NAVIGATING THE MAZE:
GETTING AHEAD IN BANKING AND FINANCIAL SERVICES
FL NTM Title page_A4.indd 1
06/08/2013 08:32
Published by Fitch Learning Publishing
4 Chiswell Street, London, EC1Y 4UP
www.fitchlearning.com
Edited by David Mignano and Caroline Herbert
Fourth edition
Copyright © Fitch7City Learning Limited 2015
(trading as Fitch Learning)
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Preface
Preface
Why have this manual?
Navigating the Maze is a guide aimed at those people looking to enter into banking and financial
services. The manual focuses on both the undergraduate and postgraduate entrants, as well as
those of you looking for a career change.
Many of you will gain initial experience as an intern. These internships are often just 8-10 week
interviews. Secure an internship at an investment bank and you have greatly increased your
chances of securing a job offer at the end of the process.
Internship training tends to be limited to three to five days. There will be a significant amount of
material passed onto the interns, not only during this time, but also across the 10 week internship.
There is a great deal to take in. This manual provides a very practical reference point to reinforce
the in-class and on-the-job learning.
The manual will act as an aid to ensure continuing learning throughout the internship and also
during the period between the end of the internship and the commencement of full-time
employment.
Is Navigating the Maze useful whichever part of the bank you go into?
Navigating the Maze is aimed at interns intending to get into or already working within banking.
At this level, much of the core subject matter is relevant across a number of divisions.
The manual will examine:
 Interview skills
 Your application and the process
 Technical skills
 Corporate banking
 Credit
 M&A
 Capital markets origination
 Asset management
 Private wealth
 Markets
 Technology and operations
 Preparing for work – turning your internship into a full-time offer
 Bloomberg skills
 Excel skills
Why is Navigating the Maze unique?
There are a number of generic publications in the market that will provide a myriad of interview tips
and advice on how to get a job.
This manual differentiates itself from the entire market as it is written by professionals who
have worked in the market, recruited in the market, and who, now being at Fitch Learning, will train
the new entrants once they have secured their dream job within banking.
The manual has brought together experience from banking professionals from the banking division,
sales and trading as well as experienced banking recruiters.
1
Preface
We want the reader of this manual to enter the recruitment process with their eyes wide open,
100% professionally prepared, and with a competitive advantage over the rest of the recruitment
population.
The start of your working career can be daunting and the language can be confusing so we’ve
prepared Navigating the Maze so you can hit the ground running and get ahead of your
competition.
The Navigating the Maze along with other components of the Complete Analyst series can now be
purchased online at www.thecompleteanalyst.com
2
About Fitch Learning
About Fitch Learning
Fitch Learning is a global provider of learning and development solutions for the financial services
industry. We train nine out of ten of each of the largest Investment Banks, Asset Managers and
Global Banks, delivering in-house, public and online training.
Fitch Learning operates worldwide with trainers based in Europe, the US and Asia. We have
trained in over 80 cities globally. Our public (open enrolment) courses are now offered in 16
locations across EMEA, US, Canada and Asia Pacific, and also delivering training in French and
Mandarin, as well as in English.
Fitch Learning has over thirty years of experience delivering high quality training which enhances
and hones the skills of experienced professionals. Our ability to consistently deliver this level and
quality of training is intrinsically linked to our dedicated trainers who train only for us.
In 2015, we offer over 250 courses as we continue expanding our course offerings, our locations
and our language capabilities to ensure we can respond to the needs of our clients.
3
About Fitch Learning
4
Contents
Contents
Preface ....................................................................................................................................................... 1
About Fitch Learning .................................................................................................................................. 3
Introduction ................................................................................................................................... 11
Navigating the Maze ................................................................................................................................. 11
Section 1: Your Application
Your Application............................................................................................................................ 15
Introduction ............................................................................................................................................... 15
What is banking?........................................................................................................................... 17
What do these divisions do?..................................................................................................................... 18
Interactions between IBD and markets .................................................................................................... 31
What to expect as an Analyst within a bank ............................................................................................. 33
What makes a complete Analyst? ............................................................................................................ 34
Preparing to apply ......................................................................................................................... 37
Preparing for the recruitment process ...................................................................................................... 37
1. Research the financial services industry .............................................................................................. 38
2. Attend recruitment events..................................................................................................................... 39
3. Build up your resume............................................................................................................................ 41
4. Decide what kind of role is right for you ............................................................................................... 42
5. Writing your resume or application ....................................................................................................... 43
6. The cover letter/motivational section .................................................................................................... 46
7. The first round interview ....................................................................................................................... 48
8. The day of the interview ....................................................................................................................... 49
9. During the interview .............................................................................................................................. 50
Answering behavioral/compentency-based questions ............................................................................. 51
The STAR interviewing technique ............................................................................................................ 52
So what’s your biggest weakness? .......................................................................................................... 53
Menuing .................................................................................................................................................... 53
Section 2: Your Interview
Your interview................................................................................................................................ 57
Introduction ............................................................................................................................................... 57
Providing color to your response .............................................................................................................. 57
Read the financial press ........................................................................................................................... 58
Read the research .................................................................................................................................... 58
Investment banking blogs ......................................................................................................................... 58
Accounting and Financial Analysis Q&A .................................................................................... 61
Introduction ............................................................................................................................................... 61
What are the key components of a set of financial statements? .............................................................. 64
What is meant by financial statement integration? ................................................................................... 67
Why do accounts show depreciation and amortization? .......................................................................... 68
How can D&A numbers be manipulated? ................................................................................................ 68
How does…impact the financials? ........................................................................................................... 70
How does depreciation affect the financial statements? .......................................................................... 70
How does an impairment write-down affect the financial statements? .................................................... 71
How does the purchase of an asset affect the financial statements? ...................................................... 71
What is the impact on the accounts of a company entering into a new lease of an asset? ..................... 72
How does a provision affect the financial statements? ............................................................................ 75
What is working capital? ........................................................................................................................... 77
What is net debt and how is it used? ........................................................................................................ 78
Does net debt capture all of a company’s debt? ...................................................................................... 79
Why is net debt ‘net’? ............................................................................................................................... 81
What does equity on the balance represent? ........................................................................................... 82
What is a minority interest? ...................................................................................................................... 83
What is the NOSH? .................................................................................................................................. 84
What is EBIT? ........................................................................................................................................... 84
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What is EBITDA? ...................................................................................................................................... 85
How and why would you normalize a metric? .......................................................................................... 86
What are pro-forma numbers? ................................................................................................................. 88
What does LTM mean? ............................................................................................................................ 88
What is EPS and how is it used? ............................................................................................................. 89
What is the difference between basic and diluted EPS?.......................................................................... 90
What is equity dilution?............................................................................................................................. 91
What is the treasury method?................................................................................................................... 92
Why is the cash flow statement so important? ......................................................................................... 93
How do you move from EBIT to operating cash flow? ............................................................................. 94
Why does profit not equate to cash flow? ................................................................................................ 96
How would you analyze a cash flow statement in five minutes?.............................................................. 97
What could a company do if it had excess cash on its balance sheet? ................................................... 98
What type of pension schemes do companies have? Why are they sometimes problematic? ............... 99
What is deferred tax? ............................................................................................................................. 100
Valuation Q&A ............................................................................................................................. 103
Introduction ............................................................................................................................................. 103
Why is valuation important? ................................................................................................................... 104
What are traditional valuation methodologies? ...................................................................................... 104
Valuation isn’t just about theories and models – what else should an Analyst consider when valuing a
company? ............................................................................................................................................... 106
What is the difference between buy and sell-side M&A? ....................................................................... 106
Which valuation techniques are likely to give the highest valuations? ................................................... 107
What is a valuation football field? ........................................................................................................... 108
What is market capitalization and how do you calculate it? ................................................................... 109
What is enterprise value? ....................................................................................................................... 109
Walk me through a discounted cash flow ............................................................................................... 110
What is free cash flow to firm? ............................................................................................................... 118
What is beta? .......................................................................................................................................... 119
Why and how would you de-lever a beta? ............................................................................................. 120
Walk me through a comparable company valuation .............................................................................. 122
What are the pros and cons of EV vs. Equity multiples? ....................................................................... 123
What are the pros and cons of using the EV/EBITDA multiple? ............................................................ 124
What drives an EV multiple? .................................................................................................................. 124
Why would multiples of a company trade at a premium or discount to its peers? ................................. 126
What is a control premium? .................................................................................................................... 127
What does a merger model do? ............................................................................................................. 128
What factors can make a deal EPS accretive? ...................................................................................... 129
What are the pros and cons of equity and debt as transaction finance? ............................................... 130
Who does what on a deal? ..................................................................................................................... 131
How can a company defend itself from a takeover? .............................................................................. 129
What is a company profile? .................................................................................................................... 133
What is a pitch book? ............................................................................................................................. 133
Statistical and Financial Math Q&A ........................................................................................... 135
Introduction ............................................................................................................................................. 135
What are the common measures of central tendency and dispersion? ................................................. 136
What is standard deviation? ................................................................................................................... 138
What is a geometric mean? .................................................................................................................... 139
What is correlation coefficient? .............................................................................................................. 140
What is the difference between simple and compound interest? ........................................................... 142
What is discounting? .............................................................................................................................. 145
What is an annuity? ................................................................................................................................ 146
What is a perpetuity? .............................................................................................................................. 146
How is discounting used? ....................................................................................................................... 147
What is net present value? ..................................................................................................................... 147
What is the internal rate of return (IRR)? ............................................................................................... 148
Equities Q&A ............................................................................................................................... 149
Introduction ............................................................................................................................................. 149
What are the basic characteristics of common stock or ordinary shares? ............................................. 150
What is an ADR? .................................................................................................................................... 151
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Why would a corporation choose to raise finance via an equity issue as opposed to a debt issue?..... 152
What are the advantages and disadvantages of being a publicly listed corporation? ........................... 152
What does ex-div mean? ........................................................................................................................ 152
What is the difference between primary and secondary markets? ........................................................ 153
How can new equity be issued? ............................................................................................................. 153
What is stabilization? .............................................................................................................................. 154
What is ‘book-building’?.......................................................................................................................... 154
What is underwriting? ............................................................................................................................. 154
What are the key stages in an IPO process? ......................................................................................... 156
What is a dual track process? ................................................................................................................ 159
What is a syndicate? .............................................................................................................................. 159
What is a prospectus? ............................................................................................................................ 159
What is a pilot fishing exercise? ............................................................................................................. 160
What is a Greenshoe option? ................................................................................................................. 161
What is a secondary offering? ................................................................................................................ 162
What are the full advantages and disadvantages of a fully marketed book-built offering? .................. 162
What is an accelerated book-built offering (ABB) or a placing? ............................................................. 162
What is a rights issue? ........................................................................................................................... 163
What is TERP? ....................................................................................................................................... 163
What is an index? ................................................................................................................................... 165
What aris the difference between a market capitalization weighted index and an unweighted index? . 165
What is the Dow Jones Industrial Average (DJIA?) ............................................................................... 165
What is the Nasdaq? .............................................................................................................................. 166
What is the S&P 500? ............................................................................................................................ 166
What is the FTSE 100? .......................................................................................................................... 166
Money Markets Q&A ................................................................................................................... 167
Introduction ............................................................................................................................................. 167
What are the money markets? ............................................................................................................... 168
What is the inter-bank market? .............................................................................................................. 168
How are inter-bank rates quoted? .......................................................................................................... 169
What is commercial paper? .................................................................................................................... 169
What is a certificate of deposit? ............................................................................................................. 170
Fixed Income Q&A ...................................................................................................................... 171
Introduction ............................................................................................................................................. 171
Why would a corporate choose to raise finance via a debt issue as opposed to an equity issue? ....... 172
What are the two main types of debt finance and what are their key features? .................................... 172
What is a bilateral loan/syndicated loan/club deal? ............................................................................... 173
What are the advantages and disadvantages of loan finance? ............................................................. 173
What is a term loan?............................................................................................................................... 174
What is a revolving credit facility? .......................................................................................................... 175
What is the interest rate on a loan based on? ........................................................................................ 176
What is LIBOR? ...................................................................................................................................... 177
What is EURIBOR? ................................................................................................................................ 177
What is a covenant? ............................................................................................................................... 177
Who are the main credit rating agencies? .............................................................................................. 178
Why are credit ratings more important for bonds than loans? ............................................................... 178
What is the lowest investment-grade rating? ......................................................................................... 179
What is a bond? ...................................................................................................................................... 180
What are the key features of a vanilla bond? ......................................................................................... 181
What are the advantages and disadvantages of bonds? ....................................................................... 182
What is a floating rate note? ................................................................................................................... 183
What is an index-linked bond? ............................................................................................................... 184
What is a callable bond? ........................................................................................................................ 184
What is a putable bond? ......................................................................................................................... 184
What is a convertible bond? ................................................................................................................... 184
What is a Eurobond? .............................................................................................................................. 185
How would you determine the coupon on a bond? ................................................................................ 185
What is a high yield bond? ..................................................................................................................... 185
What is PIK? ........................................................................................................................................... 186
What is the Yield to Maturity (YTM)? ...................................................................................................... 186
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Contents
What is the difference between a clean and dirty price?........................................................................ 187
What is duration? .................................................................................................................................... 188
What is a yield curve? ............................................................................................................................ 189
What is an asset backed security? ......................................................................................................... 190
Derivatives Q&A .......................................................................................................................... 193
Introduction ............................................................................................................................................. 193
What is the difference between cash and derivatives securities? .......................................................... 194
What is the difference between OTC and exchange traded? ................................................................ 194
What is a future? .................................................................................................................................... 195
How are futures used in practice? .......................................................................................................... 197
What is basis? ........................................................................................................................................ 199
What is the difference between contango and backwardation? ............................................................. 199
What is a forward contract? .................................................................................................................... 200
What is a futures contract? ..................................................................................................................... 200
What is a long position on a future? ....................................................................................................... 200
What is a short position on a future? ...................................................................................................... 201
How does a future settle? ....................................................................................................................... 201
How can a future be used to hedge? ..................................................................................................... 202
What is an option? .................................................................................................................................. 203
What are the basic option positions? ..................................................................................................... 204
What drives the price of an option? ........................................................................................................ 206
What factors influence the time value of an option? .............................................................................. 207
What is an interest rate swap? ............................................................................................................... 209
What is a cross currency swap? ............................................................................................................. 210
What is an equity swap?......................................................................................................................... 211
What is a credit default swap?................................................................................................................ 211
What is a structure product?................................................................................................................... 212
What is arbitrage? .................................................................................................................................. 213
Foreign Exchange Q&A .............................................................................................................. 215
Introduction ............................................................................................................................................. 215
How are foreign exchange rates expressed? ......................................................................................... 216
What is a cross rate? .............................................................................................................................. 216
What is foreign exchange quoted? ......................................................................................................... 217
What is a forward forex deal? ................................................................................................................. 218
How are forward rates quoted? .............................................................................................................. 218
How are forward exchange rates determined? ...................................................................................... 219
What is the Fisher effect? ....................................................................................................................... 221
Asset Management Q&A............................................................................................................. 223
Introduction ............................................................................................................................................. 223
What is asset management? .................................................................................................................. 224
What is portfolio construction? ............................................................................................................... 225
What is the efficient market hypothesis? ................................................................................................ 225
What is passive fund management? ...................................................................................................... 227
What is active fund management? ......................................................................................................... 227
How can portfolio performance be measured? ...................................................................................... 228
What is risk? ........................................................................................................................................... 231
What is a risk premium? ......................................................................................................................... 232
What is the difference between systematic and non-systematic risk? ................................................... 232
How can risk be measured? ................................................................................................................... 233
What is the Sharpe ratio? ....................................................................................................................... 234
Section 3: Preparing for Work
Preparing for Work ...................................................................................................................... 237
Introduction ............................................................................................................................................. 237
Life as an Intern ........................................................................................................................... 239
The Internship.............................................................................................................................. 243
Training ................................................................................................................................................... 243
Joining your team ................................................................................................................................... 247
Building confidence ................................................................................................................................ 251
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Contents
Appendix 1: Bloomberg for Analysts ........................................................................................ 255
Introduction ............................................................................................................................................. 255
Bloomberg skills coverage...................................................................................................................... 255
The Bloomberg keyboard ....................................................................................................................... 256
Using Launchpad .................................................................................................................................... 257
Exporting data from Bloomberg .............................................................................................................. 259
Finding a company ticker........................................................................................................................ 260
The equity screen ................................................................................................................................... 261
Accessing shareholder data (holders) .................................................................................................... 262
Getting NOSH via the description (DES) screen .................................................................................... 263
Accessing company filing data ............................................................................................................... 264
Finding company news (and research) for normalization purposes (corporate actions) ....................... 265
Picking a relevant broker report (company research) ............................................................................ 266
What are the current Analyst recommendations (analyst recs)? ........................................................... 267
Getting share price data (graph price) .................................................................................................... 268
Annotating Bloomberg share price graphs ............................................................................................. 269
Creating a relative share price graph ..................................................................................................... 270
Importing Bloomberg share price data into Excel................................................................................... 271
Gettting a Hoover’s profile ...................................................................................................................... 272
Accessing the related securities screen ................................................................................................. 273
Accessing the issuer description screen ................................................................................................ 274
Creating government (international) yield curves ................................................................................... 275
Creating yield curve analysis (‘yield curve relative’) ............................................................................... 276
Credit profile summary ........................................................................................................................... 277
Creating a Bloomberg beta profile .......................................................................................................... 278
Accessing the WACC profile .................................................................................................................. 279
Accessing the new issues monitor ......................................................................................................... 280
Accessing debt term sheets ................................................................................................................... 281
Creating debt maturity profiles................................................................................................................ 282
Accessing money market rates .............................................................................................................. 283
Accessing forex rates ............................................................................................................................. 284
Accessing world equity indices ............................................................................................................... 285
Accessing economic data ....................................................................................................................... 286
Using the Bloomberg MA search functionality........................................................................................ 287
Creating league tables............................................................................................................................ 288
Bloomberg news codes .......................................................................................................................... 289
Appendix 2: Excel shortcuts ...................................................................................................... 291
Appendix 3: FactSet .................................................................................................................... 295
Introduction ............................................................................................................................................. 295
FactSet application ................................................................................................................................. 296
How to store a list of comparable companies on FactSet ...................................................................... 297
Research companies in depth ................................................................................................................ 298
Share price data ..................................................................................................................................... 300
Company filings ...................................................................................................................................... 301
Download multiple PDF TravelBooks ..................................................................................................... 302
Exporting data from FactSet ................................................................................................................... 303
Updating and maintaining custom template models, reports and presentations in Microsoft Excel, Word
and PowerPoint ...................................................................................................................................... 304
Downloading ‘Ready-made’ models ....................................................................................................... 306
Improve efficiency and productivity in everyday tasks ........................................................................... 307
Link Excel charts/tables to PowerPoint or Word .................................................................................... 308
Use ActiveGraph to create easy-to-update, Pitchbook-ready financial graphs using your firm’s
corporate colors, fonts and standards .................................................................................................... 309
Index ............................................................................................................................................. 311
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Contents
10
Navigating the Maze
Navigating the Maze
Navigating the Maze has been written as a guide for those who want to work in banking and
financial services. Whether you are an undergraduate or postgraduate student, or even
someone looking for a career change, this manual will provide you with the information you
need to start your investment banking journey.
1
The starting point for many bankers is their internship. An internship is, on the face of it, a
good chance to get work experience at a bank. For many, it is actually an 8-10 week job
interview. Secure an internship and you have greatly increased your chances of getting a job
offer at the end of the process.
This manual provides a comprehensive guide to your internship. We can advise you how to
apply for your internship, what to do at your interview and also give you advice about what
work as an intern will be like. Our advice also covers what you should do to land a full-time
job at the end of your experience.
Our authoring team includes people who were in charge of hiring interns, people who were
once themselves interns, and also people who managed and interviewed interns for jobs as
bankers. Fitch Learning also provides specialist intern and analyst training to professionals at
leading global financial institutions. So, it is safe to say that we know all about the internship
process.
You can be confident that the advice in this manual will give you a competitive advantage
over other applicants. You will be fully aware of the process and well prepared for success.
You’ll also gain the benefit of our combined wisdom about what not to do. So many
applicants make the same mistakes and we can tell you how to avoid these from the get-go.
Navigating the Maze covers these key areas:
Introduction to banking
Getting recruited
Maximizing the benefit of your intern experience
Technical Q&A
Introduction
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Navigating the Maze
12
SECTION 1:
YOUR APPLICATION
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Your Application
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Your Application
Introduction
This section of the book will give you advice about how you should go about entering the
investment banking field, whether it be as an intern or as an Analyst. Applying for a job in the
industry is notoriously competitive. Your application will literally be one of thousands and
securing a job offer can be tough.
2
That said, improving market conditions mean that now is a great time to apply for jobs in
investment banking. With the right preparation, you will be able to give yourself a head-start
against many of the other applicants. Myths persist that jobs in investment banking only go to
those with MBAs from Harvard Business School, or graduate degrees in finance-related
topics. This is not the case, and through careful research coupled with thorough preparation,
it is possible to forge a career in the banking area of your choice.
You need to lay some careful ground work in order to impress potential recruiters. Make sure
that before you apply you have done your homework and know all about your chosen field.
Whether you’re applying for an Analyst position within the healthcare sector or as an equity
derivatives trader, you need to know enough about that field to hold an intelligent
conversation with a banker who works in that area.
In this section of the book, we aim to give you some tips to help you decide which area of the
bank to apply to, and also to help you with your application once you have decided. There
are a range of different jobs in investment banking that all require different skills. For
example, if you work in sales and trading, client interaction is very important. You will be
calling clients regularly and interacting with them so that they do the deal with you. This
means you need to be comfortable talking to and working with others. In a more quantitative
or analytical role, you should be comfortable working on your own to figure out problems.
Advanced mathematical skills may be required for these roles.
Once you’ve decided what you want to do, you need to make sure that you approach the
application process in a professional manner. You cannot simply expect to send a resume to
a bank with a covering letter and make it through to interview. You will need to investigate
the recruitment process, attend recruitment events and talk to as many people as you can.
Rachel Anderson, our recruitment specialist, has outlined all you need to know about how
banks recruit and what the other candidates will be doing.
