 and welcome to this session. This is Professor Farhad and this session we would look at the players in the financial market. This topic is typically covered in an undergraduate or graduate essentials of investment course. As always, I would like to remind you to connect with me on LinkedIn if you haven't done so. YouTube is where you would need to subscribe. I have 1,700 plus accounting, auditing, tax, finance, as well as Excel tutorials. If you like my lectures, please like them, share them, put them in playlists. If they benefit you, it means they might help other people. Subscribe to my YouTube, connect with me on Instagram. On my website, farhadlectures.com, you will find additional resources to supplement your accounting education or your professional certification such as the CPA exam. So if you're looking to add 10 to 15 points to your CPA exam, I strongly suggest you check out my website. There are three major players in the financial market and those are households, firms, which is companies and governments. Let's take a look at the role of each player. Households. Households are supplier of capital or supplier of money. How so? Think about when you work. If you have a job, let's assume you make $80,000 per year just for the sake of illustration. Then let's make it $100,000 per year, $100,000 per year. While you're going to spend this money on living expenses, so let's assume you spend $50,000 on living expenses and let's assume you have to pay another $15,000 in taxes. So simply put, you're going to be left with $35,000. Of this $35,000 you might invest let's say $10,000 in your 401k, which is this is extra money, which let's make it $15,000. Let's assume you're going to invest $15,000 in your 401k. What you're going to be left with is $20,000. Let's assume this is extra money. What are you going to do with this extra money? You're going to either deposit this money in the bank or you're going to buy stocks, buy bonds, invest yourself. When you invest this money in the bank, the bank would lend your money out. So simply put, you are a supplier of money. Household is what supplies money to the market. How so? By depositing the money in the bank, by purchasing securities issued by firms because companies issue securities. Now if household supply to firms, firms are demanders of capital. Firms, they need money. Why do they need the money? Think about why firms need the money. They need the money to expand. They need the money to buy property, plant and equipment. So that's what they do. They raise money to pay for investments in property, plant and equipment. And what's going to happen? This property, plant and equipment will generate income and this income will, some of it is paid back to the household in form of a profit. So this is how it works. So the income generated by the real assets, the real assets means plant and equipment, provide return to the investors who purchase those securities issued by the firm. So this is the second group. The third group is the government and the government can be either a supplier or a demander. So sometimes the government is in need of money. Sometimes it's in need of money. They borrow. Sometimes they have enough money. They lend out depending on the relationship between the tax revenue and the government expenditure. So if the government raise more taxes than the expenditure, then they have what's called a surplus. But if the government, the taxes that they have is less than the expenditure, I'm sorry, if the taxes are more, yes, they have a surplus. If the taxes are less, they have what's called a deficit. And historically speaking, since World War II, we mostly had deficit. It means we could not collect enough taxes, which is enough revenue, to cover the expenditure. Okay, this is what deficit is. So what happened when you have a deficit? The government will issue, it means they sell Treasury Bill, notes and bonds in simple language. They borrow money to finance themselves. Now, in the late, latter part of the 1990, during the dot com error, when Clinton was in office, the government enjoyed a brief two, three years of budget surplus, and they were able to pay some of the outstanding debt. So those are the three major players. We have to understand the three major players. Now, for these three major players to interact together, to interact together, we needed intermediaries. We need intermediaries. So what are the intermediaries? Well, simply put, a financial intermediary is someone that sits in between those groups. So think about it. If I have this extra $20,000 a year, what am I going to do with this money? What am I going to do with this money? Well, I need to invest it. Well, one way to invest it is to go around, ask people about what business are they in. And if I like their business, I can lend them their money. I can lend them my money. Well, that's time consuming. Then if they agree, that yes, we would like you to lend us our money, then I have to assess their credit risk. I have to assess their business. Well, I don't have time to do that. I don't have the expertise to do that. So what do I do? I'm going to go to the bank, deposit my money in the bank, and the bank will lend money to the borrowers. And I don't have to worry about who that borrower is. So simply put, if we look at household, household would like to earn some money on their investments, invest on their savings. So they deposit this money