CHAPTER 6
Securities Funds and Investment Banking
Securities Industry
1. Corporate Finance
a. Assisting firms in raising capital and providing advice about M&A, corporate restructuring and Finance
b. Investment Banks → Primary Market
2. Brokerage and Market Making
a. Sale and trading of securities
b. Securities firms (Brokers and Dealers) → secondary market
Bank
1. Commercial bank
2. Investment Bank
a. Global markets: sales and trading (Equity; FICC; Derivatives), research
b. Investment Banking: Corporate finance (Coverage; execution), M&A, ECM, DCM, Rating advisory
c. Support Functions:Legal, compliance, credit risk, market risk, operations, finance
3. Private Bank
4. Asset Management
Securities Brokers and Dealers
Securities Brokers
- Full service brokers offer cliende research and investment advice but usually charge a higher commission on trades (Merrill Lynch)
- Discount Brokers provide facilities to buy/sell securities but offer no advice (Charles Schwab)
Securities Dealers
- Hold inventories of securities on their own account
- Provide liquidity to the marker by standing by, ready to buy/sell securities (Market Maker)
Investment Banks
- Investment Banks were essentially created in the US by the passage of the Glass-Steagall Act (1933). Prior to this, investment banking activities were part
of large, money-center commercial banks
- The lines between investment banks and commercial banks again begins to blur as legal separation between investment banks and commercial banks is
no longer required
- Following the City-Travelers merger in 1998, the Gramm-Leach-Bliley Act (1999) effectively repealed Glass-Steagall
Basic Framework for Banking and Securities
Global Banks
1. Universal Banking : banks can provide a full range of financial services (including insurance, securities, real estate) under same legal entity
2. Financial Supermarkets (Financial Holding Companies [FHC] and Bank Holding Company [BHC])
a. Banks can provide a full range of financial services (including insurance, securities, real estate) but each different activity must be carried out
under a different legal entity
3. Legal Separation : Banks are prohibited from engaging in securities activities and other financial services such as insurance
Current Issue: Should Glass-Steagall be reinstated? Pros and cons of narrow banking
Pro Con
- Protect depositors - Restricts financial innovation
- Simplify regulation of depository institution - Limits profit opportunity and competition
- More transparency for depository institution customers - Banks will find loopholes just like in the past
- Lessens systematic risk
Products and Services of Investment Banks
Advisory Underwriting Securities Broker/Dealer
- Provide strategic advice to - Debt and Equity
firms
M&A : Mergers and acquisition Origination ECM : Equity capital market Selling
- Primary Market
Capital Raising Syndications DCM : Debt capital market Trading
Trading: Client vs Risk-driven Revenues
1. Flow trading → Client-driven revenues = fees and commissions, markups and spears as measures through sales and production credits
2. Prop trading → Risk-driven revenues = dedicated proprietary trading that is delinked from customer business and substantial residual revenue between
sales and production credit
- For most players, capital markets are primarily a client business, not a proprietary trading business → client franchise building and delivery are crucial
- The “Volcker Rule” (part of Dodd-Frank Act) prohibits “prop” trading in banks in the US but is in the process of being repelled
Chinese Walls and Information Barriers
- Separates private and public - Prevents price sensitive info leaking and prevent insider trading - People of the wall → the boss
Clients Bankers Trading
Corporate finance execution group Sales
Derivative
M&A → has the most price sensitive info Risk Management
ECM Credit
DCM Research
Derivatives
,Actors in Investment Banks
1. Relationship Banker
a. Gatekeeper between clients and product specialist
b. Needs to know opportunities → must understand the client very well → keep up with the new
c. Building relationship
d. Be extroverted, have soft skill, handle rejection well
2. Product Specialist
a. Gatekeeper between banker and sales team/traders/risk management/credit
b. Really good in the product → need to be able to price the product → know everything about the product
c. Compete with each other for the banker
d. Deal dynamics: is in both the sell side and the Buy side
Investment Banks Commercial banks
- M&A - Debt capital Markets
- Equity Capital Markets - Securitization (ABS, MBS)
- Debt capital Markets - Derivatives
- Securitization (ABS, MBS) - FX and MM
- Derivatives - Syndicated Loans and Asset Sales
- FX and MM - Project and Structured Finance
- Syndicated Loans and Asset Sales - Cash Management
- Project and Structures Finance - Trade Finance
Deal Dynamics at CA-CIB
Issuers Corporations, Financial Institutions, Sovereigns, Supranationals, Agencies
CA-CIB Coverage Teams Corporate Coverage, FInancial Institutions Group, Structured Finance (SFI), Investment Banking, Caisses regionales,
Baking afficialtes of CASA, etc.
