Download Investment Banking: A Comprehensive Q&A Guide and more Exams Business Economics in PDF only on Docsity!
Solution Manual For
Investment Banks, Hedge Funds, and Private Equity 4e By David P. Stowell and Paul Stowell
Chapter 1-
Chapter 1 – Overview of Investment Banking
Q1. Describe the three principal businesses of an investment bank. A. The investment banking business arranges financing and advises on M&A transactions. The sales and trading division sells and trades securities and other financial assets as an intermediary on behalf of institutional investing clients, and provides research to investing clients. The asset management division is responsible for managing money for individual and institutional investing clients. Q2. Investment banking clients can be categorized into two broad groups of issuers and investors. These two groups often have competing objectives (for example companies want to issue equity at the highest possible price vs. investors want to acquire stock in companies at lowest possible price). Who within the investment bank is responsible for balancing these competing interests? A. Capital Markets Group (CMG) bankers are the intermediaries between these two parties and are charged with balancing the needs of each. Q3. Explain the principal differences between a commercial bank and an investment bank. A. A traditional commercial bank offers checking and savings deposit accounts, lends the majority of the deposited funds to businesses and individuals, and profits from the difference between the interest earned on its loans and the lower interest it pays to depositors. By contrast, an investment bank primarily serves clients that have needs and aspirations best met through the securities markets or through mergers and acquisitions. While other entities become clients of investment banks at times, the primary client base consists of large companies and institutional investors. Q4. What is the role of Client Coverage Bankers in the Investment Banking Division? A. Bankers assigned to industry teams are required to become experts in their industry's dynamics and to understand the strategic and financing objectives of their assigned companies. They help CEOs and CFOs focus on strategic issues including how to enhance shareholder value and reduce corporate risk. Q5. A financing or M&A assignment usually results in a partnership between what two Investment Banking Division Groups? A. A financing or M&A assignment usually results in a partnership between client coverage bankers and product bankers to explain, recommend, and potentially execute a transaction for a corporate client.
Q6. Describe how Capital Markets bankers execute capital raising transactions and who do they partner with in the firm to complete these transactions? A. The capital markets bankers execute the capital raising by determining marketing strategy, timing, size, pricing, and other aspects of the transaction, in cooperation with sales professionals and traders in the Trading Division who assist the capital market teams in selling the securities to investors.
Q7. What are the two groups within the Capital Markets group and what are their respective responsibilities? A. Equity Capital Markets (ECM), which specializes in common stock issuance, convertible security issuance, equity derivatives, and share repurchases; and Debt Capital Markets (DCM) which focuses principally on debt financings for corporate and government clients, who are either investment grade and noninvestment grade issuers.
Q8. What are the four principal products of the M&A Group?
A. The principal products of the M&A Group include (1) “sell-side” assignments that involve advising on the sale or merger of an entire company or disposition of a division (or assets) of a company; (2) “buy-side” assignments that involve advising on the purchase of an entire company or a division (or assets) of a company; (3) restructurings or reorganizations that focus on either carving out businesses from a company to enhance shareholder value or dramatically changing a company's capital structure to either avoid bankruptcy or facilitate a sell-side transaction; and (4) hostile acquisition defense advisory services.
Q9. What are the principal activities of the Trading Division of an Investment Bank?
A. The Trading Division (also known as Sales and Trading or Global Markets) offers market access and execution in global stock and bond markets, provides liquidity by making markets, lends money to enable leveraged and other investments, lends securities to facilitate short selling, provides research and investment ideas, sets up meetings and conferences between investors and company management, and creates derivatives and structured products that enable investors to target more precisely the sources of risk and return to which they want exposure.
Q10. What are the two businesses withing the Trading Division and what are their respective product responsibilities? A. Fixed Income, Currencies, and Commodities (FICC) makes markets in and trades government bonds, corporate bonds, mortgage-related securities, asset-backed securities, currencies, and commodities, as well as derivatives related to all of these products. Equities makes markets in stocks, convertible securities, other equity-related products, and associated derivatives. The business also generates commissions from executing and clearing client transactions on global stock, options, and futures exchanges.
