Chapter 5 Terms to know Investment baking Underwriting Financial activities that involve underwriting new security issues and providing advice on mergers and acquisitions An activity in which an investment bank guarantees to the issuing corporation the price of a new security and then resells the security for a profit Spread The price difference between what the investment firm buys the securities and then sells them IPO Initial public offering The first time a firm sells a stock to the public Syndicate Proprietary Trading Interest rate risk Credit Risk Leverage A group of investment banks that jointly underwrite a security issue Investment banks buying and selling securities for the banks own account rather than for clients The possibility that changes in interest rates will result in losses in the bond s value The possibility the borrower will default on his or her repayment obligation resulting in a loan loss to the lender Using borrowed funds to make purchases thus increasing the user s purchasing power potential rate of return and risk of loss Leverage Ratio The ratio of banks assets to its capital assets equity Deleveraging The process of reducing leverage Repurchase agreements repos Short term loans backed by collateral Counterparty risk Risk that the party on the other side of a financial transaction will not fulfill its obligation Financial holding companies Regulated by the Federal Reserve and are eligible for discount loans through their bank subsidiaries Example Goldman Sachs Investment Institutions A financial firm such as a mutual fund or hedge fund that raises funds to invest in loans and securities Mutual Funds A financial intermediary that raises funds by selling shares to individual savers and invests the funds in a portfolio of stocks bonds mortgages and money market securities Money market mutual funds A mutual fund that invests exclusively in short term assets such as treasury bills negotiable certificates of deposit and commercial paper Commercial Paper Hedge Funds Financial Companies Short term unsecured promissory notes issued by companies Financial firms organized as a partnership of wealthy investors that make relatively high risk speculative investments A non bank financial intermediary that raises money through sales of commercial paper and other securities and uses the funds to make small loans to households and firms Contractual Saving institution A financial intermediary such as a pension fund or an insurance company that receives payments from individuals as a result of a contract and uses the funds to make investments Pension Fund A financial intermediary that invests contributions of workers and firms in stocks bonds and mortgages to provide for pension benefit payments during workers retirements Insurance company A financial intermediary that specializes in writing contracts to protect policyholders from the risk of financial loss associated with particular events Systemic Risk Random Facts Risk to the entire financial system rather than o individual firms or investors Paul McCauley a managing director of PIMCO pacific investment management company coined the term shadow banking Bear Stearns Lehman Brothers and AIG were the three large financial firms that originated the financial crisis The two core investment banking activities are o Providing advice on an underwriting new securities o Providing advice on mergers and acquisitions Commercial banks finance their investments primarily from deposits Because a banks return on equity equals its return on assets multiplied by its leverage ration the higher the leverage ration the greater the ROE for a given ROA Following the crisis none of the larger investment banks survived as stand alone firms engaged in only investment banking Representing 10 trillion in assets in the US in 2010 pension funds were the largest institutional participants in capital markets Chapter Notes 5 1 Explain how investment banks operate Main concerns of investment banking 1 Providing advice on new securities Providing advice to larger companies such as Microsoft and coca cola on how to raise their funds by investing their money in things such as stocks and bonds and the current willingness of investors to buy securities 2 Underwriting new security issues Investment firms go through a process called due diligence process which it researches the firms that will sell them the securities and then come up with a prospectus which contains all of the information on the firm that a potential investor would find helpful and necessary to make a purchase Investors usually trust the investment firms but during the crisis they didn t because of their poor choices on mortgage backed securities They typically ear 6 8 of the total dollar on IPO s and 2 4 on secondary offerings 3 Providing advice and financing for mergers and acquisitions When a smaller company wants to be bought out by a larger company investment banks contact them with potential purchases sales or merges They try to find a large firm that is willing to buy them for more then their book value Which is the value of their assets minus their liabilities As part of the advising process the investment firms help the larger companies understand what they need to do to make the acquisition whether its by taking out loans or issuing stock This is particularly profitable for investment banks because the only capital they are using is the salaries of their bankers involved 4 Financial engineering including risk management Investment banks play a major role in designing new securities a process called financial engineering This involves developing new securities and strategies through really sophisticated models Derivatives are used to hedge reduce risk The example states that an airline can use future contracts in oil to reduce the risk that an increase in oil prices will reduce the airlines profit Investment banks construct risk management with firms who need to know how best to hedge risk using derivatives 5 Research Investment banks conduct a lot of research They send out research analyst to large companies like Apple General Electric or to automobile or oil industries The analysts gather information for the public and sometimes interview their managers This research is used to show the public and most importantly investors which stocks they should buy The investment banks typically classify stock ad overweight or underweight based on their recommendation This information is
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