at the bank or the financial institution or they buy stocks and they buy bonds. So household, don't solicit, don't solicit investments on their own. Now you can do that. Sometimes your relative, your friend, they'll come to you and they'll say, look, many times I have relatives that are in the car dealership and they always ask me, would you be interested in investing some money with us? I was like, no, I'm not interested. So simply put, you do have investments like this, but usually you don't, you know, you can if you want to invest, but that's, you're taking a lot of risk. But it's, again, you have to evaluate your risk. That's your call. So it's time consuming, constantly a need expertise to assess credit and market risk. So that's why financial intermediaries are important. Same thing with corporation and government. They don't sell all or even most of their securities directly to individuals. So when the government, when the government borrows money or when a corporation borrows money or they sell stocks, they usually sell to institutions rather than to individuals. Why? Because the individual already gave their money to the institutions. Okay. For example, about half of all stocks is held by large institution, such as pension funds, mutual fund, insurance companies and banks. Now, where do these companies get their money from? Guess what? All these companies got their money from the household. So simply put, they sell them to households, but through intermediaries. And that's why financial intermediaries are critical to our economy because they play that intermediary role between household and suppliers of fund household and demanders of fund corporation and government. So these financial institutions stand between the security issuer and the ultimate owners of the securities, which are back to household investors. Now, who are these financial intermediaries? Well, we mentioned banks. Let's take a look at each one of them real briefly. Bank, what are we talking about here? Hopefully, we're all familiar with the concept of bank, like Bank of America, like Wells Fargo. Sometimes we call them commercial banks. They raise funds by borrowing. So banks, they borrow money and they lend it to other two borrowers. So they bring money, they pay you 3%, they lend it at 6%. And in between, they keep a little bit of money as profit. So the spread between the interest rate paid to the depositor, so let's assume they pay the deposit of three, and the rate charge to borrowers is the source of bank's profit. So they make three, in this situation, let's assume they lend it at 7%, they make a 4% profit because they brought it at three, lend it at seven. Now, bear in mind that they have a lot of expenditure, a lot of expenditure, a lot of expenditure to pay, for example, employees. So this 4%, they may even spend another 3% in expenses. And what they left with is 1% in net profit. But that's how they make, simply that's how a bank makes money. In this way, lenders and borrowers do not have to contact each other directly. So the bank, basically, it's a matchmaker between the two. And this is why it's an important financial intermediaries. So financial intermediaries are distinguished from other businesses is that both their assets and their liabilities are financial. So they accept money and they lend money. So they don't buy property, plant, and equipment. Yes, they do need a bank, a physical bank, to operate. But that's not how they make money. They make money from their money. Even nowadays, there are banks with no physical existence, like E-Trade Bank, literally have like one building. They do have branches now, but they don't have to if they don't have to. So other examples of financial intermediaries, we talked about banks, we have investment companies, insurance companies, and credit union. They're basically, they play the same role. They offer similar advantages in their intermediary role. First, they pull resources of many small investors that are able to lend considerable sums, large of money. So what they do is they bring those small depositors, small depositors, now they have a large amount of money, then they can lend it to large corporation all at once. By lending to many borrowers, intermediaries achieve significant diversification. So what they do, rather than lending the money to one group or to one industry or to one company, they lend it to many other, to many industries, which is they create diversification, which in turn reduces the risk. Yeah, right. I mean, you know, sometimes banks, you know, and these companies blow up, but that's the purpose of diversification. Okay, the third thing that they do, they build expertise through the volume of business they do, and they can use economies of scale and scope to assess, to assess and monitor risk. Let me tell you something, banks, investment companies, insurance companies, they know a lot about what's going on in the economy before this information is public. Think about if you work in a bank or in an investment company, and you notice that people are not paying their bill. Overall, for example, historically 3% don't pay their mortgage. Now you notice it's going from 3% to 4%. You will notice there's an uptick in the late payment. You would know immediately there's something going on in the economy that's making that the people not pay, or they are not paying their mortgage payment on time. So you're gonna