Q11. Describe the role of professionals in private wealth management.
A. Professionals in private wealth management act as advisors to individuals and families, helping them decide how to invest their funds. In some cases clients of
Q4. What is the role of states in the U.S. in regulating investment banks?
A. Only anti-fraud matters.
Q5. What type of U.S. securities offerings do not need to be registered with the SEC?
A. Private offerings to limited number of persons or institutions; offerings of limited size; intrastate offerings; securities of municipal, state and federal governments
Q6. What is a “Red Herring”?
A. A “Red Herring” is a preliminary registration statement that has been filed with the SEC and which carries a front-page statement (written with red ink) which cautions prospective investors that the SEC has not approved the registration and sales cannot be completed until a “final” registration statement is declared effective by the SEC and is delivered to investors. Red Herrings are provided by sales people to their prospective clients to educate, rather than to be used as a final sales document.
Q7. Before an SEC registration statement is declared effective, companies (or their underwriters) that sell stock or are deemed to be promoting the sale of stock have a securities law problem. What is this problem called and what are its consequences? A. Gun jumping. The company must withdraw the issuance until the SEC is satisfied that no fraud or manipulation has occurred. The company may also be required to pay a fine.
Q8. What are the “Risk Factors” in a prospectus? Why are they important to the issuer
and to the investor? A. Risk Factors are disclosures about potential problems the company may encounter, including possible losses, unpredictable revenue, capacity constraints, reliance on suppliers, technological change, competition, litigation regulation, customer mix, etc. i. Issuer: The issuer must list every reasonable risk in order to meet full disclosure requirements of securities laws and to therefore have a defense in case they are sued by shareholders if the company's share price drops.
ii. Investors: Investors should read these disclosures to ensure that they understand all relevant risks before making decisions regarding purchase of securities.
Q9. What is the significance of the Gramm-Leach-Bliley Act of 1999 in relation to the securities industry? A. The Gramm-Leach-Bliley Act, in essence, repealed the Glass Steagall Act of 1933 and allowed the creation of financial holding companies that could participate in both commercial and investment banking, a practice formerly separated by the Glass-Steagall Act. This act paved the way for conglomerate, multi-service providers such as Citigroup and JP Morgan and permitted the convergence of banking, insurance and securities businesses.
Q10. What were the two main arguments for rejoining investment banks and retail deposit-taking banks that led to the passing of the Gramm-Leach-Bliley Act? A. The first argument is that the rejoining of the two banking businesses provides for a more stable and countercyclical business model for these banks. The second argument is to allow US banks to better compete with international counterparts that were less encumbered by the Glass–Steagall Act.
Q11. What does the Dodd-Frank Act of 2010 mainly focus on?
A. This Act mainly focused on protecting consumers, ending “too big to fail” bailouts, improving coordination between various regulatory agencies, identifying systemic risk early, creating greater transparency for complex financial instruments and providing greater transparency for executive compensation.
Chapter 3 – Financings
Q1. What type of securities offerings do not need to be registered with the SEC?
A. 144A private placements to QIBs Q2. What is meant by an investment bank underwriting?
A. A capital markets financing is usually underwritten and/or “placed” by investment banks, meaning that the banks (1) engage in significant marketing and sales efforts (often including coordinating opportunities for corporate management to speak directly with investors), and (2) take on certain risks by purchasing securities from an issuer and reselling them to investors. Q3. What are league tables and why are league tables important in investment banking? A. Record of underwriting volume and M&A advisory volume. They keep score on which investment banks are completing the most and largest volume of transactions, giving them a marketing advantage in soliciting new business. Q4. Describe the function of the equity capital markets group, including the two major divisions they directly work with and the two types of clients they indirectly work with. A. They are an intermediary between the trading division and the investment banking division, providing information regarding the equity market, including pricing, structure and timing advice to corporate issuers of equity and convertible securities. Their indirect clients are corporations and, through equity sales colleagues, institutional and high net worth investors. Q5. Describe the unique process utilized by Google in its IPO, intended advantages and potential disadvantages. A. Google utilized a Dutch auction where the highest bid that allows a company to sell all the shares it wants to sell is the price at which all shares are sold. A complex software program was written to meet Google's requirements for total
A. An interview with the CEO was published during the quiet period preceding pricing of the company's IPO.
Q11. Provide seven reasons that an investment bank might give to support their advice
that a private company should “go public”.
