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					Investment Banking
Class
Week 1

Topic
Introduction  What will the class cover?  Who should take the class?  Work and assignments Investment banking – who does what?  Investment banking (M&A)  Capital raising  Fixed income and equity trading  Sales  Research Structure of the financial markets  Corporate and government bond markets  Equity markets  Types of financial intermediaries Why and how do companies raise money?  Capital structure issues  Marketing, mandates, syndication and sales  IPOs Outside speakers  We will invite investment bankers to join us to discuss their work The structure of the investor base  What is the role of a financial market?  What kinds of investors are there?  What roles do each play? Fund management  Hedge funds, mutual funds, pension funds, etc.  Who does what? Trading  The role of traders  Risk management Outside speakers  We will invite traders to join us to discuss their work How traders evaluate markets Derivatives and structured products  Disaggregating risks  Using swaps, futures, options  Hedging new issues CBOs, CMOs, CLOs etc. Outside speakers: the life of an investment banker  We will invite newly hired bankers to join us discuss their work Review of material Exam

Week 2

Week 3

Week 4

Week 5 Week 6

Week 7

Week 8

Week 9 Week 10 Week 11

Week 12 Week 13 Week 14

Class 1
In this class we will outline the goals of the course, discuss why it is important to understand the markets, and go into a brief history of investment banking as a separate part of the financial intermediation process. What will the class cover?  The different functions of what are called investment banking  The markets in which investment banks operate  General descriptions of specialized but widely used products Who should take the class?  Students who hope to become investment bankers or traders  Students who plan to go into policy-making  Students who plan to work for large corporations What are investment banks?  Universal banking  Banking regulation in the US following the 1929 crash  What is a commercial bank? What is an investment bank?  The gradual erosion of legal distinctions  Why does investment banking continue to be treated separately? Why study about or go into investment banking? 1. Financial system is at heart of economic development  Markets allocate capital  Market structure determines cost of capital  Market structure determines the economic impact of external and internal shocks  The only way to understand the markets is to be in the markets 2. The failure of the financial markets may be China’s biggest impediment to growth  Excessive concentration in the banking system  Bankrupt banks  Wholly speculative stock markets  Degradation of national balance sheet 3. Great opportunities for ambitious students  Responsibilities come very quickly  Immersion into markets gives direct knowledge of how they function  Shortcut to senior positions in government and large corporations  Contacts and compensation

Class 2
What are the basic functions we associate with investment banking and how are they related? 1. Retail vs institutional financial intermediation 2. Functions of investment banking Primary function: Capital markets  Equity  Bonds – CP, corporate bonds, junk bonds, tax-exempt,  Loans Supporting capital market liquidity: Trading  Market making vs. principal trading  Bonds: Government, corporate, emerging markets, foreign currency, junk, tax exempts  Equity: Common, preferred, international, emerging markets  Currencies: majors, exotics  Commodities  Derivatives  Structuring Supporting trading: Sales Supporting sales: Research  Equity  Macro  Credit Equity relationship: Advisory  M&A  Liability management  Capital raising Associated function: Fund management  Mutual funds  Private equity, venture capital  Other (NPLs, restructurings, arbitrage)  Third party vs. propietary

Class 3-4
In these two classes we create a “map” of the financial markets setting out the types of financial instruments and their inter-relations.

Structure of financial markets  Bond markets  Government  Developed markets vs. undeveloped markets  Trading issues  Chinese market  Exchange traded  FI  OTC  Corporate  CP, notes, bonds  Junk vs. investment grade  Traded vs. OTC  Samurai, eurodollar, etc.  Financial institutions  Active source of funding  FRNs  Other  Project finance  Municipals and provinces  Securitization  Trade finance  CBOs  Mortgages  Receivables  Equity markets  Major global exchanges  Local exchanges  Exchange traded vs OTC vs. automated trading  Should Chinese companies list overseas?  Financial intermediaries  Banks  Investment banks  Insurance companies  Pension funds  Hedge funds and other active managers  Leasing companies  Official institutions  National development banks  International institutions

Classes 5-6
Why do companies raise capital and what is involved in the capital raising process? Liability management issues  Why does capital structure matter?  Absorbs external shocks  Less susceptibility to shocks reduces financial distress costs  Capital structure can permit speculative strategies  Determines the distribution of operating earnings  Determines investment strategy  Changes risk appetite  In undeveloped markets investors cannot hedge or speculate directly and issuers may face restrictions on their ability to raise capital, so capital structure strategies are affected by investor needs as well as by limitations in issuing equity, debt and hedges  Why do companies hedge?  In developed markets, investors can limit volatility directly, so hedging does not increase value by reducing the volatility of earnings or asset value  In undeveloped markets, investors have few hedging tools  Hedging increase marginal benefit of debt and reduces marginal cost of debt (financial distress) thereby permitting more leverage

Doing the deal: the mechanics of capital markets transactions 1. Company makes funding decision BANKERS, CAPITAL MARKETS  Purpose of funding  Overall liability management issues  investment or acquisition may reduce overall earnings volatility  overall exposure to currency, interest-rate or commodity risk may change  Market conditions  low interest rates? maturity demand? currency demand?  using derivatives to reconcile market conditions and client needs  Investment banks may advise issuer, or propose transactions during this period 2. Awarding of mandate BANKERS, CAPITAL MARKETS  Banks compete on the basis of  relationship with and understanding of client  understanding of industry  understanding of optimal investor base  distribution skills  innovative proposal  price talk (sometimes) 3. Syndication  Lead and co-lead managers
SYNDICATION DESK

