Sunflower Intelligence
Finance & Accounting

F00 · Introductory

Foundations of Finance

9 lessons

F00 · Module 3, lesson 2 · Lesson 8 of 9

Market participants

Banks, investment banks, pension funds, insurers, mutual funds, hedge funds, brokers and dealers each do a different job in moving money and risk, and central banks and regulators set the rules they work under. Learn who does what, how each is paid, and what the protections such as deposit insurance do and do not cover.

About 80 minutes

Before you start

You will be able to

  • Identify households, firms and governments as savers and borrowers, and describe the job of each kind of financial institution.
  • Distinguish commercial banks from investment banks, and brokers from dealers and market makers.
  • Compare pension funds, insurance companies, mutual funds, exchange-traded funds and hedge funds by whose money they manage and how investors get it back.
  • Calculate a bid-ask spread, the net proceeds of a share offering and a fund’s net asset value per share.
  • Describe what the Federal Reserve, the SEC, FINRA, the CFTC and the FDIC do, and calculate how much of a deposit FDIC insurance covers.

Review first

  • Financial markets — You need direct and indirect finance, primary and secondary markets, and exchanges versus over-the-counter markets.
  • Capital and liquidity — Debt, equity and liquidity are used throughout.

Fictional case A fictional coffee business founded by Ana Lim. It starts as a catering and barista-training service, opens its own cafés and an online shop for beans, and plans a canned cold brew.

The idea

Fictional case

Count the financial institutions in Ana Lim’s life in early 2026. Her $26,000 of savings sits in an account at Coastline Bank, a commercial bank, and is covered by federal deposit insurance. On 1 March Coastline lends $10,000 to her new company. Her former employer’s staff may be saving for retirement through a pension plan whose fund owns shares in Harbourline Roasters, the listed roaster that sells beans to coffee businesses like Lantern. Those shares change hands every day through brokers and dealers. The interest rates that Coastline pays and charges move with the wider level of rates, which the Federal Reserve influences. Ana has dealt directly with only one of these institutions; all of them shape the terms she gets.

The last lesson described financial markets by what is traded and how. This one is about who does the trading and the lending, and why each kind of participant exists. A useful question to ask of each one is: whose money does it handle, what does it do with it, and how is it paid?

Savers and borrowers

At the two ends of every financial transaction are the people whose money it is and the people who use it. There are three groups, and each can be on either side.

The three groups at the ends of the financial system
GroupAs savers and investorsAs borrowers and issuers
HouseholdsBank deposits, retirement saving, insurance policies, shares and fundsMortgages, car loans, student loans, credit cards
FirmsSpare cash held in deposits and money-market instrumentsBank loans, bonds and new shares to pay for equipment and growth
GovernmentsReserves and funds held for future spendingTreasury bills, notes and bonds to cover spending above tax revenue

Ana shows how one person can be both. As a household with $26,000 in the bank she is a saver; as the owner of Lantern she arranges a company loan. Everyone else in this lesson is an intermediary or a helper: an institution that stands between the two ends or makes the trade possible.

Commercial banks

A commercial bank takes deposits from households and firms, makes loans, and provides payment services that let people pay one another by card, cheque and transfer. Coastline Bank is one. It is the textbook case of indirect finance: depositors hold a claim on the bank, the bank holds claims on its borrowers, and it is paid through the interest-rate spread and through fees.

Banks turn short-term, easily withdrawn deposits into longer-term loans. That is useful, and fragile: if many depositors ask for their money at once, the bank cannot call in two-year loans to pay them, and even a sound bank can fail in a bank run. Two public protections exist largely because of that fragility. Deposit insurance (below) removes most depositors’ reason to run. And the central bank can lend to sound banks that are short of cash: the Federal Reserve’s discount window lends to depository institutions in generally sound condition, against collateral, to help them manage their liquidity.

Investment banks

An investment bank helps companies and governments raise money directly from investors and advises them on large transactions. Its best-known job is underwriting: managing and selling a new issue of shares or bonds. In an initial public offering, the underwriters are the investment banks that manage and sell the offering for the company; before the sale they gather indications of interest from prospective investors, and they help recommend the price. They are paid through the underwriting spread, the difference between the price investors pay and the amount per share the issuer receives.

