the company. The structure and composition of a board of directors vary across countries and companies. The number of directors may vary, and the board typically includes a mix of expertise levels, backgrounds, and competencies. Board members must have extensive experience in business, education, the professions and/or public service so they can make informed decisions about the company's future. If directors lack the skills, knowledge and expertise to conduct a meaningful review of the company's activities, and are unable to conduct in-depth evaluations of the issues affecting the company's business, they are more likely to defer to management when making decisions. Executive (internal) directors are employed by the company and are typically members of senior management. Non-executive (external) directors have limited involvement in daily operations but serve an important oversight role. In a classified or staggered board, directors are typically elected in two or more classes, serving terms greater than one year. Proponents argue that by staggering the election of directors, a certain level of continuity and skill is maintained. However, staggered terms make it more difficult for shareholders to make fundamental changes to the composition and behavior of the board and could result in a permanent impairment of long-term shareholder value.

Two primary duties of a board of directors are duty of care and duty of loyalty.

Among other responsibilities, the board is to:

• establish long-term strategic objectives for the company with a goal of ensuring that the best interests of shareholders come first and that the company's obligations to others are met in a timely and complete manner.

• establish clear lines of responsibility and a strong system of accountability and performance measurement in all phases of a company's operations.

• hire the chief executive officer, determine the compensation package, and periodically evaluate the officer's performance.

• ensure that management has supplied the board with sufficient information for it to be fully informed and prepared to make the decision that are its responsibility, and to be able to adequately monitor and oversee the company's management.

Stakeholder relationships and corporate governance are continually shaped and influenced by a variety of market and non-market factors.

Market Factors
Shareholder engagement involves a company's interactions with its shareholders. It can provide benefits that include building support against short-term activist investors, countering negative recommendations from proxy advisory firms, and receiving greater support for management's position.

Shareholder activism encompasses a range of strategies that may be used by shareholders seeking to compel a company to act in a desired manner. It can take any of several forms: proxy battles, public campaigns, shareholder resolutions, litigation, and negotiations with management.

Corporate takeovers can happen in different ways: proxy contest or proxy fight, tender offer, hostile takeover, etc. The justification for the use of various anti-takeover defenses should rest on the support of the majority of shareholders and on the demonstration that preservation of the integrity of the company is in the long-term interests of shareholders.

Non-Market Factors

These factors include the legal environment, the media, and the corporate governance industry itself.

From a corporation's perspective, risks of poor governance include:

• weak control systems or inefficient monitoring tools;

• ineffective decision making;

• legal, regulatory, and reputational risks;

• default and bankruptcy risks.

Benefits of effective governance and stakeholder management include:

• better operational efficiency and control brought by effective monitoring tools and control mechanisms;

• better operating and financial performance;

• lower default risk and cost of debt.

Economic Ownership and Voting Control
What is the company's ownership and voting structure among shareholders?
Why do some shareholders own a small portion of a company's stock but get most of the voting power?
Does the practice really insulate managers from Wall Street's short-term mindset?

Dual-class structures create an inferior class of shareholders, and may allow management to make bad decisions with few consequences.

Board of Directors Representation
Analysts should assess whether the experience and skill sets of board members match the needs of the company.
Are they truly independent?
Are there inherent conflicts of interest?

Remuneration and Company Performance
What are the main drivers of the management team's remuneration and incentive structure?
Does the remuneration plan reward long-term or short-term growth?
Is it based on the performance of the company relative to its competitors or other peers?

Equity-based remuneration plans can offer the greatest incentives.
Are they linked to the long-term performance of the company?
What is the impact on the income statement?

Investors in the Company
What is the composition of investors in a company?
Are there any significant investors in the company?
Any sizable affiliated stockholders that can block the votes of the majority?
Any activist shareholders that could bring rapid changes for the company?

Strength of Shareholders' Rights
How robust are the shareholder rights at the company?
How robust compared to those of peers?

Managing Long-Term Risks
How effectively is the company managing long-term risks, such as securing access to necessary resources, managing human capital, exhibiting integrity and leadership, and strengthening the long-term sustainability of the enterprise?

ESG integration is the practice of considering environmental, social, and governance factors in the investment process. It can be implemented across all asset classes. ESG Factors in Investment Analysis Environmental factors include natural resource management, pollution prevention, water conservation, energy efficiency and reduced emissions, the existence of carbon assets, and adherence to environmental safety and regulatory standards. Social factors generally pertain to human rights and welfare concerns in the workplace, product development, and, in some cases, community impact. ESG Implementation Methods Asset managers and asset owners can incorporate ESG issues into the investment process in a variety of ways.

• Negative screening is a type of investment strategy that excludes certain companies or sectors from investment consideration because of their underlying business activities or other environmental or social concerns.

• Positive screening and best-in-class strategies focus on investments with favorable ESG aspects.

• Thematic investing focuses on a single factor, such as energy efficiency or climate change.

• Impact investing strategies are targeted investments, typically made in private markets, aimed at solving social or environmental problems.

It is important to understand how prices of derivatives are determined. Whether one is on the buy side or the sell side, a solid understanding of pricing financial products is critical to effective investment decision making. After all, one can hardly determine what to offer or bid for a financial product, or any product for that matter, if one has no idea how its characteristics combine to create value.