Your Application
Make sure that you think about this carefully. You are not likely to be successful in applying
for a role that does not match your skills. Even if you manage to convince a recruiter that you
can do the job by faking it through the interview process, it is likely that when you start work
you will constantly face challenges that cause stress or make you feel inadequate compared
to others. Carefully consider how you like to work and what makes you feel motivated. As
you read through the next section of the book, try and think about whether the roles that are
listed fit in with your skills.
15
Your Application
16
What is Banking?
What is banking?
Traditionally banks have either operated as commercial or investment banks. Commercial
banking focuses on the savings and loans model. Investment banking focuses on the
provision of transaction advice, the underwriting of acquisition finance, risk and liquidity
management.
3
In the US it was illegal to operate as both an investment and commercial bank. In 1999, the
Gramm-Leach-Bliley Act legalized the idea of a universal bank that could operate as an
investment bank and a commercial bank.
Banks are large enterprises, albeit somewhat smaller as a result of the credit crunch. They
are complicated businesses that will service the needs of a wide variety of clients such as:
 Corporations (listed and unlisted)
 Institutions such as insurance companies, pension and private equity funds
 Charities
 Governments
For example Barclays Capital, the investment banking division of Barclays Bank, is a
significantly different operation now compared to what it was at the beginning of the
millennia. Back then, Barclays Capital (BarCap) was largely a debt advisory and rates, sales
and trading business. Now, with the acquisition of the Lehman Brothers business in the US
and its strategic growth path, the services that BarCap can provide to its clients are much
wider. Likewise the credit crunch has seen the disappearance/swallowing up of a number of
banks into other institutions. For instance, JP Morgan has absorbed Bear Stearns and
Washington Mututal. Its service provision and operating model has evolved as a result.
Hence traditional definitions or outlines of what a bank does must evolve and be clarified.
The term ‘investment banking’ is used to cover a variety of different roles within the world’s
banks. It can refer to the provision of services as wide as:
 Corporate finance advisory covering M&A advisory and finance underwriting
 Banking for corporate entities and governments
 Investment management
 Securities trading
 Treasury services
What is Banking?
Banking is a widely used term but lacks a precise definition. These days, banks have a much
wider remit than they had even ten years ago. One of the reasons that the remit has changed
over the years is due to the consolidation that has taken place in the industry.
17
What is Banking?
The term ‘investment bank’ is often used these days to generically cover the full spectrum of
banking services. Due to the consolidation in the industry, most banking institutions will provide
advisory services to its clients.
Most of these institutions will however separate, in their own way, the banking activities into
divisions. A typical structure is illustrated below:
This structure highlights the typical business divisions within a bank. However each division will be
supported by cross-divisional units such as human resources and operations etc.
What do these divisions do?
We will examine some of these activities in further detail in due course – but just as an overview:
Asset management
Asset managers provide advice and products for clients with cash to invest. Essentially an asset
manager is managing another client’s cash. Asset or fund managers will invest in a variety of
assets ranging from equities to fixed income and commodities. The asset manager’s objective is to
increase the value of a client’s investments within the constraints of the client’s desired risk
exposure.
Asset management is the ‘buy-side’ of the firm. In other words, they buy the ‘stuff’ being peddled
by the ‘sell-side’ (investment banking and the capital market side of the business). They pay the
commissions, they pay the spread, and they are the source of the capital that is raised for
investment banking clients. As such, asset management is separated from the rest of the firm and
the sell-side businesses will treat the asset management division the same as an unrelated
independent asset manager. In industry jargon, the asset management arm is treated as an
‘account’.
The ‘buy-side’ takes many different forms: the world’s largest managers have over 1 trillion US
dollars of assets under management (‘AUM’).
The larger asset managers typically offer a broad array of products to meet investors varied needs.
These large platform managers utilize every conceivable product developed by the financial
18
What is Banking?
industry. This starts with the primary asset classes, fixed income, equity and money markets but
also includes their derivatives and structured products. Some asset managers will also have
specialized area like commodities, currency or real estate.
Asset management roles tend to reflect the type of clients and investment products. The key clients
for asset management are:
 Institutional investors – pension funds, insurance companies, charities
 Retail investors – developing products sold through retail banks
 Investment management – client investment managing specializing in particular types of
products such as equities, fixed income, growth and value funds
 Alternatives – real estate, hedge fund investing opportunities
XYZ Bank
Corporate and
commercial
banking
Asset
management
Private banking
Markets
Investment
banking
Institutional
investors
Retail
investors
Investment
management
Alternatives
What skill set do I need?
 Excellent skills with numbers and analysis
 Detail orientated
 Strong communication and networking skills
 Ability to work with key investors
 Ability to work long hours
 You will probably need to take professional exams
19
What is Banking?
Corporate banking
The role of corporate banking is to provide solutions to the needs of a corporation. The relationship
manager’s role is to understand the strategic aims of the corporate and the factors which will
contribute to the success or failure of this aim. This can only be achieved by developing a close
relationship with the customer and a solid understanding of the sector in which they work. It is for
this reason that corporate banking relationship management teams are often split by sector.
The needs of the corporate are often linked to its size, therefore the banks are often organized in a
way which accommodates this.
 Commercial banking – small businesses, sole traders, small partnerships etc.
 Main client – Owner
 Corporate banking – above a certain size often driven by turnover up to multi-national
corporation (MNC)
 Main client – Financial controller
 Global banking – the needs of the largest MNCs are better serviced by global markets or
global banking
 Main client – Treasurer
The needs of the corporation could be split as follows:
Loans
Lending is still the backbone of the corporate banking relationship. However, the cost of loans to
the banks is shifting emphasis to other forms of finance. Cash flow lending takes up a significant
amount of the bank’s balance sheet and therefore either needs to be charged at an appropriate
rate (higher interest rates), or the corporate must offer the bank other methods of giving their
shareholders a return (ancillary business). With smaller businesses, loans are often secured
against the owner’s home to reduce the bank’s risk.
20
What is Banking?
Invoice finance/factoring
Invoice finance/factoring is a method of raising finance using the receivables of the organization as
collateral. Therefore the bank’s risk is reduced as it will only lend money against relatively safe
receivables.
Asset backed
The banks will also lend against the items which the corporation intends to use financing to buy.
These assets should be relatively liquid as they will need to be sold by the bank should the
corporate default.
Trade finance
This is often linked to exports and is similar to the methods described above, as the loan will be
backed by future receipts when the importer pays.
Risk management
The corporation may suffer from a variety of financial risks such as foreign exchange, commodity
and interest rates. The corporate bank will offer a variety of solutions to help reduce these risks.
Cash
Internet banking will provide the corporation with visibility as to where the business’s cash is.
Transaction services will help the corporate to move and manage money for example:
 Payments and receipts in a variety of currencies
 Sweeping cash into a central account to achieve interest rate efficiency
The larger corporate banks will also offer outsourcing capabilities such as payroll, employee law
mentors etc. to help the client reduce head count and fixed costs.
What skill set do I need?
 Confidence with numbers and analysis
 Strong communication and networking skills
 Ability to build relationships and become a trusted advisor
 Understand a wide variety of financial instruments
 Good market awareness (economics and rates)
 Ability to work with finance professionals and entrepreneurs
Private banking
Private banking is the terminology for the provision of banking services to high net worth
individuals (HNWI). The hurdle rate for what makes someone a HNWI varies from bank to bank.
But consider yourself outside the remit unless you have liquid assets in excess of seven figures.
Private banking is providing a personal retail banking service to these clients. Most of the major
banks have successful private banking businesses.
21
What is Banking?
The key areas of wealth management that a private banker will provide advice around are:
 Investment management
 Liquidity management
 Tax planning
 Estate management and planning
 Markets
What skill set do I need?
 Strong communication and networking skills
 Ability to work and understand a client’s needs
 Excellent skills with numbers and analysis
 Understand a wide variety of financial instruments
 Develop strong sector specific skills
22
What is Banking?
Markets
Often when people think of investment banking, they think corporate finance and markets.
Markets, or global markets at many institutions, have changed markedly over the last 20 years.
To the uninitiated, there is disappointment when the trading floor is not full of traders screaming
‘buy’ or ‘sell’ at each other. ‘Open outcry’ trading still exists in small pockets around the globe – for
instance on the Chicago Mercantile Exchange or the London Metal Exchange – however the
trading floor these days is generally a much quieter place, with rows of computer screens,
sometimes more akin to The Matrix.
The markets business is normally split into ‘desks’ covering defined markets or regions. A typical
structure for the markets division is illustrated below:
XYZ
Investment bank
Asset
management
Retail and
commercial
banking
Private banking
Markets
Investment
banking
Sales
Structuring
Trading
Money markets
and forex
Research
Derivatives and
commodities
Sales
The sales people are responsible for making sure that clients are fully up-to-date with investment
opportunities, potential trading strategies and products.
The sales team must be in constant contact with the traders and research teams to ensure that
they are in touch with the market, strategy, exposure and current trading book risk.
Sales will also work with capital market origination teams (equity and debt capital markets – see
later) in terms of placing new issues into the market with investors.
Trading
Traders will make markets (give prices) and book trades for clients. They will work with the sales
teams to ensure that they understand the client’s requirements and risk appetite, as well as relying
on the sales teams for ideas and market appetite information.
23
What is Banking?
Research
Research can be equity, credit or economic in terms of focus. They are the intellectual and
academic engine of the bank. They present views on the markets, economic outlook and individual
stock recommendations.
Structuring
Structurers create complex and tailored financial instruments for clients, for example, to achieve a
required risk profile, particular cash flow patterns, or maybe satisfy certain regulatory requirements.
Money markets and forex
Money markets is a general term for the part of the financial system concerned with short-term
borrowing and lending. This is as opposed to capital market whose products have longer, if not
infinite, maturities such as bonds and equities.
Money market products typically have a maturity of less than 12 months although slightly longer
products do exist. The shortest period for a money market product is overnight lending/borrowing.
Other money market products include:
 Treasury bills – short-dated zero coupon government borrowing instruments.
 Commercial paper – similar to a Treasury bill but the issuer (borrower) is a company.
 Certificate of Deposit (CD) – a fixed term deposit which the investor (depositor) can sell.
 Repos (repurchase agreement) – a short-term sale of securities (often government bonds) with
a future repurchase at an agreed date and price. This effectively is a cheap method of
borrowing money using the securities as collateral.
Banks also offer clients forex services to buy and sell foreign currency now (spot) or through
the use of derivatives in the future.
Derivatives and commodities
Derivatives are complicated instruments that are used by clients to manage and transfer risk. The
markets division is able to structure, trade and sell these instruments to clients. Derivatives can be
structured around:
 Equities
 Credit
 Commodities
 Foreign exchange
What skill set do I need?
 Strong analytical skills
 The ability to pick up complex work quickly – lots of on-the-job training
 Ability to work under pressure
 Work well within a high pressure team environment
 Understand a wide variety of financial instruments
 Strong communication and networking skills
 Strong mathematical skills for some desks such as structured products or the Quant areas
 Ability to work long hours – very early starts prior to market opening
24
What is Banking?
Investment banking division (IBD)
The structure of the investment banking business within ‘an investment bank’ varies from bank to
bank. This terminology creates a great deal of confusion as an investment bank and an investment
banking division are quite different terms.
An investment bank is a collective term for the wide range of activities that an investment bank
may engage in. For instance, JP Morgan is termed an investment bank. Its activities cover:
 Private banking
 Investment banking
 Commercial banking
 Markets
 Retail banking
 Security services
The investment banking division, investment banking or just banking at some institutions, typically
services the needs of large corporates and multinationals. Traditionally investment banking
focused on advisory services and acted as an intermediary with potential debt and equity investors.
However, as the banking model has evolved, IBD has often entered into lending activities with its
clients.
Investment banking division (IBD) deals with the provision of advice to clients on mergers and
acquisitions (M&A advisory), as well as assisting in the raising of funds in the equity and debt
capital markets. The term ‘corporate finance’ is often used to describe these activities.
IBD is typically structured along industry and product lines. This can sometimes create an overlap
of responsibilities and can create confusion:
IBD advisory assignments can include:
 Acquisition searches
 Balance sheet advisory (capital structure advice)
 Business portfolio review
 Buy-side advisory
 Sell-side advisory
 Corporate governance
 Dividend policy making
 Fairness opinions (second opinions on a valuation)
 Financing advisory
 Public takeovers
25
What is Banking?
An overview of the investment banking division:
XYZ
Investment bank
Asset
management
Retail and
commercial
banking
Private banking
Markets
Investment
banking
Industry groups
Consumer
Diversified
industries
Energy
FIG
Healthcare
Nat Res
TMT
Product groups
M&A
Debt capital
markets
Equity capital
markets
Leverage
finance
Industry/client coverage
Industry or client coverage groups will focus on specific industries such as technology, media and
telecoms (TMT), healthcare, natural resources and industrials. Industry groups will provide a broad
range of services to key industry clients.
Coverage groups can be geographically defined as well.
The bankers in these groups are industry specialists. This allows clients access to experienced
bankers who have a deep understanding of their clients’ markets and business models. Once a
coverage team has identified a particular need for a client, they will call on specialist product
advice from the product coverage teams.
26
What is Banking?
Product coverage
Some banks will collectively refer to these groups as ‘corporate finance’.
Product coverage groups include:
 Mergers and acquisitions (M&A)
An M&A transaction is a critical moment in the life of a client. The transaction can be an acquisition,
a disposal, a restructuring, an initial public offering (IPO) or a spin-off. These transactions carry
significant risks and are critical to the development and strategic growth of the client. Hence clients
will pay large fees for high quality advice concerning valuations, financing, and buy and sell-side
options.
 Equity capital markets (ECM) and debt capital markets (DCM)
Equity and debt capital markets (sometimes referred to as global finance or capital market
origination) are the capital raising divisions working to raise capital for clients.
A strong capital markets business requires origination strength and the ability to structure the
products according to the needs of the client and the desires of the investor base. These strengths
then need to be coupled with the ability to distribute the product.
Typical origination capabilities are:
 IPOs
 Follow-on issues
 Block trade and accelerated equity issues
 Equity linked issues such as convertibles
 Private placements
 Loan origination
 Syndication
 Bond issues
 Leverage finance origination
What skill set do I need?
 Excellent skills with numbers and analysis
 Strong modeling skills
 A precise attention to detail
 Excellent presentation skills – be a PowerPoint Jedi
 Very steep learning curve
 Very much a client-facing role, so strong communication and networking skills are a must
 Ability to work long hours
 Develop strong sector or product specific skills
27
What is Banking?
Technology
Technology and operations are key divisions for a bank. Without good technology, a bank will not
be able to operate on a competitive level. Finance in the modern era is a complicated business.
Products are increasingly sophisticated, trading strategies more involved and regulation is
continually growing.
The technology business has often been described as working within a software house
environment while maintaining a strong connection to finance and banking. The technology teams
will work on software development, implementation and service. The work can involve long-term
projects, software migrations as well as ad-hoc software development in reaction to changes
driven by the market.
The work will not be in isolation from the rest of the business. Communication and working
relationships are key to the job. The work is varied across the business areas and on a day-to-day
basis.
This will give you exposure to a range of programming languages and development tools including
Java, C, C++, C#, etc.
There are also a few roles in production support, which manages the servers, networks and
operating systems. This will introduce you to web-based languages including PHP, XML, Java
Script and CSS; platforms such as Linux, Mac OS X, Windows, Solaris, MS DOS and UNIX; and
database systems including Oracle, Access and SQL Server 2000.
What skill set do I need?
 The ability to work across a number of divisions – high exposure to many different businesses
and products
 Understand the life cycle of a trade
 A desire to work at the frontiers of new technology
 Ability to take on early responsibility
 Very steep learning curve working with very complex systems and some unique and
challenging problems
 Very much a client-facing role, so strong communication and networking skills are a must
 Often a better work/life balance than some other areas of the business
28
What is Banking?
Operations
Operations are involved in the full spectrum of financial products, from bonds and equity derivatives
to swaps and options, and partners with almost every group in the firm. The operations teams
support the lifecycle of the trade from trade capture, client confirmation and risk management, to
settlement, margin, and effective collateral and cash management. Technological progress, in
areas such as e-commerce, and globalization mean that Operations is continually evolving.
The main functions that you would expect to find within an operations area are:
 Recording and reconciliation of positions
 Matching and processing of the day's trading
 Transfer of monies between banks and exchanges
 Monitoring and payment of margins
 Corporate actions
 Dividends collected and allocated
As an Operations graduate, you’ll gain broad-ranging, in-depth understanding of both established
and emerging markets within banking, leading to exceptional career development opportunities.
What skill set do I need?
 The ability to work across a number of divisions – high exposure to many different businesses
and products
 Understand the life cycle of a trade
 A desire to work at the frontiers of new technology
 Ability to take on early responsibility
 Very steep learning curve working with very complex systems and some unique and
challenging problems
 Very much a client-facing role, so strong communication and networking skills are a must
 Often a better work/life balance than some other areas of the business
29
What is Banking?
Legal, compliance and risk
All companies operate under the veil of risk. These risks must be recognized, managed and to the
extent it is possible; hedged. Banks are exposed to market volatility, credit, legal and regulatory
issues, as well as reputational risks. However for banks to return a profit to its shareholders, risk
must be taken. The objectives of these business areas are to manage these risks, and to make
sure that the legal and compliance issues are dealt with on a transactional basis, as well as at the
macro-bank level.
XYZ Bank
Asset
management
Corporate and
commercial
banking
Private banking
Markets
Investment
banking
Legal, compliance and risk
The compliance function will ensure that the bank complies with the regulations of the jurisdictions
that the bank operates under. Failure to manage these regulations can lead to the bank losing
business, incurring fines and suffering reputational damage.
The risk management functions are often aligned with the subject of the risk. For instance a bank
may have risk management areas for:
 Credit risk
 Market risk
 Operational risk
The risk management functions will act as independent approval and monitoring functions, as well
as providing advice on transactions and the bank’s potential and actual risk exposures.
What skill set do I need?
 The ability to work across a number of divisions
 High exposure to many different businesses and products
 Ability to deal with demanding clients working at a strategic level
 Ability to take on early responsibility and work to tight deadlines
 An exact attention to deal
 Often a better work/life balance than some other areas of the business
30
What is Banking?
Interactions between the investment banking division
and markets
The relationship between IBD and markets is interesting. The relationship is controlled and
monitored with a ‘Chinese wall’. A Chinese wall is a barrier that is created to separate parties who
make investment decisions from parties that are privy to material inside information, that may
influence these decisions. The wall is intended to avoid conflicts of interest.
IBD and markets represents such a conflict of interest. Suppose there is a potential transaction in
the deal pipeline of an M&A team. The transaction could materially change the fortunes of a listed
client. If this information were to fall into the hands of the traders, there is a risk that the information
would be used to take a position in the market using information that is not freely available to all.
The traders would be trading on the basis of ‘insider information’.
Investment banks will create a Chinese wall between IBD and Markets.
The wall can take the form of:
 Physical restriction – whereby investment bankers cannot get access to trading floors where
the sales, trading and research teams may sit.
 Information restrictions – restrictions can be systems-driven, in terms of restricting access to
networks, servers and files.
Markets to IBD
Markets teams are restricted
from interacting with the
origination teams because
of client confidentiality issues.
Markets
Investment
banking
IBD to Markets
IBD, particularly the capital
market origination businesses
will interact with markets
teams.
The origination teams will ask
the markets teams for
information about the market,
current and expected market
sentiment as well as
investor appetite.
The markets team are close to
the potential investors that the
origination teams will be
pitching their ideas to.
This market information can
provide a competitive
advantage during this
pitching process
31
What is Banking?
Illustration of how the various divisions within a bank can interact on a deal:
32
What is Banking?
What to expect as an Analyst within a bank
Pursuing a career within a bank or any profession for that matter is an important decision – a
crucial life-changing decision. It is a decision to be taken with as much information as possible to
hand – high quality and relevant information should make for a better informed decision.
Banking is a tough job whether it is markets, corporate, origination or IBD. The jobs are different,
and so are the stresses, strains and rewards.
So what to expect:
 Challenging hard work
 To be stretched
 To learn, grow and develop
 To react
 A lot of jargon
 Intense competition and an ambitious working environment
 To be flexible in terms of your work, your social life and your career
 To work long hours
 Diversity in terms of your work, your clients and the people you work with/for
 To enjoy it – otherwise what is the point?
 To be rewarded for good work
And what not to expect:
 A pat on the back every time you do something well
 A stress-free existence
 A coddled working environment
 An easy ride
33
What is Banking?
What makes a complete Analyst?
An interview with a director at a bank
Compliments for good work may seem few and far between for an Analyst. There is often a feeling
of being at the bottom of a long corporate ladder and acting as a ‘gopher’ with a degree. However,
one of the ultimate and most understated accolades an Analyst can receive from their associate is
that they are deemed to be ‘a good Analyst’.
What makes a ‘good Analyst’?
We asked this question to a director at a large global bank:
A good Analyst has to demonstrate a wide range of qualities.
Most of these qualities are simple qualities but it’s the range that poses the most challenges
to these people as they come into the business. I guess if an Analyst helps me to get the job
done and done well – she is a ‘good Analyst’. I will then make sure we work together again
and as the trust builds, so will responsibility.
From my perspective, the list of qualities or competencies of a good Analyst would certainly
include (and I will assume top rate intelligence and technical excellence as givens):
Attention to detail – Analysts will spend a significant amount of time putting pitch books and
profiles together and running comps models. They will take responsibility for making sure that
these documents are client ready, free from error and presented in line with the bank’s
presentation protocols.
Listen – they need to be good listeners. We know they are intelligent; otherwise they would
not be here. However, a new Analyst will benefit from the knowledge of those around them
as well as the client. It’s an advisory role and often the best person to listen to is the client –
they know the business they work in better than anyone else.
Think – we work in a tough industry, the time pressure can be immense and the hours can
be long. In this environment, it’s very easy for the job to become just a number crunching role.
Crunching the numbers is necessary, as it then gives us the ability to think about the
implications and the softer side of our work. Think – what are the implications of what I am
doing? How does this fit into the deal? How do I sell the idea to the client? Don’t just process
your work – take time to think about it. I am the first to admit this is easier said than done at
the Analyst level, when tiredness, deadlines and general workload can be serious issues. My
advice is to find time to stop, push your work away, go for a walk, grab a coffee and then
come back to the desk and take a few minutes to stand back and view the bigger picture.