Investment banks also advise on mergers and acquisitions, the buying and selling of whole companies, and many trade securities for clients and for themselves. The line between commercial and investment banking is a line between activities more than between firms: several large banking groups do both.

Institutional investors

Institutional investors invest large pools of other people’s money. Because they buy in bulk and employ professional analysts, their decisions can move prices and their votes carry weight at shareholder meetings. The main kinds differ in whose money they hold and when it must be paid back.

Pension fund
Invests money set aside by employers and employees to pay retirement income, often decades later. Its long horizon lets it hold assets that may fall in value for years before recovering, such as shares, property and long-term bonds.
Insurance company
Collects premiums from policyholders and invests them until claims must be paid. A life insurer, whose claims may come decades later, can invest for the long term; a property insurer, which pays claims after storms and fires, needs more liquid assets.
Mutual fund
Pools money from many investors and invests it in a portfolio of securities, such as shares or bonds. Investors buy their shares from, and sell them back to, the fund itself, at a price calculated once each business day.
Exchange-traded fund
A fund whose shares trade on a stock exchange throughout the day at market prices, like a company’s shares. Those prices may differ slightly from the value of the fund’s assets per share. Often called an ETF.

Funds give small savers what they could not build alone: a diversified portfolio, professional management and, for mutual funds and ETFs, the ability to get money back on any business day. They are not bank deposits. Mutual funds and ETFs are not guaranteed or insured by the FDIC or any other government agency, and their value rises and falls with the securities they hold.

Hedge funds

A hedge fund is a private, unregistered investment fund. It is generally open only to investors who meet tests of wealth, income or sophistication set by securities law (accredited investors or qualified purchasers), and it is not subject to the many rules that govern mutual funds and ETFs, though it is subject to the same prohibitions on fraud. The fund itself is unregistered, although its manager may be an investment adviser registered with the SEC. That freedom lets hedge funds use strategies that registered funds largely cannot: leverage (investing borrowed money to magnify gains and losses), short selling (selling borrowed securities in the hope of buying them back more cheaply) and derivatives.

Investors pay for this, in fees and in access to their money. A typical arrangement charges a management fee of 1–2% of the fund’s assets a year plus a performance fee of 15–20% of the profits. Investors can usually take money out only four times a year or fewer, often after an initial lock-up of a year or more. Despite the name, a hedge fund need not hedge anything: the name describes a legal form, not a low-risk strategy.

Brokers, dealers and market makers

Investors rarely meet each other. In the secondary market they trade through firms whose job is to make trades happen, and these firms work in two different ways.

  • A broker acts as an agent: it finds the other side of a client’s trade and earns a commission or fee. It does not own the securities it trades for clients. A discount broker executes trades cheaply without advice; a full-service broker charges more and adds advice and planning. Many US online brokers now charge no commission on many trades and are paid in other ways, such as interest on clients’ cash and payments from market makers for routing clients’ orders to them, which creates its own conflict of interest.
  • A dealer acts as a principal: it buys securities from clients into its own inventory and sells to clients out of it. It earns the difference between its buying and selling prices, and bears the risk that the securities it holds fall in value before it can sell them.
  • A market maker is a dealer that stands ready, continuously, to buy a particular security at one price and sell it at a slightly higher one. By always being willing to trade, it gives the market liquidity.

Many firms do both, and in US law they are called broker-dealers. The price at which a dealer will buy is its bid; the price at which it will sell is its ask (or offer); the gap is the bid-ask spread. If a market maker quotes Harbourline shares at $42.48 bid and $42.52 ask, an investor who buys and immediately sells 500 shares loses 500×0.04=20500 \times 0.04 = 20 dollars, which is the market maker’s gross reward for standing ready to trade.

In depth

Inside a dealer’s quote

The bid-ask spread is the price of immediacy: what an investor pays to trade now rather than wait for a buyer or seller to arrive. Spreads are narrow for securities that trade constantly, such as the shares of large companies, and wide for those that trade rarely, such as many bonds and small companies’ shares, because a dealer holding a rarely traded security may wait days to sell it, and the price can move against it meanwhile. Comparing spreads across securities of different prices needs the relative spread: the spread divided by the midpoint of the bid and ask.