Understanding the pricing of financial assets is important. Discounted cash flow methods and models, such as the capital asset pricing model and its variations, are useful for determining the prices of financial assets. The unique characteristics of derivatives, however, pose some complexities not associated with assets, such as equities and fixed-income instruments. Somewhat surprisingly, however, derivatives also have some simplifying characteristics. For example, as we will see in this reading, in well-functioning derivatives markets the need to determine risk premiums is obviated by the ability to construct a risk-free hedge. Correspondingly, the need to determine an investor’s risk aversion is irrelevant for derivative pricing, although it is certainly relevant for pricing the underlying.

The purpose of this reading is to establish the foundations of derivative pricing on a basic conceptual level. The following topics are covered:

• How does the pricing of the underlying asset affect the pricing of derivatives?

• How are derivatives priced using the principle of arbitrage?

• How are the prices and values of forward contracts determined?

• How are futures contracts priced differently from forward contracts?

• How are the prices and values of swaps determined?

• How are the prices and values of European options determined?

• How does American option pricing differ from European option pricing?

In a general sense, economics is the study of production, distribution, and consumption and can be divided into two broad areas of study: macroeconomics and microeconomics. Macroeconomics deals with aggregate economic quantities, such as national output and national income, and is rooted in microeconomics , which deals with markets and decision making of individual economic units, including consumers and businesses. Microeconomics is a logical starting point for the study of economics.

Microeconomics classifies private economic units into two groups: consumers (or households) and firms. These two groups give rise, respectively, to the theory of the consumer and the theory of the firm as two branches of study. The theory of the consumer deals with consumption (the demand for goods and services) by utility-maximizing individuals (i.e., individuals who make decisions that maximize the satisfaction received from present and future consumption). The theory of the firm deals with the supply of goods and services by profit-maximizing firms.

Global investors must address two fundamentally interrelated questions: where to invest and in what asset classes? Some countries may be attractive from an equity perspective because of their strong economic growth and the profitability of particular domestic sectors or industries. Other countries may be attractive from a fixed income perspective because of their interest rate environment and price stability. To identify markets that are expected to provide attractive investment opportunities, investors must analyze cross-country differences in such factors as expected GDP growth rates, monetary and fiscal policies, trade policies, and competitiveness. From a longer term perspective investors also need to consider such factors as a country’s stage of economic and financial market development, demographics, quality and quantity of physical and human capital (accumulated education and training of workers), and its area(s) of comparative advantage.

This reading provides a framework for analyzing a country’s trade and capital flows and their economic implications. International trade can facilitate economic growth by increasing the efficiency of resource allocation, providing access to larger capital and product markets, and facilitating specialization based on comparative advantage. The flow of financial capital (funds available for investment) between countries with excess savings and those where financial capital is scarce can increase liquidity, raise output, and lower the cost of capital. From an investment perspective, it is important to understand the complex and dynamic nature of international trade and capital flows because investment opportunities are increasingly exposed to the forces of global competition for markets, capital, and ideas.

Merchandising and manufacturing companies generate revenues and profits through the sale of inventory. Further, inventory may represent a significant asset on these companies’ balance sheets. Merchandisers (wholesalers and retailers) purchase inventory, ready for sale, from manufacturers and thus account for only one type of inventory—finished goods inventory. Manufacturers, however, purchase raw materials from suppliers and then add value by transforming the raw materials into finished goods. They typically classify inventory into three different categories: raw materials, work in progress, and finished goods. Work-in-progress inventories have started the conversion process from raw materials but are not yet finished goods ready for sale. Manufacturers may report either the separate carrying amounts of their raw materials, work-in-progress, and finished goods inventories on the balance sheet or simply the total inventory amount. If the latter approach is used, the company must then disclose the carrying amounts of its raw materials, work-in-progress, and finished goods inventories in a footnote to the financial statements.

Inventories and cost of sales (cost of goods sold) are significant items in the financial statements of many companies. Comparing the performance of these companies is challenging because of the allowable choices for valuing inventories: Differences in the choice of inventory valuation method can result in significantly different amounts being assigned to inventory and cost of sales. Financial statement analysis would be much easier if all companies used the same inventory valuation method or if inventory price levels remained constant over time. If there was no inflation or deflation with respect to inventory costs and thus unit costs were unchanged, the choice of inventory valuation method would be irrelevant. However, inventory price levels typically do change over time.

IFRS permit the assignment of inventory costs (costs of goods available for sale) to inventories and cost of sales by three cost formulas: specific identification, first-in, first-out (FIFO), and weighted average cost. US GAAP allow the same three inventory valuation methods, referred to as cost flow assumptions in US GAAP, but also include a fourth method called last-in, first-out (LIFO). The choice of inventory valuation method affects the allocation of the cost of goods available for sale to ending inventory and cost of sales. Analysts must understand the various inventory valuation methods and the related impact on financial statements and financial ratios in order to evaluate a company’s performance over time and relative to industry peers. The company’s financial statements and related notes provide important information that the analyst can use in assessing the impact of the choice of inventory valuation method on financial statements and financial ratios.

In this reading we explain why the portfolio approach is important to all types of investors in achieving their financial goals. We compare the financial needs of different types of individual and institutional investors. After we outline the steps in the portfolio management process, we compare and contrast the types of investment management products that are available to investors and how they apply to the portfolio approach.