build that expertise from that knowledge. Okay, so and that's gonna create an opportunity for this institution to share with investors. We'll talk about this later on in form of newsletters, research notes and databases, so on and so forth. So we talked about those three. Let's talk about investment companies. When you think of investment companies, things of Charles Schwab and Vanguard groups, they manage funds for investors. So what they do, you give them money, and they will manage your money. An investment company may manage several mutual funds. What is a mutual fund? Basically, mutual fund is an investment, but that investment is a pool or a portfolio of securities. So what they do, they buy, for example, 20 different stocks and 20 different industries, and they bundle it in one mutual fund. So when you buy, you buy one share of that mutual fund and that one share represent 20 stocks, 20 stocks, maybe in 20 different industries. So this is what a mutual fund is, and we have all sorts of mutual funds. So the mutual funds, they have the advantage. We'll talk about mutual funds later on. Large-scale trading and portfolio management while participating investors are assigned a pro-retta share of the total fund according to the size of their investment. So if we invested a million dollar in this fund and you own 100,000, well guess what? You own 10% of that fund. So if the fund pays 10%, 10% in dividend, so if the mutual fund paid, let's assume they paid $10,000 in dividend out of that mutual fund, you're going to get 10% of that, which is you'll get $1,000. So you participate in that diversification through the mutual fund. So this system gives small investors advantage. They are willing to pay via a management fee to a mutual fund operator. So rather than you doing all the research to put all those 20 stocks together, you pay a fee with other investors. The investment company will put this mutual fund together and you'll be able to take advantage of this diversification. Like a mutual fund, we have something called hedge funds. Also they pool and invest money of many clients. Think about Citadel and Fortress and BlackRock. They all have those tough names, but usually those hedge funds every once in a while, they blow up because they make the wrong investments basically, but they have really catchy names, BlackRock, Citadel, and Fortress, all powerful names. So these usually are open to institutional investors or wealthy individuals. Institutional investors here are talking about pension fund, endowment funds like Harvard fund and large pension funds like the California pension fund. There are more likely to pursue complex and higher risk strategies and because of that, that's why they blow up. That's why they go bad. That's why they go bad. They typically keep a portion of their trading profit as part of their fee. So what they do is, whether they charge you, so for example, if they made a 20%, they may keep 5% from the profit and you earn 15%. That's how they usually do it, but also they can get a fixed fee as well. Okay, but oftentimes they basically, they would say, look, we're going to make you money, don't worry about it. And if you don't make money, you don't make money. That's how they kind of entice you to invest. So they undertake very risky strategies. So remember, we talked about the knowledge that these firms have because of this knowledge and the economies of scale because they have many, many investors, what they can do, they can provide investors with newsletters, databases and brokerage house research services like, for example, Citibank, Merrill Lynch, they all issue those research notes telling me about the economy. There's also some newsletters like Motley Fould, you know, Stock Advisor, those are private newsletters. And what they do, they try to help investors make a better decision. That's, that's all what they do. Investors clearly they want information, but with small portfolio to manage, they do not find it economically to personally gather all of it. So what you do is you rely on these investment companies, you rely on banks, you rely on the research department to do that research for you and share it with you because you cannot do it. But since it's worth it for them, because they have millions and millions of clients, they all have to do it once. It's an economy of scales and they can share it with everyone. But as an individual investor, it will take you a lot of time, effort and expertise to do it. It's not worth it for you. So they do provide the service. So that's a profit opportunity as firm can perform the service for many clients and sometime they charge you for it. Okay. Another form is investment bankers, which is different than commercial banks, you know, investment banks or investment bankers. Remember, we talked about commercial banks, commercial banks, they, you know, they accept deposits, they give out loans, usually mortgages or business loans, investment bankers, they're banked, but they're a little bit different investment banks like JP Morgan, Morgan Stanley, Goldman Sachs. What they do, they specialize in the sale of new securities to the public, typically by underwriting the new issue. I think of Facebook. Your Facebook was private company. Then I believe if my memory serves me right, 2010, 2010, they went public. So when they went public, what did they do? They used, I don't remember which investment firm or they