 Hello and welcome to the session. This is Professor Farhad and the session would look at the financial market and the role it plays in the economy. This topic is typically covered in an essentials of investment course, CPA exam, as well as the CFA exam. 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 tutorial. If you like my lectures, please like them, share them, put them in playlist, subscribe to my YouTube. If it's helping you, it means it might help other people, share the wealth, connect with me on Instagram. On my website, farhadlectures.com, you will find additional resources to supplement your accounting, your finance courses, as well as your professional certifications, especially if you are studying for your CPA exam. So in the prior lesson, we learned about real assets and we said that real assets determine the wealth of an economy and basically real assets are machinery, equipment, land, inventory, knowledge. So we need this real asset to serve to produce income. Then if we combine real assets with financial assets and what are financial assets, financial assets represent the claim of real assets. For example, if you own stocks in Tesla, you don't own the assets themselves, you have a claim on the assets. So the financial assets represent a claim to the real assets. Now, if we combine financial assets with real assets, which is if we combine equipment with bonds and stocks, what we have literally is Wall Street, we have the financial market. So the financial markets, which is something like Wall Street allows us to make the most of the economy's real and financial assets. So the real and the financial assets, they express themselves in the financial market. The financial market has five characteristics. It plays an informational role that has an informational role. It helps us in consumption timing. It helps us with the allocation of risk. It helps with the problem of separation of ownership and management. And it helps with corporate governance. Now we're going to have to look at each one of these topics separately to see how the financial market help in all those five topics, starting with the informational role of the financial market. Generally speaking, logically speaking, capital should flow. The money should go to the best companies. Now how would that happen? So capital should flow to the best companies. It means they have the best prospect, the best future. Now, how do we know if a company is doing well or not? Well, one thing to do is to look at their stock price. What does the stock price represent? Well, the stock price represent the investor's collective assessment. Remember, the investors could be professional investors, amateurs, institutional investors. Everyone is typically an investor and the stock price represent the collective decision of those individuals. And what happened is this, if the stock price goes up, we assume that we should have an optimistic view about the company. Okay? So optimistic future means the stock price rises. What does that mean? It means if the stock price is rising, it means we need to channel more capital. It means there's a good prospect for the company. So it would help us. It's a signal that this company is doing well. Higher prices makes it easier for the firm to raise capital and encourage investments. Again, I'll take, I will use example as Tesla. As Tesla stock goes up, although Tesla is not making any profit currently, the prospect of Tesla in the future is high. Therefore, we assume the more profit they, the higher the stock price, the better is their prospect. So if Tesla needs to raise money, if Tesla needs money, anyone will give Tesla money. And this happens on a regular basis. On a regular basis, Tesla need to raise money. They need to issue stocks. And guess what? All investors are willing to give them money. Why? Because their stock price keep on rising. Why does their stock price keep on rising? Because it reflects the investor's collective assessment. A positive view about their future, an optimistic future. Okay? No, stock prices play a major role in allocation of capital. Because remember, as I just said, if your stock price goes up, you have an optimistic future. More people would, would invest money in you. But bear in mind, that's not a science. Okay? So directing capital to the firms with the greatest potential could be also wrong. I mean, think about the dot com. Many people invested money in companies that did not survive a year or two when we had the dot com boom and bust in the 99, 2000 and 2001. So we had a dot com boom, then a dot com bust, several of these companies survive, like Amazon, for example, Amazon still exists and Amazon doing great. And this is Amazon as part of the dot com. But many other companies other than Amazon really went bust. So the point is, the stock price is not always correct. Just want to let you know. But we use it as the collective assessment for everyone, for everyone. Okay? Now stock price reflect collective judgment, analysts, professional investors and amateurs. But remember, it's not always right. So this is one way the financial market will help us. It gives us informational role. It just gives us more information about where to invest. So let's take a look at consumption timing. What does that mean? Think about right now, right now you are working and you are still healthy, you can produce, you are building your career. So you're going to be making money now. Okay? But later on in life, you want to work class or you don't want to work at all. Actually, you want to stop working. So what happened is this, you want to save this money into the future when you are not working. So simply put, financial asset store your wealth. What we can do is we can buy financial assets in the financial market today and when we are earning money and store that value in the future. So on high earning periods, when we are working now, you can invest in financial assets, stocks, bonds, real estate, whatever you want to invest in. Later on, when you have low earning periods, when you are simply retiring, you can sell those assets to fund your consumption. So simply put, what you are doing is you are shifting your consumption from now into the future and who allows you to do that, the financial market over