One of the biggest challenges faced by individuals and institutions is to decide how to invest for future needs. For individuals, the goal might be to fund retirement needs. For such institutions as insurance companies, the goal is to fund future liabilities in the form of insurance claims, whereas endowments seek to provide income to meet the ongoing needs of such institutions as universities. Regardless of the ultimate goal, all face the same set of challenges that extend beyond just the choice of what asset classes to invest in. They ultimately center on formulating basic principles that determine how to think about investing. One important question is: Should we invest in individual securities, evaluating each in isolation, or should we take a portfolio approach? By “portfolio approach,” we mean evaluating individual securities in relation to their contribution to the investment characteristics of the whole portfolio. In the following section, we illustrate a number of reasons why a diversified portfolio perspective is important.

Agricultural societies experience good harvest times and bad ones. Weather is a main factor that influences crop production, but other factors, such as plant and animal diseases, also influence the harvest. Modern diversified economies are less influenced by weather and diseases but, as with crops, there are fluctuations in economic output, with good times and bad times.

This reading addresses changes in economic activity and factors that affect it. Some of the factors that influence short-term economic movements—such as changes in population, technology, and capital—are the same as those that affect long-term sustainable economic growth. Other factors, such as money supply and inflation, are more specific to short-term economic fluctuations.

Analysts gather and process information to make investment decisions, including buy and sell recommendations. What information is gathered and how it is processed depend on the analyst and the purpose of the analysis. Technical analysis uses such information as stock price and trading volume as the basis for investment decisions. Fundamental analysis uses information about the economy, industry, and company as the basis for investment decisions. Examples of fundamentals are unemployment rates, gross domestic product (GDP) growth, industry growth, and quality of and growth in company earnings. Whereas technical analysts use information to predict price movements and base investment decisions on the direction of predicted change in prices, fundamental analysts use information to estimate the value of a security and to compare the estimated value to the market price and then base investment decisions on that comparison.

This reading introduces equity valuation models used to estimate the intrinsic value (synonym: fundamental value ) of a security; intrinsic value is based on an analysis of investment fundamentals and characteristics. The fundamentals to be considered depend on the analyst’s approach to valuation. In a top-down approach, an analyst examines the economic environment, identifies sectors that are expected to prosper in that environment, and analyzes securities of companies from previously identified attractive sectors. In a bottom-up approach, an analyst typically follows an industry or industries and forecasts fundamentals for the companies in those industries in order to determine valuation. Whatever the approach, an analyst who estimates the intrinsic value of an equity security is implicitly questioning the accuracy of the market price as an estimate of value. Valuation is particularly important in active equity portfolio management, which aims to improve on the return–risk trade-off of a portfolio’s benchmark by identifying mispriced securities.

Previous readings examined risk characteristics of various fixed-income instruments and the relationships among maturity, coupon, and interest rate changes. This reading introduces an additional level of complexity—that of fixed-income instruments created through a process known as securitization . This process involves transferring ownership of assets from the original owners into a special legal entity. The special legal entity then issues securities backed by these assets, and the assets’ cash flows are used to pay interest and repay the principal owed to the holders of the securities. These securities are referred to generically as asset-backed securities (ABS); the pool of securitized assets from which the ABS’s cash flows are generated is called the collateral. Assets that are used to create ABS are called securitized assets . These assets are typically loans and receivables and include, among others, residential mortgage loans (mortgages), commercial mortgages, automobile (auto) loans, student loans, bank loans, accounts receivables, and credit card receivables. Advances and innovations in securitization have led to securities backed, or collateralized, by all kinds of income-yielding assets, including airport landing slots and toll roads.

This reading discusses the benefits of securitization, describes securitization, and explains the investment characteristics of different types of ABS. The terminology regarding ABS varies by jurisdiction. Mortgage-backed securities (MBS) are ABS backed by a pool of mortgages, and a distinction is sometimes made between MBS and ABS backed by non-mortgage assets. This distinction is common in the United States, for example, where typically the term “mortgage-backed securities” refers to securities backed by high-quality real estate mortgages and the term “asset-backed securities” refers to securities backed by other types of assets. Because the US ABS market is the largest in the world, much of the discussion and many examples in this reading refer to the United States. Note, however, that many non-US investors hold US ABS, including MBS, in their portfolios.

With bonds outstanding worth many trillions of US dollars, the debt markets play a critical role in the global economy. Companies and governments raise capital in the debt market to fund current operations; buy equipment; build factories, roads, bridges, airports, and hospitals; acquire assets, and so on. By channeling savings into productive investments, the debt markets facilitate economic growth. Credit analysis has a crucial function in the debt capital markets—efficiently allocating capital by properly assessing credit risk, pricing it accordingly, and repricing it as risks change. How do fixed-income investors determine the riskiness of that debt, and how do they decide what they need to earn as compensation for that risk?

This reading covers basic principles of credit analysis, which may be broadly defined as the process by which credit risk is evaluated. Readers will be introduced to the definition of credit risk, the interpretation of credit ratings, the four Cs of traditional credit analysis, and key financial measures and ratios used in credit analysis. The reading explains, among other things, how to compare bond issuer creditworthiness within a given industry as well as across industries and how credit risk is priced in the bond market.

The reading focuses primarily on analysis of corporate debt; however, credit analysis of sovereign and non-sovereign, particularly municipal, government bonds will also be addressed. Structured finance, a segment of the debt markets that includes securities backed by pools of assets, such as residential and commercial mortgages as well as other consumer loans, will not be covered here.

