Investment Banking Services cont’d How IBFs facilitate new stock offerings corporation and investors Origination IBFs evaluate the corporation’s financial condition to determine th
Trang 1Chapter 24
Securities Operations
Trang 2Chapter Outline
Investment banking services
Brokerage services
Sources of income
Regulation of securities firms
Risks of securities firms
Valuation of a securities firm
Interaction with other financial institutions
Participation in financial markets
Globalization of securities firms
Trang 3Investment Banking Services
One of the main functions of investment banking firms (IBFs) is raising capital for corporations
IBFs originate, structure, and place securities in the capital markets
They serve as an intermediary rather than a lender or investor
Their compensation is typically in the form of fees
Trang 4Investment Banking Services
(cont’d)
How IBFs facilitate new stock offerings
corporation and investors
Origination
IBFs evaluate the corporation’s financial condition to determine the appropriate stock price
Trang 5Investment Banking Services
(cont’d)
How IBFs facilitate new stock offerings (cont’d)
Origination (cont’d)
The issuing corporation registers with the SEC
The registration statement is intended to ensure that
accurate information is disclosed by the issuing corporation
Included in the registration information is the prospectus,
disclosing relevant financial data on the firm and provision applicable to the security
The IBF and the issuing firm may engage in a road show to meet with institutional investors
Trang 6Investment Banking Services
(cont’d)
How IBFs facilitate new stock offerings (cont’d)
other IBFs to underwrite a portion of the stock
In a best-efforts agreement, the IBF does not guarantee a
price to the issuing corporation
Trang 7Investment Banking Services
The issue is advertised to the public
Some IBFs have brokerage subsidiaries that can sell stock
on a retail level
The corporation incurs two types of flotation costs:
Fees paid to the underwriters
accounting expenses
Trang 8Investment Banking Services
IBFs may be able to place an entire offering with a small set
of institutional investors
Rule 144A allows firms to engage in private placement without the registration statement
The issuing firm’s costs are lower
Trang 9Investment Banking Services
(cont’d)
How IBFs facilitate new bond offerings
Origination
on existing debt levels
The coupon rate, maturity, and other provisions are decided
The asking price on the bonds will be determined by evaluating market prices of existing bonds
Issuers of bonds must register with the SEC and a registration statement must be filed
Trang 10Investment Banking Services
IBFs provide several services to the issuer
Underwriting spreads on newly issued bonds are normally lower than on newly issued stock
The IBF may organize an underwriting syndicate to participate in placing the bonds
Distribution of bonds
A prospectus is distributed to all potential purchasers
The issue is advertised to the public
The asking price is normally set to ensure a sale of the entire issue
Flotation costs range from 0.5 to 3 percent of the value of the bonds
Trang 11Investment Banking Services
In a private placement, the issuing corporation sells the
issue to a purchaser of the entire issue
Avoids underwriting fees
stocks
Trang 12Investment Banking Services
(cont’d)
IBFs assess the market value of the firm
IBFs arrange financing, which involves raising funds and
purchasing any common stock outstanding that is held by the public
IBFs may be retained in an advisory capacity
IBFs may purchase a portion of the firm’s assets to provide
financial support
Exposes the IBF to a high degree of risk
Merrill Lynch has designed a mutual fund that finances LBOs
Purchase junk bonds of firms that went private
Provides bridge loans that offer temporary financing to firms until
junk bonds can be issued
Trang 13Investment Banking Services
(cont’d)
How IBFs facilitate arbitrage
Arbitrage activity involves the purchasing of
undervalued shares and the resale of those shares for a higher profit
Arbitrage firms search for undervalued firms and
IBFs raise funds for these firms
Asset stripping involves acquiring the firm and
selling its individual divisions off
The sum of the parts is greater than the whole
Trang 14Investment Banking Services
(cont’d)
How IBFs facilitate arbitrage (cont’d)
IBFs generate fee income from advising arbitrage firms and
receive a commission on the bonds issued to support the
arbitrage activity
IBFs receive fees from divestitures of divisions
IBFs may provide bridge loans if additional financing is needed
IBFs may provide advise on defense takeover tactics and
finance takeovers
Some arbitrage firms take positions in hostile takeover targets
to benefit from the expected takeover by another group
Some attempts at arbitrage fail because target firms are successful
at defending against a takeover
Trang 15Investment Banking Services
(cont’d)
How IBFs facilitate arbitrage (cont’d)
History of arbitrage activity
targets with the expectation that targets will buy back the shares at a premium
Arbitrage activity has been criticized because:
It often results in excessive financial leverage and risk for corporations
The restructuring of divisions after acquisitions results in
