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
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 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, 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

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
Changes in expected cashflow
associated with asset
Changes in appropriate discount rate
Financing cost
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
Primary impact
Has only a small impact in the short-
term
Little impact in discounting near-
term 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
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 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)