Statistical methods provide a powerful set of tools for analyzing data and drawing conclusions from them. Whether we are analyzing asset returns, earnings growth rates, commodity prices, or any other financial data, statistical tools help us quantify and communicate the data’s important features. This reading presents the basics of describing and analyzing data, the branch of statistics known as descriptive statistics. The reading supplies a set of useful concepts and tools, illustrated in a variety of investment contexts. One theme of our presentation, reflected in the reading’s title, is the demonstration of the statistical methods that allow us to summarize return distributions.

We explore four properties of return distributions:

• where the returns are centered (central tendency);

• how far returns are dispersed from their center (dispersion);

• whether the distribution of returns is symmetrically shaped or lopsided (skewness); and

• whether extreme outcomes are likely (kurtosis).

These same concepts are generally applicable to the distributions of other types of data, too.

Analysts often confront competing ideas about how financial markets work. Some of these ideas develop through personal research or experience with markets; others come from interactions with colleagues; and many others appear in the professional literature on finance and investments. In general, how can an analyst decide whether statements about the financial world are probably true or probably false?

When we can reduce an idea or assertion to a definite statement about the value of a quantity, such as an underlying or population mean, the idea becomes a statistically testable statement or hypothesis. The analyst may want to explore questions such as the following:

• Is the underlying mean return on this mutual fund different from the underlying mean return on its benchmark?

• Did the volatility of returns on this stock change after the stock was added to a stock market index?

• Are a security’s bid-ask spreads related to the number of dealers making a market in the security?

• Do data from a national bond market support a prediction of an economic theory about the term structure of interest rates (the relationship between yield and maturity)?

To address these questions, we use the concepts and tools of hypothesis testing. Hypothesis testing is part of statistical inference, the process of making judgments about a larger group (a population) on the basis of a smaller group actually observed (a sample). The concepts and tools of hypothesis testing provide an objective means to gauge whether the available evidence supports the hypothesis. After a statistical test of a hypothesis we should have a clearer idea of the probability that a hypothesis is true or not, although our conclusion always stops short of certainty. Hypothesis testing has been a powerful tool in the advancement of investment knowledge and science. As Robert L. Kahn of the Institute for Social Research (Ann Arbor, Michigan) has written, “The mill of science grinds only when hypothesis and data are in continuous and abrasive contact.”

Hypothesis testing is part of statistical inference, the process of making judgments about a larger group (a population) on the basis of a smaller group actually observed (a sample). The concepts and tools of hypothesis testing provide an objective means to gauge whether the available evidence supports the hypothesis. After a statistical test of a hypothesis we should have a clearer idea of the probability that a hypothesis is true or not, although our conclusion always stops short of certainty. Hypothesis testing has been a powerful tool in the advancement of investment knowledge and science. As Robert L. Kahn of the Institute for Social Research (Ann Arbor, Michigan) has written, “The mill of science grinds only when hypothesis and data are in continuous and abrasive contact.”

The economic decisions of households can have a significant impact on an economy. For example, a decision on the part of households to consume more and to save less can lead to an increase in employment, investment, and ultimately profits. Equally, the investment decisions made by corporations can have an important impact on the real economy and on corporate profits. But individual corporations can rarely affect large economies on their own; the decisions of a single household concerning consumption will have a negligible impact on the wider economy.

By contrast, the decisions made by governments can have an enormous impact on even the largest and most developed of economies for two main reasons. First, the public sectors of most developed economies normally employ a significant proportion of the population, and they are usually responsible for a significant proportion of spending in an economy. Second, governments are also the largest borrowers in world debt markets.

Government policy is ultimately expressed through its borrowing and spending activities. In this reading, we identify and discuss two types of government policy that can affect the macroeconomy and financial markets: monetary policy and fiscal policy.

Monetary policy refers to central bank activities that are directed toward influencing the quantity of money and credit in an economy.1 By contrast, fiscal policy refers to the government’s decisions about taxation and spending. Both monetary and fiscal policies are used to regulate economic activity over time. They can be used to accelerate growth when an economy starts to slow or to moderate growth and activity when an economy starts to overheat. In addition, fiscal policy can be used to redistribute income and wealth.

The overarching goal of both monetary and fiscal policy is normally the creation of an economic environment where growth is stable and positive and inflation is stable and low. Crucially, the aim is therefore to steer the underlying economy so that it does not experience economic booms that may be followed by extended periods of low or negative growth and high levels of unemployment. In such a stable economic environment, householders can feel secure in their consumption and saving decisions, while corporations can concentrate on their investment decisions, on making their regular coupon payments to their bond holders and on making profits for their shareholders.

The overarching goal of both monetary and fiscal policy is normally the creation of an economic environment where growth is stable and positive and inflation is stable and low. The challenges to achieving this overarching goal are many. Not only are economies frequently buffeted by shocks (such as oil price jumps), but some economists believe that natural cycles in the economy also exist. Moreover, there are plenty of examples from history where government policies—either monetary, fiscal, or both—have exacerbated an economic expansion that eventually led to damaging consequences for the real economy, for financial markets, and for investors.

The balance sheet provides information on a company’s resources (assets) and its sources of capital (equity and liabilities/debt). This information helps an analyst assess a company’s ability to pay for its near-term operating needs, meet future debt obligations, and make distributions to owners. The basic equation underlying the balance sheet is Assets = Liabilities + Equity.