A. The seven reasons include: i. Access to a vast, continuing source of capital ii. Liquidity and non-cash compensation for employees (give employees stock or options to incent existing employees and find new employees)
iii. Wealth creation – principals can sell their shares in a secondary offering
iv. Prestige
v. Create an acquisition currency vi. Increase confidence in suppliers and creditors vii. Liquidity for investors
Q12. List six characteristics of companies that are good targets for an equity issuance.
A. The characteristics include:
i. In favor sector, strong stock performance or supportive equity research ii. Large insider holdings or small float/illiquid trading iii. Overly leveraged capital structure iv. Strategic event: finance an acquisition or large capital expenditure
v. Sum of the parts analysis indicates hidden value vi. Need more investor focus based on a roadshow and additional research
Q13. Describe the key differences between convertible bonds and mandatory convertible securities. A. Convertible bonds are debt: they must be repaid in cash on the maturity date, unless the investor chooses otherwise. Therefore, they are treated identically to regular bonds by credit rating agencies and for a company's liquidity planning purposes. The stock price at which the value of the underlying common shares exceeds the face value of the bond is the “conversion price,” above which convertible holders participate alongside shareholders. Mandatory convertible securities are instruments that will automatically convert to common stock after a specified period of time, often 3 years, and therefore should be thought of as a substitute for issuing common stock. Similar to a common stockholder, the buyer of a mandatory typically has 100% exposure to the downside, but unlike the common stockholder, they have no exposure to the first 15%–25% of price appreciation and only 80%–85% exposure to further appreciation. In return for giving up the first 15%–25% of the upside and accepting reduced exposure above
that threshold, the mandatory holder receives cash payments for 3 years, which exceed common stockholder dividends in the upside of the common stock. Q14. What are some methods used by investment banks to help equity issuers mitigate price risk during the marketing process? A. Fully marketed (issuer bears share price risk), Accelerated offering (issuer bears less risk), and block trade (issuer bears no risk and investment banker absorbs principal risk).
Q15. Explain what a “green shoe” is.
A. Green shoe is the industry term for a 15% overallotment option: the name came from a company with this name that was the first user of this option. Overallotments are created to provide price support for stock in a new offering: the underwriter sells more shares in the offering than the issuer originally agrees to sell, creating a “short” position.
Q16. When a company has agreed to a green shoe, who does the underwriter buy shares from if the share price drops? Who do they buy shares from if the share price increases? A. If, after issuance, the share price drops, the underwriter can stabilize the price by buying stock from investors to cover the short. If the share price increases, the underwriter can buy up to 15% more shares at the offered price from the issuer to cover the short, utilizing the green shoe option.
Q17. Calculate the investment bank's fees and profit for a five million share equity offering at $40/share, with a 15% green shoe option (fully exercised) assuming a 2% gross spread, assuming the issuer's share price decreases to $38/share after the offering. A. Total fees and short profit of $3.5 million:
- Investment bank (IB) sells five million shares @ $40/share = $200 million in proceeds.
- IB shorts 750,000 shares at $40/share = $30 million in proceeds.
- IB buys back 750,000 shares at $38/share and pays $28.5 million to cover its short.
- $30 million - $28.5 million = $1.5 million in short-related profit.
- Fee of 2% on the $200 million issuance = $2 million
- Total fees and short profit of $3.5 million Q18. What is the tradeoff for having a stabilizing green shoe option in a common equity offering? A. Additional dilution from the extra shares
Chapter 4 – M&A
Q8. Assume an investment bank has provided a fairness opinion on a proposed M&A transaction. Does this mean the board should go ahead and approve the transaction?
A. Maybe. The fairness opinion only states that the deal is “fair from a financial point of view”. It does not review the deal on the merits of its strategic rationale.
Q9. Why might a board want to include a “go-shop” provision in the merger/purchase
agreement? A. It helps protect the board against shareholder lawsuits relating to Revlon Duties.
