Lesson 2: Secruities Firms and investment Banks Flashcards
Question 8 is missing due to lots of Images in the answer
What are the key activity areas for investment banks and securities firms?
How does each activity area assist in the generation of profits and what are the major risks for each area? (pt 1)
Investment Banking.
Investment banks specialise in underwriting and distributing both debt and equity issues in the corporate market. New issues can be placed either
privately or publicly and can represent either an initial public offering (IPO) of debt or equity or a secondary issue. Secondary issues of seasoned firms typically will
generate lower fees than an IPO.
Securities underwritings can be undertaken through either public offerings or private offerings. In a private offering the investment bank receives a fee for acting as the agent in the transaction. In best-efforts public offerings, the bank acts as the agent and receives a fee based on the success of the offering. In a firm commitment underwriting, the bank acts as a principal, purchasing the securities from the issuer at one price and seeking to place them with public investors at a slightly higher price. Thus, the risk of loss is higher. Finally, the bank may perform similar functions in the government markets and the asset-backed derivative markets. In all cases, the investment bank receives fees related to the difficulty and risk in placing the issue.
What are the key activity areas for investment banks and securities firms?
How does each activity area assist in the generation of profits and what are the major risks for each area? (pt 2)
Venture Capital.
A difficulty for new and small firms in obtaining debt financing from commercial banks is that commercial banks (CBs) are generally not willing or able to
make loans to new companies with no assets and business history. In this case, new and small firms often turn to investment banks (and other firms) that make venture capital investments to get capital financing as well as advice.
Venture capitalis a professionally managed pool of money used to finance new and often high-risk firms.
Venture capital is generally provided to back an untried company and its managers in return for an equity investment in the firm. Venture capital firms do not make outright loans. Rather, they purchase an equity interest in the firm that gives them the same rights and privileges associated with an equity investment made by the firm’s other owners.
What are the key activity areas for investment banks and securities firms?
How does each activity area assist in the generation of profits and what are the major risks for each area? (pt 3)
Market Making.
Security firms assist in the market-making function by acting as brokers to assist customers in the purchase or sale of an asset. Market making can involve either agency or principal transactions. Agency transactions are two-way transactions on behalf of customers, for example, acting as a stockbroker or dealer for a fee or commission. In principal transactions, the market maker seeks to profit on the price movements of securities and takes either long or short inventory positions for its
own account. These principal positions can be profitable if prices increase, but they can also create downside risk in volatile markets.
What are the key activity areas for investment banks and securities firms?
How does each activity area assist in the generation of profits and what are the major risks for each area? (pt 4)
Trading.
Trading activities can be conducted on behalf of a customer or the firm. The activities usually involve position trading, pure arbitrage, risk arbitrage, programme trading, stock brokerage, and electronic brokerage.
Position trading involves the purchase of large blocks of stock to facilitate the smooth functioning of the market.
Pure arbitrage involves the purchase and simultaneous sale of an asset in different markets because of different prices in the two markets.
Risk arbitrage involves establishing positions prior to some anticipated information release or event.
Programme trading involves positioning with the aid of computers and futures contracts to benefit from small market movements. In each case, the potential risk involves the movements of the asset prices, and the benefits are aided by the lack of most transaction costs and the immediate information that is available to investment banks.
Stock brokerage involves the trading of securities on behalf of individuals who want to transact in the money or capital markets.
Electronic brokerage, offered by major brokers, involves direct access, via the Internet, to the trading floor, therefore bypassing traditional brokers.
What are the key activity areas for investment banks and securities firms?
How does each activity area assist in the generation of profits and what are the major risks for each area? (pt 5, 6, 7, 8)
5.Investing.
Securities firms act as agents for individuals with funds to invest by establishing and managing mutual funds and by managing pension funds. The securities firms generate fees that affect directly the revenue stream of the companies.
6.Cash Management.
Cash management accounts are checking accounts that earn interest and may be covered by FDIC insurance. The accounts have been beneficial in
providing full-service financial products to customers, especially at the retail level.
7.Mergers and Acquisitions.
Most investment banks provide advice to corporate clients who are involved in mergers and acquisitions.
8.Back-Office and Other Service Functions.
Security firms offer clearing and settlement services, research and information services, and other brokerage services on a fee basis.
What are the risk implications to an investment bank from underwriting on a best-efforts basis versus a firm commitment basis?
If you operated a company issuing stock for the first time, which type of underwriting would you prefer? Why?
What factors may cause you to choose the alternative?
In a best efforts underwriting, the investment bank acts as an agent of the company issuing the security and receives a fee based on the number of securities sold. With a firm commitment underwriting, the investment bank acts as a principal, purchasing the securities from the company at a negotiated price and selling them to the investing public at what it hopes will be a higher price. Thus, the investment bank has greater risk with
the firm commitment underwriting, since the investment bank will absorb any adverse price movements in the security before the entire issue is sold.