Analysts should be aware that different items of assets and liabilities may be measured differently. For example, some items are measured at historical cost or a variation thereof and others at fair value.1 An understanding of the measurement issues will facilitate analysis. The balance sheet measurement issues are, of course, closely linked to the revenue and expense recognition issues affecting the income statement. Throughout this reading, we describe and illustrate some of the linkages between the measurement issues affecting the balance sheet and the revenue and expense recognition issues affecting the income statement.

• What is risk management, and why is it important?

• What risks does an organization (or individual) face in pursuing its objectives?

• How are an entity’s goals affected by risk, and how does it make risk management decisions to produce better results?

• How does risk governance guide the risk management process and risk budgeting to integrate an organization’s goals with its activities?

• How does an organization measure and evaluate the risks it faces, and what tools does it have to address these risks?

The answers to these questions collectively help to define the process of risk management.

This reading is organized along the lines of these questions.

Section 2 describes the risk management process.

Section 3 discusses risk governance and risk tolerance.

Section 4 covers the identification of various risks.

Section 5 addresses the measurement and management of risks.

Section 6 provides a summary.

Long-lived assets , also referred to as non-current assets or long-term assets, are assets that are expected to provide economic benefits over a future period of time, typically greater than one year.1 Long-lived assets may be tangible, intangible, or financial assets. Examples of long-lived tangible assets, typically referred to as property, plant, and equipment and sometimes as fixed assets, include land, buildings, furniture and fixtures, machinery and equipment, and vehicles; examples of long-lived intangible assets (assets lacking physical substance) include patents and trademarks; and examples of long-lived financial assets include investments in equity or debt securities issued by other companies. The scope of this reading is limited to long-lived tangible and intangible assets (hereafter, referred to for simplicity as long-lived assets).

The first issue in accounting for a long-lived asset is determining its cost at acquisition. The second issue is how to allocate the cost to expense over time. The costs of most long-lived assets are capitalised and then allocated as expenses in the profit or loss (income) statement over the period of time during which they are expected to provide economic benefits. The two main types of long-lived assets with costs that are typically not allocated over time are land, which is not depreciated, and those intangible assets with indefinite useful lives. Additional issues that arise are the treatment of subsequent costs incurred related to the asset, the use of the cost model versus the revaluation model, unexpected declines in the value of the asset, classification of the asset with respect to intent (for example, held for use or held for sale), and the derecognition of the asset.

Judged by total market value, fixed-income securities constitute the most prevalent means of raising capital globally. A fixed-income security is an instrument that allows governments, companies, and other types of issuers to borrow money from investors. Any borrowing of money is debt. The promised payments on fixed-income securities are, in general, contractual (legal) obligations of the issuer to the investor. For companies, fixed-income securities contrast to common shares in not having ownership rights. Payment of interest and repayment of principal (amount borrowed) are a prior claim on the company’s earnings and assets compared with the claim of common shareholders. Thus, a company’s fixed-income securities have, in theory, lower risk than that company’s common shares.

In portfolio management Fixed-income securities are a way by which investors can prepare to fund, with some degree of safety, known future obligations such as tuition payments or pension obligations.

The correlations of fixed-income securities with common shares vary, but adding fixed-income securities to portfolios including common shares is usually an effective way of obtaining diversification benefits.

Among the questions this reading addresses are the following:

• What set of features define a fixed-income security, and how do these features determine the scheduled cash flows?

• What are the legal, regulatory, and tax considerations associated with a fixed-income security, and why are these considerations important for investors?

• What are the common structures regarding the payment of interest and repayment of principal?

• What types of provisions may affect the disposal or redemption of fixed-income securities?

Embarking on the study of fixed-income securities, please note that the terms “fixed-income securities,” “debt securities,” and “bonds” are often used interchangeably by experts and non-experts alike. We will also follow this convention, and where any nuance of meaning is intended, it will be made clear.

Global fixed-income markets represent the largest subset of financial markets in terms of number of issuances and market capitalization. These markets bring borrowers and lenders together to allocate capital globally to its most efficient uses. Fixed-income markets include not only publicly traded securities, such as commercial paper, notes, and bonds, but also non-publicly traded loans. At the end of 2010, the total amount of debt and equity outstanding was about $212 trillion globally.1 The global fixed-income market represented approximately 75% of this total; simply put, global debt markets are three times larger than global equity markets.

Understanding how fixed-income markets are structured and how they operate is important for debt issuers and investors. Debt issuers have financing needs that must be met. For example, a government may need to finance an infrastructure project, a new hospital, or a new school. A company may require funds to expand its business. Financial institutions also have funding needs, and they are among the largest issuers of fixed-income securities. Fixed income is an important asset class for both individual and institutional investors. Thus, investors need to understand the characteristics of fixed-income securities including how these securities are issued and traded.

Among the questions this reading addresses are the following:

• What are the key bond market sectors?

• How are bonds sold in primary markets and traded in secondary markets?

• What types of bonds are issued by governments, government-related entities, financial companies, and non-financial companies?

• What additional sources of funds are available to banks?

For firms with controlling shareholders, separation of ownership and control generates a two-level agency problem:

1. Between controlling shareholders and management.
2. Between minority shareholders and controlling shareholders.

Edward Freeman, the original proposer of the stakeholder theory, recognised it as an important element of Corporate Social Responsibility (CSR), a concept which recognises the responsibilities of corporations in the world today, whether they be economic, legal, ethical or even philanthropic. Nowadays, some of the world’s largest corporations claim to have CSR at the centre of their corporate strategy. Whilst there are many genuine cases of companies with a “conscience”, many others exploit CSR as a good means of PR to improve their image and reputation but ultimately fail to put their words into action

In the past, the investment community had great difficulty making meaningful comparisons on the basis of accurate investment performance data. Several performance measurement practices hindered the comparability of performance returns from one firm to another, while others called into question the accuracy and credibility of performance reporting overall.