For Harbourline’s quote, the midpoint is (42.48+42.52)÷2=42.50(42.48 + 42.52) \div 2 = 42.50 dollars and the relative spread is 0.04÷42.50≈0.094%0.04 \div 42.50 \approx 0.094\%. A thinly traded bond quoted at $97.00 bid and $98.00 ask has a spread of $1.00 on a midpoint of $97.50, or about 1.03%, roughly eleven times as wide in relative terms.

How a share offering pays its bankers

In an underwritten offering the issuer receives the offer price minus the underwriting spread on each share sold. If a company sells N shares at an offer price P and the underwriters’ spread is a fraction g of the price, the company’s net proceeds before its other costs (lawyers, auditors, registration fees) are N×P×(1−g)N \times P \times (1 - g). Before an IPO the company files a registration statement with the SEC, typically on Form S-1, including a prospectus describing the business and the terms of the offering. The SEC requires that disclosure, but its declaration that the registration is effective is not an approval of the offering’s merits, and its staff does not evaluate the merits of any IPO.

An IPO creates a tension inside the underwriter’s job. The issuer wants the highest price; the investors to whom the underwriter sells, many of them its regular clients, want a low one. If the shares close well above the offer price on their first day, the investors gain and the issuer has raised less than it might have. Existing shareholders usually agree to a lock-up, typically 180 days, during which they will not sell their own shares.

Fund arithmetic: net asset value

A fund’s net asset value (NAV) per share is the value of its assets minus its liabilities, divided by the number of fund shares outstanding. Mutual funds calculate it once each business day, typically after the major US exchanges close, and every order received before that day’s cut-off is filled at that NAV (plus any sales charge); later orders get the next day’s. An investor who places an order at 11 a.m. therefore does not know the exact price until the evening. ETF shares, by contrast, trade on an exchange all day at market prices, which can sit slightly above or below the ETF’s NAV.

Central banks and regulators

Markets need rules, someone to enforce them, and a lender of last resort when panic strikes. In the United States these jobs are split among several bodies. The main ones for this course are the following.

Federal Reserve
The central bank of the United States, created by the Federal Reserve Act of 1913. It is a system of a Board of Governors in Washington, D.C. (seven governors nominated by the President and confirmed by the Senate), twelve regional Reserve Banks, and the Federal Open Market Committee (FOMC), which sets monetary policy. That policy influences money and credit conditions in pursuit of the goals Congress set in the Federal Reserve Act: maximum employment, stable prices and moderate long-term interest rates. The Fed also supervises and regulates banks, works to keep the financial system stable, provides certain financial services to the US government, and helps operate and oversee the nation’s payments systems.
SEC
The Securities and Exchange Commission, founded in 1934 during the Great Depression. Its mission is protecting investors, maintaining fair, orderly and efficient markets, and facilitating capital formation. It requires companies offering securities to the public to disclose the truth about their business, and it oversees those who sell, trade and advise on securities, such as broker-dealers, investment advisers and exchanges.
FINRA
The Financial Industry Regulatory Authority, a self-regulatory organisation: an industry body that writes and enforces rules for its members. It is the largest in the securities industry and the frontline regulator of broker-dealers, and the SEC oversees it.
CFTC
The Commodity Futures Trading Commission, created in 1974 to regulate US derivatives markets. It oversees futures and most swaps. Options on individual shares trade on securities exchanges overseen by the SEC, and swaps based on a single security, a loan or a narrow group of securities (security-based swaps) also fall under the SEC.
FDIC
The Federal Deposit Insurance Corporation, an independent federal agency established in 1933. It insures deposits at insured banks, supervises many banks, and steps in when an insured bank fails. It receives no appropriations from Congress: it is funded by assessments that insured banks pay.

