Week 1 Introduction
What will the class cover?
Who should take the class?
Work and assignments
Week 2 Investment banking – who does what?
Investment banking (M&A)
Fixed income and equity trading
Week 3 Structure of the financial markets
Corporate and government bond markets
Types of financial intermediaries
Week 4 Why and how do companies raise money?
Capital structure issues
Marketing, mandates, syndication and sales
Week 5 Outside speakers
We will invite investment bankers to join us to discuss their work
Week 6 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?
Week 7 Fund management
Hedge funds, mutual funds, pension funds, etc.
Who does what?
Week 8 Trading
The role of traders
Week 9 Outside speakers
We will invite traders to join us to discuss their work
Week 10 How traders evaluate markets
Week 11 Derivatives and structured products
Using swaps, futures, options
Hedging new issues CBOs, CMOs, CLOs etc.
Week 12 Outside speakers: the life of an investment banker
We will invite newly hired bankers to join us discuss their work
Week 13 Review of material
Week 14 Exam
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?
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
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
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
What are the basic functions we associate with investment banking and how are they
1. Retail vs institutional financial intermediation
2. Functions of investment banking
Primary function: Capital markets
Bonds – CP, corporate bonds, junk bonds, tax-exempt,
Supporting capital market liquidity: Trading
Market making vs. principal trading
Bonds: Government, corporate, emerging markets, foreign currency, junk, tax
Equity: Common, preferred, international, emerging markets
Currencies: majors, exotics
Supporting trading: Sales
Supporting sales: Research
Equity relationship: Advisory
Associated function: Fund management
Private equity, venture capital
Other (NPLs, restructurings, arbitrage)
Third party vs. propietary
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
Developed markets vs. undeveloped markets
CP, notes, bonds
Junk vs. investment grade
Traded vs. OTC
Samurai, eurodollar, etc.
Active source of funding
Municipals and provinces
Major global exchanges
Exchange traded vs OTC vs. automated trading
Should Chinese companies list overseas?
Hedge funds and other active managers
National development banks
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
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
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
price talk (sometimes)
3. Syndication SYNDICATION DESK
Lead and co-lead managers
Allocation of issue among managers
4. Marketing issue SYNDICATION DESK, SALESMEN, RESEARCH
Price talk and investor circles
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 SYNDICATION DESK, TRADERS
Syndicate desk is usually short
Initial trading for price discovery
Hot deals versus dogs
7. Secondary market trading TRADERS
We discuss broadly in the various ways in which individuals, corporations and
Individuals: Bank deposits, direct investment in markets, mutual funds, pension schemes,
Corporations and governments: Bank deposits, cash management accounts, insurance
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
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
How do traders profit?
What are the risks for market makers?
Holding period risk
Risks not associated with assets traded
What are the risks for proprietary desks?
The incentive problem (option analysis)
Holding period risk
Three types of investment strategy:
What are the investment goals of the three different strategies?
How does each strategy contribute to the market?
What are the tools needed for each strategy?
How do traders operate and manage risk?
What kind of information do traders look at?
Types of information Primary impact Secondary impact
Changes in expected cashflow Has only a small impact in the short- Can affect value investor behavior
associated with asset term
Changes in appropriate discount rate Little impact in discounting near- May change financing cost, and can
term variables affect value investor behavior
Financing cost Can have large impact on margin NA
positions, derivative pricing, and
Changes in behavior of value Can have large near-term impact on NA
investors supply or demand
Fund flows Can have large near-term impact on NA
supply or demand
Changes in supply of asset, such as Can have large near-term impact Can affect value investor behavior
government sales of stock, etc.
Changes in demand for asset, such as Can have large near-term impact Can affect value investor behavior
by new entrants into market, etc.
Insider behavior and market Can have large near-term impact on Can reduce role of value investor
manipulation supply and demand factors
Legal and regulatory changes Can have large near-term impact on Can affect value investor behavior
supply and demand factors
Analysts’ reports No impact Can affect value investor behavior
How does the structure of the market matter? Positive vs. negative feedback
Structural factor Behavior Impact
Substantial number of Tend to act against market moves by buying when prices Stabilizing
value investors decline against target price and selling when they rise
against target price
Existence of Buy undervalued assets and sell overvalued assets, Stabilizing
arbitrageurs thereby forcing pricing consistency and crossing markets
(which increases liquidity)
Margin owners of When prices rise, buying power increases, when assets Highly destabilizing
assets decline, selling pressure increases
Large open short Short covering on big price moves Stabilizing on the way down,
positions reinforcing on the way up
Large option positions Delta hedging Highly destabilizing
Program trading Delta hedging Highly destabilizing
Trend trading Buy rising market and short declining market Highly destabilizing
Holdings across asset When coupled with other destabilizing structures can lead Highly destabilizing
classes to contagion
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
Interest rate 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
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,
Emerging market CBOs (short-term versus long-term risk
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
Provides a better mix of risks
Leverage can be imbedded into product
Total return swaps, super-floaters, futures, options
Investors or corporations can identify and eliminate risks they do not want
Treasury locks, commodity futures, commodity-indexed notes, floating-credit-
spread notes (like Argentina deal)