4. Investment Banking & Brokerage

4.1 What is an Investment Bank?

An investment bank, simply put, is an intermediary organization that uses its expertise and financial knowledge to make it possible for companies, institutions and governments to take advantage of business or investment opportunities. More specifically:

1. Investment banks link companies that need money to grow with other companies, institutions or investors willing to provide them with that money via a variety of forms, be it loans, stocks, bonds or hybrid financing arrangements. The investment bank structures these transactions and is capable of bringing them to market in the case of stock and bond offerings.

      2.   Investment banks use financial expertise to provide corporate finance advice. For                    example, the banks can help clients manage their business and investment risks, buy             other companies, divest themselves of unwanted operations or finance their                              expansion into new countries or industries.

      3.  Sales and Trading areas of investment banks (also termed as ‘Brokerage’) link                          investors with the world’s financial markets, including stock (equity) markets, bond                (fixed income) markets, derivative markets, foreign exchange, commodities and more.           Research areas (equity and fixed income) may contribute expertise to these market                  activities by monitoring companies, industries, market sectors and key economic                     factors, then providing the investment bank’s traders and clients with information that           helps them to invest intelligently.

• Investment Banking Functions

1. Strategic Advisory - 

                  1.1 Mergers and Acquisition (M&A) - 

Acquisition

When a company takes over another one and becomes the new owner, the purchase is called an acquisition. Acquisitions can be either friendly or unfriendly. Friendly acquisitions occur when the target firm agrees to be acquired; unfriendly acquisitions don't have the same agreement from the target firm.

Merger

Merger is the combining of two or more companies, generally by offering the stockholders of one company securities in the acquiring company in exchange for the surrender of their stock.

M&A Advisory

Investment banks provide advice to clients on all aspects of buying, selling, and merging with other companies. They assist with everything from suggestions about the timing of a sale or purchase, to identification of potential buyers or sellers, and negotiation of a favorable price. If a client company is subject to an unwanted takeover bid, M&A bankers will also offer advice on repelling unwanted advances.

Typically, deals between $50 million and $ 1 billion are charged investment banking fees equivalent to between 1% and 2% of the transaction value. Deals worth more than $ 1 billion are usually charged a base fee of $ 10 million plus additional costs based on the amount of work involved.

           1.2 Financial Restructuring - 

When a company cannot pay its cash obligations - for example, when it cannot meet its bond payments or its payments to other creditors (such as vendors) - it goes bankrupt. When this happens, the company would need to file for protection under the bankruptcy laws in the country. The company can either stop all operations and liquidate the company’s assets or restructure to remain in business.

                1.3 Securitized Products - 

Securitization is the process of converting whole assets into smaller tradable securities through appropriate structuring. The most commonly securitized assets are mortgage loans and credit card receivables.

       2. Securities Underwriting -

When an organization needs money, it has two options. It can either directly go to someone who has the money (like a bank), or go to a “broker” (an Investment Bank) which would help it raise the money from lenders/investors. The money may be raised in form of stocks (equity) or bonds (debt).

The Investment Bank, acting as the broker, prices the security and sells it to the target customers, usually guaranteeing the sale of a certain number of securities. This process is called underwriting.

  

3. Financial Markets

•  Types Of Financial Markets

There are basically two types of markets - 

1. Primary Market
2. Secondary Market 

1. Primary Market

Primary market is one where new financial instruments are issued for the first time. They provide a

standard institutionalized process to raise money.

2.  Secondary Markets

Secondary Market is a place where primary market instruments, once issued, are bought and sold.

Some of the financial markets are:

•  Stock Markets
•  Bond Markets
•  Derivatives Markets
•  Money Markets
•  Forex Markets
•  Commodity Markets

1. Stock Markets

Stock markets are a place where organized trading of stocks is done through exchanges. Stock markets

are most commonly known among all financial markets because of the large participation of ‘retail

investors’ i.e. common people who invest from their own savings.