Trang 16Investment Banking Services
(cont’d)
How IBFs facilitate corporate restructuring
IBFs assess potential synergies that might result from the combination of two businesses
The sum of the whole is greater than the sum of the parts
IBFs may suggest a carve-out in which the firm sells a unit
of the firm to new shareholders through an IPO by the unit
The sum of the parts is greater than the sum of the whole
The unit may also be spun off, where new shares of the unit are created and distributed to existing shareholders
Trang 17Investment Banking Services
(cont’d)
How IBFs facilitate corporate restructuring
(cont’d)
IBFs are critical in the valuation of the business
IBFs have loaned out their funds to companies involved in mergers and acquisitions or even provided equity financing
The IBF can help finance an acquisition by:
Providing loans to the acquirer
Underwriting bonds or stock for the acquirer
Investing their own equity in the acquirer’s purchase of the target
Trang 18Brokerage Services
Market orders are requests by customers to purchase
or sell securities at the market price existing when the order reaches the exchange floor
Limit orders are requests by customers to purchase or
sell securities at a specified price or better
Specialists monitor limit orders and execute transactions in
accordance with the limits specified
If investors order a sale of securities when the price reaches a
specified minimum, it is a stop-loss order
Trang 19Brokerage Services (cont’d)
Short selling involves the sale of securities investors do
Full-service brokerage firms provide information and advice
as well as executing transactions
Discount brokerage firms only execute transactions upon
requests and do not provide advice
The required minimum opening balance is typically between $1000 and $3,000
Most discount brokers offer some degree of research on a website
Trang 20Brokerage Services (cont’d)
Online orders
reduced costs of brokerage firms
Prices charged are low, typically $25 or less for 100 shares
of stock
Trang 21Sources of Income
Investment Banking Services
Underwriting Fees from underwriting stock or bond offerings
Advising Fees for advice to firms about identifying potential
targets, valuing targets, identifying potential acquirers, protecting against takeover
Restructuring Fees for facilitating mergers, divestitures, carve-outs,
spin-offs
Brokerage services
Management fees Fees for managing securities portfolios
Trading commissions Fees for executing trades securities requested by
individual or firms in the secondary market Margin interest Interest charged to investors who buy securities on
margin
Investing its own funds
Trang 22Sources of Income (cont’d)
The proportion of income derived from each source varies
among securities firms in any particular year
e.g., when IPOs are hot, income from underwriting fees will be high
therefore generate a high proportion of income from
underwriting and advising fees
e.g., Goldman Sachs
proportion of income from trading commissions
e.g., Charles Schwab
Many securities firms attempt to diversify their services so that they can capitalize on economies of scope
Trang 23Sources of Income (cont’d)
Impact of the September 11 Crisis on revenue sources
declined
number of IPOs and secondary offerings
Trang 24Regulation of Securities Firms
Securities firms are subject to a variety of
regulations
The SEC attempts to ensure that investors have access to financial information
The SEC has power to ensure that
publicly-traded companies provide sufficient financial
information to existing or prospective investors
The SEC tends to establish general guidelines that can affect trading on security exchanges
Trang 25Regulation of Securities Firms
(cont’d)
prevent unfair or illegal practices, ensure orderly trading, and address customer complaints
regulation of exchange trading
Surveillance departments monitor trading patterns and behavior
by specialists or market makers and floor traders
Enforcement divisions investigate possible violations and can enforce disciplinary actions
Trang 26Regulation of Securities Firms
(cont’d)
The Fed determines margin requirements
The Securities Investor Protection Corporation (SIPC) offers insurance on cash and securities deposited at brokerage firms and can liquidate failing brokerage firms
premiums by the SIPC
The insurance limit is $500,000, including $100,000 against claims on cash
The SIPC has a $500 million revolving line of credit and can borrow up to $1 billion from the SEC
Trang 27Regulation of Securities Firms
(cont’d)
Financial Services Modernization Act
The Act allowed banking, securities activities, and
insurance to be consolidated in a financial holding
company
The Act resulted in the creation of more financial
conglomerates that included securities firms
A primary benefit to securities firms is cross-listing
The bundling of financial services can generate more business for each type of financial institution that is part of the conglomerate
Trang 28Regulation of Securities Firms
(cont’d)
Regulation FD:
Requires that firms disclose any significant
information simultaneously to all market participants
Was partially intended to prevent a firm from leaking information to analysts
Prevented analysts working for securities firms to