Debt Capital Market Focused on the origination and execution of new bond issues
Bond Syndicate Part of the credits and rates division of FIM
CA-CIB Sales CA-CIB’s global sales force
Investors Insurance companies, mutual funds, pension funds, hedge fins, asset managers, private banks
The Roles of Actors in Deal Development
Bankers Origination Underwriting Sales
- Where the deal is put
together
Coverage teams Debt Capital Markets Syndicate Sales
- Take the deal to the market
Liaise with corporations, financial Works alongside the coverage teams Execute bond transactions originated Liaise with variety of institutional
institutions and public sector entities and diretiry with the banks customers by DCM, acting as the liaison investor in the context of selling
- Lending products and other to between DCM and sales. bonds, both primary issues (for DCM)
bank products - Originates debt capital and secondary flows (for Trading)
- Capital market products market trades Provide regular market color and
- Interest rate and currency - Pitch new issues feedback to DCM Regularly reflect investor sentiment to
swaps - Develop new ideas (eg. syndicate
- Treasury Products and liability management) Provide pricing for new issues at pitch
cash management - Promote out DCM track stare and during execution
- M&A advisory record and capabilities
- Win Mandates
- Structure new issues that
are aligned with investors
needs
3. Corporate Finance and IB
Corporate FInance Execution (CFE) Head
Geographical Team A Geographical Team B Geographical Team C
- 1 Director - 1 Director - 1 Director
- 1-2 VP - 1-2 VP - 1-2 VP
- Associates - Associates - Associates
- Analysts - Analysts - Analysts
,Number Crunching
- Credit/financial analysis and the use of financial ratios
- Forecasting cash flows, pro-forma financial statements and financial modeling
- Capital budgeting and project evaluation
- MarKet Valuation
- CAPM
Pitch Books
- Deal structure and Pricing
- Rationale for the dea
- Deal structure
- Pricing Information
- Impact of deal on companies financial structure
- Proposed placement strategy and market impact
- Consensus of analyst
- Shareholder analysis
- Comps:
- Industry comparisons: financial ratios, market cap and stock prices, industry reports
- Deal comparisons: pricing, after issue performance
Executive Summary
League table
- For marketing purposes
- For internal purposes
- For performance evaluation
4. Sales
a. Mirror image of a banker → provides incentive for customers by doing research
b. Spending all day talking to clients
c. Gets price for traders but they need a profit for them
d. Need to be able to handle rejection and have soft skills
5. Trading
a. Gives prices and takes to product specialists and sales or pricing purposes
b. Makes deal with market counterparties
c. Extremely disciplines
6. Research
a. Publishes opinions
7. Other Key Players : Research, Credit, Risk Management, ALCO
, CHAPTER 7
Definition of Insurance
- Insurance provides indemnification against loss or liability from specified events and circumstances which may occur or be discovered during a specific
period (FASB113)
- The essence of insurance if the transfer of risk from the insured to one or more insurers
- Insurance companies are financial intermediaries who collect premiums and invest them in securities and other financial assets
Insurance Policy: benefit provided by a particular kind of indemnity contract
Insurer: issued by one of several kids of legal entities
Policyholder or Insured: in which the insurer promises to pay on behalf of or to indemnify another party
Insurance premium: that protects the insured against loss caused by those perils subject to the indemnity in exchange for consideration
Fundamentals of Insurance → seven basic principles all insurance companies are subject to
1. There must be a relationship between the insured and the beneficiary
a. The beneficiary must be someone who would suffer if it weren't for the insurance
b. “Insurable Interest” : the right of the policyholder to effect insurance, arising out of a certain relationship that may exist between the policyholder
and the subject matter insured.