Stock exchanges provide a system that accepts orders from both buyers and sellers for shares that are

traded on a particular exchange. Exchanges then follow a mechanism to automatically match these

orders based on the ‘quoted price’, ‘time when the order was placed’, ‘order quantity’ and the ‘order type’.

A successful match of a buy order with a sell order is known as a trade. As in any other market the price

of the stock depends on the demand and supply of the stock.

The modern stock markets are basically the stock exchanges like the London stock exchange (UK), New

York stock exchange (USA), Euronext (Europe) National Stock Exchange (India) etc.

2. Bond Markets

Bond markets, as the name implies are financial markets where bonds and other debt instruments are

issued and traded. Government bonds constitute the major bulk of the bonds issued and traded in these

markets. The different bonds traded in the bonds market are treasury bonds (Government bonds with

maturity>10 years), treasury bills (maturity < 1 year) and treasury notes (1-10 years), municipal bonds

(Bonds issued by local Government and Government bodies) and corporate bonds (Bonds issued by

companies).

3. Derivatives Markets

Derivatives markets are one in which trading can be done in derivative instruments like futures and

options. A futures contract is a type of derivative instrument, or financial contract, in which two parties

agree to transact a set of financial instruments or physical commodities for future delivery at a particular

price. An option is a contract giving the buyer the right, but not the obligation, to buy or sell an underlying

asset at a specific price on or before a certain date.

In recent years, the market for financial derivatives has grown tremendously in terms of variety of

instruments available, their complexity and also turnover. In the class of equity derivatives, futures and

options on stock indices have gained more popularity than on individual stocks, especially among

institutional investors, who are major users of index-linked derivatives. Even small investors find these

useful, due to the high correlation of popular indexes with various portfolios and ease of use. The lower

costs associated with index derivatives vis-à-vis derivative products based on individual securities is

another reason for their growing use. Some of the exchanges that offer trading in derivative instruments

are Chicago Board Options Exchange (CBOE) and London International Financial Futures and Options

Exchange (LIFFE).

4. Money Markets

A money market is a market for short-term debt instruments such as negotiable certificates of deposit,

Treasury bills, commercial paper, repos (repurchase agreements), bankers’ acceptances, etc.

Instruments that are traded in money markets are typically of a short maturity (from as less as 1-7 days to

less than a year.

5. Forex Markets

A forex market is not what may be termed as a securities market but it is an important financial market

nevertheless, accounting for extremely large financial transactions in terms of volume and value.

2. Financial Instruments in Investment banking

Financial  instruments can be classified into following types -

1.  Equity
2.  Debt (or Fixed Income)
3.  Hybrids
4.  Derivatives

1. Equity -  

Equity is kind of ownership in the company, it takes form of shares. Share possess owenship. There are basically two types of shares, as follows - 

                   a)  Common Shares

                   

                   b)  Preference Shares

a)  Common Shares - 

Common share is the most common method of providing stocks in a company. The

characteristic feature of this stock is that the holder of is entitled to voting rights as well as the dividends.
Important point to note is that there is no guarantee of dividends

There are various flavors of common shares like Class A and Class B. Class A and Class B shares are
shares that are issued at different point of time with slightly different characteristics. These characteristics

mainly deal with the voting rights, which differ across these classes.

b)  Preference Shares - 

Preference Share is the stock in which the owner has a guaranteed dividend payment at a specified rate.
Preference Share has features of both equity and debt securities. It represents ownership in a corporation,
but it does not have the voting rights as common stocks Although preferred stock does not typically have
the same growth potential as common stock, it does have two distinct advantages over common
stockholders.

No dividends can be paid to common shareholders before obligations to preferred shareholders are met
Preferred stock also has priority claims over common stock; that is, if a company declares bankruptcy, the
preferred stock holders are paid before common shareholders. These are also known as preference

shares.