Q10. When is a break-up fee paid? What is the normal fee as a percent of equity value?
A. A break-up fee is paid if an M&A transaction is not completed because a target company walks away from the transaction after a merger or sale agreement is signed. The fee is usually set at 2–4% of the target company's equity value.
Q11. Under what circumstances would an investment bank hold a public auction in an attempt to help sell a company? A. When the company to be sold is unlikely to be damaged or disrupted by the public process, and the investment bank expects difficulty in finding a buyer without a public auction. This process is designed to obtain the highest offer.
Q12. List the four principal alternative methods for establishing value in an M&A transaction. A. Discounted cash flow analysis; publicly-traded comparable company analysis; comparable transaction analysis; leveraged buyout analysis
Q13. Of the major valuation methods which one(s) are based on relative values? …on
intrinsic values? …on ability to pay?
A. Relative: comparable company/transaction; intrinsic: DCF; ability to pay: LBO
Q14. Suppose you are the sell-side advisor for a multinational household and personal products manufacturer and marketer that sells primarily to the mass consumer markets. The analyst on your deal team prepares the following comparable companies analysis. Which, if any, of the companies in the list would you potentially remove from the analysis?
Comparable Companies Analysis $ in billions
Location Market Cap
Enterprise Value (EV)
LTM Revenue
LTM EBITDA
LTM EBITDA Margin
EV / Revenue
EV / EBITDA Alberto Culver Co. U.S. $2.4 $2.3 $1.5 $0.2 11.2% 1.5x 13.1x Beiersdorf AG Germany $15.9 $15.1 $8.0 $1.2 14.6% 1.9x 12.9x Chattem Inc. U.S. $1.4 $1.7 $0.4 $0.1 29.4% 4.4x 15.1x Church & Dwight Co. U.S. $3.9 $4.2 $2.1 $0.3 15.6% 2.0x 12.7x Colgate-Palmolive Co. U.S. $42.8 $41.9 $13.4 $2.9 21.8% 3.1x 14.4x Henkel KGaA Nvtg Prf Germany $21.6 $26.2 $19.3 $2.5 13.0% 1.4x 10.5x McBride PLC U.K. $0.3 $0.9 $1.2 $0.1 8.7% 0.8x 9.2x Prestige Brands Holdings Inc. U.S. $0.4 $1.0 $0.3 $0.1 31.5% 3.0x 9.6x Procter & Gamble Co. U.S. $232.2 $268.1 $77.9 $18.9 24.3% 3.4x 14.2x Reckitt Benckiser Group PLC U.K $38.1 $41.3 $10.3 $2.7 26.1% 4.0x 15.4x
A. P&G may be too big; Prestige may be too small; McBride only sells in Europe (and may be too small) Q15. Which valuation method tends to show the lowest valuation range? Why?
A. Comparable companies – no control premium. DCF w/no synergies can also be low Q16. Which of the following companies would make a better LBO target, and why? (a) a diversified manufacturer of consumer snack products or (b) a manufacturer of factory automation equipment for car makers, agricultural equipment and other heavy machinery.
A. (a) – more stable cash flows; lower capital expenditures.
Chapter 5 – Trading
Q1. How does the Trading Division serve institutional investors? A. The sales and trading division serves institutional investors by providing analysis and ideas, facilitating market access and execution, financing client positions, and providing liquidity through “market making” activities at the bank's risk.
Q2. How do professionals in sales, trading and research work together?
A. Research provides investment ideas to sales, who contacts the bank's investing clients with specific trade ideas based on research's recommendations. Should the client decide to go ahead with the trade, sales works with traders to execute the trade. Q3. Describe what Prime Brokerage is, including four principal products in this area and the generic name of the financial institutions that are targeted for this business. A. Prime Brokerage is a Trading Division business area that focuses on hedge funds and provides the following products: lending and clearing securities; margin loans; securities trading; securities processing and clearing; global securities custody and trust services; cash management and asset administration.
Q4. Explain traders' market-making function.
