Corporate Banking Flashcards
Who within the IB bank is responsible for making bridge financing?
A) Prime Brokerage
B) Leveraged Finance (capital market)
C) Sales and Trading
D) Private Wealth Management
B) Leveraged Finance Group
arrange bridge financing in connection with a stock issuance. It is not sure that this issue will be successful. Therefore, the bank engages itself into bridge financing, where if the issuance is not successful, the money will be given by the bank.
In a best efforts transaction, the issuer will bear ___ price risk, and in a bought deal, the issuer will bear ___ price risk
A) All; all
B) No; all
C) No; no
D) All; no
D)
In a best-efforts transaction, the bank sells without taking any risk; it makes its best effort to sell, but if they are not successful, the issuer bears all the price risk.
In a bought deal: the bank buys the security from the issuer and resell the security to investors. i.e., they bear the entire price risk.
Issuing securities is costly. Which of the following securities issuances incur the LOWEST direct cost?
A) Convertibles
B) Bonds
C) IPO
D) Seasoned Offering
B) Bonds issuance is least expensive.
Usually, this is done with a private placement (99% of bonds are sold privately to institutional investors in order to avoid filing with the supervisory board and the corresponding hassle).
Issuing securities is costly. Which of the following securities issuances incur the HIGHEST direct cost?
A) Convertibles
B) Bonds
C) IPO
D) Seasoned Offering
C) IPO is the most expensive issuance since this entails huge costs connected to raising investor interest (roadshows, conference calls, individual meetings with investors)
When might an IB decline participation in an underwriting agreement and why?
A) When perceived risks of participation outweigh the expected underwriting fees
B) If the trader believes demand for new securities from the issuer is lower than the contemplated issuance size
C) If the IB has several potential underwriting commitments at once and is limited by regulatory capital requirements
D) Because of reputational concerns or issues found during due diligence
E) All of the above
ANSWER: All of the above
A) if the bank cannot resell the securities, they must absorb the loss. Hence, the underwriting agreement might be rejected if the risks of participation outweigh the expected fees.
B) if supply exceeds demand of the stock issuance, the bank might not be willing to underwrite, because they bear the risk if they are not sold.
C) Whenever IBs bear risk, they must have regulatory capital to absorb potential losses. If this regulatory capital is not high enough, they might be forced to decline a mandate because it is too risky.
D) Reputational concerns or problems found during due diligence can be the reason for declining an underwriting agreement. It is the IB that writes the prospectus (the document that is given to potential investors in order for them to decide). If there are any mistakes or omission in this document, the liability is upon the bank. Hence, if the IB thinks the issuer is not truthful, they may decide not to pursue to mandate.
What drove the need to separate research and investment banking?
A) Conflicts of interest B) Competition from foreign banks C) The credit crisis D) Research was not generating enough profits E) All of the above
A)
Not C: The separation of research and IB (2003) predates the financial crisis (2008).
Not D: research is paid as an indirect part of the trading contract with clients. I.e., part of the fees that the trading division received is paid to the research department
A firm has agreed to a green shoe. The underwriter buys shares from ___ if the share price drops and from ___ if the share price increases
A) Investors; issuer
B) Investors; investors
C) The issuer; investors
D) The issuer; the issuer
A)
If the share price increases, the underwriter exercises its option, which entails the issuer issuing additional shares.
If the price decreases, they buy the shares from investors in the secondary market since this price is now lower than the issuing price.
In general, strategic buyers are ___ likely to invest in an industry which is doing poorly, and ___ likely to generate synergy cost savings than financial buyer
A) Less; less
B) Less; more
C) More; less
D) More; more
Answer: B
Strategic buyers are LESS likely to be able to invest in an industry which is doing poorly. Usually, the strategic buyer is operating within that same industry as the target – so if the entire industry performs poorly, the buyer would not have enough money to perform acquisition.
Strategic buyers tend to invest MORE with the aim of generating synergy cost savings than financial buyers.
Which of the following is NOT a method used by IBs to help equity issuers mitigate price risk during the marketing process?
A) Accelerated offering
B) Block trade
C) Privileged option
D) Greenshoe option
C) Does not exist
The longer the marketing effort period, the higher the risk that market conditions change, leading to prices deviating from those set by the IB. So, to offset that, they may (i) accelerate the offering, or they (ii) organize a block trade. Additionally, (iii) the green shoe option is also a method to mitigate price risk, because the IB gets some flexibility in terms of the quantity of stocks issues in order to stabilize the prices.
Why are revenue synergies given less weight than cost synergies when evaluating the combined benefits of a transaction?
A) Requires more assumptions than cost synergies
B) Revenue synergies are more difficult to estimate and capture
C) key valuation multiple (EV/EBITDA) is not based on revenue
D) A and B are correct
E) B and C are correct
Answer: D: both A and B are correct.
