Investment Banking


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Investment Banking

  1. 1. Financial markets and investment banking Course outline and description 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 Professor Michael Pettis (MIA, MBA – Columbia University) is a former investment banker with fourteen years of experience in the international fixed income markets. He has also been a professor of finance at Columbia University for the past nine years. He has headed bond trading, capital markets and liability management desks at various major Wall Street firms, and has taught courses in international economics, finance and financial history. In addition he has written extensively on trading, risk management, international capital flows, and sovereign debt policy. 1
  2. 2. 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 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 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 2
  3. 3.  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 3
  4. 4.  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 4
  5. 5. 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 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 5
  6. 6. 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, 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 6
  7. 7.  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 7
  8. 8. 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 8
  9. 9. 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 9
  10. 10.  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) 10