This approach to work will also identify the majority of errors you may have made in your own
work. Self-review is another key skill.
Ask questions and communicate – an Analyst needs to ask questions. They are
surrounded by people who have more experience and they can learn from them. Asking
questions from my perspective is reassuring; it shows thought, hopefully, and it provides
comfort that they have the clarity to complete their work as efficiently as possible. It is very
annoying to have an Analyst who is unclear about the task in hand and who then spends
hours trying to work out what they are trying to do in isolation, when a quick question would
have sorted the problem. We are all under time pressure at the best of times – a well thought
out question can ease this pressure significantly.
Judgment – this job does have a significant technical aspect to it, however it requires good
judgment – it is an advisory role for the most part. For instance, a financial model provides a
lot of numbers in the output, but that is not the answer.
34
What is Banking?
The answer – for example the valuation, is a judgment call in terms of addressing the client’s
needs and the behavior of the market. A good banker will demonstrate excellent judgment
throughout her career. Too often I see Analysts so set in the numbers and the detail that they
cannot see the big picture. Without the bigger picture, judgment is impossible.
Desktop applications – become a whiz-kid with the firm’s desktop tools. Being able to
quickly navigate through Bloomberg, FactSet and Thomson as examples, is a great skill.
Hit your deadlines.
Know when to keep a low profile.
A bit of flair, humility and charm doesn’t go amiss either!
RLM – Director Global Bank
35
What is Banking?
36
Preparing to Apply
Preparing for the recruitment process
Investment banking is a notoriously competitive industry. Large investment banks will
typically receive thousands and thousands of applications. After receiving the applications,
the recruitment team then reviews the resumes and picks hundreds of applicants to
interview. Banks will interview on average eight applicants for every one job – so more than
ever, you must be proactive about producing a stand-out resume and perfect your
interviewing skills in order to get the job.
4
Your education is usually the first thing to be seen on your resume, however, it doesn’t
necessarily matter what you are currently studying. As long as you have the drive, learning
potential and appropriate people skills, there’s likely to be a role within an investment bank
to suit you. That said, to stand out from the crowd and be hired is tough. The more effort you
put into getting your desired position, the more likely you are to get it.
Having read literally thousands of intern applications and interviewed hundreds of potential
interns, here are what I see as the key things you should be doing to prepare for the intern
recruitment process.
Rachel Anderson
Rachel is one of Fitch Learning’s Management and Personal
Development instructors. She has been facilitating courses in London for
eight years, firstly in her role at Goldman Sachs and then as a full-time
instructor at Fitch Learning.
Rachel uses her experience in recruiting graduates to great effect to be able to offer some
first-hand advice about what recruiters are looking for.
One of her main focuses as a trainer is in consulting, developing and delivering graduate
programs. She has been involved in a whole range of programs, delivering everything
from traditional courses on basic communication skills, to ‘fused courses’ which blend
technical skills with soft skills using case studies and simulations.
Preparing to Apply
At Goldman Sachs, Rachel worked in the Human Capital Management
Division where she was involved in attracting and recruiting graduates into
the Analyst and Associate programs and working on the summer Analyst and Associate
learning initiatives.
37
Preparing to Apply
1. Research the financial services industry
Resumes from candidates who understand the financial services industry stand out from the
resumes of candidates who simply think banking sounds glamorous. Interviewees who can chat
comfortably about the markets stand out even more. So, if a job in finance is your goal, putting in
the time to learn as much as you can about the industry is essential.
If you’re not a finance or economics major, this may be a daunting task. Even if you are majoring in
a finance-related subject, it may still be a daunting task. But it doesn’t need to be.
Where to start?
Let’s take the Wall Street Journal (WSJ) for example. Hop on any subway train during rush hour
and you’re sure to see men and women in business suits awkwardly trying to read through this
monster of a newspaper. The key to reading the financial press is to know what you want to take
from it. I doubt many people actually read through the WSJ from front to back. It would take far too
long, and there’d be far too much information to take in.
So instead of wrestling through the entire WSJ, you may for example, simply want to make a habit
of reading particular columns. The best columns contain analysis, as well as opinion covering
global business and financial topics.
Alternatively, if your focus is more on learning about different companies, you should turn straight
to the articles about companies and markets. To make your reading a bit more palatable, focus
your reading on just a few industries or companies so that you can become a real expert on them.
This will be far more beneficial for you than trying to absorb information on every industry and
every company out there.
Also, by focusing your reading, you’re actually starting to prepare yourself for interviews. It can be
extremely impressive to an interviewer when a candidate can talk about a specific sector with real
insight, and especially impressive if the candidate shares a well-thought-out opinion.
What if you don’t have time to read the financial press
each day?
If you’re time poor, you can still make research part of your daily routine. For example, you may
listen to the radio as you get ready for classes each morning. Why not listen to Bloomberg instead?
You might listen to your iPod on the bus or train. Well there are plenty of financial podcasts that
you can download. You may have to shop around to find one which suits your tastes, but there’s
bound to be something which hits the spot.
Perhaps you’re someone who’s glued to your smart-phone. You can actually follow the WSJ or
Financial Times on Twitter. This means even if you don’t have time to get a copy of the WSJ and
read it thoroughly, you can still keep up-to-date with the latest analysis and opinions.
38
Preparing to Apply
2. Attend recruitment events
My job for a number of years was to make sure that the bank I worked for had a presence on
university campuses. The reasons for information sessions on campus are twofold.
Firstly, banks want to educate students about their bank’s culture, roles within the bank and
opportunities for interns and graduates.
Secondly (and probably most importantly) banks look to identify and make contact with potential
hires as soon as possible. So it’s never too early to start to turn up to workshops, networking
events and presentations. In fact, take it one step further. Turn up with a view to meet people, ask
questions, make a great first impression and make contacts.
Recruitment event dos
Know about the event you’re attending
If the event is called ‘Technologists in Investment Banking’ you’re highly unlikely to meet anyone
who works in M&A.
Look the part
Bank representatives won’t expect you to wear a pin-stripe suit, complete with suspenders and a
monocle. Equally, bank representatives won’t expect you to turn up straight from the gym. Just
make sure you look well-groomed and tidy.
Be aware of your behavior at all times during the event
If you chat during a presentation made by a VP, roll your eyes during the chat from the recruiter, or
go overboard at the free bar, it’s highly likely that someone from the bank will notice and take note.
I once attended a presentation made for students by an MD in Sales. A couple of students got
bored and so passed the time by playing hangman. Not only did I notice, the MD noticed too.
Prepare questions for professionals from the line
I’ll let you in on a secret – a lot of people from the line will be a little nervous and feel awkward
about networking with students. With this in mind, you should ask open questions which will get
conversations flowing easily and help you to build rapport. So instead of asking ‘do you agree with
emissions trading?’ which will get you a ‘yes’ or a ‘no’ answer, ask ‘can you tell me about the firm’s
stance towards emissions trading?’
If all else fails, remember people love talking about themselves. So you can ask about career paths,
a typical day in their role, and deals/projects they’ve worked on.
Prepare questions for recruiters
Save any questions on the recruitment process, interviews, and compensation etc. for a recruiter.
Other people from the line are unlikely to be able to answer these types of questions and the HR
professionals often tell them not to even try to answer these questions.
Also, (and clearly I’m biased here) don’t underestimate the value of getting a recruiter on your side.
A skilled recruiter will be able to spot a good potential hire, and often their influence within a bank
will be significant. So, avoid this kind of conversation:
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Preparing to Apply
Student:
Hi, nice to meet you. Which division do you work in?
Recruiter:
I work in Human Resources. I’m part of the team who recruit for Asset
Management.
Student:
Oh… ok. Do you know of anyone who actually works for the bank?
I haven’t got long so I want to make the most of my time.
Amazingly, I often had this kind of interaction with students. A recruiter’s input to the recruitment
process will vary from bank to bank and there’s likely to be variation between different divisions in
the same bank. Some recruiters will decide which resumes the line will get to review, some will
decide which candidates make it to interview and some will conduct first round interviews.
Whatever a recruiter’s involvement in the hiring process, you can’t afford to not make a great first
impression with them.
Follow up with the contacts you make
By asking some thoughtful questions, which get the conversation flowing and prove that you’re well
researched and genuinely interested in the industry, it’s likely that some line people will happily
share their contact details. Feel free to follow up by writing them a succinct and professional email.
 Thank them for their time
 Remind them of who you are. It’s likely that they spoke to a lot of students. For example, say
‘we had the discussion about hybrid bonds.’
 Mention if you learned anything useful or interesting from meeting them
 State if the recruitment event has strengthened your resolve to work for the bank/industry
Recruiters often have this kind of email forwarded to them, with a recommendation that they look
out for, or even interview the candidate. This happens not every time, but often.
To help with the follow-up emails follow this simple tip: When someone gives you a business card,
immediately write down any information about the person who gave it to you, and a note about the
conversation you had.
Recruitment event don’ts
Don’t ask too many questions at a busy recruitment event
Many times I’ve seen students monopolize someone’s time by asking question after question.
Desperate to make the most of the opportunity, they fail to realize that there is a line of people also
hoping to speak to that person. A huge part of working for a bank involves teamwork, so this kind
of disregard for other people won’t be well-received.
Don’t steal business cards
So many times I’d innocently put down my stack of business cards, blink and then realize that
attendees had stolen half of them! The next day I’d receive emails from students thanking me for
my time and asking if I’d review their resume or put them in contact with a banker. This didn’t bode
well for the business card thieves as I would judiciously note down their names to remember this if
I came across their resume or application in the future. This is another reason why your follow-up
emails should remind the recipient who you are.
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Preparing to Apply
Don’t ask repeat questions
If you’re waiting to speak to somebody, listen to the questions that others are asking. If two people
have already asked if they think that the Euro is sustainable, make sure you’re not the third.
Repetitive questions make networking events arduous while new questions can be a breath of
fresh air.
Don’t stalk your contacts
A follow-up email is absolutely fine. Unless your contact initiates more, leave it at just an email.
I’ve had students call me at my desk saying, ‘I’m outside your office, let’s get coffee!’ I’ve also had
home-made cards, handwritten letters and holiday postcards. Sadly, none of these strategies were
successful for the candidates involved.
With the exception of LinkedIn, don’t try to connect with line professionals or recruiters on any
social networking websites. It can come across as intrusive as most professionals try to distance
their work and home lives.
Don’t lose all self control when faced with a decent freebie or two
Every year I worked as a recruiter I was shocked at how perfectly mature students would lose all
self control when there was the opportunity to pick up a free USB drive or notebook. At one
university, students started banging tables when the freebies ran out. Pretty appalling stuff!
Don’t hang around awkwardly when you’ve exhausted your questions
The best way to close a conversation is to thank the person you’ve been chatting to for their time,
and state that you appreciate that there are other people who must be waiting to speak to them.
Try to make the most of recruitment events. If you do, at best when you submit your application the
recruiter or the line may be looking out for your application. At worst, your application will be better
thought-through.
3. Build up your resume
Clearly, there is a huge amount of competition for intern roles at banks. So it’s vital to understand
that many applicants may have grades which are just as impressive as yours, as well as having a
whole host of extra-curricular activities and work experience.
Why are extra-curricular activities and work experience important?
Why can’t I just focus on getting good grades?
If you do well enough and receive an intern position, it’s highly likely that your employer will give
you real responsibilities. This may involve working with different sorts of people, dealing with
deadlines, using your initiative, working from limited information as well as a whole load of other
challenges. Your IQ will only get you so far.
So while academic achievements certainly tell a bank how intellectually capable you are,
extra-curricular achievements communicate your ability to apply your knowledge and skills to
activities outside of academia.
What kind of extra-curricular activities and work experience are valuable?
When you’re applying to a bank, take a look at their business objectives or guiding principles.
Often these will give clues as to what they may value.
For example, a bank’s guiding principles may be:
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Preparing to Apply
 Team work: Here you could highlight team sports or an orchestra you play in.
 Client orientation: Mention any work experience that involved going the extra mile for the
client. This may have been working in a solicitor’s office or a fast food restaurant.
 Innovation: Are you part of your University’s Entrepreneurs’ Society? Or perhaps you
overhauled the way a particular process worked during a summer job?
Additionally look at the skills and aptitudes required for the divisions to which you are applying.
If you’re applying to work in sales or trading, highlight any work experience or activities that have
involved operating in a fast-paced environment. If you’re applying to work in investment banking,
then talk about experiences where diligence and attention to detail were key.
If your dream job involves working in a team, but all of your extra-curricular activities are solitary
pursuits, it’s unlikely that your resume will win you an interview.
4. Decide what kind of role is right for you
Not everyone is born to be an investment banker or a trader. Frankly, the world would be a very
strange place if that were the case.
Many internship applications fail because the applicant assumed that they were trader or banker
material. Your intern application will only be successful if you have considered which role is right
for you. Yes, the traditional banker and trader roles may initially appeal, but corporate treasury,
compliance or market risk may be equally as interesting and potentially a better fit to your skill set.
As well as attending recruitment events, reading company websites and reading the financial press
to decide what part of an investment bank you want to work in, you should also ask yourself a
number of questions:
What are your strengths?
Think back over your academic achievements. Is there a theme linking your most successful
projects or assignments?
In what kind of working environment do you thrive?
Are you more of a group worker or do you prefer working alone to get things done? Can you only
work with peace and quiet? Do you need things happening around you to be able to concentrate?
How important will it be to have an active social life?
If leaving the office at a reasonable hour is honestly an important factor for you, then M&A probably
isn’t for you. Similarly, if you can’t function before 8.00am, then working on the trading floor
probably isn’t going to work.
What’s more important to you – people or process?
Some people are naturally good at upholding process and working with deadlines. There are lots of
opportunities to put this skill to good use; product control for example. If you’re naturally a people
person, a role in sales or private wealth management may be for you.
Is working in the back office a good way to get a front office role?
In short, no. So many people have tried this strategy. Sadly, few succeed.
If you take this approach, you may not only fail to get the front office role, but also the back office
role. For example, if the interviewer asks what your motivation is to work in market risk, and you
reply that you see it as a way to get into trading, sadly it’s game over.
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Preparing to Apply
Even if you keep your front office desires to yourself, candidates who secretly hanker after the
glamour of front office are pretty obvious. Sadly, in my experience, they never get a second
interview. Competition is fierce so banks can often afford to only interview candidates who
genuinely want to work in, say, operations.
5. Writing your resume or application
Having read thousands of resumes I have observed two main mistakes applicants make.
These are:
 A non-reader friendly format: resumes/applications are too long and verbose
 Too generic: The application could be sent to any bank and does not stand out against the
thousands of other resumes
Getting the format right
Before you begin to write your resume or application, it will serve you well to consider the people
who will be reviewing it.
Firstly, whoever reviews your resume is likely to be reviewing a lot of them. Whether it is a recruiter
or an investment banker who reviews your resume, yours will be one of many.
Sadly many reviewers will skim resumes. Your resume may have less than 30 seconds to make an
impact. So if it takes the reviewer 15 seconds to discover what you’re studying, you’ve fallen at the
first hurdle.
The reviewer will need to be able to quickly see the key information which will tell them if you are
interview worthy very quickly.
So, format your resume or application to be as readable as possible. Also go for brevity; your
resume should be one side long. This isn’t a hard and fast rule, but for many reviewers it’s a
turn-off if an intern or graduate resume goes on for much longer. I’ve known some recruiters and
bankers who won’t read an intern resume that is any longer than one side.
In order to keep your resume short and snappy, try following the technique below:
 Without too much thought, write down everything that you could possibly ever put into your
resume. You’re looking to create a data dump containing all of your skills, qualifications,
experiences, sporting achievements…everything.
 Review the role that you are applying for and the skills that are required
 Look back at your data dump and highlight or underline anything which could be relevant to
the skills involved in the role you’re applying for.
 Next, look at the firm you are applying to – what are the firm’s business principles or firm-wide
competencies?
 Go back to your data dump. Again highlight or underline anything you think relates to what is
important to the firm.
 Now look at the rest of the information on your data dump. Judiciously review every piece of
information on there. If it doesn’t add to your application, take it away.
Be ruthless, if there isn’t a reason to have something on your resume, hit the delete button.
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Preparing to Apply
There are numerous ways to format a resume. The common elements to include are:
 Contact details*
 Educational history (including degree and major)
 Language skills
 Work experience
 Additional skills
 Extra-curricular activities
* In some countries, it is appropriate to include a photograph. Feel free to do so if it is right for the
region.
Insert the information you have prepared. Do this in a simple, space efficient and easy-to-read
manner.
Remember, the reviewer wants to be able to quickly and effortlessly pull out key information from
your CV. Don’t over format, but do make sure the important points stand out.
Contact details
Your contact details should be in the header of the resume. Ensure that your name is slightly
bigger than the rest of your contact details. But don’t try to jazz-up your contact details with a
patterned frame or swirly writing.
You are likely to receive most communication by email, especially in the initial stages of the
recruitment process. Make sure that your email address sounds professional. An email address
which references your teenage nickname for example, might not give the best first impression.
Similarly ensure that your voicemail message is clear and professional.
Educational history
List your university information first. Include the name of the university, the degree you are
pursuing or have obtained, and the year that you will graduate. Also include your GPA (Grade
Point Average).
It can be tempting to write in detail about your coursework and research. Only do this if it relates in
some way to the role for which you’re applying.
Next, list the courses you took and the grade you achieved for each.
Language skills
Highlight any language skills that you have. Be realistic about your ability. If you oversell your basic
Italian, you may trip up during an interview when you meet an Italian speaking interviewer.
Work experience
All work experience is valid. If you’re lucky enough to have an abundance of examples, don’t feel
the need to write about every single one. Simply choose the most interesting and relevant two or
three examples. This will make much more of an impact than making a bulleted list of the 23 roles
you’ve had over the years.
Also, think about how much space to allocate to each piece of work experience. If you want to list
your role as a store supervisor, a banking internship and a leadership role in a varsity sport club,
the banking role would clearly be deserving of the most space.
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Preparing to Apply
Write about your work experiences in a task focused or a project focused manner and try to marry
the tasks or projects to a quantifiable result. This will make your resume a far more compelling
read.
The example below is generic and doesn’t actually speak about what you did:
I interned in Financing Group, a team which advises financial
companies, corporations and sponsors on financing and refinancing plans.
This example is more specific and task-orientated. It gives the reviewer an insight into the
responsibilities that you had:
I interned in Financing Group. One of my key roles was to contact the
structure team to identify the best hedging products. We then prepared the
information that we advised the client with.
The next example is more project-orientated. It also has the benefit of focusing on results:
I interned in the Investment Banking Division. In my final two weeks, I worked
on a $250m Initial Public Offering and was responsible for creating a model
from financial data.
Your work experience will be instantly more compelling if you link the tasks or projects you
worked on to quantifiable results.
If you are writing about non-financial work experience, you can use the exact same format. You
may find a task focused approach works best in these situations.
For example:
I worked in the Accounts department of my local council office.
Processed over 2,000 invoices with 100% accuracy over a three month period.
Additional skills
Here is your chance to show off anything that you so far haven’t mentioned.
The types of skills you should list are:
 Any financial study/qualifications e.g. CFA, accounting skills
 Computer programming ability
 Exemplary computer software knowledge (Working knowledge of Microsoft Office is nothing to
shout about nowadays. If you’re a whiz with Excel VBA however feel free to shout.)
Extra-curricular activities
Choose carefully what you list here. Don’t make this list too long, but don’t make it so short that
you look like you don’t have any interests outside of finance.
As with your work experience, be specific. So instead of writing ‘playing music’ as an
extra-curricular activity, write: ‘I play violin to Grade 7 standard. I regularly play in a string quartet.’
Instead of writing: ‘I enjoy running’, write: ‘Over the past two years I have taken part in three
half-marathons.’
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Preparing to Apply
6. The cover letter/motivational section
Whereas your resume lists the facts that make you who you are, the cover letter should give the
reviewer an insight into your character.
Note: Not every reviewer will read your cover letter, but don’t assume that they won’t. You need to
make sure you have a strong covering letter just in case they do.
What not to write
It is in the cover letter where applicants seem to get most creative…that is they think that in order
to stand out they need to take a risk and do something different.
Some people write poems, some people include pictures, some people quote films. It’s wise to
avoid these tactics. Your resume will be remembered, but not for positive reasons.
What you should write
Your cover letter should have three main sections:
 Why you want to work in the industry
 Why you want to work for the firm
 What you think you can bring to the organization
Throughout each of these three sections, your passion, enthusiasm and your appetite to learn
should shine through.
Why do you want to work in the industry?
Here is where you can tell a little bit of your story in a concise manner. What led you to apply to a
bank? What is it about the working environment that appeals? Are there any stories in the news
that led you to have a particular interest in banking?
Be succinct though. If you begin by writing ‘when I was five years old…’ you need to rethink your
approach.
Why do you want to work for the firm?
Here you should avoid any generic statements about the firm. Don’t quote the company website as
this will stand out as a copy and paste job. It’s also highly unoriginal.
Write about deals that you’ve been following in the press, campus events you have attended and
employees of the firm you have met. Make it explicitly clear that you’ve done your homework and
know the difference between the bank you’ve applied to and the rest of the banks out there.
What you think you can bring to the organization?
You may not know how to analyze a balance sheet or understand the ins and outs of a pitch-book;
thankfully neither will most other internship candidates.
You will have an education, work experience and life experiences; you now need to use the cover
letter to highlight how these skills have combined to make you intern material. Additionally you
need to highlight your willingness and ability to learn. An internship is, after all, a learning
experience.
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Preparing to Apply
‘I have excellent attention to detail’
When it comes to spelling, grammar and formatting, anything you submit must be perfect.
Remember that most bankers spend a substantial amount of time spotting mistakes. Any slight
error you make will be obvious. Making a spelling error will communicate to a banker that you lack
the attention to detail that is required to work in the industry.
Do not underestimate how much these small mistakes will count against you. You may be top of
your class, but if you make a small spelling error, your resume will go straight on the ‘No’ pile.
Ways to avoid making small mistakes:
 Take your time in submitting your application: Don’t leave it to the day of the deadline.
