FIN3244 EXAM 2 REVIEW CH 5 6 7 1 Investment Banking Processes Profit Measurement Investment Banking financial activities that involve underwriting new security issues providing advice on mergers acquisitions Concerned w the following activities 6 1 Providing ADVICE ON NEW SECURITY ISSUES Central to IB Firms turn to IBs for advice on how to raise fund Issuing stock or bonds or taking out loans IB s have info about the current willingness of investors to buy diff types of securities on the prices new investors require It s a good way for firms to get info that would otherwise be costly for them to obtain 2 UNDERWRITING new security issues Central to IB Typical way investment banks earn income is to underwrite firms during an Underwriting IPO activity in which an investment bank guarantees to the issuing corporation the price of a new security then resells the security for a profit the difference is known as the spread IB s typically earn 6 8 on the Initial public offering IPO the first time a firm sells stock to the public 2 4 on the secondary offering security sales by a firm that has sold securities previously A Syndicate is a group of investment banks that jointly underwrite a security issue mainly deal with large issues Due diligence research done on the firm and its value in question by IBs to insure that it is profitable and investors have all relevant information see below After due diligence the investment bank prepares a prospectus All the information about a firm that a potential investor would find relevant in making a decision to buy the firm s stocks or bonds profitability net worth risks like pending lawsuits Underwriting can lower information costs between lenders and borrowers because investment banks put their reputations behind the firms that underwrite and the investors are confident enough to trust the research done during the due diligence process that they purchase the firm s securities without incurring excessive risk 3 Providing ADVICE FINANCING FOR MERGERS ACQUISITIONS Central to IB Larger firms can expand by acquiring merging w other firms Many small firms decide this is the fastest way to expand IB s advise both the buyers the buy side mandate sellers the sell side mandate IB s take the initiative in contacting firms about potential purchases sales or mergers When advising a firm seeking to be acquired IBs try to find an acquiring firm willing to pay more than the book value value of firm s assets value of firm s liabilities As part of the advising process IBs help acquiring firms raise funds to make acquisition via issuing of stock or bonds or taking out loans Why it s profitable unlike underwriting and other IB activities IBs don t have to invest their own capital Only the bankers salaries are involved in the deal 4 FINANCIAL ENGINEERING including risk management Emerged in IB more recently Financial engineering Developing new financial securities or investment strategies using sophisticated mathematical models Firms come to the IB s to get info to help hedge reduce risk for the future IB s supply knowledge by constructing risk management strategies for a firm in return for a fee Example airplane company uses future contracts in oil to reduce risk of sharp increase of oil prices 5 RESEARCH Emerged recently Can research large firms Apple or GE industries automobiles or oil industry Gather publicly available information on firms sometimes visit a firm s facilities interview managers Help to identify merger acquisition targets for clients making some of the research public through financial media as research notes Analysts provide advice to investors for particular stocks buy sell or hold Analysts use term overweight for a stock they recommend and underweight for a stock they do not recommend Analysts can specialize in different things the current state of the financial markets helpful at trading desks or economic research The opinions of senior analysts at large investment banks can have a significant impact on the market Ex research note that comes back unexpectedly negative about a firm can cause the price of the firm s stock to fall 6 PROPRIETARY TRADING Emerged recently Is the buying selling securities for the bank s own account rather than for a client Exposes banks to both interest rate risk and credit risk Profit today is made up in large portion from proprietary trading During financial crisis credit risk was the most significant risk that IBs faced from proprietary trading Most MBSs that consisted of primarily subprime or Alt A mortgage loans had credit risks much higher than IBs and credit rating agencies expected When the market prices of said securities started to decline and eventually freeze it was difficult to sell them which resulted in huge losses for IBs The problems IB s faced during the financial crisis were made worse because they had used large amounts of borrowed funds to finance their proprietary trading Using borrowed funds increases leverage which increases risk Profit today is made up in large portion from proprietary trading 2 Investment Banking Organization Types of Investment Bank Trading IB Organizations 1 Goldman Sachs 2 Lehman Brothers 3 Merrill Lynch 4 Bear Stearns 5 Morgan Stanley Types of IB Trading how IBs finance Issuing commercial paper 1 Proprietary trading 2 3 Repurchase agreements repos short term loans back by collateral 1 Ex bank might borrow by selling Treasury bills to another bank or a pension fund and at the same time the investment bank would agree to buy the Treasury bills back at a slightly higher price either the next day or w in a few days 3 3 3 IBs facilitate the trading of securities through underwriting mergers and acquisitions research helps people decide what securities to buy and trade IBs 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 Lenders who buy commercial paper or repos have no federal guarantee 3 If IB fails lenders suffer large losses unless loans are collateralized with assets that don t decline in value Counterparty risk risk that the other party of a financial transaction will not fulfill its obligations played a huge role in financial crisis 3 3 Various types of securities risk their emergence as an effect on markets securities Faced a maturity mismatch the maturity of their liabilities commercial paper or repos is shorter than the maturity of their assets
View Full Document
Unlocking...