Factors causing preference to the issuing firm include
general volatility in the market, stability and maturity of the financial health of the issuing firm, and the perceived appetite for new issues in the market place. The investment bank will also consider these factors when negotiating the fees and/or pricing spread inmaking its decision regarding the offering process.
An investment bank agrees to underwrite an issue of 15 million shares of stock for Looney Landscaping Corp.
1. If the investment bank underwrites the stock
on a firm commitment basis, it agrees to pay $12.50 per share to Looney Landscaping Corp. for the 15 million shares of stock. It can then sell those shares to the public for $13.25 per share.
How much money does Looney Landscaping Corp. receive?
What is the profit to the investment bank?
If the investment bank can sell the shares for only $11.95, how much money does Looney Landscaping Corp. receive?
What is the profit to the investment bank?
If the investment bank sells the stock for $13.25 per share, Looney Landscaping Corp.
receives $12.50 x 15,000,000 shares = $187,500,000. The profit to the investment bank is ($13.25 - $12.50) x 15,000,000 shares = $11,250,000. The stock price of Looney Landscaping Corp. is $13.25 since that is what the public agrees to pay. From the perspective of Looney Landscaping Corp., the $11.25 million represents the commission that it must pay to issue the stock.
If the investment bank sells the stock for $11.95 per share, Looney Landscaping Corp. still receives $12.50 x 15,000,000 shares = $187,500,000. The profit to the investment bank is ($11.95 - $12.50) x 15,000,000 shares = -$8,250,000.
The stock price of Looney Landscaping Corp. is $11.95 since that is what the public agrees to pay. From the perspective of the investment bank, the -$8.25 million represents a loss for the firm commitment it made to Looney Landscaping Corp. to issue the stock.
An investment bank agrees to underwrite an issue of 15 million shares of stock for Looney Landscaping Corp.
2. Suppose, instead, that the investment bank agrees to underwrite the 15 million shares on a best-efforts basis. The investment bank is able to sell 13.6 million shares for $12.50 per share, and it charges Looney Landscaping Corp. $0.275 per share sold.
How much money does Looney Landscaping Corp. receive? What is the profit to the investment bank? If the investment bank can sell the shares for only $11.95, how much money does Looney Landscaping Corp. receive? What is the profit to the investment bank?
If the investment bank sells the stock for $12.50 per share, Looney Landscaping Corp. receives ($12.50
- $0.275) x 13,600,000 shares = $166,260,000, the investment bank’s profit is $0.275 x 13,600,000 shares = $3,740,000, and the stock price is $12.50 per share since that is what the public pays.
If the investment bank sells the stock for $11.95 per share, Looney Landscaping Corp. receives ($11.95
- $0.275) x 13,600,000 shares = $158,780,000, the investment bank’s profit is still $0.275 x 13,600,000 shares = $3,740,000, and the stock price is $11.95 per share since that is what the public pays
An investment bank pays $23.50 per share for 4 million shares of JCN Company. It then sells those shares to the public for $25 per share. How much moneydoes JCN receive?
What is the profit to the investment bank?
What is the stock priceof JCN?
JCN receives $23.50 x 4,000,000 shares = $94,000,000. The profit to the investment bank is ($25.00 - $23.50) x 4,000,000 shares = $6,000,000. The stock price of JCN is $25.00 since that is what the public must pay. From the perspective of JCN, the $6,000,000 represents the commission that it must pay to issue the stock.
XYZ, Inc., has issued 10 million new shares of stock. An investment bank agrees to underwrite these shares on a best-efforts basis. The investment bank is able to sell 8.4 million shares for $27 per share, and it charges XYZ $0.675 per share sold.
How much money does XYZ receive?
What is the profit to the investment bank?
What is the stock price of XYZ?
XYZ receives ($27.00 - $0.675) x 8,400,000 shares = $221,130,000, the investment bank’s profit is $0.675 x 8,400,000 shares = $5,670,000, and the stock price is $27 per share since that is what the public pays.
What is venture capital?
Venture capital is a professionally managed pool of money used to finance new and often high-risk firms. Venture capital is generally provided by investment institutions or private individuals willing to back an untried company and its managers in return for an
equity investment in the firm. Venture capital firms do not make outright loans. Rather, they purchase an equity interest in the firm that gives them the same rights and privileges associated with an equity investment made by the firm’s other owners.
As equity holders, venture capital firms are not generally passive investors. Rather, they provide valuable expertise to the firm’s managers and sometimes even help in recruiting senior managers
for the firm. They also generally expect to be fully informed about the firm’s operations, any problems, and whether the joint goals of all of the firm’s owners are being met.