have a competitive information advantage
Trang 29Regulation of Securities Firms
(cont’d)
Rules regarding analyst compensation and
ratings
they are more likely to hire a securities firm whose
analyst would rate the stock highly
2002 period was sometimes aligned with the new
business they brought in
Analysts were tempted to inflate the ratings of stocks and investors were misled
Trang 30Regulation of Securities Firms
(cont’d)
Rules regarding analyst compensation and
ratings (cont’d)
If a securities firm underwrites an IPO, it cannot use its analysts to promote the stock for the first 40 days after the IPO
Analyst compensation cannot be directly aligned with the amount of business that the analyst bring to the securities firm
Analysts cannot be supervised by the investment banking department within the securities firm
An analyst rating must divulge any recent investment banking business provided by the securities firm that assigned the rating
Trang 31Regulation of Securities Firms
(cont’d)
Rules preventing abuse in the IPO market
Some securities firms that served as underwriters allocated shares to corporate executives who were considering an IPO for their firm (spinning)
Some securities firms that served as underwriters encouraged institutional investors to place bids for the shares on the first day that are above the offer price in order
to be allowed to participate in the next IPO
fines
Trang 32Regulation of Securities Firms
(cont’d)
Specialists were sometimes able to jump ahead of other orders (called penny-jumping)
Prevented other investors from having their orders executed
In 2004, the SEC ruled that investors could circumvent the
trade-through rule to avoid penny-jumping by specialists
In 2003, some funds were allowing their large clients to buy or sell shares after the 4 p.m closing but at the 4 p.m prices (late trading at stale prices)
Violates 1968 SEC laws
The SEC imposed heavy fines on those mutual funds and is working on laws requiring more disclosure of the fees that mutual funds charge and better governance
Trang 33Risks of Securities Firms
When stock prices are rising there is a greater volume of stock offerings and secondary market transactions
Securities firms benefit from a bullish stock market
Some take equity positions in the stocks they underwrite
Some take a partial equity interest in target firms
Acquisitions tend to be more common in bullish markets
Interest rate risk
The market values of bonds held as investment by securities firms increase as interest rates decline
Lower interest rates can encourage investors to withdraw
Trang 34Risks of Securities Firms (cont’d)
Many securities firms have operations in foreign countries
Earnings remitted by foreign subsidiaries are reduced when the foreign currencies weaken against the parent firm’s home
currency
Market values of foreign investments decline as the currencies weaken against the parent firm’s home currency
Trang 35Valuation of a Securities Firm
The value of a securities firm is the present
value of its future cash flows
expected cash flows and the required rate of return:
Factors that affect cash flows:
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Trang 36Valuation of a Securities Firm
(cont’d)
Economic growth increases the level of income of firms and
households and can increase the demand for the firm’s services
The volume of brokerage activity increases
Business expansion increases
Debt securities are less likely to default
Equity securities should perform well
Change in the risk-free interest rate
The valuation of a securities firm is inversely related to interest rate movements
Assets are adversely affected by rising interest rates
Trang 37Valuation of a Securities Firm
(cont’d)
Affected by regulations, technology, and competition
expected cash flows
Managers can attempt to make decisions that will capitalize on external forces the firm cannot control
Securities firms need skillful management to create new
financial services that may complement the brokerage services they already offer
Trang 38Valuation of a Securities Firm
(cont’d)
Factors that affect the required rate of return by
investors:
The risk-free rate is positively related to inflation, economic
growth, and the budget deficit level, but inversely related to
money supply growth
The risk premium is inversely related to economic growth and the company’s management skills
Regulatory constraints may discourage firms from taking
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Trang 39Type of Financial
Commercial banks
and SIs
Compete with commercial banks and SIs for brokerage services
Compete with commercial banks offering advice on M&As and underwriting commercial paper
Mutual funds Execute trades for mutual funds
Some mutual funds are organized by securities firms
Mutual funds purchase newly issued securities Insurance companies Advise portfolio managers of insurance companies on trades
Execute securities transactions for insurance companies
Advise portfolio managers on hedging interest rate and market risk
Underwrite stocks and bonds purchased by insurance companies
Compete with insurance companies in the sales of mutual funds
Obtain financing on LBOs from insurance companies
Have acquired or merged with insurance companies
Interaction with Other Financial Institutions