Deposit insurance: what it covers and what it does not

The standard FDIC insurance amount is $250,000 per depositor, per FDIC-insured bank, for each account ownership category. Ownership categories include single accounts (owned by one person), joint accounts, certain retirement accounts, trust accounts, and accounts of corporations, partnerships and associations. Within one category at one bank, a depositor’s accounts are added together before the limit applies; different categories, and different banks, are insured separately. Joint accounts are insured up to $250,000 for each co-owner’s share, and a corporation’s deposits are insured separately from its owners’ personal deposits. Depositors do not need to apply: coverage is automatic at an insured bank. The FDIC states that since it began in 1933 no depositor has lost a penny of FDIC-insured funds.

Insurance covers deposits: checking, savings, money market deposit accounts and certificates of deposit. It does not cover investments, even when a bank sells them: shares, bonds, mutual funds, annuities, life insurance policies, Treasury securities and crypto assets are all outside it. For Ana, the $26,000 in her Coastline savings account is well inside the limit. Lantern’s own deposits, as a corporation’s, would be insured separately from hers.

Other economies have their own central banks and regulators, with similar jobs divided in different ways; deposit-insurance limits, and the rules that separate commercial from investment banking, also differ from country to country. The US bodies are described here because this course’s examples are American.

Conflicts of interest

Most participants in this lesson act for someone else: a broker for its client, a fund for its investors, an underwriter for an issuer and its investors at once. Their pay does not always line up with their clients’ interests. A broker paid per trade earns more if the client trades more; an underwriter is torn between issuer and buyers; a fund manager paid on the size of the fund may care more about attracting money than about returns. Rules on disclosure and on duties to clients exist to manage these conflicts. The next lesson studies the same problem inside companies, where managers act for shareholders, and shareholders’ interests can clash with lenders’.

Formulas

Bid-ask spread and relative spread

Spread=Pask−Pbid,Relative spread=Pask−Pbid(Pask+Pbid)÷2\text{Spread} = P_{\text{ask}} - P_{\text{bid}}, \qquad \text{Relative spread} = \dfrac{P_{\text{ask}} - P_{\text{bid}}}{(P_{\text{ask}} + P_{\text{bid}}) \div 2}
PaskP_{\text{ask}}
The price at which the dealer will sell to you$ per share
PbidP_{\text{bid}}
The price at which the dealer will buy from you$ per share

Assumes. Quotes for the same quantity at the same moment. The relative spread is often written as a percentage.

A round trip (buying at the ask and selling at the bid straight away) costs the spread times the number of shares.

Net proceeds of an underwritten offering

Net proceeds=N×P×(1−g)\text{Net proceeds} = N \times P \times (1 - g)
NN
Number of new shares soldshares
PP
Offer price paid by investors$ per share
gg
Underwriting spread as a fraction of the offer price

Assumes. Before the issuer’s other costs, such as legal, audit and registration fees.

N × P is the gross proceeds; N × P × g is what the underwriters keep.

Net asset value per fund share

NAV per share=Assets−LiabilitiesN\text{NAV per share} = \dfrac{\text{Assets} - \text{Liabilities}}{N}
Assets\text{Assets}
Market value of everything the fund owns$
Liabilities\text{Liabilities}
Everything the fund owes, such as fees due$
NN
Number of fund shares outstandingshares

Assumes. Valued at the end of the business day, using that day’s closing prices.

FDIC-insured amount in one ownership category at one bank

Insured=min⁡(B, 250,000),Uninsured=B−Insured\text{Insured} = \min(B,\ 250{,}000), \qquad \text{Uninsured} = B - \text{Insured}
BB
The depositor’s combined deposits in that ownership category at that bank$

Assumes. One depositor, one insured bank, one ownership category. For joint accounts apply the limit to each co-owner’s share; trust accounts follow their own rule (per beneficiary, with a cap).

Source: FDIC, “Your Insured Deposits”. Apply the formula separately to each bank and each category, then add.

Worked examples

A first example: Pricing a mutual fund share

Fictional figures

At the close of trading on Friday, the fictional Tidewell Balanced Fund holds securities and cash worth $412 million and owes $2 million (management fees due and unsettled purchases). It has 20 million shares outstanding. What is its NAV per share, and how many fund shares does an investor get for $5,000 invested that day?