American Depository Receipts (ADR) - 

The purpose of an ADR is to facilitate the domestic trading of a foreign stock. An ADR is a receipt for a
specified number of foreign shares owned by an American bank. ADRs trade like shares, either on a U.S.
Exchange or Over the Counter. The owner of an ADR has voting rights and also has the right to receive
any declared dividends. An example would be Infosys ADRs that are traded in NASDAQ

2. Fixed Income - Debt 

Fixed income instruments are those instruments that offer a fixed amount of money for a specified period

of time. In other words, the amount of income to be received is known before hand to an investor.

2.1  Bonds

Bonds are the loans taken by governments or corporate. Typically a bond pays a fixed rate at a prespecified

amount of time.

Some of the basic terminology with regard to bond is as follows - 

   1. Par Value/Face Value

The principal amount that is returned at the end of the maturity is known as the Par value. It is also

known as the principal or face value. Par value will vary depending on the type of bond. When the

bond matures and the lump sum is returned, the debt obligation is complete.

  2. Coupon Rate

It is the annual rate of interest on the bond's face value that a bond's issuer promises to pay the

bondholder. The interest rate is calculated upon the par value of the bond. The coupon is determined

at time of issuing the bond and is usually expressed as an annual percentage of the par value of the

bond. Payments usually occur every six months, but this can vary. If two bonds with equal maturities

and face values pay out different coupons, the prices of these bonds will behave differently in the

secondary market. For example, the bond with a lower coupon rate will be less expensive because

the bondholder is going to be getting more of his/her return from the return of principal at maturity

than will the holder of a bond with a higher coupon. There are some bonds that do not pay out any

coupons; these are called zero-coupon bonds

3. Maturity period/Term to maturity

Maturity is the date on which the principal value of a bond becomes due and payable in

full to the holder. Time to maturity is the time between now and when the bond matures. 

Maturities range significantly, from 1 month for some municipal notes to 40+ years for some corporate

bonds.

Government Bonds

When a government borrows money they are called as treasury instruments. Treasury instruments can be
of three types. Treasuries are highly liquid and have the lowest risk.

1.  Treasury bills (T-bills):  These instruments mature with in a year. Thus these are short-term loans.

     2.   Treasury notes: These are the bonds that mature within one to ten years.

     3.   Treasury bonds: These are the bonds, which mature after ten years.

3. Hybrids

           Hybrids are securities, which combine the characteristics of equity and debt.

        3.1 Convertible bonds

          Convertible Bonds are instruments that can be converted into a specified number of shares of stock after a specified number of days. However, till the time of conversion the bonds continue to pay coupons.

       3.2 Warrants

           Warrants are a type of security that gives the holder the option to buy a preferred or a common stock  at a specified price within a specified time. Warrants are call options – variants of equity. For example, a company is planning to issue bonds, but the market dictates a 9% interest payment. The issuer does not want to pay 9%, so they “sweeten” the bonds by adding warrants that give the holder the right to buy the issuers
stock at a given price over a given period of time. Warrants can be traded, exercised, or expire worthless.
In case, warrants are exercised, new securities are issued.

4. Derivatives

                  A derivative is a product whose value is derived from the value of an underlying asset, index or reference rate. The underlying asset can be equity, foreign exchange, commodity or any other item.

        4.1 Options

               An option is a contract, which gives the buyer the right, but not the obligation to buy or sell shares of the underlying security at a specific price on or before a specific date.

Options value depends on the value of an underlying investment. The underlying investment can be a stock, an index, a currency, a commodity, or any number of other securities. There are two kinds of options:
Call Options and Put Options.

     4.1.1 Call Options

               Call options are options to buy a stock at a specific price on or before a certain date (Expiration Date). Call options usually increase in value as the value of the underlying instrument rises. The price paid,
called the option Premium, secures the investor the right to buy that certain stock at a specified price
(Strike price) on or before the expiration date.

Profit in call option = Actual Price – Strike price – cost of option

   4.2.2 Put Option

    A put option provides the holder with the right to sell shares of the underlying stock at the strike price at the maturity date.

   Option Classification - 

Options are classified as in-the-money, out-of-the-money or at-the-money.