A. In its market making role the bank acts as a risk-taking principal, seeking to buy securities from institutional investors and at some point (perhaps minutes, hours, or weeks later), seeking to resell those securities to other investors. From a customer's perspective, the bank stands ready at any time to quote a bid price and an offer price at which the investor may sell or buy a specified amount of a security or derivative. Q5. Why would a prospective issuer prefer to hire as underwriter an investment bank that has traders already active in its security?
A. A credit default swap (CDS) is a contract between two counterparties whereby one party makes an upfront payment and periodic payments in return for receiving a payoff if an underlying security or loan defaults. Q12. Describe margin financing. A. When an investor borrows money to purchase securities and the securities (or other agreed-on assets) are posted as collateral, an investor is buying on margin. Investment banks arrange margin accounts for their investing clients when investors want to leverage their investments. Q 13. What do equity traders trade? A. Equity traders trade common shares, derivatives on common shares or equity indexes (options, swaps, forwards and futures), convertible securities, and exchange-traded funds (ETFs).
Chapter 6 – Asset Management, Wealth Management,
and Research
Q1. What is the difference between asset management and wealth management? A. AM provides fund investment services to individuals, families and institutional investors. Assets are managed on a fund level. WM provides specialized services to meet the wealth planning, investing and financial management needs of wealthy individuals, families and institutional investors, and has a more holistic view of each client's needs. For example, a wealth manager may place a portion of a client's assets in a fund within AM or help them invest in individual stocks or bonds. Wealth managers focus more on asset allocation for investing clients, whereas asset managers manage funds.
Q2. Why would a wealth manager choose to allocate some of a client's asset to another bank?
A. The funds offered by the other bank's AM division may better fit the client's risk/return objectives. Q3. Describe Regulation FD
A. FD stands for fair disclosure. This regulation prohibits a company's executives from selectively disclosing material information that could impact a company's share price. This means that prior to discussing any potential stock-moving information with research analysts, the company must disclose this information in a publicly available medium, such as a press release, Website posting, or SEC filing. The benefit of this regulation is that it levels the playing field, enabling all investors to receive the same information at the same time. Q4. What conflicts might exist as a result of having both an Asset Management business and a Private Wealth Management business at the same firm?
A. PW advisors may be encouraged to invest client assets in funds managed by the AM division, even when it's not in the best interest of the client
Q5. What drove the need to separate research and investment banking?
A. Conflict of interest – Investment banking, a much larger revenue area, was pressing research to alter its investment opinions to help banking secure M&A and financing mandates. This was a conflict since investors looked to research to provide unbiased opinions. Q6. How have the U.S. enforcement actions against sell-side research in 2003 heightened the issue of declining research revenues? A. M&A and financing revenues historically helped to justify costs of maintaining a large research department. Now that the investment banking side is separated from research and can't “count on” research to help in its origination efforts, it is harder to justify the high fixed cost of maintaining a research department, relative to declining commissions. Q7. Which clients receive investment banking research and what does the research principally cover? A. Research is provided by all large investment banking firms to institutional and select individual investors on a global basis. This research primarily covers equity, fixed income, currency, and commodity markets. A smaller number of research professionals focus on broader issues including economics, portfolio strategy, and derivatives, offering insights and ideas based on fundamental and technical research. Q8. What advisory role do wealth management advisors perform for investing clients? A. Wealth management advisors help investors define their risk tolerance and diversification preferences, then use this information to recommend allocations to different asset classes.Within each asset class, wealth managers recommend particular mutual funds or other investment vehicles that they feel are suitable for their clients. Some wealth management advisors will also recommend individual stocks and bonds for clients to consider, while others advise their clients to use broad-based ETFs, mutual funds, or other products as they view individual security selection as the role of asset managers.
Chapter 7 – Credit Rating Agencies, Exchanges and
Clearing and Settlement
Q1. Compare the different roles provided to the investor community by credit rating analysts and sell-side research analysts. A. Credit rating analysts help investors assess the credit risk of their investment in debt-related securities. Sell-side analysts have a dual-role, to assess security valuations and generate compelling investment ideas for investing clients that ultimately should generate trading revenues for the sales and trading division.
metaphor of dark pools draws a contrast to “lit” exchanges on which bid and offer prices and quantities are publicly available. While bids and offers are not shown on dark pools, trades on dark pools are reported instantly to the public tape, just as with exchange-based trading.