used a few of them, they used them. So what they did, Facebook, they sold, not sold the stock, the investment bank, okay, told them, we're going to sell your stocks to the public. So it was a primary, primary, in the primary market. We'll talk about this in a moment. Also what they do, they advise and issue incorporation on the price of the stock. So they all tell Facebook, you know, you should, you know, price the stock at, I remember, 40, I don't know, $49 or $20. Now, you know, if you bought the stock, you'll be way, way in good shape for now. So that's what they do. They determine the stock price. If you're a showing bond, they will tell you which interest rate to charge. And how do they know this? Because they are in the market. They know what's going on. They have, they are in contact with large investors, wealthy investors. And sometime what they do, they handle, not sometime, they handle the primary, the marketing of the security in the primary market. And what is the primary market is one, this Facebook stocks go the first time in public. This is what the primary market is. A market which new issues of securities are offered to the public. Now we have the primary market. It's when the company sells their stocks for the first time to the public and the company gets the money. So here what happened Facebook sells their stock and Facebook gets the money. And they use the intermediary or the investment banker, let's say Goldman Sachs. Then once the, once the people that buy Facebook stocks, they have Facebook stocks and they trade it among themselves, we call this the second secondary market, market which previously issued securities are traded among investors. So, you know, at this point when the people trade stocks, Facebook is not, you know, it's not really involved in this process. It's the secondary market. Also we have another group which is called venture capitals. Most venture capital are set set up as limited partnership, most but not all. And the reason is because Google, Alphabet, Alphabet, they have a Google venture. And what is it? What is it? What is a venture capital? It's a management company start with its own money and raises additional capital from limited partners such as pension funds. So what they do is you have a few people that they pulled their money together and they'll say, okay, let's find startup companies to invest in. Now Google, before they became famous and enlarge, they needed a venture capital. So Google needed a VC to go when they initially started and all the VCs that invested in Google, now there be billionaires because they made the right choice. Okay. That capital may need to be invested in a variety of startup companies. Usually they don't put their ax all in one basket. They look at several startup because one of them will fail eventually or several of them. They just need one homerun. Okay. The management company usually sits on the startup company's board of directors because they're given you money. If they're given you money, they want to make sure they know what's going on. They help you recruit senior managers and they provide business advice because they have their money invested. Okay. It's going to charge a fee to oversee the investments. After some period, usually what they do, the fund liquidate the proceeds and distribute to the investors. Then they sell the company and all the people that invested will get some profit. That's how they usually operate. It doesn't have to. Venture capital investors commonly take an active role in management of the startup firm. They do. When you invest your money, you want to take an active role to make sure the investments is doing well. Okay. And other active investors may engage in similar hands, hands-on management, but focus instead on the firms that are in distress or firms that be bought up, improved, and sold for a profit. And sometimes only they get involved with firms that need help, that needs help. Okay. So collectively, these investments and firms that do not trade on the publicly stock exchange are known as private equity investment. So VCs deal with private equity. Private equity means the stocks is not public. It means if you want to buy a stock in this company, you have to find a VC or someone who the VC sold the shares to, and they'll be happy to sell you the stock, assuming there are no restriction on them. So this is called private equity because we have private and we have public. Public is like Facebook is public, but at some point, Facebook was private. Uber was private. Now it's public. So once the company goes public, then it's no longer private equity. It's public. Then they have to report their numbers with the SEC, so on and so forth. And this is basically the role of financial intermediaries in the next session. We would look at the financial crisis of 2008 because it's very important to see the role of financial intermediaries in a crisis. So what role did they play? What role should they play and what happened? So we went into the financial crisis of 2008. As always, I would like to remind you to like this recording, share it, put it in playlist, and don't forget to visit my website, farhatlectures.com for additional resources, especially if you are an accounting or to a lesser degree finance student, or if you are studying for your CPA or CFA exam. Good luck, study hard. And if we are still living through this coronavirus, of course, stay safe.