The Role of Investment Banking

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					Investment Banking
Class     Topic
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)
            Capital raising
            Fixed income and equity trading
            Sales
            Research
Week 3    Structure of the financial markets
            Corporate and government bond markets
            Equity markets
            Types of financial intermediaries
Week 4     Why and how do companies raise money?
            Capital structure issues
            Marketing, mandates, syndication and sales
            IPOs
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
            Risk management
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
            Disaggregating risks
            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
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
       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

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
    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
 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                                                 SYNDICATION DESK
    Lead and co-lead managers
      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       SYNDICATION DESK, TRADERS
    Syndicate desk is usually short
    Initial trading for price discovery
    Hot deals versus dogs

7. Secondary market trading                                       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,
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
    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:


       Arb                                        Value
 What are the investment goals of the three different strategies?
  Profits
  Risks
  Holding period

 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
        Classes 11-12
        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
                                        short positions
 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
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-credit-
          spread notes (like Argentina deal)

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