Revenue synergies are much more difficult to estimate and capture than cost synergies, which is also why they require a lot more assumptions.
As seen in the Freeport McMoRan case, what is the role of Equity Capital Market Syndicate Group in terms of underwriting?
Two roles:
A) to coordinate with sales force management to decide among investors when demand for the security exceeds supply
B) To ultimately decide the price range at which the security is offered and the final price at which the security will be sold
Is it true that a fairness opinion must always be provided by a bank that is not advising the selling company?
it SHOULD be the case than a fairness opinion is provided by an independent third-party (bank), since this would eliminate the bias that would be present if the IB has an interest in the deal going through. BUT, typically, the IB that acts as a sell-side advisor has all the insight and information about the company, and the process would be more difficult if another independent IB was to acquire all relevant data and information itself. So, the answer is that this SHOULD be the case from a fairness POV, but the involved IB to do the fairness opinion is not legally prohibited from it.
Is it true that a fairness opinion gives an opinion on the merits of the deal’s strategic rationale?
No. A fairness opinion states the fairness of the deal from a FINANCIAL POV – not strategic.
IB clients can be categorized into two broad groups; issuers and investors. The two groups have competing objectives. Who within the IB is responsible for balancing these competing interests?
A) Prime brokerage
B) Equity capital market
C) Sales and trading department
D) Private wealth management division
The capital market division helps issuers of securities, while also helping investors. This department links the two groups of clients.
Which valuation method tends to typically show the LOWEST valuation range?
A) Comparable comp
B) Comparable transaction
C) DFC with synergies
D) A, B and C typically give the same valuation
A) Comparable Comp:
- In comparable transaction analysis, there is control premium and synergy.
- In DCF with synergies (we have synergies).
Therefore, comparable companies valuation, which is based on stock prices and enterprise value provides the lowest valuation range since shareholders do not pay a premium for neither control nor synergies.
In a merger, the breakup fee:
A) Is paid by the target to IB
B) Is paid by acquirer if deal does not go through
C) Is NOT paid by anyone of the deal closes
D) Is paid by target if it does not sign the merger agreement
C) It is not paid by anyone if deal closes
The breakup fee is paid by the target company if it walks away AFTER signing the merger agreement.
This serves as a “penalty” for walking away, e.g., if the target gets a better offer.
The REVERSE BREAKUP FEE is paid by the acquirer if it walks away AFTER signing the merger agreement.
What is a potential risk of trying to complete a stock-based acquisition during periods of high market volatility?
A) if it is a fixed exchange ratio deal, significant fluctuations in share prices could lead to high variations in the final economic deal value.
B) If it is a floating exchange ratio deal, significant fluctuations in share prices could lead to high variations in the final economic deal value.
C) If it is a floating exchange ratio transaction, a down market (acquirer stock price decreases) could lead to more shares issued by the acquirer to pay for the transaction, thereby diluting acquirer shareholders more.
D) A + C are correct
Answer: D (A+C)
A) Fixed exchange ratio deal: # of shares exchanged in the deal is fixed, BUT, if the stock price of acquirer decreases significantly, target shareholders ends up getting very little economic value from the deal. Meanwhile, if the price of acquirer increases significantly, the target shareholders get higher economic value from the deal than expected.
B) Floating exchange ratio deal: not correct. A floating exchange ratio means that the economic value of the deal is fixed, and given changes in stock prices, the exchange ratio will adjust accordingly to ensure that the final economic value is equal to the predetermined deal value. (THEREFORE NOT A RISK IN TERMS OF ECONOMIC VALUE)
C) The problem with floating exchange ratio: if the acquirer stock price decreases, the acquirer must give in more shares, so the equity stake that target shareholders ends up being larger. I.e., the acquirer shareholder’s equity will dillute
Why were pure-play IBs able to operate at much higher leverage ratios than bank holding companies?
A) IBs were able to convince SEC that they could make more accurate estimations of capital requirements by using internal models, as compared to adhering to the capital requirements, leverage, etc. laid out for deposit-taking institutions (bank holding comps).
B) The whole difference between the regulation posed on banks holding comp (commercial banks) and IBs stems from the commercial bank’s deposit-taking activity
C) both
D) none
Two reasons:
A: IBs were able to convince SEC that they could make more accurate estimations of capital requirements by using internal models, as compared to adhering to the capital requirements, leverage, etc. laid out for deposit-taking institutions (bank holding comps).
B) the whole difference between the regulation posed on banks holding comp (commercial banks) and IBs stems from the commercial bank’s deposit-taking activity.
Why might a universal bank be better able to compete against a pure-play IB for M&A and other IB engagements?
A) Universal banks are better able to use their balance sheet to lend money to clients
B) Universal banks are only regulated in their country of incorporation
C) Some companies prefer doing business with a bank that can provide loans and IB products like M&A
D) A + B
E) A + C
E) A + C is correct.
