FIN3244 Test 2 Chapter 5 Investment Banks Mutual Funds Hedge Funds and the Shadow Banking Systems o Investment Banks are financial firms that in contrast to commercial banks don t take in deposits but rather deal with the following set of activities Providing Advice on New Security issues Companies come to I Banks for advice on current market conditions and willingness of investors to buy securities Underwriting Security Issues Typical way I Banks earn income is to Underwrite firms during an IPO I Banks guarantee a certain price to the firm they are hired by and sell the newly issued securities to investors for a higher price profiting on the spread I Banks put their reputation on the line when they underwrite firms if they over estimate market condition and cannot sell stock at a higher price they stand to make a loss o Due Diligence Research done on the firm in question by I Bank to insure that it is profitable and investors have all relevant information For large IPO s one I Bank acts as lead manager and others act as a Syndicate to help underwrite the IPO Providing advice for Mergers and Acquisitions Firms expand by buying other firms or by being bought out by other firms I Banks advise both sides the buyers and sellers o I Banks work by finding buyers and sellers and helping them with pricing and financing for the purchases o Typically very profitable because I Banks don t have to invest their own capital Financial Engineering Risk Management Financial Engineering is creating new Financial Securities or Strategies based off advanced math o Derivatives are Financial Engineering used to reduce or hedge risk o Example Airplane company uses future contracts in oil to reduce risk of sharp increase of oil prices Gather research on companies and advise on what position to take on Research stock buy sell hold Proprietary Trading Buying and Selling securities for banks portfolio rather than clients o I bank faces credit risk and interest rate risk o Commercial banks finance investments through deposits I Banks must finance investments through capital or equity Capital is funds from shareholders plus retained earnings o Financing by borrowing rather than using capital increases financial leverage Ratio of assets to capital is called Leverage ratio Regulation on Commercial banks leverage ratio but not I Banks I Banks financed by repurchase agreements or repos Short term loans backed by collateral such as T Bills I Bank sells T bills to bank and agrees to buy back in a few days for higher price spread is the interest Possible maturity mismatch liabilities mature faster than assets such as mortgage backed securities o Prior to Depression of 1930 s banks could act as both commercial and investment banks until passing of Glass Steagall Act which required separation later repealed in 1999 by Gramm Leach Bililey Act Based off fact that congress didn t think investors deposits should be allowed to be used in risky investments o Other nonbank financial firms include Investment Institutions that raise funds to invest in loans and securities Mutual Funds Investors purchase shares which get reinvested in a shared portfolio of securities to reduce risk and transaction cost of diversifying Two types Closed end and Open end o Closed end is fixed number of shares that can be traded for over the market asses while Open end shares may be sold for a price tied to the value of assets in the fund Exchange Traded Funds more popular now they aren t actively managed but rather hold a set number of assets No load funds don t charge a fee for buying or selling but rather charge a small management fee based off value of funds assets Funds that invest in short term assets such as T Bills and CD s and allow investors to write checks against their accounts above a certain amount typically 500 o Popular among small savers o MMMF compete with banks by giving out short term loans with competitive interest rates by selling commercial paper and instruments to companies Money Market Mutual Funds Hedge Funds Similar to Mutual Fund except it is a partnership of 99 or fewer investors that typically makes high risk investments for wealthy investors and are unregulated o Typically short stock when they think prices will decline Borrow securities from a dealer sell them on the open market and buy them back after price declines making money on the spread after giving back the securities to dealer o Criticized for heavy fees and risk Finance Companies Raise money through sale of commercial paper and other securities then make small loans to households and firms Typically factor accounts receivable meaning they will buy A R from firms for less than their value and make money off the spread o Firms do this when they have high A R and need cash o Contractual saving institutions such as pension funds and insurance companies take deposits and make investments based on contract obligations Pension Funds For companies to pay retirement benefits typically long term investments 10 trillion dollars in U S assets Workers must vest to receive benefits or work for a certain number of years firm Defined contribution plans firm invests for employees who own value of Defined benefit plan Firm promises employees certain dollar benefit Insurance Companies Write contracts to help investors deal with risk associated with events by charging premiums which are then invested Life insurance protects households from loss of income due to death Property and Casualty to protect from risk of illness theft fire or other events Typically don t make profit from premiums but rather from profits in which premiums are invested Profits based on ability to reduce risk o Risk Pooling Use of law of large numbers to try to predict how much they will pay out o Adverse Selection through screening and risk based premiums People most eager for insurance most likely to make claim higher premiums for riskier people o Reducing Moral Hazard Once people get insurance they may choose to act riskier so insurance companies include deductibles which is a certain amount they won t pay up to and copayments o Definitions Investment Banking Financial Activities that involve underwriting new security issues and providing advice on mergers and acquisitions Underwriting An activity in which an investment bank guarantees to the issuing corporation the price of a new security and resells for profit Initial Public Offering IPO First time a firm sells stock to public Syndicate Group of I
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