Misleading practices included:

• Representative Accounts : Selecting a top-performing portfolio to represent the firm’s overall investment results for a specific mandate.

• Survivorship Bias : Presenting an “average” performance history that excludes portfolios whose poor performance was weak enough to result in termination of the firm.

• Varying Time Periods : Presenting performance for a selected time period during which the mandate produced excellent returns or out-performed its benchmark—making comparison with other firms’ results difficult or impossible.

Making a valid comparison of investment performance among even the most ethical investment management firms was problematic. For example, a pension fund seeking to hire an investment management firm might receive proposals from several firms, all using different methodologies for calculating their results.

The GIPS standards are a practitioner-driven set of ethical principles that establish a standardized, industry-wide approach for investment firms to follow in calculating and presenting their historical investment results to prospective clients. The GIPS standards ensure fair representation and full disclosure of investment performance. In other words, the GIPS standards lead investment management firms to avoid misrepresentations of performance and to communicate all relevant information that prospective clients should know in order to evaluate past results.

Industry analysis is the analysis of a specific branch of manufacturing, service, or trade. Understanding the industry in which a company operates provides an essential framework for the analysis of the individual company—that is, company analysis . Equity analysis and credit analysis are often conducted by analysts who concentrate on one or several industries, which results in synergies and efficiencies in gathering and interpreting information.

Among the questions we address in this reading are the following:

• What are the similarities and differences among industry classification systems?

• How does an analyst go about choosing a peer group of companies?

• What are the key factors to consider when analyzing an industry?

• What advantages are enjoyed by companies in strategically well-positioned industries?

Measured by daily turnover, the foreign exchange (FX) market—the market in which currencies are traded against each other—is by far the world’s largest market. Current estimates put daily turnover at approximately USD4 trillion for 2010. This is about 10 to 15 times larger than daily turnover in global fixed-income markets and about 50 times larger than global turnover in equities. Moreover, volumes in FX turnover continue to grow: Some predict that daily FX turnover will reach USD10 trillion by 2020 as market participation spreads and deepens.

The FX market is also a truly global market that operates 24 hours a day, each business day. It involves market participants from every time zone connected through electronic communications networks that link players as large as multibillion-dollar investment funds and as small as individuals trading for their own account—all brought together in real time. International trade would be impossible without the trade in currencies that facilitates it, and so too would cross-border capital flows that connect all financial markets globally through the FX market.

These factors (Ursula and seven eleven) make foreign exchange a key market for investors and market participants to understand. The world economy is increasingly transnational in nature, with both production processes and trade flows often determined more by global factors than by domestic considerations. Likewise, investment portfolio performance increasingly reflects global determinants because pricing in financial markets responds to the array of investment opportunities available worldwide, not just locally. All of these factors funnel through, and are reflected in, the foreign exchange market. As investors shed their “home bias” and invest in foreign markets, the exchange rate—the price at which foreign-currency-denominated investments are valued in terms of the domestic currency—becomes an increasingly important determinant of portfolio performance.

Even investors adhering to a purely “domestic” portfolio mandate are increasingly affected by what happens in the foreign exchange market. Given the globalization of the world economy, most large companies depend heavily on their foreign operations (for example, by some estimates about 40 percent of S&P 500 Index earnings are from outside the United States). Almost all companies are exposed to some degree of foreign competition, and the pricing for domestic assets—equities, bonds, real estate, and others—will also depend on demand from foreign investors. All of these various influences on investment performance reflect developments in the foreign exchange market.

The cash flow statement provides information about a company’s cash receipts and cash payments during an accounting period. The cash-based information provided by the cash flow statement contrasts with the accrual-based information from the income statement. For example, the income statement reflects revenues when earned rather than when cash is collected; in contrast, the cash flow statement reflects cash receipts when collected as opposed to when the revenue was earned. A reconciliation between reported income and cash flows from operating activities provides useful information about when, whether, and how a company is able to generate cash from its operating activities. Although income is an important measure of the results of a company’s activities, cash flow is also essential. As an extreme illustration, a hypothetical company that makes all sales on account, without regard to whether it will ever collect its accounts receivable, would report healthy sales on its income statement and might well report significant income; however, with zero cash inflow, the company would not survive. The cash flow statement also provides a reconciliation of the beginning and ending cash on the balance sheet.

L i k e s u r g i c a l m i t r a l v a l v o t o m y , P T M C i n c r e a s e s M VA b y s p l i t - ting the fused commissures to produce dramatic relief of MV obstruction and improved hemodynamics. The valve area obtained by PTMC is similar to that achieved by surgery, with comparable rates of restenosis.

In addition to information about cash generated (or, alternatively, cash used) in operating activities, the cash flow statement provides information about cash provided (or used) in a company’s investing and financing activities. This information allows the analyst to answer such questions as:

• Does the company generate enough cash from its operations to pay for its new investments, or is the company relying on new debt issuance to finance them?

• Does the company pay its dividends to common stockholders using cash generated from operations, from selling assets, or from issuing debt?