Universal banks, with their commercial banking activities are better able to provide loans to their clients. This is likely preferred by the client that is advised in a transaction.
• Recall: Freeport McMorran: the bridge loan provided to the client was syndicated and sold to other banks, since the IB was not able to grant the loan directly.
What is “dry powder” in PE?
A) Capital committed by LP
B) Capital invested by GP
C) Investment capital committed by LP
D) Capital committed by LP that, net of lifetime management fees, has still not been invested
D: Capital committed by LP that, net of lifetime management fees, has still not been invested
What are positive consequences resulting from large increase in no. hedge funds around the world?
A) Increased market liquidity B) More efficient asset pricing C) New sources of capital for borrowers D) Increased financial innovation E) All of the above
E) All of the above
PE Managers are:
A) usually paid periodic performance fees
B) usually paid a large chunk of the price coming from selling their fund’s portfolio companies when the sale occurs
C) are subject to hurdle rates when receiving performance fees
D) often paid transaction fees by their fund’s portfolio companies
E) C + D
F) B + D
E) C + D
C) PE funds are subject to hurdle rates when receiving performance fees
D) often paid transaction fees by their fund’s portfolio companies
Why B is Wrong: The PE fund is paid a large chunk of the PROFIT (above hurdle) from the sale of their portfolio companies, NOT a chunk of the price.
How were senior tranches of a CDO able to obtain investment-grade ratings when some of the underlying assets were non-investment grade?
A) lower tranches absorb initial losses
B) rating agencies, issuers and investors believed that risk could be limited through diversification of assets underlying CDO
C) Rating agencies, issuers and investors believed that by slicing the CDO into tranches, the risk of the underlying pool if assets were greatly reduced for senior tranches
D) All options are correct
A) correct: There is a senior tranche of a CDO, a mezzanine and a junior tranche. The tranche that absorbs the first losses is the junior tranche. Then, if losses is too large, exceeding the junior tranche, losses are absorbed by the mezzanine tranche. Only when the losses are beyond absorbable for the mezzanine tranche, will the loss be absorbed by the senior tranche.
B) correct: It is true that risk can be limited through the diversification of assets underlying the CDO (e.g., geographical diversification).
C) correct: This essentially has the same meaning as A.
Why do many large institutional investors lend their shares to IBs, who re-lends to other parties?
A) To create a bearish position in a stock
B) As a means of enhancing return coming from holding that asset
C) To hedge downside share price risk positions
D) For tax purposes
E) All of the above
B) As a means of enhancing return coming from holding that asset
Explanation of Wrong A: Creating a bearish position in a stock: is a position that generates the investor profit if the price goes down (bearish market)
HFs create leverage by:
A) margin loans from banks B) fire sales whose proceeds are used as collateral for obtaining loans from banks C) repo agreements D) Derivatives E) A+C+D are correct F) All of the above are correct
E) A+C+D are correct
Margin loans, derivatives & repo agreements
Which of the following is a strategy that HFs employ to mitigate dangers of asset/ liability mismatch?
A) Lock ups B) Gates C) Side pockets D) Suspensions on withdrawals E) All of the above F) A + B + D
E) All of the above
In a closed-end fund, the investors have no redemption right until the fund is liquidated.
In an open-end fund, the investors may choose of withdraw their invested capital app. every quarter.
A) Lockup: investors’ capital is locked up in the initial period after the fund has been raised
B) Gates: kicks in after lock-up period. This provision limits the amount of withdrawal of investors. This limit is usually a x% of total AUM of the HF
C) Side pockets: park illiquid hard-to-value assets. Only investors who were already participants in the fund at the acquisition of the illiquid asset will participate in the ownership of this asset
D) Suspension on withdrawals: given liquidity trouble and given mismatch of assets and liabilities, HFs can suspend any withdrawals.
Why are average returns coming from investing in HFs an unreliable measure of HFs’ ability to create value?
A) Due to high skewness of HFs’ results: median return is much higher than average return, indicating top performers’ create superior value than the rest
B) Low mandatory disclosure implies that the data used to track HFs’ performance are biased - i.e., not all HFs’ performances are incl. in data
C) Average returns do not take into account that HFs’ returns might be obtained at lower risk
D) All of the above
E) Only A and B
D: all of the above are correct
A) Due to high skewness of HFs’ results: median return is much higher than average return, indicating top performers’ create superior value than the rest
B) Low mandatory disclosure implies that the data used to track HFs’ performance are biased - i.e., not all HFs’ performances are incl. in data
C) Average returns do not take into account that HFs’ returns might be obtained at lower risk
Mutual fund managers have a ___ role and their compensation is typically based on ___ of the AUM
A) Intermediary; the amount
B) Intermediary; the performance
C) Advisory; the amount
D) Advisory; the performance
A) Mutual fund managers have a INTERMEDIARY role and their compensation is typically based on AMOUNT of the AUM
Mutual funds are paid a fee that is based on AUM.