  1. Net assets: 412−2=410412 - 2 = 410 million dollars.
  2. NAV per share: 410,000,000÷20,000,000=20.50410{,}000{,}000 \div 20{,}000{,}000 = 20.50 dollars.
  3. Every order placed on Friday before the cut-off is filled at this NAV, calculated after the close. The investor gets 5,000÷20.50≈243.905{,}000 \div 20.50 \approx 243.90 shares (funds issue fractional shares, and Tidewell charges no sales load).

Answer. NAV is $20.50 per share, and $5,000 buys about 243.90 shares.

What it means. The investor learns the price only after placing the order. If the same fund’s portfolio were held in an ETF, she could buy at any moment during the day at the market price, which might be a few cents above or below the NAV.

A harder example: How much of the Lindqvists’ money is insured?

Fictional figures

Priya and Tomas Lindqvist (fictional) bank at Shorebird Bank, a fictional FDIC-insured bank. Priya has a savings account of $180,000 in her own name. Tomas has two accounts in his own name: checking of $90,000 and a certificate of deposit of $200,000. They share a joint savings account of $340,000, owned equally. Their company, Lindqvist Design Inc., a corporation, has $410,000 in its business account. Priya has also bought $60,000 of a mutual fund through the bank’s investment desk. How much is insured, and how much is not?

  1. Work category by category, adding accounts within a category first. Priya’s single accounts: $180,000, under $250,000, so all insured.
  2. Tomas’s single accounts are combined: 90,000+200,000=290,00090{,}000 + 200{,}000 = 290{,}000. Insured min⁡(290,000,250,000)=250,000\min(290{,}000, 250{,}000) = 250{,}000; uninsured 290,000−250,000=40,000290{,}000 - 250{,}000 = 40{,}000 dollars.
  3. The joint account is insured up to $250,000 per co-owner. Each owns 340,000÷2=170,000340{,}000 \div 2 = 170{,}000, under the limit, so all $340,000 is insured, even though it is more than $250,000.
  4. Lindqvist Design is a corporation: its deposits are a separate category, insured separately from the owners’ personal deposits. Insured $250,000; uninsured 410,000−250,000=160,000410{,}000 - 250{,}000 = 160{,}000 dollars.
  5. The mutual fund is not a deposit, so it is not FDIC-insured at all, even though it was bought at a bank. Totals: deposits 180+290+340+410=1,220180 + 290 + 340 + 410 = 1{,}220 thousand dollars; insured 180+250+340+250=1,020180 + 250 + 340 + 250 = 1{,}020 thousand; uninsured 40+160=20040 + 160 = 200 thousand.

Answer. Of $1,220,000 in deposits, $1,020,000 is insured and $200,000 is not ($40,000 of Tomas’s single accounts and $160,000 of the company’s). The $60,000 mutual fund is not covered by deposit insurance.

What it means. Coverage depends on who owns each account and in what capacity, not on the family’s total. To insure everything, Tomas could move $40,000 and the company $160,000 to a different FDIC-insured bank, where each would be within that bank’s separate limit. The mutual fund’s risk is of a different kind: its value can fall, and no insurance covers that.

Applied: a business decision: Saltfern Energy Storage goes public

Fictional figures

Saltfern Energy Storage, a fictional US company that builds and installs large battery systems, sells 8 million new shares in an IPO at $15.00 each. Its underwriters’ spread is 7% of the offer price. On the first day of trading the shares close at $18.00. How much does Saltfern raise, what do the underwriters earn, and did Saltfern price its shares well?