 Sleep on your application: Reviewing your application with fresh eyes can highlight errors and
areas for improvement.
 Show your application to a friend: Ask them to be ultra critical. Choose the friend who is most
pedantic and detail-focused!
 Be aware of your language ability: At many universities, if English/the local language is your
second language you will not be penalized for having less than perfect grammar and spelling.
In applying for internships, you will not be given this level of grace.
 Consult a career advisor: Many career services offer a resume workshop or clinic service –
utilize this service if it’s available.
 Use Word: If you are required to fill out an application form or submit your resume details
online (rather than upload a document) always type your application up in Word first. This way
you can benefit from the spelling and grammar check.
 Beware copy and paste: Every time I reviewed a stack of resumes, at least one or two would
go straight in the recycling bin simply because the candidate had written down the wrong bank
name. Or even worse, they’d written:
‘I know that XXX has an outstanding reputation in the market…’
This says to a reviewer that you haven’t written a unique application to their bank and also that
you lack attention to detail.
When to apply
Most banks take one of two approaches when it comes to setting application deadlines.
The rolling deadline: This is where recruiters review applications as they come in. This means
that they will conduct interviews as soon as they have enough strong applications. If a bank has a
rolling deadline, you will benefit by applying as soon as you are able.
The hard deadline: This is where a bank will not review applications until the deadline has hit.
They do this so that they can be comparative and select the best candidates to interview, not just
the candidates who applied the earliest.
Dealing with different bank’s deadlines
If you submit multiple applications, you may find yourself in this position:
Bank A wishes to make you an offer before Bank B has even looked at your application.
This can cause conflict if Bank A requires a quick decision on their offer. It can be especially
frustrating if you really do want to work for Bank B. Should you turn down Bank A and keep your
fingers crossed that Bank B will hire you? Or do you accept the offer with Bank A?
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Preparing to Apply
This can be extremely stressful on the part of the candidate. If you experience this problem, the
best thing that you can do is communicate with both parties openly and honestly.
Here’s what you can do to deal best with this situation:
 Always be open. Tell the bank that has already made you an offer that you are still in the
recruitment process elsewhere. It’s completely normal for an intern candidate to be in the
recruitment process with a number of banks.
 Ask for an extension. If the offering bank tells you that you have two weeks to accept an
offer, but you think you need three weeks then ask for an extension.
 Contact the bank who has not reviewed your resume. Explain the situation and that you
are still enthusiastic that they should consider you.
By communicating that you have an offer at another bank, you are showing yourself to be a strong
candidate. So it’s highly likely that they will look at your resume ahead of the deadline. Having
looked at your CV, the recruiter may be able to give you an indication of whether they will offer you
an interview or not. In some cases, but not all, you may even be fast-tracked.
Also reach out to any contacts within the banks that you have made. It’s times like these that
having a network can be invaluable.
If you ever feel like a bank is putting undue pressure on you, contact your career service. Explain
the situation and ask for their advice. Banks are usually very keen to have a good relationship with
career services so they are well-placed to advise you on how to proceed and in extreme cases act
as an advocate.
7. The first round interview
So you’ve written a knockout resume or application and you’ve received the coveted email
requesting an interview! Even if you have a ridiculously heavy workload, you need to put in some
hours to prepare for your interview.
There are three main areas you need to focus your preparation on:
Preparation: Yourself
Mock interviews
Some college career services run mock interviews. A few will even film you in the interview so you
can watch and listen to yourself. This is a cringe-worthy experience for many people but it is highly
beneficial – many improve their interview technique tremendously by watching themselves back.
If your career service does not provide mock interviews, use your roommates, family or friends to
practice your interviewing technique. People who work in the industry will be especially helpful.
Revising your resume
The night before your interview, review your resume. Remember that your interviewer is likely to be
using your resume as a roadmap to drive the interview. You need to be ready to discuss anything
listed on your resume with enthusiasm. It would also serve you well to remind yourself of how the
things listed on your resume make you intern material.
When revising your resume, ask yourself these questions:
 What are your key selling points?
 Which are the key experiences you want to position?
 Which of your skills are directly transferrable to banking?
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Preparing to Apply
Preparation: The industry
Hopefully you have been preparing yourself by keeping abreast of the financial press. Don’t
overwhelm yourself by trying to become an expert in the whole of the financial services industry.
Instead familiarize yourself with the basics. Also, try to become an expert in one or two deals,
products or sectors that are broad enough for the interviewer to have heard of. It’s far more
compelling to hear a candidate talk with confidence and genuine enthusiasm about a big deal than
to listen to a candidate ramble on about the markets generally.
So try to focus your research onto a couple of specific areas. Stay on top of the markets in general
but be strategic in how you focus your research.
When researching the industry, formulate your own opinions and views. Ensure that your opinion is
well thought-out and logical, and look at what Analysts, journalists and other commentators are
saying. Sharing an opinion in an interview will impress (if it is well thought-out). It will also give the
interviewer insight into your interests and thought processes.
Preparation: The firm
Don’t scrimp on firm research and don’t make the mistake that all banks are the same. There are
several things which differentiate banks.
The firm’s culture
Most, if not all banks will have something along the lines of ‘Business Principles’, ‘Firm-wide
Objectives’, ‘Company Mission’ or ‘Guiding Values’. These principles are likely to be prevalent
throughout the day-to-day running of the firm.
Interviewers won’t expect you to be able to recite these values in your interview but by reviewing
these, you may be able to anticipate the kinds of questions your interviewer is likely to ask you and
you can then prep your responses accordingly.
So a firm may have creativity as a guiding principle. Here you would do well to ensure you have
thought about an anecdote or experience when you were creative.
The firm’s businesses
You don’t need to know the exact share price movements of the last 12 months but you should be
up-to-date with any stories that have made the news recently.
Additionally, try to find out what sets a bank apart from other banks in the market. Are they
particularly risk averse? Do they have a reputation as being a debt house? Are they particularly
innovative? You need to know how the market sees the firm and their brand.
When asked ‘why do you want to work here?’ you need to say more than ‘this is a premier
investment bank with a reputation for excellence.’
Know the language of a firm
One bank may have IBD, another Credit, another, IBK. You need to be aware of the particulars of
the firm for which you are interviewing.
8. The day of the interview
As soon as you get up, start to drink water. A typical sign of nerves is a dry mouth. If you’re not
fully-hydrated, this can exacerbate the problem. Chugging down water ten minutes before your
interview won’t make any difference.
Aim to arrive at your interview an hour early. Check that you are at the right building and then find
a coffee shop nearby that you can wait in until it is time for your interview.
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9. During the interview
Introducing yourself
One of the most commonly asked questions to open the interview will be ‘so, tell me about
yourself?’ This may seem a benign icebreaker question, but there is huge potential for it to go
wrong. When asked this question, many people will ramble on endlessly or give a laundry list of
skills and attributes.
So instead of going off on an unstructured and forgettable ramble, prepare yourself thoroughly to
give a short and sharp answer. You should touch on a few things during your answer:
Be specific: this is a golden rule to follow when it comes to interviewing and it applies to this
question just as it does the rest. If you talk generically about how exciting the financial markets are
and how much you want to be involved in the industry, you will not stand out from the six or seven
other candidates that the interviewer may be meeting with that day. To be compelling you need
specificity. The best way to do this is with concrete examples.
So instead of answering the ‘so tell me about yourself?’ question by saying:
‘I’m a highly motivated, goal-orientated team player with a huge appetite for learning.’
Your reply should be something like this:
‘I’m a second year undergrad student majoring in Politics. (reminder of your background).
Politics suits my analytical nature (your character), as I hope will investment banking
(highlighting the relevance to banking).
I’m most happy working on long-term team projects (relevant to IB).
My most recent experience was as a group research assignment (an experience).
I was able to lead the research element of the project as that’s where my strengths lie (your
skills)……and a classmate was able to show me how to structure the presentation to best effect.
It was through my interest in politics in the BRIC economies that I became interested in finance.”
A response like this has clarity, evidence of your skills and experience and is rich enough that the
interviewer will be able to ask you a follow-up question.
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Answering behavioral/competency-based questions
A lot of first round interviews will be behavioral or competency-based. A bank will have a number of
firm-wide competencies and each candidate must demonstrate that they have each of these as
part of the recruitment process. Before you have the opportunity to show your quantitative abilities,
you will have to show that you possess these competencies, so don’t scrimp on preparation.
If you’ve done your homework, you should know what these competencies are. This knowledge will
enable you to pre-empt the questions that you are likely to receive and prepare yourself
thoroughly.
Revise at least two interesting examples per competency. Make these examples anecdotes that
you can comfortably talk about and receive questions on. If you’re enthused about these examples,
even better. Emotions are contagious, so if you’re enthused about a particular experience that you
share, then your interviewers are likely to be as well.
Avoiding the generic
The reason that interviewers are asking for examples is because they need evidence that you have
demonstrated the competencies they are trying to assess.
Also, concrete examples will stick in the interviewer’s memory. This will work in your favor if your
interviewer/s is meeting a lot of candidates in the same day.
As soon as you start talking generically, you will at worst sound insincere, at best boring.
Below are some generic answers alongside answers which involve specific examples.
Question
Generic answer
Specific example
Tell me about
a time when
you have
worked in a
successful
team.
I always work well in a
team. All of the successful
projects I’ve been involved
in have required teamwork.
I think teamwork is one of
the most important skills a
person can have.
While I was in my first year of university
I worked in a project team. We had to
research and build a presentation on
which country we thought would be the
next big emerging economy. It was an
open-ended briefing. The way we
decided to approach it was…
Have you ever
had to deliver
excellent client
service?
All of my jobs to date have
included delivering client
service. I always ensure
that in everything that I do, I
put the client first and that
they are100% happy with
my work.
While I was working in a restaurant,
one night we hosted a large birthday
party. On the day of the party, the client
came in to look at the layout and it
transpired that the client had invited
way more guests than the restaurant
had the capacity to accommodate. I
had three hours to work out how to
accommodate the extra guests. The
first thing I did was…
Give me an
example of a
time when you
had to solve a
problem?
I actually think problem
solving is a notable strength
of mine. I can think both
linearly and laterally. At
college, I do have a
reputation for being able to
work out solutions to
problems.
One assignment last term was to build
a computer game for children using
C++. The scope of the requirements
was especially specific which presented
me with a number of problems to solve.
The first problem was…
51
Preparing to Apply
What if the interviewer does not ask for examples?
Most good interviewers will ask you for concrete examples. The best way to gauge future
performance is to focus in on past behaviors. If the interviewer is less experienced or just less
savvy, he or she may ask you hypothetical questions such as:
What would you do if you were working in a team that wasn’t quite performing?
In this instance, it may be tempting to reply with a hypothetical answer such as:
‘I think I would get the team to sit down and analyze where we were going wrong.’
Even though the interviewer has asked for a hypothetical answer, you’re never going to be
compelling or memorable with a hypothetical answer. So, when an interviewer asks you a
hypothetical question, answer it by giving a specific example.
For example:
Interviewer: What would you do if you were working in a team that wasn’t quite performing up to par?
Candidate: I actually have an example of a time when this happened. The way I dealt with this was…
Also, feel free to add to the anecdote, specifically what you feel you learned from the experience.
The STAR interviewing technique
When you are preparing your examples for the interview, always bear in mind the STAR interview
technique. Many interviewers learn this technique as a way to probe candidates. The technique
works by opening candidates up so that they will talk expansively about their past experiences.
STAR stands for:
Situation
Here’s where the interviewer will ask you to describe a situation which required you to demonstrate
a certain quality.
Task
At this point, the interviewer will ask what it was that actually needed doing. Give enough color to
paint a picture for the interviewer but don’t overwhelm with detail.
Action
Here the interviewer will ask what you specifically did. If you have so far been talking about a team
for example, the interviewer will check that you were an active member of the team.
Results
To wrap up, the interviewer will want to know what it was that you achieved. If you can quantify the
results, do. If not, talk about the feedback you received or the impact your work had. Also, talk
about what you learned from the experience or what you would do differently next time.
Even if your interviewer does not use the STAR interviewing technique, using it in your preparation
will mean that you are thoroughly prepared.
52
Preparing to Apply
‘So what’s your biggest weakness?’
It’s worth mentioning that good interviewers will not use this question. This question is incredibly
old fashioned and harks back to the 1950s aversive interviewing style which was designed to put
the candidates under pressure. Clearly not a great way to bring out the best in a person. So,
decent recruiters will advise their interviewers never to ask this question.
Despite this, many interviewers still insist on asking the weakness question. This may partly be
because they can’t think of anything else to ask, or because they genuinely believe that it’s a
question worth asking.
On the surface, there are two ways to answer this question:
1. Genuinely admit to your biggest weakness. At this point, it may well be game over. All of us
have at least one quality we’d rather keep under wraps in the presence of a potential
employer.
2. Offer up a weakness which is really a strength such as:
‘I’m just too much of a perfectionist,’ or;
‘I get too caught up in my work. I never know when to switch off.’
This approach is equally as dangerous as the first. Insincerity is not an approach that an
interviewer will take kindly to.
So how do you handle this question?
Exactly as you handled the other questions, with an example. Begin your answer by saying:
‘One thing which I have to manage/be aware of is…’
This shows that you have control of your less-strong points. Next, give the interviewer an example
where you had to manage the said weakness. Wrap it up by explaining how you managed yourself,
what you learned and what you would do differently next time.
Here’s an example:
‘One thing which I have to manage is that I’m not a big picture person. I tend to focus more on
the smaller details. An example of where I had to manage this was when we took part in an
online trading simulation at my university. A number of people and I were sharing responsibility
for a portfolio. The way that I managed this was to…’
Menuing
Menuing is a technique that you can use to really stand out from other candidates. Everyone likes
to get a menu and the choice in what they select. Here you give the interviewer the choice about
what they listen to.
Imagine the interviewer asks if you have ever had to assume a leadership role. Instead of
launching off in giving your rehearsed answer, you reply by saying:
‘I’ve got two good examples, actually. One is from the time I was working in the family business
and the second is when I was interning at a local law firm. Which one would you like to hear about?’
By giving the interviewer the opportunity to select which anecdote they listen to, they will listen
more actively. You also give the impression of having a wealth of different experiences.
Use this technique sparingly – maybe once or twice during an interview; anymore than that would
be definite overkill.
53
Preparing to Apply
54
SECTION 2:
YOUR INTERVIEW
FL Sec 2 Title page_A4.indd 1
06/08/2013 08:31
Your Interview
56
Your Interview
Introduction
This section of the manual focuses on technically prepping potential entrants into investment
banking. While no technical Q&A can cover all topics and considerations, the reader should
also focus on the nature of the questions, the structure of the answer presented and what the
interviewer may be looking for in the answers. Part of the success story will be the
techniques used to answer the questions, so:
5
 Take your time to respond – shows that you’ve thought through the answer
 Plan and structure your response
 Where applicable, incorporate practical examples into the answer
 Do not rush the answer
 Be concise – do not waffle
 Weigh up different arguments if relevant
The Q&A section has been organized into a number of parts in order to address the key
aspects of an investment bank:
 Accounting and analysis
 Valuation
 Financial math
 Equities
 Fixed income and loans
Providing color to your response
Interviewers generally know what they are talking about. They will know the answers to the
questions they are asking, or at least they will know what answers or structures they are
looking for. Do not try to bluff your way through an answer!
Also they really do not want to listen to text book regurgitation of answers gleaned from
college textbooks.
 Provide an opinion where appropriate.
 Link the answer to a practical example.
For instance if answering a question about valuation, it may be possible to link the
answer into a recent transaction or a current discussion – such as a potential IPO of a
company like Facebook.
 Link the answer into how the information may be used by bankers.
 Don’t just regurgitate the text book answer – think about the practical considerations.
For instance, you could be answering a question on how useful is DCF valuation as a
technique. It is very easy to get sucked into long-winded technical answers. One point
could be ‘DCF is also very useful as a sanity check against my comparable valuation’.
So how can we add this color to the answers?
Your Interview
How can you differentiate your answers from the rest of the population?
57
Your Interview
Read the financial press
The technical Q&A work must also be supplemented by regularly reading the financial press, such
as the Financial Times or the Wall Street Journal. Reading such financial dailies will keep you
up-to-date with current financial events, show how the markets react to economic events, as well
as providing insights to opinions from market professionals. Most financial dailies are also written
with the intent to educate the reader. That is, not all knowledge is assumed. There will be
explanations of market mechanics as well as terminology.
Read the research
Depending on what area of the investment bank you are applying for, reading up on recent
research (issued by the interviewing bank in question, if possible) is an excellent way of getting an
overview of current market and economic conditions. Research is not just limited to equity research.
Investment banks will provide research on areas such as:
 Credit
 The economics
 Commodities
 Strategic research
Get familiar with the desktop products. A way to set you apart from the population is to get up to
speed with the desktop products used within the investment banks.
Get to know:
 FactSet
 CAPIQ
 Bloomberg
 MergerMarket
Knowledge of these products is a great way to introduce practical content to answers. For instance,
if you were answering a question on yield curves, it would be rather impressive to steer the
conversation toward how you would build a yield curve in Bloomberg.
We have included introductory material on Bloomberg and FactSet towards the end of this manual.
Investment banking blogs
There are a whole host of investment banking blogs and websites which are useful as part of the
prep process. The list below is not exhaustive but it is good:
 American Banker
 Bankers Ball
 Businessinsider.com
 Dealbreaker
 IPO Scoop
 Leveraged Sell-Out
 Pure Potential
 Silobreaker.com
58
Your Interview
 StreetInsider.com
 TheStreet.com
 Thompson Financial League Tables
 Wall Street Journal Online
 I-Banking Blog
 ibanking resumes
 Mergers and Inquisitions
 The All Nighter
 Trader Mike
59
Your Interview
60
Accounting and Financial Analysis Q&A
Introduction
A banker does not need to be an accountant; however you must have an excellent command
of the numbers that are reported in a set of financial statements, as well as those that are
analyzed by research brokers – it’s a core skill.
6
The skill with the numbers will be used to:
 Extract and normalize financials for analysis
 Analyze the performance, leverage, liquidity and efficiency
 Forecast the financials, often under different scenarios, going forward
While the accounting knowledge is a fundamental finance skill, this skill must be considered
within the context of the nature of the job being applied for. It is an essential skill for those of
you looking to apply for or working in:
 M&A and corporate finance
 Capital markets origination
 Corporate banking roles
However for jobs on the markets side of the bank, the accounting skills are not an
operational day-to-day skill. Market professionals require a solid knowledge of how
companies report their numbers and how research brokers disclose their forecasts.
This knowledge will aid them in their decision making and risk assessment.
Amy Drury BA (Hons) ACA
Amy qualified as a Chartered Accountant at Deloitte where she worked
within assurance and advisory for a number of years and also in the
forensic accounting and restructuring departments.
Her training experience started with a global financial training company
where she delivered ACA professional qualification courses to Chartered
Accountants. She managed the team of technical subject specialists in order to make sure
that they were up-to-date with the latest accounting developments.
After this, she moved into the investment banking industry, developing and delivering a
range of graduate training programs to global investment banks. She specialized in the
accounting, valuation and modeling courses and has used her in-depth knowledge of the
specific slant Analysts need to have to make this accounting section relevant and focused
to investment banking interns.
Accounting and Financial Analysis Q&A
 Understand a corporation’s operations and activities
61
Accounting and Financial Analysis Q&A
What are the three primary financial statements?
A set of financial statements will include the following three key financial statements:
 Balance sheet
 Income statement
 Cash flow statement
The balance sheet
The balance sheet is a financial statement that discloses information about an entity’s financial
position. It is a ‘snapshot’ of the assets, liabilities and equity.
Irrespective of the entity’s country of incorporation, all balance sheets adhere to the same basic
equation – the accounting equation:
Assets - Liabilities = Equity
Again this is a product of double-entry bookkeeping (there’s no need to know about debits and
credits – that’s more relevant for bookkeepers).
As with any equation, the elements of the equation can be rearranged:
Assets = Liabilities + Equity
Both equations are perfectly acceptable ways to present a balance sheet, the latter form being the
most prevalent in Europe and the US.
The numbers on the balance sheet will change from one period to the next. The majority of this
movement is due to the financial performance of the entity.
62
Accounting and Financial Analysis Q&A
The income statement
The income statement shows financial performance, or profitability. It is the income statement that
presents an entity’s ability to generate income and incur expenses. The net result of income less
expenses is profit or earnings. The type of profit (earnings) is dependent on the nature of the
expenses deducted against income. There are a number of different profit figures shown in an
income statement:
 Gross profit
 Operating profit
 EBIT (earnings before interest and tax)
 EBITDA (earnings before interest, tax, depreciation and amortization)
 EBITDAR (earnings before interest, tax, depreciation, amortization and rent)
 PBT or EBT (profit, or earnings, before tax)
 PAT or EAT (profit, or earnings, after tax)
 Net income (earnings) – this is different to PAT (or EAT). Net income will have been adjusted
for the amount of profit attributable to the non-controlling interests (minority interests)
The cash flow statement
The cash flow statement is a refreshing change for non-accountants. It is a clear statement of what
cash the entity generated from operations, what cash the company paid or received from investing
activities, and what cash came in and went out for financing reasons. It is a ‘clean’ statement,
almost free from the distortions of accounting policies. It is important that investment bankers
understand the cash flow statement as it is the basis for discounted cash flow valuations and a
cornerstone of analysis.
63
Accounting and Financial Analysis Q&A
What are the key components of a set of financial
statements?
Before examining any of the financial statements in detail, let’s look at their key components. A set
of financials is comprised of data from five key elements which interact to produce the financial
statements.
The five financial statement elements are:
The elements interact with each other and combine in order to produce a full set of financial
statements, that is, the balance sheet, income statement and cash flow statement.
What is an asset?
An asset is a store of future benefit that an entity controls.
Assets can be tangible; that is, they have a physical substance.
Or they can be intangible, in that they lack physical substance.
Examples of tangible and intangible assets are:
Tangible assets
Intangible assets
Property, plant and equipment (PPE)
Goodwill
Inventories
Brands
Licenses
Research and development
Software
64
Accounting and Financial Analysis Q&A
Assets are classified according to the purpose for which they are held:
 Non-current assets (also known as long-lived or fixed assets)
 Current assets
Current assets are assets that the entity will be seeking to realize into cash within the next year or
within the entity’s operating cycle, whichever is greater. Non-current assets are those assets where
the entity’s intention is that they will be employed for the longer-term. They are typically those
assets with which, or within which, the entity runs the operations and generates cash flow.