They don’t advise, they solely trade (act as intermediary).
Following is TRUE about Credit Default Swaps (CDS):
A) are often used by HFs as a way to increase leverage
B) can be bought by investors who don’t hold the underlying security
C) can be traded by insurance companies only
D) have been heavily used by PE firms to magnify returns in LBO deals
Answer: B
Credit Default Swap (CDS) is basically an insurance policy – you pay a premium, in exchange, if the underlying asset (whose credit risk is insured) defaults, the insurer/protection seller compensates you.
• Difference between CDS and insurance policy: if you buy protection, you don’t have to own the underlying asset insured. You can bet/speculate by buying the CDS.
Following is true about the (EBITDA-CAPEX)/ (Interest expense + amortization) ratio:
A) Measures firm leverage
B) Measures firm’s ability to cover debt service. It must always be below 1 for an LBO deal to be sustainable from the POV of the lender
C) Measures a firm’s return on investment
B)
The ratio measures a firm’s ability to cover debt service. If the ratio is above 1, it means that the CFs produced by the assets of the firm are enough to cover debt interest and amortization.
Funds of funds have sold themselves to investors on the basis that they offer some key benefits. Which of the following are NOT among them?
A) Diversification among HFs
B) Due diligence process of HF managers
C) Savings on cost for a result that is similar to the one delivered by direct investment in HFs
D) Access to HFs for investors who do not meet the minimum investible capital criterium
C) you have to pay for the HF fees AND, on top of this, you have to pay the FoF manager. So FoF investment is more expensive from a fee POV than direct investment in HFs.
All the others are true.
In the Magnetar Peleton case, is it true that:
one of the two funds would have been able to fetch a very good return to its investors during 2007 anyway because it was exploiting a price misalignment between different CDO tranches. The fund went long and short in different tranches in order to exploit price misalignment.
In one of the funds, (Peloton) the managers received a prize due to outstanding performance during 2007. But they failed miserably in 2008. When Peloton defaulted, it was investing in mezzanine tranches.
Yes or No?
Yes
The output of an LBO is___
while the output of a DCF is___
The output of an LBO is IRR
while the output of a DCF is PV of future CFs (company enterprise value)
Which of the following is an alternative asset? A) Real estate B) HFs C) PE D) All of the above
D) All of the above- Real estate, HFs and PE are all alternative asset classes
When are management fees paid to a PE fund GP?
A) Every contractually agreed upon period
B) PE funds GPs are not paid any management fee
C) When returns from investment are higher than the hurdle rate
D) When the sale of a portfolio company generates a profit
MANAGEMENT FEE is paid every contractually agreed upon period.
PERFORMANCE FEE is paid when returns from investment are higher than the hurdle rate
The NAV of a HF has been following the following path:
Inception= 100 Q1 = 90 Q2 = 120
What is the performance fee paid to HF given a high-water mark clause and 20% performance fee in Q2?
You always have HWM Clause in HFs. Given the high-water mark clause, HF managers are only paid a performance fee on the portion of the NAV that exceeds the highest historical NAV. So, given 20% performance fee, the performance fee to be paid in end of 2nd quarter is:
Performance Fee of 20%(HWMClause) = (120 -100)*0.2 = 4
Equity bridges are offered to PE fund clients with the purpose of…?
Equity bridges: in PE funds, investors have committed an amount of capital to the PE fund. Whether the investor actually has this money can be uncertain. So, as a PE fund bids on a target company, the target shareholders may, due to mistrust, not believe that the fund has the money available, and therefore reject the offer.
LPs may have problems with providing the capital they have committed to PE fund. Therefore, to reassure target shareholders, IBs can step in and provide a temporary loan (equity bridge): which is a commitment where the IB will give the money to the target shareholders if there is an issue with the payment of LPs.
Following is true about IBs:
A) IBs are never allowed to manage mutual funds due to conflict of interest problems
B) IBs also run HFs, even though they compete with some of their biggest clients for investors’ money
C) When advising clients on managing their wealth, IBs are prohibited form recommending their own products
D) IBs systematically exploit their wealth management division clients’ trust in order to have them buy securities they are underwriting and that are hard to sell
B) IBs also run HFs, even though they compete with some of their biggest clients for investors’ money
IB Traders….
A) Cannot be involved in primary market deals
B) Are not allowed to trade outstanding securities issued by firms that are launching a public offering with the bank
C) Whenever asked, they supply sales professionals with prices for their clients
D) Have always the goal of maximizing the bank client’s profits, even if that implies losses for the bank
C) Traders, whenever asked, supply sales professionals with prices for their clients
Which type of transaction has the highest probability of success? A) Sell-side transaction B) Buy-side transaction C) Mergers of equals D) Joint Venture
A) Sell-side assignment: the IB gets a mandate to find a buyer.