Chapter 8 – International Banking
Q1. What is meant by Euromarkets and Eurobonds? A. Euromarkets is the generic term used in international capital markets for securities issued and held outside the issuer's country of origin. Bonds that trade in this market are called Eurobonds. Euromarkets help facilitate cross-border financings by corporations. Q2. What is an American Depository Receipt (ADR)? A. An ADR represents US investor ownership of non-US company shares. The issuer deposits common shares with a custodian (a “depositary,” generally an affiliate of large global banks), which then issues listed equity securities backed by those common shares. ADRs are priced in US dollars and pay dividends in US dollars, with the depositary converting any non-USD dividend paid on the common shares (“ordinaries”) into USD by conducting an FX transaction.
Q3. How has recent legislation accelerated the development of the Japanese M&A market? A. Japanese legislators have passed laws permitting foreign companies to use their own stock to acquire Japanese companies, and lowered the threshold shareholder approval requirement for an acquisition.
Q4. How has the Chinese government's relaxation of its foreign exchange controls helped facilitate growth in the Chinese economy? A. Current account renminbi (RMB) became convertible into other currencies. Additionally, the creation of the Qualified Financial Institutional Investor (QFII) program allowed qualifying foreign investors to participate in the Chinese equity market via historically domestic-only A-shares and also in the Chinese debt market. Q5. In a comparable transactions analysis, what additional considerations might an investment banker factor in when valuing an emerging market company? A.Unique country characteristics/risks; significant events in the country that would affect valuations (major political, economic, regulatory changes) Q6. Suppose you are a wealth advisor and a client has asked for your recommendation on which of the BRIC countries poses the least risk and most opportunity for investment growth. Briefly compare the perceived risks and benefits of each of the countries and provide support for your selection.
A.Open-ended question. Students should look at issues such as corporate governance standards, history of government intervention in capital markets, transparency, accounting standards, diversification of economy (i.e. Brazil and Russia have commodity-dominant economies), etc.
Chapter 9 – Convertible Securities and Wall Street
Innovation
Q1. After an initial hedge is in place, what do hedge fund investors in convertible bonds do with shares of the underlying stock when the stock price increases or decreases? A. When delta hedging, hedge fund investors in convertible bonds short more shares of the underlying stock when the stock price increases, and buy shares when the stock price decreases. Q2. True or false (and explain your answer): Convertible arbitrage hedge funds invest in convertible bonds because the fund managers have a bullish view on the company's stock.
A. False: convertible arbitrage is a market neutral strategy that seeks to generate profits from trading in the underlying stock.
Q3. Assume Hedge Fund A purchases a portion of Company B's convertible and will execute a delta hedge strategy. Describe the steps Hedge Fund A will take in the event the price of Company B's shares fall, and explain the reasoning behind each action.
A. Hedge Fund A's hedge ratio will fall with the drop in share price. Hedge Fund A will buy shares on the open market, and deliver those shares to the parties who originally lent them shares. By covering these shares, Hedge Fund A now has a smaller short position, and has corrected its hedge ratio back to an appropriate level. Q4. If company A and B are identical in every respect except B has higher stock price volatility, which company would likely achieve better convertible pricing? Assuming convertibles issued by A and B have the same terms except for conversion price, would the company you selected above have a higher or lower conversion price?
A. Company B – the value of the embedded option would have greater value in a stock with higher volatility, which results in a convertible for Company B that would have either a higher conversion price or a lower coupon. Q5. WheelCo is raising $200 million via a mandatory convertible bond issuance. Assuming the company's share price on the date of issuance is $20 and the convertible bond carries a 25% conversion premium, what is the number of shares
an up-front EPS benefit compared to the company buying shares in the market, because in this case the EPS benefit would be realized over time. IBM was able to reduce their tax bill by approximately $2 billion by involving an overseas subsidiary in an ASR transaction.
