The following is a concise outline of Chapters 5 6 7 which will be on Thursday s exam The bolded words are vocabulary words noted in the margin of the text Chapter 5 Investment Banking IB financial activities that involve underwriting new security issues providing advice on mergers and acquisitions IB is mainly concerned w the following activities 1 Providing advice on new security issues IBs have info about the current willingness of investors to buy different types of securities and on the prices investors are likely to require Firms such as Coca Cola turn to IBs for advice on how to raise funds by issuing stock bonds or by taking out loans 2 Underwriting new security issues Underwriting is an activity in which an IB guarantees to the issuing corp the price of a new security and then resells the security for a profit The profit the IB keeps the difference between the guaranteed price selling price is known as the spread Initial public offering is the 1st time a firm sells stock to the public Typically IBs earn 6 8 of the total dollar amount raised for an IPO and 2 4 of the total dollar amount raised in a secondary offering Syndicate is a group of investment banks that jointly underwrite a security issue 3 Providing advice and financing for mergers and acquisitions IB can estimate the value of firms lead negotiations prepare acquisition bids M As are particularly profitable for IBs because they do not have to invest their own capital 4 Financial engineering including risk management Developing new financial securities or investment strategies using sophisticated math models is a process called Financial Engineering Derivatives are a result of financial engineering and firms can use derivatives to hedge or reduce risk 5 Research IB assign research analysts to individual large firms or industries they gather publicly available info on these firms Research analysts provide advice to investors to buy sell or hold particular stocks The term overweight is used for a stock they recommend and the term underweight for a stock they don t recommend 6 Proprietary trading is the buying and selling securities for the bank s own account rather than for clients Proprietary trading exposes banks to both credit and interest rate risk Credit risk the risk that borrowers might default on their loans is the most significant risk IB faced during the financial crisis Repo Financing and Rising Leverage in IB IB do not take in deposits their sources for funds are the IB s capital or short term borrowing Most large IBs converted from partnerships to publicly traded corps proprietary trading became a more important source of profits Financing investments by borrowing rather than by using capital or equity increases a bank s leverage Leverage in investing is a double edged sword profits from the investment are increased but so are losses On top of being highly leveraged IBs were vulnerable during the financial crisis because of the ways in which they financed their investments issuing commercial paper or by using repurchase agreements Both are considered short term loans A maturity mismatch is possible here when the funds raised are used for long term loans because the maturity of their liabilities is shorter than the maturity of their assets Repurchase agreements repos are short term loans backed by collateral For example an IB sells Treasury bills to a pension fund and at the same time the IB agrees to buy back at a slightly higher price within a few days Lenders who buy the commercial paper or repo agreement have no federal guarantee Counterparty risk is the risk that the party on the other side of the financial transaction will not fulfill its obligations The IB Industry In 1933 Congress passed the Glass Steagall Act to legally separate IB and commercial banking Congress saw IB as inherently more risky It was designed to protect people with deposits in commercial banks from risky investment activities by banks In 1999 the Gramm Leach Bliley Act repealed the Glass Steagall Act The new act authorized new financial holding companies which would permit securities insurance firms to own commercial banks The act also allowed commercial banks to participate in securities insurance and real estate activities Where Did All The IBs Go The financial crisis of 2007 2009 had a profound impact on the IB industry IB had a hard time weathering the storm in part because they relied on short term borrowing As the crisis deepened borrowing money on a short term basis became difficult and these firms were forced to sell assets often at very low prices The only two remaining standalone IBs Goldman Sachs and Morgan Stanley petitioned the Fed to allow them to become financial holding companies FHC are regulated by the Fed and are eligible for discount loans through their bank subsidiaries They can borrow from the Fed and be eligible for injections of capital from the US Treasury purchasing their stock Investment Institutions a financial firm such as a mutual fund or a hedge fund that raises funds to invest in loans securities Mutual Funds a financial intermediary that raises funds by selling shares to individual savers and invests the fund in a portfolio of stocks bonds mortgages money market securities Advantages of MFs reduces transaction costs the portfolio of assets is diversified w liquidity benefits because savers can easily sell the shares o MFs operate as closed end or open end funds Closed end MF company issues a fixed of nonredeemable shares which investors may trade in over the counter markets just like stocks are traded Open end MFs which are more common issues shares that investors can redeem each day after the markets close for a price tied to the value of the assets in the fund o Exchange traded funds are similar to closed end MFs in that they trade continually throughout the day However ETFs differ from closed end funds in that market prices track the prices of the assets in the fund very closely and ETFs are not actively managed o No load funds do not charge buyers a commission or load instead they earn income by charging a management fee Load funds charge buyers a commission to both buy sell shares o Funds that invest in stocks or bonds are the largest category of MFs o Money market mutual fund a mutual fund that invests exclusively in short term assets such as Treasury bills negotiable certificates of deposit commercial paper The greatest growth in MFs Money market MFs allow savers to write checks above
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