c. Without insurable interest, insurance protection wortul dbe speculative in nature and not be enforceable under the law
2. The insured must provide full and accurate information to the insurance company
a. “Principle of Utmost Good Faith” : the insurer trust the policyholder to give precise and true details of the subject matter to be insured
3. The insured is not to profit as a result of insurance coverage
a. “Principle of Indemnity” : an insurance policy compensates the policyholder only to the extent of the value of the property which he has lost,
hence a policyholder should not expect to make any profit for the claim
4. If a third party compensates the insured for the loss, the insurance companies obligation is reduced by the amount of compensation
a. For policies to which indemnity applies, the purchase of several policies to cover the same subject matter will not result in the obtaining of claims
payments of several times the value of the subject matter. The insurers simply contribute to make up the amount payable as if only one policy
was issued
5. Large number of homogeneous exposure units
a. The insurance company must have a large number of insured so that the risk can be spread among many different policies
b. “Law of Large Number” : when many people are insured, the probability distribution of the losses will assume a normal probability distribution
which allows accurate predictions
6. Calculable loss: the loss must the quantifiable
a. For example : an oil company could not buy a policy on an unexplored oil field
7. The insurance company must be able to compute the probability of the loss occurring
Why get Insured?
- Premiums are likely to be more than the expected loss
- If there is no insurance, need to set aside reserves for losses, reserves cannot be invested long term as need to be immediately accessible in case of loss
(liquidity) → low return, worry that level or reserved may not be adequate to cover the loss
- Most people are risk-averse : they would rather pay a certainty equivalent (the insurance premium) than accept the gamble that they will lose their
house/car → insurance allows a peace of mind that a single event can have only a limited financial impact
- Trade-off : cost of premium vs. probability of occurrence and likely loss
Adverse Selection and Moral Hazard in Insurance
Adverse Selection Moral Hazard
- Which policies to accept - When the insured fails to take proper precautions (or takes on more
risk) to avoid losses because losses are covered by insurance policy
Solutions Solution
- Screening and fraud prevention investigations - Insurance companies use co-insurance, deductibles and restrictive
- Health insurance policies require a physical exam provisions to help control this problem
- Pre Existing condition may be excluded from the policy
A deductible is the amount of any loss that must be paid by the insure before the insurance company will be paying anything
How do insurance companies make profit?
Profit = earned premium + investment income - incurred loss - underwriting expenses
Insurers make money in two ways
1. Underwriting : the process by which insurers select the risk to insure and decide how much in premiums to charge for accepting those risks
a. An insurer's underwriting performance is measured in its combined ratio which is the ratio of losses and expenses to premiums. A combined
ratio <100% indicates underwriting profitability, which anything over 100 indicates an underwriting loss. A company with combined ratio over
100% may nevertheless be profitable due to investment earnings
2. Investing : the premiums they collect from insured parties
a. Insurance companies earn investment profits on “float”
b. Float : or available reserve is the amount of money, at hand at any given moment, that an insurer has collected in insurance premiums but has
not paid out on claims
Insurance Industry Organization
1. Distribution
a. Independent agents may sell the insurance products of a number of different insurance companies
b. Exclusive (captive) agents only sell the products of one company
c. Nowadays most insurance companies use multip[le distribution channels, including banks, professional organizations and market places
d. In the US, since 1999 other financial institutions have started competing directly with insurance companies to provide insurance services (eg.