• Does the company generate enough cash from its operations to pay for its new investments, or is the company relying on new debt issuance to finance them?

• Does the company pay its dividends to common stockholders using cash generated from operations, from selling assets, or from issuing debt?

Answers to these questions are important because, in theory, generating cash from operations can continue indefinitely, but generating cash from selling assets, for example, is possible only as long as there are assets to sell. Similarly, generating cash from debt financing is possible only as long as lenders are willing to lend, and the lending decision depends on expectations that the company will ultimately have adequate cash to repay its obligations. In summary, information about the sources and uses of cash helps creditors, investors, and other statement users evaluate the company’s liquidity, solvency, and financial flexibility

For those companies reporting under International Financial Reporting Standards (IFRS), IAS 12 [Income Taxes] covers accounting for a company's income taxes and the reporting of deferred taxes. For those companies reporting under United States generally accepted accounting principles (US GAAP), FASB ASC Topic 740 [Income Taxes] is the primary source for information on accounting for income taxes. Although IFRS and US GAAP follow similar conventions on many income tax issues, there are some key differences that will be discussed in the reading.

Differences between how and when transactions are recognized for financial reporting purposes relative to tax reporting can give rise to differences in tax expense and related tax assets and liabilities. To reconcile these differences, companies that report under either IFRS or US GAAP create a provision on the balance sheet called deferred tax assets or deferred tax liabilities, depending on the nature of the situation.

Deferred tax assets or liabilities usually arise when accounting standards and tax authorities recognize the timing of revenues and expenses at different times. Because timing differences such as these will eventually reverse over time, they are called “temporary differences.” Deferred tax assets represent taxes that have been recognized for tax reporting purposes (or often the carrying forward of losses from previous periods) but have not yet been recognized on the income statement prepared for financial reporting purposes. Deferred tax liabilities represent tax expense that has appeared on the income statement for financial reporting purposes, but has not yet become payable under tax regulations.

This reading presents several important applications of financial statement analysis. Among the issues we will address are the following:

• What are the key questions to address in evaluating a company’s past financial performance?

• How can an analyst approach forecasting a company’s future net income and cash flow?

• How can financial statement analysis be used to evaluate the credit quality of a potential fixed-income investment?

• How can financial statement analysis be used to screen for potential equity investments?

• How can differences in accounting methods affect financial ratio comparisons between companies, and what are some adjustments analysts make to reported financials to facilitate comparability among companies.

The reading Financial Statement Analysis: An Introduction described a framework for conducting financial statement analysis. Consistent with that framework, prior to undertaking any analysis, an analyst should explore the purpose and context of the analysis. The purpose and context guide further decisions about the approach, the tools, the data sources, and the format in which to report results of the analysis, and also suggest which aspects of the analysis are most important. Having identified the purpose and context, the analyst should then be able to formulate the key questions that the analysis must address. The questions will suggest the data the analyst needs to collect to objectively address the questions. The analyst then processes and analyzes the data to answer these questions. Conclusions and decisions based on the analysis are communicated in a format appropriate to the context, and follow-up is undertaken as required. Although this reading will not formally present applications as a series of steps, the process just described is generally applicable.

Assets under management in vehicles classified as alternative investments have grown rapidly since the mid-1990s. This growth has largely occurred because of interest in these investments by institutions, such as endowment and pension funds, as well as high-net-worth individuals seeking diversification and return opportunities. Alternative investments are perceived to behave differently from traditional investments. Investors may seek either absolute return or relative return.

Some investors hope alternative investments will provide positive returns throughout the economic cycle; this goal is an absolute return objective. Alternative investments are not free of risk, however, and their returns may be negative and/or correlated with other investments, including traditional investments, especially in periods of financial crisis. Some investors in alternative investments have a relative return objective. A relative return objective, which is often the objective of portfolios of traditional investment, seeks to achieve a return relative to an equity or fixed-income benchmark.

In the field of economics, microeconomics is the study of the economic activity and behavior of individual economic units, such as a household, a company, or a market for a particular good or service, and macroeconomics is the study of the aggregate activities of households, companies, and markets. Macroeconomics focuses on national aggregates, such as total investment, the amount spent by all businesses on plant and equipment; total consumption, the amount spent by all households on goods and services; the rate of change in the general level of prices; and the overall level of interest rates.

Macroeconomic analysis examines a nation’s:

Aggregate output and income.

Competitive and comparative advantages

Productivity of its labor force.

Price level and inflation rate.

the actions of its national government and central bank.

The objective of macroeconomic analysis is to address such fundamental questions as:

• What is an economy’s aggregate output, and how is aggregate income measured?

• What factors determine the level of aggregate output/income for an economy?

• What are the levels of aggregate demand and aggregate supply of goods and services within the country?

• Is the level of output increasing or decreasing, and at what rate?

• Is the general price level stable, rising, or falling?

• Is unemployment rising or falling?

• Are households spending or saving more?

• Are workers able to produce more output for a given level of inputs?

• Are businesses investing in and expanding their productive capacity?

• Are exports (imports) rising or falling?

From an investment perspective, investors must be able to evaluate a country’s current economic environment and to forecast its future economic environment in order to identify asset classes and securities that will benefit from economic trends occurring within that country. Macroeconomic variables—such as the level of inflation, unemployment, consumption, government spending, and investment—affect the overall level of activity within a country. They also have different impacts on the growth and profitability of industries within a country, the companies within those industries, and the returns of the securities issued by those companies.