Sell-side transactions have the highest probability of deal success because the seller is often financially constrained and therefore often desperate to “get rid” of certain assets/divisions
Buy-side assignment: the buyer wants to buy assets of another firm, often for strategic reasons. The assignment is often more difficult to complete because the acquirer firm is pickier.
A transaction where two firms contribute assets and form a new entity to undertake economic activity together is called: A) Merger of equals B) Joint Venture C) Sell-side assignment D) Public market seperation
B) Joint Venture
The following is NOT true for a Public Market Separation mandate:
A) It incl. carve-out, spin-off, and tracking stock
B) Completed by the IB department in coordination with equity capital market group
C) Concerns the defense against a specific take-over proposal
D) Concerns work to deter future unsolicited take-over activity
E) A+B
F) C+D
WRONG ANSWERS:
C) Concerns the defense against a specific take-over proposal
D) Concerns work to deter future unsolicited take-over activity
Both are part of the M&A product called “hostile defense” and not “public market separation”
The example of Ferrari being “separated” from the rest of the group due to it being perceived as a luxury car brand and therefore its stock may be of higher value than without the separation is an example of:
A) Joint-venture
B) Sell-side assignment
C) Hostile defense
D) Public market separation
D) Public market separation
IBs are legally prohibited from advising hostile bidders by giving strategic and tactical advice on initiating and unsolicited take-over
TRUE/ FALSE
FALSE - It is one of the underlying products of a “hostile takeover” which is one of the businesses of IBs.
Which is the largest source of profits generated by an IB (on average)?
A) Stock issuance - helping issuers raise capital from the market
B) Trading - selling/ acquiring securities for investors
C) Research - providing insights to sales department
D) Helping clients raise money from various types of debt instruments (the debt capital market division)
B) Trading: the fees that the trading department in an IB gets from investors are on average higher than the profits generated from stock issuers (bc. it only issues stocks once in a while).
Trading carries extremely high weights in terms of an IB’s revenue - around 23.2% of total revenue on average
The interest of investors is typically in contrast to the interest of the issuer. Who within the IB is responsible for balancing these different interests? A) Equity capital market group B) Debt capital market group C) Trading division D) M&A group
A) The equity capital market group act as intermediaries between the clients of other parts of the bank: link issuer of stock to investors:
Their key role is to balance the demands of investors in the securities they offer (who want to pay as low a price as possible) vs. those of the issuing clients (who want to sell their stocks at the highest possible price).
The Fixed Income, Currencies and Commodities business is a responsibility of: A) Trading division B) Capital markets group C) Debt capital market group D) M&A division
A) Trading division
Trading refers to selling and buying securities. The trading divisions can trade either on behalf of outside clients or directly on behalf of the bank.
TRUE/ FALSE
TRUE - can trade both for clients and the bank itself
Legally, and IB has no limitations in terms of proprietary trading and principal investing - i.e., it is assumed that the IB can take on as much risk as they wish because they have trading professionals who are capable of selecting good investments from bad ones.
TRUE / FALSE
FALSE: Financial reform legislation limits the risk that IBs can take on through direct own investments (the bank’s own investments).
Following is NOT true about proprietary trading:
A) It is the one direct investment activity pursued by the IB that is not managed by the trading division
B) It may involve the trading of stocks, bonds, commodities, currencies, or other instruments
C) Focused on investments in securities, commodities and derivatives in a manner similar to the trading activities of hedge funds
D) From time to time, major trading scandals emerge due to individual “rogue traders”
WRONG: A) It is the one direct investment activity pursued by the IB that is not managed by the trading division
Proprietary trading is managed by the trading division
Rogue Traders typically play with high-risk investments that can produce huge losses or gains. They may take so much risk that they put the firm at risk of bankruptcy.
TRUE/ FALSE
TRUE
Asset managers receive fees from managing money and share these fees with Private wealth advisors. This may create a conflict of interest. How?
A) Private Wealth advisors can advise clients to invest with the IB’s Asset Managers even though they might not be the best in the market
Mutual fund investments in an IB are managed by:
A) Trading division
B) Capital market division
C) Asset management (asset management division)
D) Private wealth management (asset management division)
C) Asset management (asset management division)
Alternative investment covers:
A) Fixed income, currencies, commodities
B) Private equity, mutual fund, real estate funds
C) Private equity, hedge fund, real estate funds
D) Fixed income, hedge funds, private equity
C) Private equity, hedge fund, real estate funds
If the ____ fund obtains a loan to invest for, the debt will be in the balance sheet of the firm to be acquired. This is different from a ____ fund leveraged investment, where the fund is the borrower. The ___ fund investments have a longest maturity.
A) PE; Hedge fund; PE
B) PE; mutual fund; HF
C) Hedge fund; PE, PE
D) PE; mutual find; mutual fund
A) PE; Hedge fund; PE
Which of the following funds is(are) an open-ended fund? A) PE B) Real estate fund C) Mutual fund D) A + B E) B+C
C) mutual fund is the only “open-ended fund”.