  1. Gross proceeds: N×P=8,000,000×15=120,000,000N \times P = 8{,}000{,}000 \times 15 = 120{,}000{,}000 dollars, which the investors pay.
  2. Underwriters’ spread: 120,000,000×0.07=8,400,000120{,}000{,}000 \times 0.07 = 8{,}400{,}000 dollars. Net proceeds: 8,000,000×15×(1−0.07)=111,600,0008{,}000{,}000 \times 15 \times (1 - 0.07) = 111{,}600{,}000 dollars, before Saltfern’s legal and audit costs.
  3. The first-day rise is a secondary-market event: Saltfern receives none of it. Investors who bought at $15 and could sell at $18 gained 8,000,000×(18−15)=24,000,0008{,}000{,}000 \times (18 - 15) = 24{,}000{,}000 dollars on paper, a rise of 3÷15=20%3 \div 15 = 20\%.
  4. Judgement: if investors would have paid nearer $18, Saltfern sold a slice of itself too cheaply; that $24 million is sometimes called money left on the table. But a price set slightly low helps an issue sell out, rewards the investors who took the risk of a new company, and a rising price helps any later share sale. Saltfern’s existing owners cannot cash in yet: they have agreed to a lock-up, typically 180 days.

Answer. Saltfern raises $120 million gross and $111.6 million net of the $8.4 million underwriting spread. The first-day rise of $3 a share (20%) gives IPO buyers a $24 million paper gain that Saltfern does not share.

What it means. The investment bank earns its spread by finding buyers, setting a price and standing behind the sale; it also faces a conflict between the issuer, which wants a high price, and its investor clients, who want a low one. Judging whether $15 was right means asking what the market would have paid on the day, not only what the shares did next.

Explore

The explorer starts at a quote around Harbourline’s $42.50 share price with a 4-cent spread. Widen the spread to see how much more it costs an investor to trade a rarely traded security, and change the trading volume to see why market makers want busy markets.

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Common mistakes

  • “My mutual fund at the bank is FDIC-insured.”

    FDIC insurance covers deposits: checking, savings, money market deposit accounts and CDs. It does not cover mutual funds, shares, bonds, annuities or Treasury securities, even when they are bought at an insured bank. Mutual funds and ETFs are not insured by any government agency.

  • “Deposit insurance covers $250,000 per person, full stop.”

    The limit is $250,000 per depositor, per insured bank, for each ownership category. Two single accounts at the same bank share one limit; a joint account is insured up to $250,000 per co-owner; a company’s deposits are insured separately from its owners’; and accounts at different banks are insured separately.

  • “A broker and a dealer are the same thing.”

    A broker is an agent: it finds the other side of your trade and is paid a commission. A dealer is a principal: it trades with you from its own inventory and earns the bid-ask spread. Many firms do both (broker-dealers), so ask which role the firm plays in your trade.

  • “If the SEC lets a company sell shares, the shares are a safe investment.”

    The SEC requires full and truthful disclosure, but declaring a registration effective is not an approval of the offering’s merits, and the SEC’s staff does not evaluate whether an IPO is a good investment. Investors must judge the business and the price themselves.

  • “Hedge funds hedge, so they are low-risk.”

    “Hedge fund” names a private, unregistered fund structure, not a strategy. Many use leverage, short selling and derivatives, which can magnify losses, and investors often cannot withdraw money for a year or more.

  • “The Federal Reserve sets the interest rate on my loan.”

    The Fed’s monetary policy influences the general level of short-term interest rates, and other rates tend to move with them. The rate on any particular loan is set by the lender, who adds a margin for its costs and for the borrower’s risk.

Guided practice

Work through these with hints when you need them. Every hint and every worked solution is there to be used.

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On your own

No hints this time. Answer, check, and read the feedback; the solution appears once you have answered or if you ask for it. Your first answers count toward mastery.

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In practice

Fictional case

Saltfern Energy Storage’s finance director, a year after the IPO, reviews every institution the company deals with. The company is fictional; the roles are real.

Its commercial bank. Saltfern keeps its operating cash, around $1.2 million on payday, in a business account at one bank, and has a credit line there for buying battery modules ahead of big installations. As a corporation’s account, the deposit is insured only up to $250,000, so almost $1 million is uninsured. She keeps two weeks’ payroll at the operating bank, moves a reserve to a second insured bank, and holds the rest of the company’s spare cash in Treasury bills, which are debts of the federal government rather than bank deposits, so deposit insurance is not needed for them.

Its investment bank. The bank that underwrote the IPO still advises Saltfern. It has proposed buying a smaller installer in another state and offered to arrange a bond issue to pay for it. She asks how the bank would be paid in each case, because an adviser paid only if a deal happens has a reason to favour the deal.