the course of your lifetime. That's what you can do. So financial market, they allow individual to make separate decision concerning current assumption from constraint that otherwise would be imposed by current earnings. So it gives you that flexibility that you can store your wealth into the future. And in the future, you can enjoy that wealth. So that's another role for it. Another role for the financial market is the allocation of risk. Now remember, every time you make an investment, you are taking risk. Now not all risks, not all risks, not all risks are equal. But every time you invest in even real assets, you involve some risk. When you buy a vehicle for your business, that's investing in real asset, you're taking the risk. Also, if you give your money to Tesla, you're investing in equipment, you're not buying the equipment yourself, but you are, for example, given the money to Tesla to build their auto plants. Well, that's a form of an investment. You are buying real estate, real assets indirectly through financial assets. So you don't know, you cannot know for sure what cashflow these plants will generate. So you do have a risk. So financial market, what they do is they would allow you to choose between different type of risks. So financial market and the diverse financial instrument traded in these markets allow investors with the greatest taste for risk to bear that risk, while other less risk tolerant individual can, to a greater degree, stay on the sideline or take less risk. For example, let's go back to Tesla. You can buy Tesla stocks, which is riskier than Tesla bonds. If you don't want to take a lot of risk, guess what? The financial market will tell you, look, you want to invest in Tesla, that's fine. If you are really positive and optimistic about Tesla by their stock, but if you're not really sure and you want a less, you know, a safer investment with Tesla, you can buy bonds. Matter of fact, you can avoid Tesla altogether and buy government securities if you need to, which is 100% safe. The point is the allocation of risk, the financial market gives you that allocation of risk. So you have, for example, risk level 5, 4, 3, 2, 1, you know, you can go with the highest risk, the lowest risk depending on your investment and risk factors. And we'll talk about this later on. So this allocation of risk also benefit the firm that need to raise capital to finance their investments. Again, if we go back to Tesla, if they, if Tesla wants to issue stocks, it's more expensive to issue stocks. Why? Because investors, they required a higher degree of return. Why? Because stocks are riskier than bonds. When you buy a bond, you are guaranteed, you remember, it's fixed income security. So you are, you guarantee a certain amount of money for the lenders every six months or every year. When they buy stocks, they're taken high risk. When they take high risk, they want a higher return. Therefore, we can say that bonds are cheaper than stocks and that's good for Tesla or for any company. Why? Because if they don't want to pay a lot, what they would do is they would issue bonds rather than stocks. Just like the investors will prefer bonds, Tesla might say, you know what, let's issue bonds, sell bonds to the public because it's cheaper than stocks. So given, you know, given a level of risk, generally speaking, bonds, generally speaking, bonds are less riskier than stocks. Okay, but in terms of Tesla, they might be both risky, whether it's bonds or stocks, but that's a separate story. Another thing that the financial market can help us with is separation of ownership and management. What do you mean by separation of ownership and management? Think of a sole proprietorship, a person that runs their own business. Okay, well, think about it. Will they make a decision that's not in their best interest? Obviously, no, they will not make any decision that's not in their best interest. Would they waste the resources? Would they spend the resources wastefully? And the answer is no. If that's your business, you're going to take care of that business. So with a sole proprietary, harm themselves in any way, shape or form. And the answer is no, you don't. Okay, maybe you do it by error, you make, you take the wrong decision, you make the wrong investments, but not on purpose. But what happened when you invest in a large corporation, if you have a half a million shareholders, you are no longer, you are still an owner, in one way or another, you are sole proprietary, but on a different scale. Now you can, when you invest your money in Apple, Amazon, IBM, PepsiCo, Intel, you cannot monitor what's going on constantly. So what happened is there's a separation between ownership and management and large corporation. The financial market will allow you to invest, but what's going to happen is you're going to have that separation. And what's going to be happening, the employees and the owners of the company may not be on the same page because the employee wants to increase their share, their wealth and the shareholders wants to increase their wealth. So what's going to happen is we're going to have what's called an agency problem because the employee wants to do things, spend their money to, to benefit themselves, maybe increase their salaries, maybe spend on travel expenses on office, on office material that's really necessary. And the owners with the owner, it's not in their best interest to do so because they want to keep the profit for themselves. So what can we do to reduce this agency problem through the financial market? Well, we can tie managers income to the company's performance. So we'll tell the manager, look, the more money you make, the better off you are. Therefore, if you work in the best interest of the company, we're going to be looking after your interest. Simply put, turn the manager into, into a sole proprietary. How would you, how would you do so? You give them stock options, you compensate them with stock options, you compensate them with stock rights. What are stock options and stock rights? Basically give them some equity in the business. There are some disadvantages for this method, research shows that with stock options, managers may cut down cost to drive the price up, then cash out and leave, but that's a