Open-end: investment is easily liquidated – investors can exit when they want.
Closed-end: you can only sell the investment by selling it to another investor who wants to enter your place. Investors don’t have the right to get the investment liquidated by the asset manager as they want
Which of the following funds uses the least leverage in their investment?
A) PE
B) HF
C) Mutual fund
C) Mutual fund
Both PE and HF obtain investment capital from quite handsome levels of leverage.
Provided that the cost of debt is lower than the return of the investment, leverage has \_\_\_ effect on the positive investment return: A) amplifying B) depends on the level of debt C) decreasing D) has no effect
A) Provided that the cost of debt is lower than the return of the investment, leverage has an amplifying effect on the positive investment return
If the cost of debt is equal to the return on investment, debt has \_\_\_ effect on the positive investment return: A) amplifying B) depends on the level of debt C) decreases D) has no effect
D) has no effect - I.e., return on assets will be the same as if the investment was done without leverage because the extra return made possible through debt is only just offset by the cost of debt.
NOTE: in this case, it is actually better to not take on debt, because you don’t get an extra profit, plus you now have higher leverage -> higher risk
If the cost of debt is higher than the return on investment, debt has \_\_\_ effect on the negative investment return: A) amplifying B) depends on the level of debt C) decreases D) has no effect
A) if the cost of debt is higher than the return on investment, debt has AN AMPLIFYING effect on the negative investment return
If you are losing money, your loss is magnified by the fact that you have invested a higher monetary amount compared to no leverage, and by the fact that the lenders must be paid back.
The advisory and asset management activities of IBs imply which risk(s)? A) liquidity risk B) foreign exchange risk C) reputational risk D) interest risk E) all of the above
C) The advisory & asset management activities imply no risk besides a reputational one.
Given the significant risks that asset-backed securities can have, why are they still an attractive business for investment banks?
A) High demand from clients for the product
B) Significant source of fees
C) Asset-backed securities are not risky because they are asset-backed
B) The business was very lucrative because of the fees. They started to buy these asset-backed securities because the return was higher than same-rating bonds.
Example of why ABS can be VERY RISKY:
When the real estate market collapsed in the U.S., the payment flows stopped and the mortgagers defaulted on their payments, leading to commercial banks not receiving payment, hereby not being able to pay investment banks, which in turn could not pay the special purpose vehicle, and ultimately, the investors did not get their money. The chain of payment stopped.
According to SEC (Securities act 1933),
A) Investment banks are liable for law violation if material facts are left out, or misstatements are made in the registration statements and prospectus
B) When issuing a bond, a description of the firm’s properties and business and the security to be offered for sale is required, as well as information about the management of the company and financial statements certified by independent accountants.
C) To make sure that the issuer gives all important information to the investment bank, due diligence was required to be carried out by the bank
D) All of the above
E) A+B
D) All of the above
The biggest impact on IBs from the Sarbanes-Oxley Act (2002) was: select 1-4
A) Research division must be separate from underwriting division (capital market)
B) Research analysts’ compensation can no longer be based on underwriting revenues in the same bank
C) Research analysts’ compensation must now be a part of the trading division revenue
D) Research analysts who provide a negative report on a company are protected from retaliation from underwriters
A) Research division must be separate from underwriting division (capital market)
B) Research analysts’ compensation can no longer be based on underwriting revenues in the same bank
D) Research analysts who provide a negative report on a company are protected from retaliation from underwriters
Global Research Settlement (2003) had the following implications on IBs: choose 1-4
A) Restriction on communications between the research and investment banking divisions: no influence on research opinions or coverage was now allowed
B) No payment of compensation of influence promotion
C) Disclosure on potential conflicts of interest to clients: the (research) analysts have to list all the business the bank is doing on behalf of clients to those the bank is doing research reports on
D) Clients should have access to third-party independent research
E) The practice of “spinning” hot iPOs became restricted: selling stocks in “hot” IPOs to certain executive officers (with the hope of gaining future favors) was prohibited
F) All of the above
G) A, B, D, E, F
All of the above
The Gramm-Leach-Bliley Act (1999) was deregulation that removed the mandatory separation of commercial and investment banks. The advantages of this were:
A) Creating a more stable business model for banks (=IB+commercial): in bad times, commercial banking deposit revenues increased, while in good times, cash deposits were low, but new issuance activity would be high (IB).
B) Meet the competition from foreign banks: foreign banks were not required to follow Glass-Steagall, and they had already combined investment and commercial banking.
C) Both
D) None
C) Both
A) Creating a more stable business model for banks (=IB+commercial): in bad times, commercial banking deposit revenues increased, while in good times, cash deposits were low, but new issuance activity would be high (IB).
B) Meet the competition from foreign banks: foreign banks were not required to follow Glass-Steagall, and they had already combined investment and commercial banking.