Its shareholders. Saltfern’s register now includes a pension fund that intends to hold the shares for years, two mutual funds that report their holdings regularly, an ETF that holds Saltfern because it tracks an index of clean-energy companies, and a hedge fund that bought after the IPO and may sell within months. Each wants something different from management: the pension fund patience and steady growth, the hedge fund a quick rise in the share price. Those competing demands are a governance question, which the next lesson takes up.

Its market makers. Several dealers quote Saltfern’s shares. In the first months the spread was wide, because few shares traded; as trading grew, it narrowed. A narrow spread lowers the cost of trading for every investor, which makes the shares more attractive and the next share issue cheaper.

Its regulators. As a public company Saltfern files regular reports with the SEC, and its share trading takes place under rules enforced by the SEC and, for the broker-dealers involved, FINRA. The Federal Reserve never deals with Saltfern directly, but when the FOMC changes the course of monetary policy, the rate on Saltfern’s credit line and the return on its Treasury bills move with it.

Ana’s version of this list is short: one bank, one deposit-insurance limit she is well inside, and one loan. If she later buys an ETF through a broker for her retirement, she adds a broker-dealer and SIPC protection against the broker’s failure, and she gives up the deposit insurance and the fixed value of her savings account in exchange for a chance of higher returns.

Knowledge check

Six questions, one attempt each, no hints. Score 80% or more to complete the lesson; you can take it again at any time.

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Summary

  • Households, firms and governments are the savers and borrowers at the ends of the system; banks, investment banks, institutional investors, brokers and dealers stand between them or make their trades possible.
  • Commercial banks take deposits, make loans and provide payment services; investment banks underwrite new securities and advise on deals, earning the underwriting spread: net proceeds = N × P × (1 − g).
  • Pension funds and insurers invest for future obligations; mutual funds trade with investors at the NAV calculated once a day; ETFs trade on exchanges all day; hedge funds are private, lightly regulated, fee-heavy and often leveraged.
  • Brokers are agents paid by commission; dealers and market makers are principals paid by the bid-ask spread, which is the price of immediacy and widens for rarely traded securities.
  • The Federal Reserve conducts monetary policy for maximum employment and stable prices and supervises banks; the SEC protects investors and oversees securities markets, with FINRA supervising broker-dealers; the CFTC regulates futures and most swaps.
  • FDIC insurance covers deposits up to $250,000 per depositor, per insured bank, per ownership category; it does not cover investments, and neither it nor SIPC covers a fall in an investment’s value.

Key formulas

Terms introduced

Commercial bank
A bank that takes deposits, makes loans and provides payment services to households and firms.
Bank run
A rush by many depositors to withdraw their money at once, which can bring down even a sound bank because its loans cannot be turned into cash quickly.
Investment bank
A firm that helps companies and governments raise money by underwriting new securities, advises on mergers and acquisitions, and often trades securities.
Underwriting
Managing and selling a new issue of securities for an issuer, including setting the price and finding the buyers.
Underwriting spread
The difference between the price investors pay for a new issue and the amount per share the issuer receives: the underwriters’ pay.
Net proceeds
What the issuer receives from an offering after the underwriting spread: shares sold × offer price × (1 − spread).
Lock-up
An agreement by a company’s existing shareholders not to sell their shares for a period after an IPO, typically 180 days.
Institutional investors
Organisations that invest large pools of other people’s money, such as pension funds, insurance companies, mutual funds and hedge funds.
Pension fund
A fund that invests contributions from employers and employees to pay retirement income.
Mutual fund
An SEC-registered investment company that pools money from many investors; investors buy shares from and sell them back to the fund at the NAV calculated once each business day.
Exchange-traded fund
A fund whose shares trade on a stock exchange throughout the day at market prices, which may differ slightly from its NAV (ETF).
Net asset value
A fund’s assets minus its liabilities; per share, divided by the number of fund shares outstanding (NAV).
Hedge fund
A private, unregistered investment fund, generally open only to wealthy or sophisticated investors, free to use leverage, short selling and derivatives.
Short selling
Selling borrowed securities in the hope of buying them back later at a lower price and returning them.
Broker
A firm that arranges trades for clients as their agent, without owning the securities, and is paid a commission or fee.
Dealer
A firm that trades securities with clients from its own inventory, as a principal, and earns the difference between its buying and selling prices.
Market maker
A dealer that stands ready at all times to buy a security at its bid and sell it at its ask, providing liquidity.
Bid
The price at which a dealer will buy a security.
Ask
The price at which a dealer will sell a security; also called the offer.
Bid-ask spread
The ask minus the bid: the cost of buying and immediately selling, and the dealer’s gross reward for providing liquidity.
Federal Reserve
The central bank of the United States, created in 1913, which conducts monetary policy, supervises banks and supports financial stability and the payments system.
SEC
The Securities and Exchange Commission: the US federal agency, founded in 1934, that protects investors, keeps securities markets fair, orderly and efficient, and facilitates capital formation, and has legal authority over the financial reporting of public companies.
FDIC
The Federal Deposit Insurance Corporation: the independent US agency, established in 1933, that insures bank deposits and deals with failed banks.
Ownership category
For FDIC insurance, the capacity in which deposits are held (single, joint, certain retirement, trust, business, and others); each category at each bank is insured separately.