Bancassurance)
2. Underwriting : reviews each policy prior to its acceptance to determine if the risk is acceptable
3. Claims
a. Claim adjuster : undertakes a thorough investigation of each claim, usually in close cooperation with the insured, determines if coverage is
available under the terms of the insurance contact, and if so, the reasonable monetary value of the claim and authorizes payment
Securities Funds and Investment Banking
Securities Industry
1. Corporate Finance
a. Assisting firms in raising capital and providing advice about M&A, corporate restructuring and Finance
b. Investment Banks → Primary Market
2. Brokerage and Market Making
a. Sale and trading of securities
b. Securities firms (Brokers and Dealers) → secondary market
Bank
1. Commercial bank
2. Investment Bank
a. Global markets: sales and trading (Equity; FICC; Derivatives), research
b. Investment Banking: Corporate finance (Coverage; execution), M&A, ECM, DCM, Rating advisory
c. Support Functions:Legal, compliance, credit risk, market risk, operations, finance
3. Private Bank
4. Asset Management
Securities Brokers and Dealers
Securities Brokers
- Full service brokers offer cliende research and investment advice but usually charge a higher commission on trades (Merrill Lynch)
- Discount Brokers provide facilities to buy/sell securities but offer no advice (Charles Schwab)
Securities Dealers
- Hold inventories of securities on their own account
- Provide liquidity to the marker by standing by, ready to buy/sell securities (Market Maker)
Investment Banks
- Investment Banks were essentially created in the US by the passage of the Glass-Steagall Act (1933). Prior to this, investment banking activities were part
of large, money-center commercial banks
- The lines between investment banks and commercial banks again begins to blur as legal separation between investment banks and commercial banks is
no longer required
- Following the City-Travelers merger in 1998, the Gramm-Leach-Bliley Act (1999) effectively repealed Glass-Steagall
Basic Framework for Banking and Securities
Global Banks
1. Universal Banking : banks can provide a full range of financial services (including insurance, securities, real estate) under same legal entity
2. Financial Supermarkets (Financial Holding Companies [FHC] and Bank Holding Company [BHC])
a. Banks can provide a full range of financial services (including insurance, securities, real estate) but each different activity must be carried out
under a different legal entity
3. Legal Separation : Banks are prohibited from engaging in securities activities and other financial services such as insurance
Current Issue: Should Glass-Steagall be reinstated? Pros and cons of narrow banking
Pro Con
- Protect depositors - Restricts financial innovation
- Simplify regulation of depository institution - Limits profit opportunity and competition
- More transparency for depository institution customers - Banks will find loopholes just like in the past
- Lessens systematic risk
Products and Services of Investment Banks
Advisory Underwriting Securities Broker/Dealer
- Provide strategic advice to - Debt and Equity
firms
M&A : Mergers and acquisition Origination ECM : Equity capital market Selling
- Primary Market
Capital Raising Syndications DCM : Debt capital market Trading
Trading: Client vs Risk-driven Revenues
1. Flow trading → Client-driven revenues = fees and commissions, markups and spears as measures through sales and production credits
2. Prop trading → Risk-driven revenues = dedicated proprietary trading that is delinked from customer business and substantial residual revenue between
sales and production credit
- For most players, capital markets are primarily a client business, not a proprietary trading business → client franchise building and delivery are crucial
- The “Volcker Rule” (part of Dodd-Frank Act) prohibits “prop” trading in banks in the US but is in the process of being repelled
Chinese Walls and Information Barriers
- Separates private and public - Prevents price sensitive info leaking and prevent insider trading - People of the wall → the boss
Clients Bankers Trading
Corporate finance execution group Sales
Derivative
M&A → has the most price sensitive info Risk Management
ECM Credit
DCM Research
Derivatives
,Actors in Investment Banks
1. Relationship Banker
a. Gatekeeper between clients and product specialist
b. Needs to know opportunities → must understand the client very well → keep up with the new
c. Building relationship
d. Be extroverted, have soft skill, handle rejection well
2. Product Specialist
a. Gatekeeper between banker and sales team/traders/risk management/credit
b. Really good in the product → need to be able to price the product → know everything about the product
c. Compete with each other for the banker
d. Deal dynamics: is in both the sell side and the Buy side
Investment Banks Commercial banks
- M&A - Debt capital Markets
- Equity Capital Markets - Securitization (ABS, MBS)
- Debt capital Markets - Derivatives
- Securitization (ABS, MBS) - FX and MM
- Derivatives - Syndicated Loans and Asset Sales
- FX and MM - Project and Structured Finance
- Syndicated Loans and Asset Sales - Cash Management
- Project and Structures Finance - Trade Finance
Deal Dynamics at CA-CIB
Issuers Corporations, Financial Institutions, Sovereigns, Supranationals, Agencies
CA-CIB Coverage Teams Corporate Coverage, FInancial Institutions Group, Structured Finance (SFI), Investment Banking, Caisses regionales,
Baking afficialtes of CASA, etc.
