FIN3244 Exam Two Study Guide Reading Notes Chapter 5 Investment Banks Mutual Funds Hedge Funds and the Shadow Banking System When Is A Bank Not A Bank When It s A Shadow Bank during the nancial crisis it became clear that commercial baks no longer played the Paul McCauley coined the term shadow banking system to describe the new role of dominant role in routing funds from savers to borrowers nonbank nancial rms What is an Investment Bank investment banking is nancial activities that involve underwriting new security issues and providing advice on mergers and acquisitions investment banking is mainly concerned with 1 providing advice on new security issues 2 underwriting new security issues 3 providing advice and nancing for mergers and acquisitions 4 nancial engineering including risk management 5 6 proprietary trading rst three activities are central to investment banking while the last three have research emerged more recently bonds or taking out loans Providing Advice on New Security Issues rms turn to investment banks for advice on how to raise funds by issuing stocks or investment banks have information about the current willingness of investors to buy this information would be dif cult for rms to gather for themselves but essential if different types of securities and on the prices investors are likely to require they are to raise funds at a low cost Underwriting New Security Issues underwriting is an activity in which an investment bank guarantees to the issuing corporation the price of a new security then resells the security for a pro t this is one way in which investment banks make a pro t initial public offering IPO the rst time a rm sells stock to the public investment banks typically earn 6 8 of the total dollar amount raised for the IPO they earn 2 4 in a secondary offering or seasoned offering which is the selling of the investment bank takes on the risk that if they misjudged the market they will have to sell securities for a lower price than it had guaranteed the issuing rm previously sold securities 1 Syndicates syndicates are a group of investment banks that jointly underwrite a security issue syndicates can underwrite large issues of stocks and bonds while a single the lead investment bank acts as a manager and keeps part of the spread while the remainder is divided among the members and brokerage rms that sell the issue to the public investment bank takes on smaller issues when an investment bank is chosen the bank carries out a due diligence process during which the bank researches the rm s value the investment bank then prepares a prospectus required by the SEC that contains all information about the rm that the potential investor would nd relevant to making a decision whether to but the rm s stocks or bonds includes pro tability net worth risks facing the rm pending law suits ect the investment bank then conducts a road show with visits to institutional investors like mutual funds and pension funds interested in buying the security issued the investment bank then sets a price for the stock that estimates what will equate the supply of the securities with the demand of the investors underwriting can lower information costs between lenders and borrowers Providing Advice and Financing for Mergers and Acquisitions larger rms often expand by acquiring or merging with other rms smaller rms sometimes decide that the fastest way to expand is to be acquired by another rm investment banks are very active in mergers and acquisitions M A they advise both sides of these buyers the buy side mandate sellers the sell side mandate investment banks take the initiative in contacting rms about potential purchases sales or mergers when advising a rm seeking to be acquired investment banks attempt to nd a rm wiling to pay signi cantly more than the book value of the rm book value is rms assets liabilities investment banks will estimate the value of rms lead negotiations and prepare acquisition bids an acquiring rm may need to raise funds through issuing stocks or bonds or by taking out loans in order to make the acquisition investment banks help arrange for this nancing advising on M A is pro table for investment banks because they do not have to invest their own capital unlike underwriting and other activities its only signi cant costs are the salaries of the bankers involved in the deal 2 nancial engineering Financial Engineering Including Risk Management investment banks have played a major role in designing new securities through nancial engineering involves developing new nancial securities or investment strategies using sophisticated mathematical models models are developed by rocket scientists or quants who have advanced degrees in economics nance and mathematics derivative securities used to reduce risk are a result of nancial engineering investment banks supply knowledge on how to raise funds by selling stocks and bonds by constructing risk management strategies for rms for a fee facilities and interview its managers some research public through he nancial media as research notes Research investment banks assign research analysts to individual large rms or to industries they will gather publicly available information on rms and sometimes visit the rm s this research is used to identify merger or acquisition targets for clients and makes research analysts often provide advice on whether to buy sell or hold stocks use terms overweight for a stock the recommend and underweight for a stock they do the opinions of senior analysts at large investment banks have a signi cant impact on some analysts specialize in offering opinions on the current state of the nancial markets during the hours the markets are open sometimes minute by minute can provide useful information to the investment banks trading desks where not recommend the market traders buy and sell securities Proprietary Trading core investment banking activities 1 providing advice on and underwriting new security issues 2 providing advice on mergers and acquisitions proprietary trading buying and selling securities for the bank s own account rather than for clients became a major part and important source of pro ts for investment banks beginning in the 1990 s risk of an increase in market interest rates and the risk that borrowers might default proprietary trading exposes banks to both interest rate risk and credit risk on their loans the problems investment banks faced during the nancial crisis from mortgage backed
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