Using the previous asset examples and reallocating them to either non-current or current assets,
we get quite a different allocation of assets:
Non-current assets
Property, plant and equipment (PPE)
Current assets
Inventories
Goodwill
Brands
Licenses
Research and development
Software
Liabilities
Liabilities are amounts owed to third parties as a result of a past event.
Typical examples are:
 Accounts payable
 Taxes payable
 Pension deficits
 Provisions
 Amounts owed to banks (loans)
 Amounts owed to debt investors (debt)
Liabilities are classified between amounts that fall due within one year, and amounts falling due
after more than one year.
Equity
Equity can be thought of as the amount that is owned by (or belongs to) the
shareholders of the business. Equity is not a liability as the amount is not an
obligation; rather it is the residual interest in the business.
65
Accounting and Financial Analysis Q&A
Income
Income is the measure of the increase in an entity’s economic benefits over a
period.
This definition normally does not mean much to the non-accountant. Most
Analysts will simply view income as the revenue or sales generated by an
entity’s operations (net of any sales taxes). This income is trading income.
But be aware that an entity can also have non-trading income such as:
 Income from investments
 Interest income
 Income from non-core operations
Income is often not recognized at the same time as cash is generated. Income is generally
recognized in a set of financial reports in the period that the transaction generating the income
takes place, not on the basis of when the physical cash was received. Therefore entities can be
income profits-rich but cash-poor.
Expenses
Expenses are the costs of using up benefits during a period. Like income, the
expense incurred may not be recognized at the same time as the cash is paid
out. Expenses are recognized in a set of financials on the basis of when the
expense was incurred or used up, rather than when the cash payment was
made.
Examples of expenses are:

Costs of sales

Selling, general and administration costs

Depreciation

Amortization

Interest

Tax
The above expenses are generally considered operating expenses; though in some jurisdictions,
some might be considered non-operating.
66
Accounting and Financial Analysis Q&A
What is meant by financial statement integration?
The financials are an integrated set of statements. You need to understand how the financial
statements interact in order to appreciate how specific adjustments that bankers make will change
the numbers and how those different numbers will flow through each financial statement. A good
understanding is also vital to building good financial models and for company valuation.
As an Analyst or intern, you need to have the ability to construct fully integrated three-statement
financial models. That is, you can build models where the balance sheet, income statement and
cash flow statements are fully integrated and robust.
There are three key links that Analysts build into a fully integrated model:
1. Income statement net profit into equity (through retained earnings)
2. Income statement profit into the cash flow statement (through a profit metric such as net income
or EBIT)
3. Cash flow statement into the balance sheet
The diagram below shows the links between the three statements:
67
Accounting and Financial Analysis Q&A
Why do accounts show depreciation and
amortization?
Depreciation and amortization (D&A) are different words for the same basic accounting principle.
Both are accounting mechanisms used to spread the cost of tangible and intangible assets through
the income statement. The expense is included in the income statement over the asset’s useful life
to accurately reflect the fact that the cost to the business is not a one-time charge; rather the
accounts match the expense to the periods the asset is in use.
Depreciation relates to the spreading of a tangible asset cost.
Amortization relates to the spreading of an intangible asset cost.
The purpose of D&A is two-fold:
 It represents the consumption of an asset’s benefits over its useful life
 It matches the cost of the asset to the benefits generated by the asset
If the whole cost of the asset was to immediately hit the income statement, it would show a
significant expense each time an entity bought a new asset. Then in subsequent periods, the asset
would be realizing benefits without an associated cost. This would result in a profit profile that
would be erratic and uncorrelated to the entity’s underlying trading performance. D&A therefore
matches the benefit and cost of tangible and intangible assets together in the same reporting
period.
D&A are probably the most common non-cash expenses – they have no cash impact but do
reduce profit and, in particular, are subtracted in order to arrive at earnings before interest and tax
(EBIT).
D&A numbers are subject to manipulation. Financial managers may have the desire to manage the
earnings number in the income statement. As D&A numbers are charged in arriving at operating
profit or EBIT and EBIT is a key metric for analysis, valuation and modeling purposes, the
weaknesses in the D&A numbers must be fully appreciated.
The key variables required to calculate D&A are the asset’s initial cost, useful life and residual
value.
How can D&A numbers be manipulated?
The simplest form of manipulation of D&A numbers is the ease with which the useful life can be
extended or reduced. Take a $600 laptop. There are no prescriptive accounting rules that state a
laptop should be depreciated over a set number of years. It is relatively easy to justify that a laptop
should be depreciated over two years – hence we have an annual depreciation charge of $300, if
depreciation is calculated on a straight line basis. Three years is also an easy justification. The
annual depreciation charge then is $200. EBIT has been managed upwards by $100. Apply a 10x
EBIT valuation multiple to this and the valuation has been altered by $1,000. Bear in mind this is
just one asset and it’s a small number in this illustration.
D&A can also be manipulated in the financials through the choice of D&A method. An entity
wishing to suppress current earnings may opt for a reducing balance D&A method, thus
accelerating the charge to the income statement and reducing the short-term earnings profile.
68
Accounting and Financial Analysis Q&A
D&A numbers are also non-cash numbers – that is, they are pure accounting numbers which
widens the disconnect between earnings and cash.
There are no prescriptive requirements in the accounting rules for particular assets to be
depreciated in a particular way. Therefore it is common for similar assets on the balance sheets of
similar entities in the same peer group to be depreciated differently.
D&A policy can also, depending on the jurisdiction, be driven by local tax policy. In some countries,
the D&A numbers may be tax deductible. Therefore there is a motivation to accelerate the D&A in
order to secure the tax deductions at the earliest opportunity. Comparability for analysis and
valuation purposes therefore becomes a potential issue.
In summary, D&A numbers pose issues for Analysts.
D&A numbers are:
 Easily manipulated
 Non-cash items
 Inconsistently applied between peer group entities
 Inconsistently applied internationally
As a result of this, Analysts often strip out the D&A numbers from the EBIT number. This produces
an earnings number before interest, tax, depreciation and amortization (EBITDA).
69
Accounting and Financial Analysis Q&A
How does…impact the financials?
These are very popular questions. They test your understanding of how the financial statements
link and integrate together. The interviewer is testing how comfortable you are at following the
chain of accounting events through all of the financials – balance sheet, income and cash flow
statements.
Normally the best place to start the flow of events is the income statement.
Be thoughtful, but careful when talking about the ‘after tax’ impacts of events passing through the
income statement. The tax legislation in your jurisdiction may not be applicable everywhere.
Once you have dealt with the income statement, walk through the cash flow statement impact.
Finally walk through the balance sheet impact.
Common questions will focus on the impact of:
 Depreciation and amortization changes
 Impairment write-downs
 Purchases of assets
 Leasing
 Provisions
 Entering into new loan agreements
How does depreciation affect the financial
statements?
Depreciation reduces profit at the EBIT level and all levels of profit below EBIT, such as net
income.
Depending on the tax rules of the particular jurisdiction, there may be a tax saving. However
because depreciation is a non-cash expense it has no impact on the cash generative ability of the
business.
The balance sheet impact is that the asset, within property plant and equipment, will be lower.
So, in summary, depreciation reduces equity (through its impact on profit and retained earnings)
and reduces the value of assets.
Assets
Decrease in PPE
by the amount of
the depreciation
expense
70
=
Liabilities + Equity
=
Decrease in profit, and
hence equity
by the amount of the
depreciation expense
Accounting and Financial Analysis Q&A
How does an impairment write-down affect the
financial statements?
An impairment write-down is a one-off reduction in the value of an asset, for example, following an
assessment of the value of goodwill on the balance sheet. Impairment arises where an asset in the
accounts is at a value that is above its fair value.
The impact of an impairment write-down is identical to the impact of depreciation or amortization, in
that it is a non-cash expense that reduces profit (and hence equity in the balance sheet) and the
value of the asset within the balance sheet but has no impact on cash.
Assets
=
Liabilities + Equity
=
Decrease in profit, and
hence equity
by the amount of the
impairment write-down
Decrease in asset
(eg goodwill) by
the amount of the
impairment writedown
How does the purchase of an asset affect the
financial statements?
The purchase of an asset, such as an item of machinery for $52,000 in cash, increases one
category of asset, namely PPE, but reduces another asset, cash.
Therefore, on the initial recognition of this transaction, total assets are unchanged. There is no
effect on profit and hence equity.
Assets
Assets
=
Increase in PPE
Increase
PPE
€52,000
$52,000
=
Liabilities + Equity
Decrease
in cash
cash
Decrease in
€52,000
$52,000
As mentioned earlier, as the asset is used, then the asset suffers depreciation, reducing the
asset’s book value and profits in the future.
71
Accounting and Financial Analysis Q&A
What is the impact on the accounts of a company
entering into a new lease of an asset?
The accounting treatment depends on whether the lease is a finance/capital lease or an operating
lease.
Capital (finance) leases
The accounting for a capital (finance) lease is debt-driven. The lease commitment is valued in
present value terms using the interest rate implicit in the lease agreement and on inception this
amount is then recognized as the debt commitment and asset value.
The accounting for this lease debt is then the same as for any other vanilla debt instrument and
depreciation is charged on the asset. This is done over the term of the lease or the life of the asset,
whichever is shorter.
Therefore, there are two charges to the income statement:
 Depreciation (above EBIT)
 Interest (below EBIT)
Both charges have no impact on EBITDA metrics, as EBITDA is before depreciation and interest.
This is one of a number of weaknesses of the EBITDA metric – it ignores the charges associated
with capital leases.
The capital lease cash payment (rental) has two elements:
 Interest cash payment (an operating cash flow)
 Principal cash repayment (a financing cash flow)
Operating leases
The accounting for operating leases is very straightforward. No debt or asset is recognized on the
balance sheet. The only accounting is the charging of an operating lease rental expense to the
income statement.
The rental expense is a charge to EBIT and EBITDA.
The cash flow is classified as an operating cash flow.
72
Accounting and Financial Analysis Q&A
Capital lease illustration
Calculate the present value of the minimum lease payment (MLP)
Finance lease
The capital lease is treated as
a financing commitment
because the lease agreement
is a claim on the future cash
flows of the business.
The valuation of the
commitment is a present value
approach that follows the
basics of bond valuation.
Capitalize the lease debt and asset (assumed to be PPE)
Debt and asset recognition
At the inception of the lease,
the present value of the lease
commitment is recognized as
the debt and asset elements
of the lease.
73
Accounting and Financial Analysis Q&A
Debt and asset accounting
The debt is accounted for using an amortized
cost calculation. Interest charged at 8% on the
outstanding balance of $135, 752 gives an
interest charge of $10,860. The interest is
charged to the income statement below EBIT.
The asset (normally part of PPE) is then
depreciated over the lease term, or if shorter,
the asset’s useful life. The PPE valuation was
$135,752 – this is spread over the five year
lease term giving an annual depreciation
charge of $27,150. The depreciation is
charged to the income statement above EBIT.
The cash lease payment of $34,000 is made at the end of the period
Cash payment
The cash payment of $34,000
comprises two elements.
The payment is conceptually
first services the finance – that
is pay down on the interest that
has accrued over the period.
The residual $23,140 pays
down on the debt principal.
In the cash flow statement, the
$34,000 payment will be split
on this basis between operating
(the interest of €10,860) and
financing ($23,140) cash flows.
74
Accounting and Financial Analysis Q&A
How does a provision affect the financial
statements?
A provision is an estimate of a future expense. It is a liability where there is uncertainty surrounding
the amount and/or the timing. A provision must satisfy the following to be put on a balance sheet:
 There must be a past event
 That creates an obligation
 That leads to a probable outflow
Provisions can be used to manage earnings. Establishing a provision in the financials will result in
an increase in liabilities and an earnings reducing charge to the income statement.
If the same provision is then reversed, for example in the following year, the liability would be
removed and there would be an enhancement to earnings. Earnings will have been shifted from
one period to another purely through the use of some basic accounting.
The recognition requirements for there to be a past event that creates an obligation has greatly
reduced the abuse of this area in the financials. However, its use to smooth earnings between
periods is still prevalent.
Used in the good years…
The method is used in good years for instance to reduce excess earnings and to hold these excess
earnings on the balance sheet in the form of a provision. A possible reason for this may be a desire
to reduce current earnings so that broker and shareholder expectations are not exceeded. The
earnings held on the balance sheet can be released if and when earnings take a downward turn at
some stage in the future.
75
Accounting and Financial Analysis Q&A
…and in the bad
Provisioning is also an issue in the bad years. If an entity is going to miss expectations materially,
there is an argument that all the bad news stored up in the business should be released to the
market in one period. If the news is going to be bad, it may as well be very bad. Provisions in this
context are used to clean up the financials. At least all the bad news is out in one period and the
next period starts with a clean and level playing field.
Can companies revalue their assets?
Intangible (with the exception of goodwill) and tangible assets
(in practice normally Plant, Property and Equipment – PPE)
can be revalued depending on the GAAP.
US GAAP does not allow the revaluation of PPE.
Once a company adopts a revaluation policy, it must be kept
up-to-date.
A revaluation results in an increase in the balance sheet value
of the asset. In order for the balance sheet to balance, a revaluation
reserve is set up in equity. The reserve represents an unrealized gain.
The gain cannot go to the income statement (and thereon to retained
earnings) because it is unrealized.
In some jurisdictions, the gain on the revaluation becomes
immediately chargeable to tax.
Depending on the company law of the entity’s incorporation, the
revaluation reserve might be treated as a non-distributable reserve.
That is, it is not possible to distribute a dividend out of the reserve.
If the asset is sold, any remaining revaluation reserve can be
transferred to equity, as the gain has become realized. The reserve
transfer then becomes distributable.
Why would a company revalue its assets?
Revaluations are not that common in practice. Although intuitively you might think that bigger asset
values are better, revaluations have the effect of harming performance measures such as return on
assets and return on capital employed.
However, when revaluations do happen, it is worth investigating to see if there is a background
story that drives the policy.
Why revalue?
 To reflect a better fair value of the entity
 To increase collateral for a loan
 Prior to pricing a sale and leaseback transaction
 Prior to commencing a disposal strategy
 To reduce leverage ratios (equity is increased by the creation of the revaluation reserve)
 Can help to prevent debt covenant violations
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Accounting and Financial Analysis Q&A
 As a bid defense – reflect a better fair value for the entity
 To strengthen the position as part of bid negotiations
 To manage dividend policy. A revaluation will increase the depreciation charge and hence
reduce the profits available for distribution to shareholders.
Analysis impacts:
 Increase in the depreciation charge
 Dilution of EBIT
 There is no impact on EBITDA
 In some countries, there may be an immediate tax impact as a result of the revaluation
 Return on capital employed is reduced. Profits are reduced by the increase in the depreciation
charge. Capital employed is increased by the creation of a revaluation reserve (part of equity).
What is working capital?
An understanding of working capital is essential to:
 Analyze an entity’s liquidity and cash management situation
 Derive cash flows for analysis and valuation purposes
The term 'working capital' is widely used but there are many definitions. Take care when using the
term.
Some standard academic text book definitions of working capital are too simplistic. For instance,
the definition of net working capital as current assets – current liabilities is arguably an adequate
quick and dirty definition, but it can capture items that are current by definition but not operating by
nature. For instance, Analysts often exclude tax liabilities, surplus assets, or excess cash from the
net working capital definition.
One definition of net working capital is:
 Inventories plus
 Receivables
 Less: trade payables
An increase in net working capital means that the working capital assets have increased in relation
to the working capital liabilities. This means more cash has been tied up in the working capital
assets of the entity. This type of understanding is key to the work on cash flow analysis and
valuation. An increase in net working capital is bad for the company’s cash position (when viewed
in isolation) though it might be vital for the business in order to support additional activity.
Depending on how the working capital figure is being used, it may be relevant to include that part
of the cash and cash equivalents which is essential for the proper operation of the business.
77
Accounting and Financial Analysis Q&A
What is net debt and how is it used?
Net debt is a metric that is widely used by Analysts. It is used for:
 Credit analysis
 Return on capital employed calculations
 Enterprise (or firm) value numbers
 Comparable company and transaction analysis
 The move from enterprise (or firm) value to equity value
 Assessing the credit implications in a merger model
 Leverage multiples in LBO models
As an Analyst, not knowing how to quickly extract a net debt metric from a set of financials should
be considered a sin!
78
Accounting and Financial Analysis Q&A
The basic net debt definition is borrowings - (cash + liquid resources). More often than not, these
numbers can be picked up straight off the face of the balance sheet. It is however a worthwhile
exercise to check out the notes to the financials that support these key balance sheet numbers.
Often the notes will reveal additional information that will add support to the calculation of the
metric.
Borrowings (current) 1,189m
Borrowings (non-current) 1,194m
Cash and cash equivalents – 251m
Short-term investments – 247m
Net debt – 1,885m
Does net debt capture all of a company’s debt?
Net debt is a good starting point for establishing an entity’s indebtedness, but the measure
unfortunately does not capture all items that potentially could be classified as debt, particularly
from a credit analysis or valuation perspective.
Items that possibly could be included in an ‘adjusted’ net debt figure are:
Net debt (standard calculation)
X
Operating lease commitments
X
Pension deficit
X
Debt within ‘Equity accounted’ investments
X
Adjusted net debt
X
79
Accounting and Financial Analysis Q&A
Operating lease commitments
Credit rating agencies have the fundamental belief that operating lease commitments are simply a
form of financing that have claims on the future cash flows of the entity. The fact that the
accounting rules have historically made a distinction between operating and finance/capital leases
is largely a matter for the accountants – the distinction is artificial.
According to the SEC, approximately $1.25 trillion in non-cancellable future operating lease
commitments are disclosed and are off-balance sheet. These commitments should be recognized
on the balance sheet for a number of reasons:
 Enable more meaningful peer and period-to-period comparisons
 Better reflect underlying economics
 Better reflect creditors’ risks, rights, and benefits
 Facilitate more robust financial forecasts
Credit rating agencies, when doing their own analysis, convert operating leases into capital leases.
Each credit rating agency has its own operating lease conversion model, but the main point is that,
if no estimate is made (and disclosed) regarding the equivalent debt amount of these
non-cancellable commitments, then Analysts will be considerably underestimating the extent of
indebtedness within companies.
Operating lease
conversion
Moody’s factor
model
S&P DCF model
Economic value
of the asset
Debt equivalency
of current
commitments
Factor model
DCF model
Moody’s factor model attempts to replicate
the purchase of the whole asset, not just to
capture the present value of the lease
commitments. Therefore the numbers
generated by the model represent the full
economic life of the asset. The argument for
this is that the entity will need to replace the
asset in order to maintain cash flows. The
model therefore captures lease agreements
where the entity leases long-lived assets
for short periods and rolls the leases over
with either new leases or renewal options.
The objective of the DCF model is to capture
the present value of the lease commitments,
and not to recognise the whole asset
associated with the lease as if the asset were
owned by the entity.
The approach is entirely different to the Moody’s
factor model objective – the two methods will
give different answers.
Moody’s will never capitalize operating lease
commitments at levels lower than the present
value of the lease commitment.
80
Accounting and Financial Analysis Q&A
Pension deficit
Current accounting rules around the globe often fail to recognize in full on the balance sheet, the
economic position or funded status of the defined benefit pension scheme.
If a company has a pension deficit, this will always be disclosed in the notes to the accounts, even
if this amount is not shown on the face of the balance sheet.
If a company has a pension deficit, it can be argued that the company is effectively being financed
(to the extent of the deficit) by the pension fund.
For this reason, the pension deficit is often added to the standard net debt figure to get an adjusted
net debt figure.
Debt within ‘equity accounted’ investments
Under the equity method of accounting, the investment in an affiliate/associate is shown in one line
on the balance sheet. One of the major analytical issues arising out of equity accounting is how to
assess net debt embedded in the affiliate/associate. An affiliate can be structured to hold
significant amounts of (net) debt. The lenders of this (net) debt often have no legal recourse to the
parent company – however due possibly to the strategic nature of the affiliate’s activities, the
parent might not want the affiliate to fail. As a result of equity accounting, the affiliate’s net debt
does not get consolidated directly into the net debt line of the consolidated accounts.
For instance, Coca Cola structures most of its bottlers as affiliates. These affiliates hold a
significant amount of net debt. Therefore when analyzing the accounts of Coca Cola Inc (the
consolidated group accounts), the net debt line only captures the net debt of the parent and its
subsidiaries. But the bottlers are strategically crucial to the group as a whole. So the credit risk
carried in the net debt of the affiliates must be analyzed.
Analysts will have to pick up the accounts of the affiliates and calculate the net debt of these
entities. The next issue is how much of the affiliate’s net debt should be included in the overall net
debt calculation.
The accounting would suggest that the analysts should include the group’s ownership proportion.
However, strategically, for instance with Coca Cola’s bottlers, there is an argument for including
the full 100% of the affiliate’s net debt in the analysis – as the affiliate itself is so crucial to the
overall viability of the group.
S&P and Moody’s will consider the net debt embedded in the affiliates of Coca Cola when
determining its credit rating.
The above also applies to joint ventures that are equity accounted.
Why is net debt ‘net’?
Earlier net debt was defined as ‘Borrowings - (Cash and Liquid resources)’ – but why is cash
deducted?
Cash can be considered unemployed capital or non-operating capital. It should therefore be
excluded from a valuation calculation as there is no corresponding return.
Another explanation is that this cash could be used to repay debt, hence Analysts look at net debt.
This argument can be flawed. In some industries such as retail, cash is considered an operating
asset. It is part of the working capital used to run operations and generate value.
81
Accounting and Financial Analysis Q&A
Not all cash is working capital though. If Analysts are pursuing this argument, they will have to
identify what element of cash is working capital and what element is ‘excess’. Only excess cash
should be netted off against the debt number.
What does equity on the balance represent?
Equity is a widely used term that has several meanings. It can simply refer to investing in shares or
common stocks. It can be used within a valuation context to refer to the book value or market value
of stocks/shares.