Q10. Assume a company's ADTV is 240,000 shares. How many days would it take to complete a 10.8 million share repurchase program? The company has 120 million shares outstanding and its estimated EPS for the current fiscal year is $3.40. Assuming the company meets its earnings estimate, what would year-end EPS be under an ASR program for the full 10.8 million shares, assuming it is executed 20 business days before the company's fiscal year end? Under an open market repurchase program? A. 10 ,800,000/(240,000 x 0.25) = 180 days.
- ASR: 120 – 10.8 = 109.2 million shares. $3.40 * 120 million = $408 million in net income. $408/109.2 = $3.74 EPS
- Open market: 240,000 x 0.25 x 20 =1.2 million shares. 120 – 1.2 = 118. million shares. $408/118.8 = $3.43 EPS
Chapter 10 – Investment Banking Careers,
Opportunities, and Issues
Q1. What are core differences between Investment Banking and Sales & Trading career paths? A. IB typically involves longer working hours than Sales & Trading, but often slightly higher compensation. Sales & Trading analysts may see quicker promotions, and later in their careers compensation can be higher in trading divisions. Q2. Describe the main products of the prime brokerage area. A. Hedge funds are the principal clients of the prime brokerage business. The main products of the prime brokerage area are securities lending and portfolio margin loans with careful collateral mechanisms. This group also coordinates securities clearing and provides custody and reporting services. In addition to facilitating trades in stocks, bonds, and convertibles through lending activities, the group also focuses on foreign exchange, precious metals, and derivatives prime brokerage activities. Q3. Describe the benefits and risks of mortgage securitization. A. Benefits include:
- Banks that originate mortgages can shed risk and add liquidity by selling pools of mortgages. 2. By creating a market for previously illiquid mortgages, securitization offers more efficient pricing of mortgages, which lowers interest rates for borrowers and contributes to greater home ownership. 3. Pooling
mortgages into different tranches allows for investment by agents with significantly varied risk tolerances. Risks include:
- Mortgage securitization creates an agent-principal problem as lenders who originate mortgages and then immediately pool and sell these mortgages to institutional investors have no incentive to adhere to strict mortgage underwriting standards. 2. Massive amounts of subprime mortgages bundled into mortgage securities was one of the main causes of the 2007- financial crisis. Q4. Describe a Credit Default Swap. What are regulators trying to do to mitigate risk in the CDS market? A. A CDS is a financial instrument used to either hedge against borrower default on a loan or bond obligation, or to speculate on the credit of the issuer of a bond or loan. Regulators are pushing to put most CDS activity on commodities exchanges in order to reduce counterparty credit risk. Q5. Describe the risks associated with bridge loans extended by Investment Banks
A. Bridge loans are meant to be short-term loans, but in the event of a credit crisis investment banks that have extended bridge loans to large clients may find themselves funding long-term loans which can tie up bank capital needed elsewhere in the bank, and which require capital charges. Q6. Discuss how CDS can be used for hedging and speculative purposes. A. Debt investors buy CDS contracts as protection against credit default. Speculators can gain economic exposure to a company's credit without actually holding any debt securities from that company by buying/selling CDS contracts. Q7. Describe the areas that fixed income sales focuses on. A. Fixed-income sales is divided into the following areas: (a) investment grade corporate bonds, (b) high yield corporate bonds, (c) securitized products, (d) distressed debt, (e) bank loans, (f) U.S. and other sovereign securities, (g) emerging market bonds and loans, (h) municipal securities, (i) preferred stock and commercial paper, (j) money market instruments, (k) foreign exchange, and (l) commodities. Q8. Explain what Basel III is. A. Basel III focuses on risk-based capital and leverage requirements, liquidity stress tests, single counterparty credit limits to cut credit exposure of a covered financial firm to a single counterparty as a percentage of the firm's regulatory capital, reducing credit exposure between the largest financial companies, implementing early remediation requirements to ensure that financial weaknesses are addressed in a timely way, compensation, and capital raising or asset sales. Basel III is intended to strengthen bank capital requirements by increasing bank liquidity and decreasing bank leverage.
Chapter 11 – Overview of Hedge Funds