The Dodd-Frank Wall Street Reform & Consumer Protection Act introduced a set of requirements. Which of the following requires large financial companies to submit plans regarding how they would shut down if they were to fail in the future?
A) Volcker rule
B) Regulation of over-the-counter derivatives
C) Funeral plan
D) Reporting requirements
C) Funeral plan
The Dodd-Frank Wall Street Reform & Consumer Protection Act introduced a set of requirements. Which of the following limits banks proprietary trading activity and principal investing?
A) Volcker rule
B) Regulation of over-the-counter derivatives
C) Funeral plan
D) Reporting requirements
Volcker Rule: “…restrict US banks from making certain kinds of speculative investments that do not benefit their customers.”
Volcker Rule: (1) asked banks to put their “skin in the game” for securitized products. I.e., if you want to create an ABS, you must keep a portion of the risk on your balance sheet, since this decreases the incentive of engaging in too much risk.
Volcker Rule: (2) strong limitation on proprietary trading.
Which of the following is NOT a service provided by the trading division?
A) execution of client trading orders
B) supplying liquidity services through market making
C) helping the bank execute proprietary trading
D) contact clients with investment proposals
E) offer prime brokerage services to e.g., hedge funds
WRONG: D) contact clients with investment proposals. This is done by the sales department
Traders must ensure that every trade is profitable for the bank, even if entails that the investor (client) makes a loss
TRUE/ FALSE
FALSE
If a client cannot trade profitably with an IB, he/she may eventually stop trading with the bank. Hence, with IBs being the counterparty to the investor, sometimes traders decide to accept lower trading margins (and occasional losses) to accommodate client investment objectives.
In primary market transactions, the trader of an IB must balance the interests of the issuer and investors. The trading price must reflect balancing. What is true about the price?
A) If the price is too low, the bank will not be given any mandate in the future by the issuer
B) If the price is too high, demand from investors will be smaller
C) If the IB underwrites, it means that they are financially engaged and will lose money if the fixed price set on the security is too high (excess supply)
D) All of the above
All of the above
If an IB underwrites a primary market transaction (IPO), the following is true:
A) underwriting is a risky activity since the bank is financially engaged
B) IB purchases securities from the issuer and resells them to investors at a profit while standing ready to repurchase the security
C) the pricing of the security must be high enough to satisfy the issuer, but low enough to satisfy investors and include a margin for IB
D) All of the above
D) All of the above
The term market maker refers to when an IB actively quotes two-sided markets in a particular security, providing bids and offers (asks) along with the market size of each. Market makers provide liquidity and depth to markets and profit from the difference in the bid-ask spread.
TRUE/ FALSE
TRUE
Following is NOT true about “market making”
A) Market-making services are only demanded if finding counterparties for a security trade is difficult or time demanding
B) The IB quotes a bid or offer price for securities the client wants to sell/buy
C) IB profits from this activity by capturing the bid-ask spreads
D) this activity is risk-free
D) this activity is risk-free - no.
The risk involved in capturing bid-ask spreads depends on the liquidity of the market and the complexity of the security.
Following is NOT true about the Proprietary trading activities of IBs:
A) They have become significant competitors to HFs who are the most important clients of the IBs client-related trading business
B) They are responsible for balancing their own profitability interest wit those of their clients (HFs)
C) The competition between IB and HFs have decreased HFs interest in trading with IBs with large proprietary trading businesses
D) Even if proprietary traders are allowed to trade with their own IB trading department, they always trade with other trading departments (including competing IBs)
WRONG: B) They are NOT responsible for balancing their own profitability interest wit those of their clients (HFs). I.e., they prioritize their own profits over that of clients’ (HFs)
Even when proprietary traders are allowed to trade with their own firm, they always trade with others too, including competitor firms, and will execute transactions with whichever firm best enables them to achieve profits and mitigate risks.
A) TRUE
B) FALSE - the proprietary traders always prioritize to trade with the internal trading department because it allows for higher holistic profitability of the bank
TRUE
Which of the following is NOT an activity conducted in the trading division? A) Client-related trading B) Proprietary trading C) Prime brokerage D) Secures long-term financing
D) Secures long-term financing
Following is NOT a service offered by the prime brokerage division: A) Trade clearing B) Securities lending C) Custody and settlement D) Direct contact with clients E) Performance measurement and reporting
D) Direct contact with clients
In a short-selling arrangement, the change of ownership of the security implies that whenever short buyers (investor buying) receive dividends, the borrower (and short-seller- e.g., HF) must pay to the lender (long-term investor initially owning the security) a cash amount that is equivalent to that dividend payout (so the original owner of the share still receives an equivalent to the dividend payout).
TRUE/ FALSE
TRUE
The short buyer receives dividends if title is held on a “record date”, and is able to vote if a shareholder election is held.