In a set of financials, equity refers to the numbers that appear normally at the bottom of the
balance sheet. From an accounting perspective, equity is a residual claim that the equity holders
have on the net assets of an entity.
Equity in a balance sheet will encompass an entity’s equity instruments and its reserves. This area
is referred to under a variety of names:
 Equity
 Shareholders’ funds
 Shareholders’ equity
 Stockholders’ equity
 Capital and reserves
When a company raises cash by issuing equity (stocks/shares), it is initially recorded at proceeds
less transaction costs and is not revalued to fair value.
Within the balance sheet, the nominal (or par) value is recorded within one line, called ‘share
capital’, ‘paid in capital’, or a similar type of description, and the excess over the nominal (or par)
value is recoded within a line called share premium, ‘additional paid in capital’, or some such
words.
Reserves can include:
 Revaluation reserves
 Translation reserves
 Buyback reserves
 Legal reserves
 Non-controlling interests
 Retained earnings
However, what is vital to appreciate, is that equity in the balance sheet only ever represents the
book value of what belongs to the shareholders, which could be considerably different to the
market value of their investment in the company.
82
Accounting and Financial Analysis Q&A
What is a minority interest?
Minority interests are now referred to as non-controlling interests.
Non-controlling interests (NCI) are relevant only to group or consolidated financials. They are a
component of equity and represent that part of the net assets of a subsidiary that is not owned by
the parent company. A non-controlling interest only arises when a parent does not own the entirety
of the subsidiary.
The illustration below shows a parent company owning 75% of a subsidiary (a company the parent
has control over). So, there is a 25% equity ownership in the subsidiary owned by a party other
than the parent company.
NCI is the new term for minority interests. It is likely that bankers will continue to refer to this class
of equity as a minority, rather than follow the accounting NCI terminology.
The new terminology is now in use for most published financial statements. The NCI (cumulative
value) is a component of equity on the balance sheet and the NCI adjustment to the earnings is
shown at the bottom of the income statement:
Source: Cadbury annual report with kind permission of Cadbury Holdings Limited
83
Accounting and Financial Analysis Q&A
What is the NOSH?
The correct number of outstanding shares (often referred to as the ‘NOSH’) is a key number in
comps and DCF valuations when attempting to quantify the equity value per share. Many Analysts
make serious and material errors with this number – it seems like it should be an easy number to
identify but it isn’t:




Authorized share capital
Issued share capital
Outstanding share capital
Outstanding (public valn)
 Outstanding (M&A)
The maximum number of shares a company can issue
The number of shares issued by the company
The issued number of shares net of treasury shares
Includes potential dilutive securities (outstanding and ITM)
(There is some debate here as to whether only exercisable
options should be included)
Includes potential dilutive securities
(change of control capture) at the offer price
 Include whether or not vested/exercisable
 Include treasury shares
What is EBIT?
EBIT (earnings before interest and tax) is:
$m
Revenues
X
Costs of sales
(X)
SG&A
(X)
EBIT
X
Operating profit or EBIT, as it is more commonly known by Analysts, is a very common metric.
It provides profitability information about an entity’s trading operations. How much does an entity
make from its normal trading operations? The metric takes into consideration all operating
expenses including overheads.
84
Accounting and Financial Analysis Q&A
A major weakness with the EBIT metric is that it is after the deduction of depreciation and
amortization. Hence the metric is open to manipulation and leads to comparability issues between
different time periods and between entities.
What is EBITDA?
EBITDA is defined as earnings before interest, tax, depreciation and amortization.
$m
Revenues
X
Costs of sales
(X)
SG&A
(X)
Operating profit (EBIT)
X
Add back: Depreciation
X
Add back: Amortization
X
EBITDA
X
EBITDA is a very commonly used metric in analysis and valuation. The popularity of the metric is
due to the fact it ignores the noise created by D&A. D&A are accounting mechanics that can be
easily manipulated in the financials. This leads to comparability issues. Focusing on EBITDA
makes it easier to compare the performance of different entities.
EBITDA is often described as a proxy for operating cash flow. Although this is a risky assumption
to make, it does have elements of truth. D&A are non-cash items and EBITDA does ignore them.
Hence, the metric is closer to operating cash flow than is EBIT. However, EBITDA is not operating
cash flow as it ignores the movements in working capital.
Warren Buffet has for a long time been a strong critic of EBITDA. Charlie Munger, Buffet’s
long-term business partner sums his view up nicely as follows:
Whenever you read or hear the term EBITDA, you should substitute ‘bulls**t accounting’
A little strong, but when it comes from such a successful investment fund as Berkshire Hathaway,
investors tend to take some notice.
Analysts must be aware that it is not a perfect metric and is not a cash number.
EBITDA:
 Still ignores changes in working capital
 Is only a rough proxy for cash flow
 Is still subject to revenue and operating cost recognition issues
 Ignores the costs of capital expenditure and tax, both of which are key drivers of value
 Creates comparability issues if leasing is prevalent in the sector. EBITDA ignores all the
income statement charges relevant to capital (finance) leases.
85
Accounting and Financial Analysis Q&A
How and why would you normalize a metric?
If an Analyst picks EBIT or operating profit straight from a set of financials, there is a strong
possibility that the number will include non-recurring or exceptional items. This poses an analytical
issue as the peer group and previous time period data may not be comparable.
A non-recurring or exceptional item is any item in the income statement that falls outside the
normal activities of the business.
However, from an Analyst’s perspective, whether an item is classified by accountants as
exceptional or non-recurring is less important. What is important is to make a judgment as to
whether a metric should be adjusted or normalized to remove items that are unlikely to recur.
Common examples of non-recurring items are:
 Asset write-downs
 Impairments
 Restructuring costs
 Reorganization costs
 Inventory write-offs
 Profits and losses on disposals of PPE
 Litigation expenses
Analysts will be required to normalize metrics on a regular basis. Normalizing refers to the stripping
out of non-recurring or exceptional items from metrics. The normalizing procedure can be
subjective and dependent on an Analyst’s own views, but it does improve the comparability issue.
Accountants will assist the process of normalization by disclosing what they believe to be material
non-recurring items on the face of the income statement. However, as an Analyst, you must not
simply agree with the accountants. You must be prepared to review the notes to the accounts in
order to discover additional items that may be non-recurring or exceptional.
Normalizing earnings metrics will also focus attention on whether the numbers are core to the
entity’s operations.
Cadbury provides a good example for normalizing EBIT:
86
Accounting and Financial Analysis Q&A
At first glance, Cadbury discloses two profits from operations. These can be described as EBIT
metrics. However, there is a significant difference between the total EBIT of 388m and the
underlying EBIT of 638m. You must never blindly rely on a metric just because it is described as
‘underlying’. The adjustments must be analyzed.
There are three sets of ‘non-underlying’ adjustments made to this EBIT number:
 Trading adjustments
 Restructuring adjustments
 Non-trading adjustments
These adjustments amount to 250m in total and so are material to the overall EBIT number.
The next step would be to review the notes to the accounts in order to determine the nature and
context of the adjustments.
Note 4 to the income statement provides background detail to the 194m restructuring adjustment.
It is clear from the review of the note that these items are not part of the ordinary activities of the
business and are sufficiently unusual. A reasonable and natural conclusion might be that these
numbers should be stripped out of an EBIT metric.
A similar exercise must be conducted for the trading and non-trading adjustments.
The adjustments necessary to normalize EBIT might therefore be:
EBIT per financials
£388m
Add: Restructuring costs
£194m
Add: Trading costs
£57m
Less: Non-trading items
(£1m)
EBIT (normalized)
£638m
Care must be taken with the signs on these adjustments. The reversal of an expense from a metric
will always be a positive adjustment. The opposite is the case for the reversal of an income item.
87
Accounting and Financial Analysis Q&A
What are pro-forma numbers?
Pro-forma numbers are often taken to be ‘full period’ numbers with unusual or non-recurring items
stripped out. They attempt to convey what the results are or would be under ‘normal’ operating
conditions.
In practice, the term 'pro-forma' numbers has a wide variety of meanings. Pro-forma comes from the
Latin ‘as a matter of form’. There is no uniform template for what is a pro-forma number; they are
simply numbers that a company provides in addition to their standard reporting. It is therefore
difficult to provide much confidence that pro-forma numbers are comparable with other numbers
produced by an entity. Pro-forma numbers are normally issued in the form of research or press
releases. As a result, they often (depending on the jurisdiction) do not fall under the remit of
regulatory rules. This can lead to the claim that pro-forma numbers ‘window dress’ the true
accounting numbers. During the dot.com boom, many tech companies used pro-forma numbers to
present an enhanced view of their earnings profiles.
Pro-forma numbers are often adjusted for:
 Exceptional or non-recurring items
 Like-for-like items
 New acquisitions to reflect a full year’s worth of earnings from the new acquisitions
What does LTM mean?
LTM is an abbreviation for ‘last 12 months’. The term is usually applied to financial information
found in the income statement.
LTM numbers are used to reflect the most recent publicly available information. Debt and equity
capital markets will factor this information into the pricing of equity and debt, in particular when
using multiples. It is therefore important that the metrics capture the most up-to-date information.
A LTM number is constructed using annual and interim financials. Most European public
companies are required to publish financials twice a year. In the US, the Securities Exchange
Commission requires public companies to report quarterly. The filing is a 10Q. As a result of the
frequency of US filings, the US LTM numbers have greater scope to be more up-to-date.
The construction of a LTM earnings metric (assuming US quarterly reporting) is illustrated below:
88
Accounting and Financial Analysis Q&A
What is EPS and how is it used?
EPS (earnings per share) is a key metric that is used by Analysts across the industry. It is the
earnings per ordinary share or common stock. That is, the earnings that belong to the ordinary
shareholders of the business.
Naturally, it is a focal point for stockholders.
It is used:
 As a comparison tool between peers (not the most robust tool it must be said)
 To calculate payout ratios and dividend coverage
 As a key valuation metric by research brokers
 To quantify earnings growth between periods
 As a variable to calculate P/E multiples
 In merger models to perform EPS accretion/dilution analysis
The metric is however inherently weak and it should be used with care and as a high level
analytical tool.
The metric is calculated using information at the very bottom of the income statement. Therefore it
is open to manipulation at every level above this bottom line earnings measure. This leads to real
issues of comparability between peers and over time.
In simple terms, EPS is the earnings belonging to the equity stockholders divided by the number of
equity shares. The calculation can become increasingly complicated depending on the range and
complexity of instruments held by the entity.
89
Accounting and Financial Analysis Q&A
Basic EPS is calculated as follows:
The calculation looks like it should be straightforward; but there are a few complications. The
calculation of the net income in the numerator is reasonably straightforward. The net income is
purely the income belonging to equity shareholders or common stockholders of the business. The
complications arise with the weighted average number of shares, the denominator in the
calculation. The reason for using the weighted average number of shares is to be consistent with
the net income.
Net income arises over the period of a year and so the calculation needs to include the weighted
average number of shares in issue over the whole period too. The weighted average number of
shares can be a tricky calculation if there has been share issues, buy backs or similar transactions
during the period.
What is the difference between basic and diluted
EPS?
There are two forms of EPS calculation to be aware of:
 Basic EPS
 Diluted EPS
Diluted EPS is a calculation that anticipates the impact of potentially dilutive securities on the EPS
number. Diluted EPS acts as a warning to shareholders of the potential earnings dilution. Typically,
a diluted EPS calculation is anticipating the impact of there being more shares in the company in
the future as a result of the existence of:
 Convertible debt
 Convertible preference shares
 Options
 Restricted stocks
 Warrants
A diluted EPS calculation adjusts the basic EPS. Both the earnings numerator and weighted
average number of shares denominator must be adjusted.
90
Accounting and Financial Analysis Q&A
Earnings dilution
The basic EPS earnings metric is typically adjusted for:
 Dividends on convertible preference shares – if preference shares are converted, more
earnings will be available in the numerator in the EPS calculation.
 Interest on convertible debt – if this debt is converted, then less interest hits the income
statement. However, less interest means more tax payable, so the adjustment to the earnings
number in the numerator is post-tax.
Weighted average number of shares
The basic EPS weighted average number of shares metric is typically adjusted for:
 Shares that may be issued on an anticipated conversion of convertible debt or preference
shares into ordinary shares or common stock
 Share options if they are currently in-the-money
The impact of convertible debt on diluted EPS
Claimant 4 SA has a basic EPS of $1.40. This is based on earnings of $140,000 and a basic
weighted average number of shares of 100,000. Claimant 4 SA also has a $45,000 5% convertible
debt instrument in issue. The instrument is convertible in four years time at a rate of five shares per
$10 of convertible debt.
The corporate tax rate is 35%.
The number of new shares that would be issued on conversion would be:
= $45,000 ÷ $10 x 5 shares
= 22,500 potential shares
The conversion would then save interest post-tax of:
= $45,000 x 5% x (1 - 35%)
= $1,463
So, the diluted earnings are restated at: $141,463.
The diluted EPS is: 141,463/122,500 = $1.15.
What is equity dilution?
Equity dilution is the impact on earnings per share (EPS), or any other measure that calculates the
amount attributable to a shareholder, in respect of ownership of a share (e.g. book value per
share), as a result of more shares being issued due to options, warrants, convertibles, and similar
instruments.
The concept of dilution is particularly important in takeover situations, where it is important that the
acquirer’s shareholders will not be worse off (typically from an EPS perspective) after the
transaction.
91
Accounting and Financial Analysis Q&A
What is the treasury method?
The treasury method is a way of calculating the effective ‘new’, and therefore dilutive, shares that
would result from the exercise of in-the-money options or warrants.
The treasury method works on the assumption that the proceeds from the share option exercise
will be used to buy back shares on the market at full market value. So, the net dilution from the
share option exercise is net of this buyback.
The following steps are required for the treasury method calculation. The numbers below refer to
the following Cadbury example:
 Calculate the proceeds from the share option exercise (280.07m)
 This involves identifying the share options that are in-the-money (ITM) – 62.57m
 Given the disclosures in the financials the ITM determination is normally calculated with
reference to the weighted average exercise price (WAEP)
 The proceeds = number of options ITM (62.57m) x the associated WAEP = 280.07m
 These proceeds are used to buy back shares at full market value = proceeds (280.07m) ÷
current share price (5.58) = 50.19m shares
 Therefore the net dilution, using the Treasury Method = number of shares issued through
option exercise – buyback = 62.57m – 50.19m = 12.38m shares net dilution
The dilution can be expressed
in terms of the net impact on the
EV (enterprise value) =
12.38m shares x
Current share price = 69.05m.
This net impact on EV
comprises two forces:
 The impact on market
capitalization of the new
shares issued as a result
of the share option exercise
(Number of new shares
issued x Current market
price).
 The cash proceeds received
as a result of the option
exercise which will increase
the cash number and reduce
net debt (Number of new
shares issued x Exercise
price).
Outstanding
Outstanding
options £66m
66m
options
Calculate the
number of ITM
options
Current share
price > WAEP
62.57m ITM
Cadbury options
Option proceeds =
Number of ITM
options x
Exercise price
Option proceeds
= 280.07m
Option proceeds
used to buyback
NOSH
Number of share
bought back at
current share price
50.19m
Current share
price 5.58
92
Net dilution =
62.57m-50.19m
=12.38m
Accounting and Financial Analysis Q&A
Why is the cash flow statement so important?
An entity’s survival depends on its ability to generate cash as well as whether the management of
the company make good decisions about investing the cash in worthwhile projects. A cash flow
statement is free from the distortion of accounting principles and provides a clear picture of an
entity’s activities.
A cash flow statement brings together an entity’s cash flow information in a clear manner,
separating out cash flows from operating, investing and financing. The statement is possibly the
most important source of financial information for Analysts as it is:
 An excellent source of clean numbers to analyze from an equity and credit perspective
 A key source of information for DCF valuation purposes
Also, being able to create a cash flow statement from scratch is one of the key skills required in
order to build robust financial models.
A cash flow statement provides excellent information on:
 Liquidity
 Viability
 Financial adaptability
93
Accounting and Financial Analysis Q&A
How do you move from EBIT to operating cash
flow?
The method of deriving cash flow from an earning metric is the indirect method. The indirect
method starts with an earnings metric and then strips out non-cash items in order to arrive at a
cash flow number.
Some companies will derive an operating cash flow from an EBIT number. The derivation strips out
all non-cash items or influences from the metric.
The first non-cash adjustment to an earnings metric is normally a D&A adjustment. D&A is a
non-cash expense that is charged in arriving at EBIT. So, D&A must be removed from the earnings
metric. This eliminates the non-cash impact. The D&A numbers are added back (thus reversing the
impact of the expense) to EBIT. The sub-total resulting from this add-back is EBITDA.
94
Accounting and Financial Analysis Q&A
Working capital adjustments
The next adjustments to the earnings metric are usually the working capital adjustments. The
working capital adjustments will strip out the non-cash elements of revenue and cost recognition
policies. For instance, the extract above discloses revenues of 120m. However, we can see on the
balance sheet that trade receivables have increased to 15m. Our accounting knowledge should
therefore suggest that while 120m of revenues have been recognized in the income statement,
only 105m of cash was received from customers. So, EBIT is overstated in cash terms by 15m.
An increase in receivables is ‘bad for cash flow’ – hence the adjustment to EBIT in the derivation of
operating cash flow will be negative.
Cash flow statement
EBIT
Depreciation
EBITDA
m
35
10
45
Increase in receivables
(15)
Operating cash flow
30
The same type of issue is applicable to the costs of sales number that feeds into EBIT. The
number reflects the costs incurred during the period. However, not all of these costs were paid.
The trade payables number has increased by 10m. This suggests that if cost of sales were 60m,
only 50m was paid. This leaves 10m outstanding as a payable at the end of the period. So the
EBIT number is understated by 10m when considering the cash flow implications.
Cash flow statement
EBIT
Depreciation
EBITDA
m
35
10
45
Increase in receivables
Increase in payables
Operating cash flow
(15)
10
40
An increase in payables is ‘good for cash flow’ – hence the adjustment to EBIT in the derivation of
operating cash flow will be positive.
The last standard working capital adjustment is usually inventories. The extract saw inventories
increase by 5m during the period. The inventories have been paid for during the period, but the
charge would not have passed through the income statement, as the inventories have not been
used up.
An increase in inventories is ‘bad for cash flow’ – hence the adjustment to EBIT in the derivation of
operating cash flow will be negative.
95
Accounting and Financial Analysis Q&A
Cash flow statement
EBIT
Depreciation
EBITDA
Increase in inventories
Increase in receivables
Increase in payables
Operating cash flow
m
35
10
45
(5)
(15)
10
35
The EBIT number has now been ‘cleaned up’ for non-cash items and we arrive at an operating
cash flow. This operating cash flow derivation is pre-interest and tax because it originated with a
pre-interest and tax earnings metric – EBIT.
The standard working capital adjustments can be summarized as:
Increase
Decrease
Inventories
Bad for cash
Good for cash
Receivables
Bad for cash
Good for cash
Payables
Good for cash
Bad for cash
Why does profit not equate to cash flow?
From a disclosure and financial modeling perspective, you will have to be adept at deriving a cash
flow statement using the indirect method. This method begins by deriving an operating cash flow
(indirectly) starting from an earnings metric. So it should be immediately clear that cash is not the
same thing as profit as operating cash flow is completely different to operating profit.
So you should be clear now that profit does not equal cash flow.
Why?
 Revenues are recognized when they are earned in the income statement, not when they are
received
 Expenses are recognized in the income statement on the basis of when incurred, and not
when paid
 Depreciation and amortization are non-cash items which have reduced profit but which do not
impact cash
 Generally, the income statement is concerned with performance over a period and will spread
costs to match the generation of benefits, without ever considering the timing of the cash flows
96
Accounting and Financial Analysis Q&A
How would you analyze a cash flow statement in
five minutes?
The cash flow statement is an excellent starting point for analysis, as it is a clean source of
numbers, free from most types of accounting manipulation. An Analyst can pick up a ‘story’ from a
quick review of a cash flow statement. We will use the example below – the case study company is
a hypothetical company called Sven SARL.
1.3x
97
Accounting and Financial Analysis Q&A
What could a company do if it had excess cash on
its balance sheet?
If a company has excess cash on its balance sheet, it is important to establish what the reason for
it is. It could, perhaps, be a war-chest which the company plans to use to make a large acquisition.
If a company had excess cash on its balance sheet, it could do some or all of the following:
 Make an acquisition
 Invest in further PPE to expand
 Invest in further working capital
 Pay a special dividend
 Buy back its shares
 Reduce its leverage by repaying debt
It is generally not a good idea to keep large cash balances on the balance sheet which are not
needed, as it can make the company the target for a takeover.
98
Accounting and Financial Analysis Q&A
What type of pension schemes do companies have?
Why are they sometimes problematic?
A pension is a regular income received when somebody retires. There are a number of different
types of pension schemes provided by employers, however the two most common forms are:
 Defined benefit schemes
 Defined contribution schemes
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Accounting and Financial Analysis Q&A
Potential problems with pensions
The major problem revolves around defined benefit schemes in that the employer has to ensure
there are sufficient assets within the pension fund to be able to provide the benefits when
employees retire. In periods where there are low interest rates, or the stock market is performing
poorly, then the company’s liability increases and this information needs to be disclosed within the
financials – in some cases this can be significant compared to the size of assets generated on the
balance sheet.
Pensions can become central issues in M&A deals. The Alliance Boots / KKR deal in 2007 is a
good example of pension issues causing real headaches for bankers in a deal. The KKR deal had
been approved by the shareholders. But, there had been no real consideration of the pension
scheme. The pension scheme at the time was running a surplus and those involved had not
identified it as a particularly significant issue. However, the pension scheme trustees argued for a
$1bn injection. KKR, as you can imagine, argued that a $1bn injection for a scheme already in
surplus was unreasonable. Arguments and negotiations followed. Eventually the deal cleared but
only after KKR agreed to inject $418m over ten years.
Another problematic issue is that the funded status of pensions is not always on the balance sheet
– however the deficit must be disclosed within the notes to the accounts only. Under US GAAP the
funded status must be on the balance sheet.
Finally, pension accounting, along with issues of volatility and risk can lead to volatility of numbers
within the financial statements, which can make it harder to analyze the performance of a
company.
What is deferred tax?