Sources

  1. Federal Deposit Insurance Corporation. Understanding Deposit Insurance. fdic.gov/resources/deposit-insurance/understanding-deposit-i…
  2. Federal Deposit Insurance Corporation. Your Insured Deposits. fdic.gov/resources/deposit-insurance/brochures/insured-depos…
  3. Federal Deposit Insurance Corporation. What We Do. fdic.gov/about/what-we-do
  4. Board of Governors of the Federal Reserve System. Who We Are (The Fed Explained). federalreserve.gov/aboutthefed/fedexplained/who-we-are.htm
  5. Board of Governors of the Federal Reserve System. What is the purpose of the Federal Reserve System? (FAQ). federalreserve.gov/faqs/about_12594.htm
  6. Board of Governors of the Federal Reserve System. Federal Reserve Act, Section 2A: Monetary Policy Objectives. federalreserve.gov/aboutthefed/section2a.htm
  7. Board of Governors of the Federal Reserve System. Discount Window. federalreserve.gov/monetarypolicy/discountrate.htm
  8. US Securities and Exchange Commission. Mission. sec.gov/about/mission
  9. US Securities and Exchange Commission, Investor.gov. Market Participants (How Stock Markets Work). investor.gov/introduction-investing/investing-basics/how-sto…
  10. US Securities and Exchange Commission (2016). Mutual Funds and ETFs: A Guide for Investors. SEC Pub. No. 182. sec.gov/investor/pubs/sec-guide-to-mutual-funds.pdf
  11. US Securities and Exchange Commission, Investor.gov. Hedge Funds. investor.gov/introduction-investing/investing-basics/investm…
  12. US Securities and Exchange Commission (2013). Investor Bulletin: Investing in an IPO. SEC Pub. No. 133. sec.gov/files/ipo-investorbulletin.pdf
  13. US Securities and Exchange Commission staff (2021). Staff Report on Equity and Options Market Structure Conditions in Early 2021. 14 October 2021. sec.gov/files/staff-report-equity-options-market-struction-c…
  14. Securities Investor Protection Corporation. What SIPC Protects. sipc.org/for-investors/what-sipc-protects
  15. Commodity Futures Trading Commission. Mission & Responsibilities. cftc.gov/About/MissionResponsibilities/index.htm
  16. US Securities and Exchange Commission. Derivatives (Dodd-Frank spotlight: division of authority over swaps). sec.gov/spotlight/dodd-frank/derivatives.shtml
  17. US Securities and Exchange Commission, Investor.gov. Investor Bulletin: An Introduction to Options. investor.gov/news-alerts/investor-bulletins/investor-bulleti…
  18. Dahlquist, J. & Knight, R. (2022). Principles of Finance, section 1.5, “Markets and Participants”. OpenStax. openstax.org/books/principles-finance/pages/1-5-markets-and-…