The stock loan agreement provides that whenever dividends are paid out under the ownership of short buyer (investor), the security borrower (HF) must pay to the lender (LT-owner of security) a cash amount that is equivalent to the dividends received.
I.e., the original owner of the share still receives an equivalent to the dividend payout
Following is NOT true about a security lending arrangement:
A) The lender of security are typically long-term institutional investors
B) Short sellers are the borrowers
C) The original owner of the security gets a cash collateral (higher than the value of the security lent)
D) In the event of borrower default, lender keeps entire collateral and interest income generated during lending period
E) If borrower doesn’t default, lender gets back security + rebate
F) All are true
E) IS NOT TRUE
If borrower doesn’t default, lender gets back security plus the money market rate minus rebate.
The rebate is the interest rate paid by the lender to the borrower for the cash collateral.
Following is NOT true about the rebate amount:
A) it is the interest rate paid by security lenders to security borrowers for the cash collateral.
B) the lower the rebate, the higher the effective cost of the security borrower (bc. receives a lower interest)
C) Rebate depends positively on attractiveness of borrowing the security and the liquidity
D) The profit of IBs for making security lending possible is a portion of the lender’s profit (market rate - rebate rate)
WRONG: C)
Rebate depends NEGATIVELY on the attractiveness of borrowing the security and the liquidity.
I.e., if high attractiveness to borrow (demand), rebate is lower (cost of borrowing is higher)
Following is NOT true about naked shorting:
A) refers to when equities are sold short without owning the share and without borrowing the share.
B) It is an illegal practice in all manners
C) Has a short time frame (usually 2-3 days)
WRONG: B) It is an illegal practice in all manners.
It is legal if the negotiation/sale and the settlement takes place at two different times (2-3 days’ time interval usually). That means, the seller would have 2-3 days to acquire the security in question. It is banned in US unless there is a legitimate and justifiable reason to do so
What is a margin call?
When hedge funds borrow cash from IBs (margin loans), the use of securities as collateral is required. If the value of the collateral drops over time, banks will exercise margin calls to receive payment of a portion of the loan
Following is NOT true about a CDO
A) Stands for Collateralized debt obligation
B) Traded in the FICC department of trading
C) Investors purchasing CDOs receive a slightly higher coupon than similarly rated straight bonds
D) Three tranches are created in a CDO, reflecting the repayment priority
E) All are true
E) All are true
In a CDO, the senior debt holders are paid back first (1st. repayment priority), while they also receive the highest return (coupon rate).
TRUE/ FALSE
FALSE
It is true that senior debt holders have the 1st repayment priority BUT, they enjoy the lowest coupon (return) out of the three tranches (senior, mezzanine and equity/junior)
In a CDO, a very risk-averse investor would choose to invest in the ____ tranch
A) Senior
B) Mezzanine
C) Equity/ junior
A) Senior tranch
Asset-backed securities are of ___ risk than investing in the senior tranche of a CDO
A) Higher
B) Lower
Asset-backed securities are of HIGHER risk than investing in the senior tranche of a CDO
With ABS, if 5/100 debtors default, everyone in the chain will loose 5. If 5/100 in a CDO default, senior tranche will be the last of the three tranches to suffer any loss.
Consider the following:
An investor buys $10m of a 5Y $100m face value bond. He wants to protect his investment risk by entering into a ____ on a $10m notional amount. The investor will pay 2% annually of the notional amount for 5Ys. In exchange, if the bond defaults, the investor gets the right to sell the defaulted bonds to the credit protection seller at the notional value.
A) CDO
B) CDS
C) CDB
B) CDS: credit default swap
CDS credit protection of a company becomes ___ expensive upon completion of a PE fund takeover with LBO.
A) more
B) less
CDS credit protection becomes MORE expensive upon completion of a PE fund takeover with LBO, because the corresponding increase in riskiness of default of the portfolio company makes the CDS more expensive
A separately managed account (SMA) is NOT:
A) a customized portfolio of assets managed by a professional asset manager
B) allows for more customized investment strategy than pooled investment vehicles like mutual funds
C) provide tax benefits through direct ownership of securities
D) fees of a SMA is around 1-3% of AUM
E) Targets low net-worth investors who don’t know how to invest
WRONG: E)
A separately managed account (SMA) is NOT targeted to low net-worth investors who don’t know how to invest. Instead, they target very wealthy individuals
Pooled investment vehicles target only non-wealthy investors who want to invest only a small amount of capital.
TRUE/ FALSE
FALSE:
PIV does aggregate investments from individuals, providing an opportunity for investors to participate in investments otherwise available only for larger sophisticated investors or financial institutions.
But PE and HFs are also PIV, which does not grant participation to un-wealthy investors
Mutual funds are only open-end
TRUE/ FALSE
FALSE
Mutual funds can be either open-end or closed end.
In the former, investors can enter&exit as they want. In the latter, investors can only exit if someone else is willing to take over the position or when the life of fund ends.