different story. So you want to also have a strong pressure on the board of directors by your voting power. So vote for the people that you trust because the board of directors are the people who basically oversees the company. So one way to do it is to make sure you vote competent ethical board of directors that's going to run the company on your behalf. If there's large or institutional investors, large investors, what they do, they, they are simply put, they are literally invested in the company. So you would rely, if you're a small investor, you would rely on those large investors to make sure they are monitoring the performance of the company. Why? Because if large investors are not happy, they may sell the stock, they may vote the board of directors, ask them to fire management. So you know, rely on that group as to reduce the agency problem. Also analysts, if analysts are vested, so if the company is being followed by analysts, it means they are being questions on everything that they're doing. So if the expenses go up, they may be questions. So if analysts are vested in the company, that also reduces the agency problem because the owner now they have more power in a sense that analysts are also looking after the company's performance. That's another way to reduce this problem. Also take over threat for underperformance. When managers don't do well, when managers are running down the company and the company should be doing well, what you will find out, you have other people with money, they will come over, they will buy the company and they will fire the management. And management don't like this. So that's another threat. So the threat of a takeover for underperformance is also would reduce this agency problem. Why? Because now they want to make sure they're doing a good job. So no one's going to buy the company because the company is undervalued or underperformance and fire them. So management fear being fired because when a new company takes over the current company, well, the reason to take over maybe they don't like what's going on. That's why they took it over and there's a fear you're going to be fired. Corporate governance, that's another thing that the financial market basically gives us is basically who runs or monitor the company. That's important. Now, who are the true owners of the company? The true owners are the shareholders. But the shareholders, again, you have this agency problem, they're not there every day. So what do owners do? What do shareholders do? They vote a board of directors, a board of directors who run the company on their behalf. And the board of directors, they will have an audit committee and the audit committee will hire the auditor, the external auditor and the external auditor is used as a watchdog. We have external as well as internal auditors. But I'm talking about external auditors here, but you also have internal auditor within the company. So those are also two groups, external auditors and internal auditors that are part of the corporate governance. The board of directors are part of the corporate governance. So what we're trying to do here because we are so large and we are so publicly traded, we need to keep things under control. Also what we do is we have government intervention. Now, bear in mind that with all these watchdogs, accounting scandals and frauds still happen like Enron, Wartcom, Tyco, Lehman. It doesn't mean just because we have watchdogs and we have good corporate governance that we're going to eliminate fraud or waste, but it does help reducing. Also when everything else failed, the government intervened and they do have, for example, we have the SEC security and exchange commission. We have the Sarbanes-Oxley Act post the accounting scandals of 2001, 2002. So we do have more government intervention looking over your shoulders. For example, Sarbanes-Oxley tightened the rules for corporate governance. They want to make sure that people who are in charge of the company are really looking after the best interests of the shareholders and not after their best interests. For example, now they require each CFO to personally vouch for the corporation accounting statements. Like they cannot claim we don't understand accounting. We did not know that fraud was going on. Now you are personally responsible since you are in charge. They provide an oversight board to oversees the auditing of public companies. They created a board called the PCAOB, the public committee accounting oversight board. And they prohibit auditors from providing various other services to clients because what was happening before Sarbanes-Oxley, the auditors who are supposed to be the watchdogs, they were also being used as consulting. So what you would do, you would ask someone for their opinion. They will give you their opinion as a consultant, as someone who's working in your best interests. You turn around the next day and you tell them, look, why don't you audit your own opinion? Of course, they're going to give you a good report about their opinion because they gave you their opinion. So what Sarbanes-Oxley did is said, auditors cannot be consulted. If you want, for example, your accounting firm to provide consulting work for you, they cannot be your auditor. Or if you want them to be your consulting firm, they cannot be your auditor. Or if they're your auditors, they cannot be your consulting firm. So what happened is you have that wall, so you don't have that conflict of interest. Again, that's part of corporate governance to keep everything running smoothly. Again, the real world is different. We do have accounting scandals on a regular basis. But the point is, with large companies, large corporation, large financial market, corporate governance is extremely important. Otherwise, things will fall apart. And it did fall apart on several occasions. We'll talk on one of them in the next few sessions. In the next session, we would look at the investment process. As always, if I would like to remind you to like the recording, share it, put it in playlists. And don't forget to visit my website, farhatlectures.com, whether you are looking for accounting or finance additional supplementary material. Good luck, steady hard. And if you are still living through the coronavirus days, stay safe.