Most transactions that an entity makes will have a tax consequence. The tax consequence can be
immediate or it can happen in the future (deferred). For instance, if an entity purchases some new
machinery, it will receive a tax deduction over an extended period of time. Some of the tax impact
is deferred to later periods. However if the entity makes a sale the tax consequences are probably
immediate.
If an entity enters into a transaction that results in a deferred tax consequence – whether it is a
future benefit or cost, the financials will often attempt to account for the consequence.
For instance:
100
Accounting and Financial Analysis Q&A
Deferred tax issues potentially arise:
 On an M&A transaction when the target entity’s balance sheet is revalued to fair value
 When entities recognize provisions in their financials. Provisions normally do not qualify for tax
deductions until the expenditure is actually incurred
 If an entity has made tax losses and the tax losses can be carried forward to set off against
future taxable earnings
 If an entity purchases PPE and is able to claim accelerated tax allowances
 If an entity runs a pension scheme
101
Accounting and Financial Analysis Q&A
102
Valuation Q&A
Introduction
An understanding of valuation is essential for those trying to secure a position within banking.
Valuation is used by all banking professionals in a variety of ways:
 M&A Investment Bankers use valuation to determine the value of a target company
7
 Research Analysts use valuation to determine a price target for a company
 Capital markets professionals need valuation knowledge to provide a ‘sanity check’ for
the work provided to them by the M&A teams
 Corporate bankers need to appreciate the corporate finance implications of their clients
 Market professionals need an understanding of valuation so that they are able to
interpret information provided to them from research departments.
Therefore, regardless of your area of focus, it is important for you to have a strong
understanding of the fundamentals of valuation. The purpose of this section is to equip you
with the essential knowledge and skills.
Geoff Robinson BA (Hons) FCA
Geoff Robinson is Head of Investment Banking at Fitch Learning. He has
trained investment bankers, buy and sell-side Analysts, as well as private
equity investors for over 12 years.
Geoff specializes in financial modeling and valuation, as well as accounting
for bankers and financial statement analysis from an equity and credit
perspective.
He has worked with all of the top 10 global investment banks (by 2010 deal volume),
designing and running some of the most respected global IBD programs. His training
commitments have taken him to the US, Africa, Middle and Far East, as well as Australia.
Valuation Q&A
Geoff is one of the lead authors of ‘The Complete Investment Banker’ and a co-designer of
the ‘Complete Analyst’. The system, comprised of technical material, on-the-job assistance
and post-course reinforcement has become the de facto learning system and IBD technical
resource at a number of top-tier banks.
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Valuation Q&A
Why is valuation important?
What are the traditional valuation methodologies?
Traditionally, there are three main valuation methodologies:
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Valuation Q&A
Comparable company analysis
(‘Trading comps’ or just ‘comps’)
Comparable company analysis is based on the assumption that similar companies should be
valued in a similar way and can be used to understand whether a company is relatively over or
undervalued compared to its peers. Analysts also use comparable company analysis to value
unlisted companies for which a readily available trading value does not exist.
By assessing the relationships between accounting data in similar, listed companies, Analysts can
deduce a relationship between specific earning metrics and market capitalization (or often another
value, enterprise value, which is built on the market capitalization). The relationship between the
two variables is a ‘multiple’.
The following multiples are often calculated:
 P/E – a relationship between the price of a company and its earnings
 EV/EBITDA – a relationship between the enterprise value and its EBITDA
 EV/EBIT – a relationship between the enterprise value and its EBIT
 EV/Sales – a relationship between the enterprise value and its sales
Comparable transactions analysis
(‘Precedent or transaction comps’)
Comparable transaction analysis works in a similar manner to comps, except the multiples are
calculated on past deals or transactions.
A transaction comp should generally produce a higher value than a trading comp, because the
transaction comp uses a real and specific offer price to calculate the value, rather than the current
market price used in trading comps. By using the specific offer price, a transaction comp captures
the extra control premium in the valuation.
The control premium is the premium over and above the pre-announcement price that purchasers
are willing to pay to secure control of the entity. Historically, control premiums range between 30%
and 50% above the pre-announcement share price.
Discounted cash flow valuation (DCF)
Discounted cash flow valuation works on the basis that ultimately the value of a company is just
the present value of the expected future cash flows.
DCF valuation is an example of an absolute valuation methodology. The entity is valued (in theory)
without relative reference to the market. Because this sets DCF apart from trading and transaction
comps, DCF provides an excellent sense check on the relative valuation techniques.
Although DCF requires a greater level of technical understanding in order to appreciate the
subtleties of the valuation drivers, it is a thorough valuation approach that provides excellent
information for an in-depth justification of the drivers of value.
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Valuation Q&A
Valuation isn’t just about theories and models –
what else should an Analyst consider when
valuing a company?
Number-crunching alone cannot give an Analyst all the information he or she needs to value a
company. Although the valuation methods described on previous pages involve processing
financial information to arrive at a value, the valuation process should also include a consideration
of non-financial factors.
A valuation is a mixture of soft and hard skills and must reflect considerations such as:
 Buyer motivations
 Seller motivations
 Potential legal issues
 Tax considerations
 Competitive pressures
 Potential economies of scale
 Market sentiment
 M&A strategic rationale
 Use of excess funding
 Ability to finance the deal
What is the difference between buy and sell-side
M&A?
Analysts may be advising a client on the purchase of an entity (buy-side advisory), or on the
disposal (sell-side advisory). When buying or selling an entity, clients will want to reach the most
advantageous price and it is the Analyst’s job to help them.
While the valuation model will provide a starting number (or range of numbers) for discussions, the
final selling price will only be determined after a period of negotiation. It is the Analyst’s
responsibility to provide the client with the information necessary to successfully negotiate the best
price. If advising on a buy-side transaction, the Analyst will be hoping to secure the most favorable
(lowest) transaction price for the client. If the Analyst is advising on a sell-side transaction (i.e.
sale), the client will want to maximize the value of the sale price.
Typical buy-side activities:
 Acquisition strategies
 Target searches
 Pitch book preparation
 Valuation work in respect of indicative offers
 Merger modeling for a public market transaction
 Advisory regarding financing possibilities and consequences
 Assisting with the legal documentation and the due diligence process
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Valuation Q&A
 Assessment of synergies
 Assistance regarding liaising with external parties
 Contracts and negotiation terms preparation
Typical sell-side activities:
 Grooming the entity for sale
 Initial research and screening
 Preparation of the teaser – an anonymous presentation of the company profile
 Pitch book preparation
 Putting together the information package or information memorandum
 Valuation work in respect of indicative offers
 Defense tactics in case of a hostile public market approach
 Assisting with the legal documentation and the due diligence process
 Preparing the approach buyers list
 Assisting with data room (information disclosure) issues
 Assisting with management presentations
 Preparing the contracts and negotiation terms
Buy and sell-side advisors will often try to justify very different valuations. Naturally, they should be
trying to create the most value for their clients, but this can create a significant stumbling block in
terms of trying to complete a deal. The negotiation process can be particularly painful when the
M&A markets are depressed; sellers cling to the higher historic values that prevailed during boom
times, and buyers are reluctant to part with their money in the face of a downturn.
Which valuation techniques are likely to give the
highest valuations?
Be careful answering this question – there is a difference between which valuation techniques
should give the highest valuation and which ones actually do in practice.
In theory, valuations based on past transactions (transaction comps) give the highest valuations
because acquirers generally pay a premium over and above the current trading value in order to
obtain control of the target.
However, it may be that previous transactions, for whatever reason, might not have had a
significant control premium, or perhaps the previous transactions took place when multiples were
lower.
Therefore, there is no right answer to this question and the valuation ultimately depends on the
assumptions made in the underlying calculation. For example, if forward estimates of the entity’s
EBITDA are particularly bullish, then valuations based on EBITDA multiples will be higher.
However, it is probably fair to say that DCF valuations tend to have the highest valuation for the
following reasons. When forecasting future cash flows, it always seems easier to assume that
businesses are going to grow as opposed to decline, and aggressive assumptions about growth
will lead to higher valuations. Additionally, it is easy to assume that businesses will get more
efficient and therefore margins will improve, enhancing the valuation.
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Valuation Q&A
As the ‘standard’ DCF valuation length is often ten years, it is very easy to assume that this is the
period over which the company will have a competitive advantage and experience abnormal
growth. In reality however, it might be that the competitive advantage may disappear over a shorter
period. The fact that the DCF valuation assumes that companies will carry on forever and
perpetuity growth rates tend to be positive will lead to higher valuations.
Currently, as interest rates are low, there is the tendency for the discount rate (weighted average
cost of capital or WACC) to be relatively low, therefore making the value of later cash flows higher
than they might otherwise be.
What is a valuation football field?
An Analyst’s valuation work is normally presented in a valuation summary or ‘valuation football
field’ (see below).The purpose of the summary is to show the range of valuations produced by the
various valuation methodologies in an easy-to-read format and is often a key component of a pitch
book.
Valuation summary
Transaction comps
Trading comps
LBO
DCF
Broker consensus
LTM share price
120
130
140
150
160
170
180
190
Equity value per share (p)
A good valuation summary is the cornerstone of the pitch book, adding credibility to the
presentation if the valuations are sufficiently robust to hold up to close scrutiny.
A good summary will include:
 Current or pre-announcement equity price
 Key valuation bandings for:
 DCF (possibly under different scenarios)
 Trading comps
 Precedent comps
 Implied private equity valuations
 An estimated valuation range
 Broker consensus benchmark valuations
 LTM (‘last 12 months’) share price range
108
Valuation Q&A
What is market capitalization and how do you
calculate it?
Market capitalization is the market value of the currently traded shares in the company, and can be
calculated as follows: Market capitalization = Current share price x Number of shares outstanding
(NOSH).
Market capitalization gives you an indication of the total worth of a company, representing the price
you would have to pay to acquire all the shares in the company. This calculation is high-level
however, and a number of other factors should to be considered:
The share price varies on a day-to-day basis so the value calculated will be irrelevant as soon as
the share price moves. If you wished to acquire and hence control the company, you would
probably have to pay a premium over this price in order to wrest control from the existing owners.
There may be some shares that are not freely available (i.e. the free float may not be 100%) – in
which case it would not be easy or possible to acquire 100% of the common stock. When
calculating the enterprise (or firm) value in certain instances, the fully diluted market capitalization
is calculated – this would include the not yet issued shares under options which are in the money.
What is enterprise value?
Enterprise value (EV) is a key concept in valuation, and represents the theoretical full ‘take-out’
value of an entity. In theory, if an entity is taken-over the acquirer would not just take control of the
equity, but it would assume the debt liabilities and cash as well. EV is a useful measure because it
is a capital structure neutral metric that captures all claims on the entity.
EV is useful because it improves comparability with entities that have different capital structures.
Although Analysts typically need to find an equity value, many valuations start at the enterprise
level and Analysts work out equity value from there.
EV is also referred to as:
 Total enterprise value (TEV)
 Firm value (FV) (particularly common in the US)
 Entity value
 Gross or total capitalization
 Leverage market capitalization
The start point in calculating EV is the market capitalization calculation. The calculation will then
expand to include all other claims on the business.
Typical additional components of EV are:
 Net debt (defined below)
 Non-controlling interest/minority interest (defined below)
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Valuation Q&A
Non-controlling
interests
Walk me through a discounted cash flow
Discounted cash flow valuation works on the basis that ultimately the value of a company is the
present value of the expected future cash flows.
As the technique focuses on cash flow, there is less scope for accounting manipulation or
inconsistency to impact the valuation. However, the technique is highly sensitive to a number of
key variables such as cash flow drivers, discount rates, and terminal value calculations. As a result
of this, DCF valuations are usually associated with extensive sensitivity and scenario analysis.
DCF valuation is very popular with investment bankers and research analysts. The method forces
Analysts to be forward-looking and to examine in more detail the drivers of value, and the entity’s
strategic and competitive positions. (Arguably, DCF makes Analysts think more about drivers of
value, relative to comparable techniques.)
110
Valuation Q&A
DCF valuation – a six-step structured approach
In order to calculate a value using the DCF method, an Analyst needs to forecast the future cash
flows of the company. This is a two-step process. Firstly, the Analyst calculates the cash flows of
the ‘visible period’ – this is the short-term period over which the Analyst can be more certain about
cash in or out-flows. After this time, the Analyst needs to guess a ‘terminal value’ (TV), which is
essentially the value of all the future cash flows after that period.
These cash flows are then discounted at the weighted average cost of capital (WACC) to establish
a present value, or initial enterprise value (EV).
The formula for this is:
EV =
FCF1
FCF2
FCFn
TVn
1 +
2 + ..... +
n +
(1 + WACC) (1 + WACC)
(1 + WACC) (1 + WACC)n
Once the enterprise value is established, the Analyst can take it one step further to show equity
value, by adjusting for items such as net debt and non-controlling interests.
The DCF approach can be broken down into six key steps:
Define visible
period
Estimate the
terminal value
Forecast cash
flows
Discount the cash
flows
Estimate
appropriate
discount rate
Valuation
Step 1: Define the high growth period
Generally, when forecasting the cash flows, we break down the forecast period into two distinct
periods:
High growth period
The high growth period is the forecast period where the company has a competitive advantage and
is growing at a rate that exceeds that of its peers. The length of this high growth period is one of
the key assumptions in a DCF valuation.
Analysts would guess the high growth period through reference to fundamental analysis. This
means they would look at historic patterns and trends to try and establish how long companies in
this or similar industries tend to experience high growth.
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Valuation Q&A
High growth firms tend to:
 Reinvest earnings
 Have a higher risk
 Invest in capital expenditure (capex)
 Generate a strong return on capital
Analysts estimate forecast cash flows in detail for the high growth period. We often refer to this as
the ‘visible period’.
Towards the latter part of the visible period, the company will start to mature and growth will start to
slow down. This reflects the fact that high growth is not sustainable into perpetuity.
Firms cannot keep growing at rates greater than the rest of the economy as a whole because:
 Markets are competitive – high growth will attract new entrants and these new entrants will
share in the excess returns, thereby lowering the returns of each company.
 Barriers to entry erode – other companies see that the industry is attractive and find ways to
enter the industry and compete.
 Technological advances create new markets which lowers demand for the current products.
The longer the high growth period, the more detailed forecasting will be required. So longer
high growth periods will introduce additional forecasting risk into the valuation.
Terminal period
Once the high growth period has ended, companies tend to experience a constant growth period
known as the terminal value period. The terminal value period happens when the company has
matured. During this period, the company will have a constant rate of cash flow growth or decline.
We tend to assume that this cash flow will continue into perpetuity.
A typical two-stage DCF valuation model
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Valuation Q&A
Step 2: Forecast cash flows
The DCF method values the business as the present value of the future cash flows. The cash flows
for this valuation approach are those cash flows that remain once all expenses of the business are
paid. These expenses include both the income statement expenses, but also other cash
commitments that the company has, i.e. capex.
The most common DCF valuation is at the firm or enterprise level, where the value that results is
the EV. This is where the forecast free cash flows to the firm (or enterprise) are discounted at the
WACC. In this calculation, the cash flows that are discounted must be those that belong to both the
debt, and equity providers of capital. This is free cash flow to firm (FCFF).
Free cash flow to
firm
(FCFF)
Equity providers
claim
Equity price
appreciation
Dividend stream
Debt providers
claim
Repayment of
capital
Interest payments
Repayment of
capital
An alternative way of approaching the free cash flow definition is to think of it as the cash flow pool
owned by the providers of capital. Dividend and interest payments are made from this pool and
capital can be repaid. Any remaining cash flow is re-invested within the company.
Therefore, the FCFF cash flow definition is a cash flow before:
 Any distributions to the providers of capital in the form of dividends or interest
 Any contributions to the providers
 Any returns of capital to the providers
Forecasting the FCFF drivers
Analysts will forecast FCFF for every period during the high growth (visible) period. The illustration
below provides an outline of the type of drivers that can be used for these key FCFF lines, and how
they should ideally be driven as the company forecasts mature. These drivers can be sector and
industry specific.
The drivers outlined below are generic for illustration purposes.
113
=
-
-
=
+/-
=
+
=
-
Valuation Q&A
The focus of maturing the FCFF profile is to ensure that there is a smooth transition in the FCFF
growth profile between the end of the high growth period and the terminal value period. Failure to
smooth the profile can lead to terminal value estimation problems.
For more information on this, see a later question – What is free cash flow to the firm?
Step 3: Estimate appropriate discount rate
Central to DCF valuation is the use of present values and discounting. Picking an appropriate
discount rate is therefore a fundamental decision.
There are a number of key issues for an Analyst to consider:
 The discount rate must be consistent with the cash flow. If a FCFF cash flow is being
forecasted (i.e. pre-interest), then a WACC should be used. If a FCFE cash flow is being
forecasted (i.e. post-interest), then a cost of equity should be used.
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Valuation Q&A
Focusing on FCFF DCF valuations
As FCFF is a cash flow that belongs to both debt and equity providers of capital, the discount rate
should reflect a cost of capital that takes into account the costs of both debt and equity.
In order to do this, the Analyst would estimate a cost of debt finance and a cost of the equity
finance. These costs of capital would then be weighted in proportion to the market values of the
long-term target capital structure. The value that is derived is the weighted average cost of capital
(WACC) and is used to discount the future cash flows back to present value.
Cost of equity (ke)
The cost of equity is the discount rate that reflects the risk of the cash flows to the shareholders.
The most common method of calculating the cost of equity is to use the Capital Asset Pricing
Model (CAPM)
Where:
 Risk-free rate = Rate an investor could earn on a fairly long-term government bond
(i.e. low risk)
 Beta = Measure of the relative risk or volatility of the particular company (stock) relative to the
market in which the stock is traded
 EMRP = Equity market risk premium represents the extra return expected to be earned from
investing in the stock market, compared to investing in a government bond
Cost of debt (Kd)
The cost of debt is the discount rate that reflects the risk of the cash flows to the lenders (debt
holders). Because interest is tax deductible, the cost of debt to the company is actually the cost of
borrowing, less any tax saving the company makes through having the interest expense.
Where:
 CMRP = Credit market risk premium is the extra return a lender must receive for the additional
risk of lending to the company as opposed to investing in a government bond.
 Tax rate is the corporate tax rate suffered by the company paying the interest.
Weighted average cost of capital (WACC)
The weighted average cost of capital is a weighted average of the individual costs of equity and
debt. If we consider a company that is expected (long-term) to be financed 60% by equity and 40%
by debt, the WACC would be 60% of the cost of equity plus 40% of the cost of debt.
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Valuation Q&A
Step 4: Estimate the terminal value
The next step is to estimate the terminal value. The two most common methods of calculating a
terminal value are:
 Cash flow growth perpetuity
 Multiple approach
This terminal value calculation will account for, in most cases, the majority of the valuation.
However, note that terminal values are not calculations independent of the high growth period.
They are in fact fully dependent on the high growth period. If the high growth period assumptions
are inconsistent or in some way flawed, the terminal value will also be flawed.
Cash flow growth perpetuity
The cash flow growth perpetuity approach estimates the terminal value using the terminal FCFF
(i.e. the last FCFF estimate of the high growth period). The calculation assumes that the FCFF will
grow at a constant rate into perpetuity.
The standard cash flow growth perpetuity terminal value calculation will discount the constant
growth FCFF perpetuity back to a terminal year value. For instance, a 10 year high growth period
DCF will express the terminal value in time period 10 terms. The terminal value still needs to be
discounted back to time period 0 in order to be included in the overall EV valuation.
The standard calculation for a 10 year high growth period terminal value is:
-∞
TVt t=:11
=
10
FCFF10 (1 + g )
WACC - g
Where:
FCFF10 =
g
=
Free cash flow to firm in the terminal year (time period 10)
FCFF perpetuity growth rate
∞
= Terminal value expressed in time period 10 terms.
TV t t=:11
10
Capturing the terminal value cash flows from time period 11 into perpetuity
Multiple approach
The multiple approach estimates the terminal value on the basis that the target company will be
valued at the end of the high growth period using public market valuations. The approach
introduces relative valuation into the DCF valuation.
The terminal value is typically calculated by applying an appropriate range of comparable multiples
(EV multiples if performing a FCFF valuation) to the target’s terminal earnings metrics. The
terminal value is normally based on a review of comparable trading multiples.
116
Valuation Q&A
Step 5: Discount the cash flows
This stage is simple. Discount the cash flows by using the appropriate cash flows and WACC.
The formula below shows this:
EV =
FCF1
FCF2
FCFn
TVn
1 +
2 + ..... +
n +
(1 + WACC) (1 + WACC)
(1 + WACC) (1 + WACC)n
Step 6: Valuation
The valuation produced by the DCF method depends on discounted cash flows together with the
discount rate:

FCFE discounted with a cost of equity will produce an equity valuation

FCFF discounted with a WACC will produce an EV valuation
The EV level valuation will need to be broken down to equity value.
Break down enterprise value to equity value
Enterprise value can be reconciled to equity value as shown by the diagram:
Net debt
Implied
enterprise
value
Affiliates and
joint ventures
Other claims
Non-controlling
interests
Implied equity
value
117
Valuation Q&A
What is free cash flow to firm?
Free cash flow to the firm (or enterprise) is the name for the cash flows that are forecasted when a
DCF valuation is performed at the Firm or Enterprise level.
It is a pre-financing, post-tax cash flow which is theoretically available to the capital providers.
In a Firm or EV level valuation, the cash flows being discounted must be those that belong to both
debt and equity providers of capital. This cash flow is known as free cash flow to firm (FCFF) and
would be discounted using a weighted average cost of capital (WACC).
FCFF
Revenues
Operating costs
4,947
(4,489)
EBIT
D&A
458
311
EBITDA
Decrease/(increase) in working capital
Capex (net)
Tax on operations
769
117
(190)
(170)
526
118
Valuation Q&A
What is beta?
Beta is a measure of the stock’s volatility relative to a market index. Most DCF valuations derive a
cost of equity using the Capital Asset Pricing Model (CAPM) which incorporates a beta. In most
cases, a historical beta is used.
Be aware that this is one of the flaws in a DCF calculation. Remember that a DCF model is
forward-looking, but by using a historical beta, we are to some extent, assuming that the past is a
good indication of what will happen in the future.