A call option is in-the-money when the stock price is above the strike price and out-of-the-money when
the stock price is below the strike price. For put options, the reverse is true. When the stock price and
strike price are equal, both types of options are considered at-the-money.

Also Options are classified based on their underlying assets:

•    Stock option

A stock option is a contract that guarantees the investor, who has purchased it the right, but not the
obligation, to buy or sell shares of the underlying stock at a fixed price prior to a certain date. The
buyer of an option is known as the holder and the seller is called the writer. If the option contract is
exercised, the writer is responsible for fulfilling the terms of the contract by delivering the shares to
the appropriate party or settling in cash.

•  Index Options

An Index option is a contract that guarantees the investor, who has purchased it the right, but not the
obligation, to buy or sell the underlying index at a fixed price prior to a certain date.

Based on the methods of exercising the options, they are divided into following two parts:

•  American options: The holder may exercise an American style option at any point between the time of

purchase and the expiration date.

•  European options: A European style option, on the other hand, cannot be exercised until expiration.
•  Asian options: These options can be exercised only on few selective dates as agreed upon

4.2 Forwards and Futures

       4.2.1 Financial Futures

A futures contract is a standardized, transferable, exchange-traded contract that requires delivery of a commodity, bond, currency, or stock index, at a specified price, on a specified future date. Generally, the delivery does not occur. Instead, before the contract expires, the holder usually settles his position by paying or receiving the difference between the current market price of the underlying asset and the price
stipulated in the contract.

Futures are risky investment vehicles that are appropriate for only the smallest percentage of highly
advanced investors. They are sometimes used as a hedge by investors with the resources to devote a
small percentage of their assets to such a dangerous venture. Futures trading should almost never be
attempted by individual investors.

•        Futures Trading

             Futures contracts are purchased when the investor expects the price of the underlying security to rise.This is known as going long. Because he has purchased the obligation to buy goods at the current price,
the holder will profit if the price goes up, allowing him to sell his futures contract for a profit or take
delivery of the goods on the future date at the lower price.

The opposite of going long is going short. In this case, the holder acquires the obligation to sell the
underlying commodity at the current price. He will profit if the price declines before the future date.
Hedgers trade futures for the purpose of keeping price risk in check. Because the price for a future
transaction can be set in the present, the fluctuations in the interim can be avoided.

           If the price goes up,the holder will be buying at a discount. If the price goes down, he will miss out on the new lower price.Hedging with futures can even be used to protect against unfavourable interest rate adjustments.

   4.2.2 Forward Contracts

The mechanism of forward contract is the same as the ones of a futures contract. The only difference is

that the forward contract is not traded on an exchange. A forward contract is a direct agreement between

two investors. A forward contract is more flexible than the futures contract because the two parties can

agree on all the characteristics of the contract (underlying amount, delivery date, delivery place,etc.)

4.3 Swaps

Swaps are agreements between at least two counter-parties to exchange cash flows in the future
according to a pre-specified formula.

• Interest Rate Swaps

Interest rate swap is the exchange of one set of cash flows for another. A pre-set index, notional amount
and set of dates of exchange determine each set of cash flows. The most common type of interest rate
swap is the exchange of fixed rate flows for floating rate flows.

• Currency Swaps

Currency swap is a swap contract in which two counterparties agree to exchange principal and interest
denominated in different currencies based on an agreed-upon currency exchange rate.

Contents

1. Investment Banking Basics

2. Financial Instruments in Investment banking

3. Financial Markets

4. Investment Banking and Brokerage

1. Investment Banking Basics

           

                     The basic motivation behind investment bank is to raise money.They raise money by issuing Securities in the form of Equity and Debt. Equity represents ownership of the company and takes the form of stock. Debt is funded by issuing Bonds, Debentures and various certificates.

                          A security is traded in share markets. A security is a financial instrument that signifies ownership in a company (a stock), a creditor relationship with a corporation or government agency (a bond), or rights to ownership (an option).