Weak corporate governance is a common thread found in many company failures. A lack of proper oversight by the board of directors, inadequate protection for minority shareholders, and incentives at companies that promote excessive risk taking are just a few of the examples that can be problematic for a company. Poor corporate governance practices resulted in several high-profile accounting scandals and corporate bankruptcies over the past several decades and have been cited as significantly contributing to the 2008–2009 global financial crisis.

In response to company failures in the past, specially 2008-2009 crisis, regulations have been introduced to promote stronger governance practices and protect financial markets and investors. Academics, policy makers, and other groups have published numerous works discussing the benefits of good corporate governance and identifying core corporate governance principles believed to be essential to ensuring sound capital markets and the stability of the financial system.

The investment community has demonstrated a greater appreciation for the importance of good corporate governance. The assessment of a company’s corporate governance system, including consideration of conflicts of interest and transparency of operations, has increasingly become an essential factor in the investment decision-making process. Additionally, investors have become more attentive to environment and social issues related to a company’s operations. Collectively, these areas often are referred to as environmental, social, and governance ( ESG ).

A company grows by making investments that are expected to increase revenues and profits. The company acquires the capital or funds necessary to make such investments by borrowing or using funds from owners. By applying this capital to investments with long-term benefits, the company is producing value today. But, how much value? The answer depends not only on the investments’ expected future cash flows but also on the cost of the funds. Borrowing is not costless. Neither is using owners’ funds.

The cost of this capital is an important ingredient in both investment decision making by the company’s management and the valuation of the company by investors. If a company invests in projects that produce a return in excess of the cost of capital, the company has created value; in contrast, if the company invests in projects whose returns are less than the cost of capital, the company has actually destroyed value. Therefore, the estimation of the cost of capital is a central issue in corporate financial management. For the analyst seeking to evaluate a company’s investment program and its competitive position, an accurate estimate of a company’s cost of capital is important as well.

Cost of capital estimation is a challenging task. The cost of capital is not observable but, rather, must be estimated. Arriving at a cost of capital estimate requires a host of assumptions and estimates. Another challenge is that the cost of capital that is appropriately applied to a specific investment depends on the characteristics of that investment: The riskier the investment’s cash flows, the greater its cost of capital. In reality, a company must estimate project-specific costs of capital. What is often done, however, is to estimate the cost of capital for the company as a whole and then adjust this overall corporate cost of capital upward or downward to reflect the risk of the contemplated project relative to the company’s average project.

Market efficiency concerns the extent to which market prices incorporate available information. If market prices do not fully incorporate information, then opportunities may exist to make a profit from the gathering and processing of information. The subject of market efficiency is, therefore, of great interest to investment managers

An endowment fund is an investment fund established by a foundation that makes consistent withdrawals from invested capital. The capital in endowment funds, often used by universities, nonprofit organizations, churches and hospitals, is generally utilized for specific needs or to further a company’s operating process. Endowment funds are typically funded entirely by donations that are deductible for the donors.

An investment fund is a supply of capital belonging to numerous investors used to collectively purchase securities while each investor retains ownership and control of his own shares. An investment fund provides a broader selection of investment opportunities, greater management expertise and lower investment fees than investors might be able to obtain on their own. Types of investment funds include mutual funds, exchange-traded funds, money market funds and hedge funds.

The chief investment officer (CIO) of a major university endowment fund has listed eight steps in the active manager selection process that can be applied both to traditional investments (e.g., common equity and fixed-income securities) and to alternative investments (e.g., private equity, hedge funds, and real assets). The first step specified is the evaluation of market opportunity:

What is the opportunity and why is it there? To answer this question we start by studying capital markets and the types of managers operating within those markets. We identify market inefficiencies and try to understand their causes, such as regulatory structures or behavioral biases. We can rule out many broad groups of managers and strategies by simply determining that the degree of market inefficiency necessary to support a strategy is implausible. Importantly, we consider the past history of active returns meaningless unless we understand why markets will allow those active returns to continue into the future.1

The CIO’s description underscores the importance of not assuming that past active returns that might be found in a historical dataset will repeat themselves in the future. Active returns refer to returns earned by strategies that do not assume that all information is fully reflected in market prices.

Equity, fixed-income, currency, and commodity markets are facilities for trading the basic assets of an economy. Equity and fixed-income securities are claims on the assets of a company. Currencies are the monetary units issued by a government or central bank. Commodities are natural resources, such as oil or gold. These underlying assets are said to trade in cash markets or spot markets and their prices are sometimes referred to as cash prices or spot prices , though we usually just refer to them as stock prices, bond prices, exchange rates, and commodity prices. These markets exist around the world and receive much attention in the financial and mainstream media. Hence, they are relatively familiar not only to financial experts but also to the general population.

Derivatives are financial instruments that derive their values from the performance of these basic assets.

Among the questions that this first reading will address are the following:

• What are the defining characteristics of derivatives?

• What purposes do derivatives serve for financial market participants?

• What is the distinction between a forward commitment and a contingent claim?

• What are forward and futures contracts? In what ways are they alike and in what ways are they different?

• What are swaps?

• What are call and put options and how do they differ from forwards, futures, and swaps?

• What are credit derivatives and what are the various types of credit derivatives?

• What are the benefits of derivatives?

• What are some criticisms of derivatives and to what extent are they well founded?

• What is arbitrage and what role does it play in a well-functioning financial market?