Debt Capital Market Focused on the origination and execution of new bond issues
Bond Syndicate Part of the credits and rates division of FIM
CA-CIB Sales CA-CIB’s global sales force
Investors Insurance companies, mutual funds, pension funds, hedge fins, asset managers, private banks
The Roles of Actors in Deal Development
Bankers Origination Underwriting Sales
- Where the deal is put
together
Coverage teams Debt Capital Markets Syndicate Sales
- Take the deal to the market
Liaise with corporations, financial Works alongside the coverage teams Execute bond transactions originated Liaise with variety of institutional
institutions and public sector entities and diretiry with the banks customers by DCM, acting as the liaison investor in the context of selling
- Lending products and other to between DCM and sales. bonds, both primary issues (for DCM)
bank products - Originates debt capital and secondary flows (for Trading)
- Capital market products market trades Provide regular market color and
- Interest rate and currency - Pitch new issues feedback to DCM Regularly reflect investor sentiment to
swaps - Develop new ideas (eg. syndicate
- Treasury Products and liability management) Provide pricing for new issues at pitch
cash management - Promote out DCM track stare and during execution
- M&A advisory record and capabilities
- Win Mandates
- Structure new issues that
are aligned with investors
needs
3. Corporate Finance and IB
Corporate FInance Execution (CFE) Head
Geographical Team A Geographical Team B Geographical Team C
- 1 Director - 1 Director - 1 Director
- 1-2 VP - 1-2 VP - 1-2 VP
- Associates - Associates - Associates
- Analysts - Analysts - Analysts
,Number Crunching
- Credit/financial analysis and the use of financial ratios
- Forecasting cash flows, pro-forma financial statements and financial modeling
- Capital budgeting and project evaluation
- MarKet Valuation
- CAPM
Pitch Books
- Deal structure and Pricing
- Rationale for the dea
- Deal structure
- Pricing Information
- Impact of deal on companies financial structure
- Proposed placement strategy and market impact
- Consensus of analyst
- Shareholder analysis
- Comps:
- Industry comparisons: financial ratios, market cap and stock prices, industry reports
- Deal comparisons: pricing, after issue performance
Executive Summary
League table
- For marketing purposes
- For internal purposes
- For performance evaluation
4. Sales
a. Mirror image of a banker → provides incentive for customers by doing research
b. Spending all day talking to clients
c. Gets price for traders but they need a profit for them
d. Need to be able to handle rejection and have soft skills
5. Trading
a. Gives prices and takes to product specialists and sales or pricing purposes
b. Makes deal with market counterparties
c. Extremely disciplines
6. Research
a. Publishes opinions
7. Other Key Players : Research, Credit, Risk Management, ALCO
, CHAPTER 7
Definition of Insurance
- Insurance provides indemnification against loss or liability from specified events and circumstances which may occur or be discovered during a specific
period (FASB113)
- The essence of insurance if the transfer of risk from the insured to one or more insurers
- Insurance companies are financial intermediaries who collect premiums and invest them in securities and other financial assets
Insurance Policy: benefit provided by a particular kind of indemnity contract
Insurer: issued by one of several kids of legal entities
Policyholder or Insured: in which the insurer promises to pay on behalf of or to indemnify another party
Insurance premium: that protects the insured against loss caused by those perils subject to the indemnity in exchange for consideration
Fundamentals of Insurance → seven basic principles all insurance companies are subject to
1. There must be a relationship between the insured and the beneficiary
a. The beneficiary must be someone who would suffer if it weren't for the insurance
b. “Insurable Interest” : the right of the policyholder to effect insurance, arising out of a certain relationship that may exist between the policyholder
and the subject matter insured.
