FIN3244 Test 2 1 Investment banking process and profit measurement IB s are involved in the following activities i Providing Advice on New Security issues Companies come to I Banks for advice on current market conditions and willingness of investors to buy securities ii 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 1 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 a Due Diligence Research done on the firm in question by I Bank to insure that it is profitable and investors have all relevant information 2 For large IPO s one I Bank acts as lead manager and others act as a Syndicate to help underwrite the IPO iii Providing advice for Mergers and Acquisitions 1 Firms expand by buying other firms or by being bought out by other firms I Banks advise both sides the buyers and sellers a I Banks work by finding buyers and sellers and helping them with pricing and financing for the purchases b Typically very profitable because I Banks don t have to invest their own capital iv Financial Engineering Risk Management 1 Financial Engineering is creating new Financial Securities or Strategies based off advanced math a Derivatives are Financial Engineering used to reduce or hedge risk b Example Airplane company uses future contracts in oil to reduce risk of sharp increase of oil prices 1 Gather research on companies and advise on what position to take v Research on stock buy sell hold vi Proprietary Trading 1 Buying and Selling securities for banks portfolio rather than clients a I bank faces credit risk and interest rate risk 2 Investment bank organization and types of IB trading a Investment banks facilities the trading of securities through underwriting mergers and acquisitions research helps people decide what securities to buy and trade b IB s couldn t take in deposits so they would raise funds by selling short term securities promising to pay them back for a higher cost effectively acting as a short term loan 3 Various Types of securities risk and their emergence as an effect on markets and securities a Systemic risk risk to entire financial system rather than individuals b Maturity Mismatch 1 liabilities mature faster than assets such as mortgage backed securities leaves them banks vulnerable to bank runs when customers want money but bank can t pay yet 2 When companies finance through short term loans or Repo Financing they are vulnerable to maturity mismatch i Risk that party on the other side of a financial transaction will not fufuill its c Counterparty Risk obligations d Credit Risk i Risk that borrowers might default on their loans 4 Major Legislation and components impact of to legislation a Glass Steagall Act 1933 legally separate investment banking from commercial banking Made so that customers deposits weren t gambled away in risky investments i Forced many large banks to separate into commercial and IB s b Gramm Leach BIlley Financial Services Modernization Act 1999 Repealed glass steagall authorized holding companies which allowed securities and insurance companies to own commercial banks i During recent financial crisis many argue that Glass shouldn t have been repealed 5 Types of Mutual Funds and Characteristics Mutual Funds are financial intermediaries that raise funds by selling shares to individuals and investing the funds in a portfolio cutting down on transaction and management costs a Closed End Mutual Funds Issues fixed number of nonredeemable shares investors may trade in OTC markets much like stocks price is tied to market value of assets or net asset value NAV b Open End Mutual Funds Issues shares that investors can redeem each day after markets close for a price tied to value of assets in the fund i i c Exchange Traded Funds ETF i Like close end but they are not actively managed and track price of assets in funds very closely Keep a large number of assets in a fixed portfolio 1 Creation unit aggregation large investors who purchase above a certain number of shares can redeem shares for assets in the fund 6 Insurance Companies Loans d Mutual Funds are called no load funds because they do not charge a commission or load but earn a profit on a management fee Money Market Mutual Funds are mutual funds that invest in short term assets such as T Bills CD s and commercial paper a Popular among small savers b MMMF compete with banks by giving out short term loans with competitive interest rates by selling commercial paper and instruments to companies e Hedge Funds 1 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 a Typically short stock when they think prices will decline i 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 b Criticized for heavy fees and risk i Insurance Companies are a contractual saving institution receives payments as part of a contract and invests 1 Write contracts to help investors deal with risk associated with 2 events by charging premiums which are then invested Life insurance protects households from loss of income due to death 3 Property and Casualty to protect from risk of illness theft fire or other events 4 Typically don t make profit from premiums but rather from profits in which premiums are invested 5 Profits based on ability to reduce risk a Risk Pooling Use of law of large numbers to try to predict how much they will pay out b Adverse Selection through screening and risk based premiums i People most eager for insurance most likely to make claim higher premiums for riskier people c Reducing Moral Hazard i 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 b 7 Finance company role a Raise money through sale of commercial paper and other securities then make small loans to households and firms b Three types of finance companies i Consumer finance loans for cars furniture appliance etc ii Business finance engage in factoring buying large equipment airplanes machinery and
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