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Allocation of issue among managers

4. Marketing issue SYNDICATION DESK, SALESMEN, RESEARCH  Roadshow  Price talk and investor circles  Book-building 5. Launch SYNDICATION DESK, SALESMEN, TRADERS  Price is set  Orders come in from investors  Paper is allocated  “good” versus “bad” investors 6. Stabilization/after-market support  Syndicate desk is usually short  Initial trading for price discovery  Hot deals versus dogs 7. Secondary market trading
SYNDICATION DESK, TRADERS

TRADERS

Class 7
We discuss broadly in the various ways in which individuals, corporations and governments save

Individuals: Bank deposits, direct investment in markets, mutual funds, pension schemes, insurance Corporations and governments: Bank deposits, cash management accounts, insurance

Class 8
Outside speaker

Classes 9-10
The structure of the investor base is the key determinant of the maturity of a market. Along with traders, whose function is to provide liquidity for investors, there are broadly speaking three very separate types of investment strategies that account for almost every investment activity. A well-functioning market requires all thee.

Types of players  Traders/market makers  Speculators  Arbitragers  Fundamental investors Role of trader  Make markets for clients (market maker)  Provide market information to bankers  Profit from knowledge of supply and demand (speculator)  Profit from knowledge of pricing inconsistencies (speculator) What kind of knowledge does a trader need?  How fundamental supply and demand will change  Market contagion mechanisms (how information or activity from one market is transmitted into another)  Structure of the investor base and how it affects short term supply and demand  Pricing inconsistencies How do traders profit?  Bid/offer spread  Proprietary positions

Risks  What are the risks for market makers?  Holding period risk  Trading errors  Risks not associated with assets traded  What are the risks for proprietary desks?  Positions  Trading errors  Hidden trades  The incentive problem (option analysis) Risk management  Holding period risk  Secondary risks  Interest rates  Currency  Contagion

Three types of investment strategy:

Spec.

Arb

Value

What are the investment goals of the three different strategies? Profits  Risks  Holding period
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How does each strategy contribute to the market?  Liquidity  Market integration  Capital allocation

What are the tools needed for each strategy? Discount rates  Information  Technical factors
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Classes 11-12
How do traders operate and manage risk?

What kind of information do traders look at?
Types of information
Changes in expected cashflow associated with asset Changes in appropriate discount rate Financing cost

Primary impact
Has only a small impact in the shortterm Little impact in discounting nearterm variables Can have large impact on margin positions, derivative pricing, and short positions Can have large near-term impact on supply or demand Can have large near-term impact on supply or demand Can have large near-term impact Can have large near-term impact Can have large near-term impact on supply and demand factors Can have large near-term impact on supply and demand factors No impact

Secondary impact
Can affect value investor behavior May change financing cost, and can affect value investor behavior NA

Changes in behavior of value investors Fund flows Changes in supply of asset, such as government sales of stock, etc. Changes in demand for asset, such as by new entrants into market, etc. Insider behavior and market manipulation Legal and regulatory changes Analysts’ reports

NA NA Can affect value investor behavior Can affect value investor behavior Can reduce role of value investor Can affect value investor behavior Can affect value investor behavior

How does the structure of the market matter? Positive vs. negative feedback
Structural factor
Substantial number of value investors Existence of arbitrageurs Margin owners of assets Large open short positions Large option positions Program trading Trend trading Holdings across asset classes

Behavior
Tend to act against market moves by buying when prices decline against target price and selling when they rise against target price Buy undervalued assets and sell overvalued assets, thereby forcing pricing consistency and crossing markets (which increases liquidity) When prices rise, buying power increases, when assets decline, selling pressure increases Short covering on big price moves Delta hedging Delta hedging Buy rising market and short declining market When coupled with other destabilizing structures can lead to contagion

Impact
Stabilizing

Stabilizing

Highly destabilizing Stabilizing on the way down, reinforcing on the way up Highly destabilizing Highly destabilizing Highly destabilizing Highly destabilizing

Class 13
There have been a number of derivative instruments and securitization technologies that have transformed the markets in recent years. In spite of all that has been written about their complexities, they are basically variations on a few instruments.

1. What are derivatives?  Forwards and futures  Options  Interest rate swaps  Currency swaps  Exotics: total-return swaps, swaptions, complex options, 2. What are structured products?  CBOs and CMOs  Special transactions: Treasury stripping, Brady bond stripping, IO/PO bonds  Structured notes: super-floaters, inverse floaters, multi-currency bonds

3. Purpose of derivatives and structured products  Disaggregating risks  Each risk can be separately sold to an investor best suited to take on the risk  Mortgage securities (interest-rate risk on payment streams, prepayment risk, default risk)  Emerging market CBOs (short-term versus long-term risk Combining risks  Allows investors to “get around” restrictions  Notes indexed to equity markets  Allows investors access to less accessible markets  Local currency indexed bonds  Allows investors to make complex bets  Inverse floaters  Provides a better mix of risks  Convertible bonds Leverage  Leverage can be imbedded into product  Total return swaps, super-floaters, futures, options Hedging  Investors or corporations can identify and eliminate risks they do not want  Treasury locks, commodity futures, commodity-indexed notes, floating-creditspread notes (like Argentina deal)

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posted:12/12/2009
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