c. Without insurable interest, insurance protection wortul dbe speculative in nature and not be enforceable under the law
2. The insured must provide full and accurate information to the insurance company
a. “Principle of Utmost Good Faith” : the insurer trust the policyholder to give precise and true details of the subject matter to be insured
3. The insured is not to profit as a result of insurance coverage
a. “Principle of Indemnity” : an insurance policy compensates the policyholder only to the extent of the value of the property which he has lost,
hence a policyholder should not expect to make any profit for the claim
4. If a third party compensates the insured for the loss, the insurance companies obligation is reduced by the amount of compensation
a. For policies to which indemnity applies, the purchase of several policies to cover the same subject matter will not result in the obtaining of claims
payments of several times the value of the subject matter. The insurers simply contribute to make up the amount payable as if only one policy
was issued
5. Large number of homogeneous exposure units
a. The insurance company must have a large number of insured so that the risk can be spread among many different policies
b. “Law of Large Number” : when many people are insured, the probability distribution of the losses will assume a normal probability distribution
which allows accurate predictions
6. Calculable loss: the loss must the quantifiable
a. For example : an oil company could not buy a policy on an unexplored oil field
7. The insurance company must be able to compute the probability of the loss occurring
Why get Insured?
- Premiums are likely to be more than the expected loss
- If there is no insurance, need to set aside reserves for losses, reserves cannot be invested long term as need to be immediately accessible in case of loss
(liquidity) → low return, worry that level or reserved may not be adequate to cover the loss
- Most people are risk-averse : they would rather pay a certainty equivalent (the insurance premium) than accept the gamble that they will lose their
house/car → insurance allows a peace of mind that a single event can have only a limited financial impact
- Trade-off : cost of premium vs. probability of occurrence and likely loss
Adverse Selection and Moral Hazard in Insurance
Adverse Selection Moral Hazard
- Which policies to accept - When the insured fails to take proper precautions (or takes on more
risk) to avoid losses because losses are covered by insurance policy
Solutions Solution
- Screening and fraud prevention investigations - Insurance companies use co-insurance, deductibles and restrictive
- Health insurance policies require a physical exam provisions to help control this problem
- Pre Existing condition may be excluded from the policy
A deductible is the amount of any loss that must be paid by the insure before the insurance company will be paying anything
How do insurance companies make profit?
Profit = earned premium + investment income - incurred loss - underwriting expenses
Insurers make money in two ways
1. Underwriting : the process by which insurers select the risk to insure and decide how much in premiums to charge for accepting those risks
a. An insurer's underwriting performance is measured in its combined ratio which is the ratio of losses and expenses to premiums. A combined
ratio <100% indicates underwriting profitability, which anything over 100 indicates an underwriting loss. A company with combined ratio over
100% may nevertheless be profitable due to investment earnings
2. Investing : the premiums they collect from insured parties
a. Insurance companies earn investment profits on “float”
b. Float : or available reserve is the amount of money, at hand at any given moment, that an insurer has collected in insurance premiums but has
not paid out on claims
Insurance Industry Organization
1. Distribution
a. Independent agents may sell the insurance products of a number of different insurance companies
b. Exclusive (captive) agents only sell the products of one company
c. Nowadays most insurance companies use multip[le distribution channels, including banks, professional organizations and market places
d. In the US, since 1999 other financial institutions have started competing directly with insurance companies to provide insurance services (eg.
Bancassurance)
2. Underwriting : reviews each policy prior to its acceptance to determine if the risk is acceptable
3. Claims
a. Claim adjuster : undertakes a thorough investigation of each claim, usually in close cooperation with the insured, determines if coverage is
available under the terms of the insurance contact, and if so, the reasonable monetary value of the claim and authorizes payment