Historical betas
To find a beta, the historical individual stock returns are plotted on a graph against the market
returns. Analysts call this ‘regression’. The slope of the regression line (i.e. the gradient of the line)
is the beta of the stock.
There are a number of information providers that make beta calculations. Whichever data provider
is used, it is important to carefully consider the parameters entered as the beta output will be very
sensitive to these parameters.
Key decisions for an Analyst to make when calculating beta:
Number of data points
Most beta providers allow daily, weekly, monthly, and quarterly observations of stock movements
in their calculations. The calculation will need a critical mass of observations in order to produce a
statistically reliable regression plot.
Length and period of time
Including a longer time horizon as part of the process can produce a beta that is increasingly
irrelevant. Companies evolve and change over time; as do their risk profiles. Performing a ten year
historical regression will provide more information for the calculation. However, these data points
may be outdated and so won’t give the most relevant information.
Market to be used as the basis for regression
The choice of which market to regress the individual stock against can have a material impact on
the beta output. For instance, British Airways (now International Airlines Group) was a British
incorporated company, but it is a multi-national business. Should the beta be regressed against a
national index such as the FTSE 100 or would a global index like MSCI World be more suitable?
This is a matter of judgment for the Analyst.
Where can you source a beta?
There are a number of Beta service providers that provide information on betas. The following are
a selection:
 Bloomberg
 LBS
 Barra
 Datastream
 Betasource
119
Valuation Q&A
The screenshot below shows the detail from a Bloomberg Screen for US company, Hershey Inc.
The beta is based on:
 Frequency of observations - weekly
 Length of time horizons observed – two years – 03/21/08 – 03/21/10
 Market used in regression – S&P 500 Index
Data input requirements
Bloomberg will default to a 2 yr weekly
beta. However, users can select
their own variables for the regression.
They can specify:
The date range
The observation frequency
The relative index
R squared
R squared is a measure of the strength
of the statistical relationship between the
data points.
An r-squared of 1.0 (100%) indicates a
perfect fit.
The stat states the proportion of total risk
that is market risk.
With Hershey, we are saying 32.8% of
the stock’s movement is driven by
market risks. The remaining
67.2% of the movements are
unsystematic (stock specific) risk
Standard error
Beta problems
Beta is prone to high standard errors.
It reflects the firm’s business mix
over the period of the regression,
not the current mix.
It reflects the firm’s average financial
leverage over the period rather than
the current leverage.
The standard error provides an
indication of the amount of noise
in the regression. The standard
error in the Hershey beta is 0.08.
This suggests that the Hershey beta
could range from 0.479 to 0.639.
Raw vs Adjusted beta
The raw beta is regressed historical market returns against
the returns on the individual stock. The raw beta is the
slope of the regression line.
The adjusted beta is an estimate of a security’s future beta.
It uses the historical data of the stock, but assumes that
a security’s beta tends towards the market average of 1.0 over
time. The formula is as follows:
Adjusted beta
= (.67) x Raw beta + (.33) x 1.0
= (.67) x 0.559 + (.33) x 1
= 0.706
Source: Bloomberg
Accessing beta on Bloomberg:
<Equity>
Beta
<Go>
Why and how would you de-lever a beta?
Why de-lever?
A published beta reflects two key risk aspects – systematic risk (broadly the extent to which the
company is affected by general market factors), and leverage risk (the more debt within the
company the more volatile the company’s returns and hence share price will be).
As a historical beta reflects a company’s leverage in the past, it will not be appropriate to use the
same beta in the future if the company is intending to change its capital structure. For this reason,
it will be necessary to de-lever the beta to ascertain what the beta would be without any leverage,
and then re-lever the beta for the intended leverage in the future. Furthermore, the tax rate in the
future may be different to what it was in the past.
Another situation when it would be necessary to de-lever a beta is if a cost of equity (using the
CAPM) is being derived for an unlisted company (therefore it has no beta) by using the beta of
comparable listed companies. Even though we are using comparable companies, they are only
comparable with regards to their systematic risk but are likely to have different levels of leverage.
Again, it would be necessary to de-lever the beta of the comparable(s) and then re-lever using the
anticipated leverage of the unlisted company. Also, the tax rate of the unlisted company may be
different from that of the comparables.
120
Valuation Q&A
How to de-lever and re-lever
Formulae exist for converting a levered beta into an un-levered beta and vice versa.
In order to do the calculations, you will need to do the following steps (see diagram below):
 Obtain the published (levered) beta of the company, or companies, being considered
 Obtain the existing leverage (D/E) of the company, or companies, whose beta(s) is/are being
de-levered and the corporation tax rate of the company(s) – and de-lever the published beta(s)
 Consider what the target leverage in the future is expected to be and the corporation tax rate
and re-lever the delivered beta accordingly
 Put the beta into the CAPM equation to derive the appropriate cost of equity
βu =
βL
 D

1 +  E  x(1 − t )
  



D
 x(1 − t )
E

β L = β U x 1 + 

121
Valuation Q&A
Walk me through a comparable company
valuation
As discussed earlier, the basic idea of comparable company valuation is straightforward – a target
company will be valued with reference to its peers.
By assessing the relationships between key operating metrics in similar, listed companies,
Analysts can deduce a relationship between the particular metrics and the market capitalization (or
often another value, enterprise value, which is built on the market capitalization). The relationship
between the two variables is a ‘multiple’.
The following multiples are often calculated:
 P/E – a relationship between the price of a company and its earnings
 EV/EBITDA – a relationship between the enterprise value and its EBITDA
 EV/EBIT – a relationship between the enterprise value and its EBIT
 EV/Sales – a relationship between the enterprise value and its sales
The process for conducting comparable company analysis is not complicated. First, the Analyst
must identify a ‘comp universe’. The ‘comp universe’ is made up of companies that are similar to
the target based on the following characteristics:
 Business (customers, geographical reach, strategy etc.)
 Margins (gross profit, operating profit etc.)
 Growth rates (particularly forecast)
 Size (assets, turnover etc.)
 Leverage
 Accounting policies
After gathering financial data and calculating the appropriate comparable multiples for each
company, the Analyst will analyze the ‘comp universe’ and draw a conclusion as to where the
target best fits into the sector, and decide on an appropriate multiple for the company. Although
Analysts will identify companies that are similar to the target, there are many reasons why the
Analyst may decide the target company should be valued below/above the average for the sector.
Illustration of a comps valuation
Company X is to be valued on a P/E basis, by reference to its peers. The forecast EPS of company
X is $7. Comparable companies (the table below is the result of a large amount of data collection
and analysis) have an average P/EF (based on forecast EPS) of 14.0x and a median of 14.6x.
122
Valuation Q&A
After reviewing all the information about the peer companies and Company X such as size,
margins, growth rates, capital structure, and a whole host of other factors, it is considered that
Company X is very similar to Companies C and E, and a P/E of somewhere between 14.8 and 15
should be chosen.
On that basis, the share value of Company X should be in the following range:
14 .8 x $7 = $103.6 – 15.0 x $7 = $105.0.
This is essentially how comps valuation works, though in practice it is a time consuming exercise to
collect and analyze the data, and there are other multiples (particularly based on EV) which could
have been used.
What are the pros and cons of EV vs. Equity
multiples?
EV and equity value multiples are used extensively through the financial services industry. Some
sectors will be more reliant on EV multiples, whilst others prefer the equity level. Both multiples
have their merits. The table below summarizes the relative merits of the different multiple levels:
EV multiples
Equity multiples
Rely on denominators that are less
prone to accounting issues
More relevant to equity valuation
Are capital structure neutral
Are more familiar to investors
Are comprehensive. They capture the
full claim on the enterprise.
Arguably involve less subjectivity
than EV multiples, especially in
terms of assessing off balance
sheet claims
Make it easier to capture off-balance
sheet and debt-like claims.
Have a wide spectrum of applicable
multiples
Are much more prone to accounting
issues
Are technically harder to communicate
to clients
Have an increased reliance on market
values
Require additional technical work to
derive an equity value
123
Valuation Q&A
What are the pros and cons of using the
EV/EBITDA multiple?
What are the positives?
What are the problems?
EBITDA is an approximation of
cash because it ignores D&A.
It ignores depreciation, interest and tax.
These are real costs of doing business
and are drivers of value.
It captures the impact of the
company’s cost structure.
Cannot be used if EBITDA is negative.
Most companies will generate
positive EBITDA, therefore
providing a wider universe to
select comparables from than if a
metric was used from further
down the income statement.
Leasing can distort the use of the metric –
better to rely on EBITDAR in this case.
EBITDA multiples are most
useful if the comparable universe
has a similar level of capital
intensity.
Affected by accounting policy issues such
as revenue and cost recognition, leasing,
possible proportional consolidation issues.
What drives an EV multiple?
There are generally three key drivers of a multiple:
 The quality of earnings or cash convertibility
 The risk profile of the earnings
 Growth rates
Cash Conversion:
FCF ÷ EBITDA is a measure of cash
conversion. How well does the company turn
earnings into cash flow. It is often referred to
as a measure of earnings quality. Better
earnings quality – better cash flow – higher
valuation.
EV
FCF ÷ EBITDA
=
EBITDA
(WACC − g )
Risk:
Risk:
TheWACC
WACCrepresents
representsthe
the
The
company’s
risk
profile.
A
riskyprofile
company’s risk profile. A risky
profile
will
be
captured
by
a high An
will be captured by a high WACC.
WACC
in
isolation
will
reduce
the
increase in WACC in isolation will
multiple
by
discounting
the
future
reduce multiple by discounting the
cash flows
with more
force.force.
future
cash flows
with more
124
Growth rate:
Risk and growth
rates are naturally
correlated. It is
difficult to achieve
higher growth without
taking on some risk.
However, if g can be
increased without
imposing undue risks
on the company, the
increase in g should
result in an
improvement in the
multiple.
g will be driven by
ROIC and the
reinvestment rate.
Valuation Q&A
Free cash flow:
Revenues
X
Operating costs
(X)
EBIT
X
DA
X
EBITDA
X
Changes in NWC
X/(X)
Operating cash flow X
Less:
Capex
(X)
Tax
(X)
Free cash flow
X
EV
FCF ÷ EBITDA
=
EBITDA
(WACC − g )
WACC
g = r x ROIC
Cost of equity
= Rf + ß(EMRP)
Cost of debt
= (Rf + CMRP)
x (1-Tc)
Risk-free rates
Rf
Risk-free rate
Rf
Reinvestment
rates
r
Equity market risk
premium
EMRP
Credit market risk
premium
CMRP
Return on
invested capital
(ROIC)
Beta
ß
Tax shield
Tc
125
Valuation Q&A
Why would multiples of a company trade at a
premium or discount to its peers?
The comps output sheet will illustrate that multiples will trade at a discount or premium to the mean
of the universe. Analysts must understand why these multiples trade away from the central
tendency of the comparable universe.
Possible explanations could be:
 Different margins
 Different growth rates
 Different earnings quality (cash generation ability and working capital management)
 Relative competitive positions
 Market risks
 Differences in country market sentiments
 Differences in corporate governance
 Management credibility
 Relative 52 week high and low position
 Bid speculation
 Market mis-pricing
 Earnings volatility
 Index rally
 Index tracking demand
 Degree of free float
 Ownership restrictions for foreign investors
 Accounting differences (GAAP)
 Over leverage
 Potential contingent liabilities
 Recent positive/negative news flow
 Technical errors by Analyst
 FACSET CAPIQ links not updated
 Broker forecasting (sentiment and errors)
126
Valuation Q&A
What is a control premium?
The control premium (or offer premium in a deal) is the additional amount paid in order to gain
control of an entity. In other words, it is the extra amount paid to encourage the previous owners to
sell their equity stakes. This additional amount would also reflect the willingness of the acquirer to
get the benefit of synergies and strategic fit of the target.
The control premium is the ‘market clearing price’. The size of the control premium is sector and
deal specific. A rough benchmark control premium would be between 20-30% on the
pre-announcement price.
The control premium is calculated in relation to a ‘clean’ share price. The idea of the ‘clean’ price is
to use an ‘unaffected share price’ – i.e. prior to announcement of possible sale or before the
‘evaluating strategic alternatives’ press release. Control premium pricing points are typically:
 One day pre-announcement
 One week pre-announcement
 One month pre-announcement
An Analyst will look at the market reaction during these time periods to try and determine if or how
information has leaked into the market, in relation to the deal and how the market prices reacted.
The calculation for the premium (looking at comparable transactions) is:
Premium (%) = (Offer price / Pre-announcement price) - 1
The illustration below shows how the Cadbury share price reacted after the deal went public in
September 2009. Calculating a deal premium on a post-announcement share price is not
particularly relevant because the share price will already include the market’s opinion of the deal.
The offer price for the premium calculation will use the prevailing share price information as at the
offer date.
The Analyst will try to justify the premium paid by justifying the transaction and providing
supporting valuation work.
127
Valuation Q&A
Typical justifications of the premium will focus on:
 Previous transaction premiums
 Potential cost and revenue synergies
 Buyer and seller motivations
Access to:
 New markets and products
 R&D pipelines
 Distribution channels
 Human capital
 New capital markets
Premiums can range widely and are sector specific. Typically, premiums historically average
between 30 and 50%.
The story supporting the justification must build on a strong foundation of analysis. The Analyst is
advising the client to pay what could be a significant premium over and above the preannouncement share price. The argument must be strong as the client will need to carry this
argument to the shareholders. If the shareholders do not accept, there is no deal – there is no fee!
What does a merger model do?
A good merger or acquisition finance model is a valuable analytical tool which can be used to
evaluate the attractiveness of, and financing for, a combination of two (or more) companies.
The model can address issues such as:
 At what price the transaction should take place
 What the offer structure and financing should be
 What the likely costs and benefits will be
 What the key sensitivities are
The aim of a merger model is to provide an indicative transaction finance structure for the deal.
The model will assist in weighing up the benefits and costs of debt and equity. The model balances
these constraints, with a view to maximizing EPS accretion and at the same time attempting to
maintain a credible credit rating.
Typical model outputs are:
 EPS accretion (dilution)
 Credit ratios and likely credit rating
 Offer structure
 Financing structure for the deal
 Pro-forma ownership and exchange ratios
 Contribution analysis
 Return on investment
128
Valuation Q&A
It is a model that requires an iterative approach. The model should include multiple scenarios
and sensitivities.
Often changes to certain inputs in the model will have knock impacts to other inputs in the
model.
For instance, a decision to increase the amount of debt finance in the deal will have a
knock-on impact on the post transaction credit rating for the group. This may lead to a down
grading of the credit rating and an increase in the credit spreads. Therefore, the interest rate
assumptions on new debt issued must anticipate this increase in the credit spreads.
Analysts must also consider the impact of the transaction finance structure on the offer
premiums. Some transaction finance structures may be more attractive to the target than
others. This may translate into an impact on the offer premiums they are willing to accept to
complete the deal.
What factors can make a deal EPS accretive?
If a deal produces EPS accretion then it has a greater chance of success. One of the
reasons for this is that a strongly accretive deal is likely to gain stockholder approval.
Factors that may lead to an accretive deal:
 The target has positive and growing net income
 The target’s Price/Earnings ratio is greater than the acquirer’s
 The transaction creates a minimal amount of upward fair value adjustments that require
subsequent depreciation and amortization
 New equity issued to finance the deal is kept to a minimum without sacrificing the credit
rating
 Positive synergies
129
Valuation Q&A
What are the pros and cons of equity and debt as
transaction finance?
Equity consideration – benefits
 Positive impact on the credit statistics
 Increase in the shareholder base
 If the bidding company’s valuation is high, this results in reduced dilution
 Can be used to tie in key employees
 Often more tax efficient for institutional shareholders
Equity consideration – disadvantages
 Tends to be the costliest source of capital
 Target may not be willing to take the acquirer’s stock
 Tends to be EPS dilutive
 Can lead to post-transaction selling pressure – equity flow back
 Can lead to mixed and inconsistent shareholder bases – can lead to equity flow back
 Equity consideration can increase the deal completion time, and hence the probability of deal
collapse, especially if the equity capital markets demonstrate liquidity issues
Cash/debt consideration – benefits
 Relatively clean source of finance
 Relatively cheap source of finance
 Tends to be more EPS accretive, especially in a low interest rate environment
 Greater certainty of finance and deal completion
Cash/debt consideration – disadvantages
 Negative impact on credit ratings
 Inability to access and raise finance, especially given illiquid credit environments
 Key staff can ‘cash out’ post-transaction
130
Valuation Q&A
Who does what on a deal?
How can a company defend itself from a
takeover?
The management of a target company may employ defense strategies to defend themselves from
being taken over – but also if they approve of the deal, to make sure that the maximum offer price
is extracted from the deal. There are a number of proven defense strategies:
Poison pills (legality will vary depending on jurisdiction)
Poison pills are a takeover defense that makes it costly and difficult to acquire a company if any
party acquires a certain percentage of a corporation. They are one of the most popular defense
strategies.
Poison pills can provide rights or options to shareholders and bondholders to be able to buy more
shares in the company at a discounted price. These rights trade in conjunction with other securities
and they usually have an expiration date. When a merger occurs, the rights are detached from the
security and exercised, giving the holder an opportunity to buy more securities at a deep discount.
Golden parachutes
Golden parachutes are large compensation payments to top management and board directors.
The directors and others become entitled to the payments if they depart unexpectedly. So, for
example upon termination of employment, the large lump-sum payments fall due.
131
Valuation Q&A
The amount of compensation depends on formulae using variables such as annual compensation
and years of service.
The golden parachutes underlying aim is to increase the cost of restructuring the target company
post-acquisition as well as increasing the difficulty of removing the incumbent senior staff.
Recapitalizations
One way for a company to avoid being taken over is to make a major change in its capital
structure.
For example, the company can:
 Issue significant new debt
 Buy back its own stock
 Conduct a leveraged recapitalization
If the company seeks to buy-back all of its stock, it can go private through a leveraged buy-out
(LBO). However, leveraged recapitalizations must have the operating model that is capable of
generating sufficient cash flows for servicing, and repaying the high debt loads. Maintaining these
high debt levels can make it more difficult for the acquiring company since a high debt level
prevents the acquiring company from borrowing easily against the assets of the target.
Fire sale
In some circumstances, the target company may want to consider liquidation. In this situation, the
target company’s assets are sold off. Shareholders receive the resultant cash by way of a dividend.
It is important to emphasize that all restructurings should aim to increase shareholder value and
not simply try to stop a merger at all costs. The directors must at all times act in the best interests
of the shareholders.
Standstill agreements
A standstill agreement is an agreement between the acquiring and target company. The
agreement requires the acquiring company to cease to acquire additional shares in the target for a
specified period of time. This standstill period gives the target company time to explore its options.
However, most standstill agreements require compensation to the acquiring firm since the acquirer
is open to the risk of losing value in the investment.
White knight
The ‘white knight’ strategy attempts to avoid a hostile merger by seeking out a friendly third party
investor as a more suitable merger partner. Usually, the target company will use the advisory
services of an investment bank to identify and approach a ‘white knight’.
Litigation
A very common defense strategy is to legally challenge an approach from a hostile company. The
target company may be able to seek an injunction to halt takeover proceedings. The injunction
allows the target company to mount a structured defense.
132
Valuation Q&A
Pac man defense
As a last resort, the target company can make a tender offer to acquire the stock of the hostile
bidder. This is a very extreme type of anti-takeover defense and usually signals desperation.
One of the key issues with this defense as a strategy is that there is a very blurred line between
shareholder protection and the possible natural tendency of the directors to protect themselves.
Often directors use these defenses to bid up offer premiums. This can lead to situations where the
inflated offer premiums threaten the post-acquisition value creation.
What is a company profile?
A key part of a final target selection list is a company profile. Company profiles can vary greatly in
format and content between different IBD departments. However, the purpose of a company profile
is relatively consistent – it is a short, punchy summary of a company.
The profile can include details such as:
 Recent company and sector news
 Financial information (metric forecasts, EV and equity value calculations and multiples)
 Market share data
 Geographical and product analysis
 Board representation
 Shareholder analysis and profiling
 Share price performance (often against an index and/or comparables)
Company profiles can be as brief as one page or as detailed as 20 pages, depending on their use
and importance.
Analysts will be responsible for preparing these profiles, sourcing and extracting the data, and
making sure that the profile is in line with the bank’s presentation protocols.
If a number of company profiles are prepared for the same document or target list, managers will
usually require that the form and content of the profiles are consistent in order to aid comparability
between the target profiles. Some target lists will include a sector profile that will outline key sector
news, metrics and transactions.
What is a pitch book?
The form and content of a pitch book will vary from bank to bank, even from team to team.
However, there are two main types of pitch books:
General pitch book
Bankers use the general pitch book to guide their introductions and presentations during sales
calls. These pitch books contain general information and include a wide variety of selling points
bankers make to potential clients. The general pitch book will include an overview of the bank and
details its specific capabilities in corporate finance, sales and trading (but, generally no content on
the bank’s research franchise is included). It does not differ much from deal to deal.
133
Valuation Q&A
Deal-specific pitch book
A deal-specific pitch book is highly customized. It often requires at least one Analyst or Associate
all-nighter to put together! That said MDs, VPs, Associates and Analysts all work closely together
to create and finalize the book.
The book includes:
 Strategic rationale for the deal
 Valuation summary
 Valuations and financial modeling results
 Comparable company and transactions and industry analysis
 EPS accretion or dilution analysis
 The performance of other IPOs or similar offerings managed by the bank
 The bank’s expertise as an underwriter in the industry, including its ranking in the ‘league
tables’
 Deal tombstones
134
Statistical and Financial Math Q&A
Introduction
A basic understanding of financial maths is assumed in most areas of finance. Whilst the
banking teams will make use of discounting knowledge such as discount rates, annuities and
perpetuities, they will rarely get involved in the detail of statistics and regression analysis.
However, the derivation of beta for valuation purposes is essentially a historical regression
analysis, so some statistical knowledge can be beneficial.
8
Meabh de Frinse MA (Oxon) ACA
After completing her degree in Mathematics from Oxford, Meabh qualified as
a Chartered Accountant working with Deloitte in London. She then moved
into training, working first for a large training company providing training for
the ACA qualification.
After several years of success in this role, she then moved into the field of
investment banking and has been working with investment bankers and equity researchers
for over six years. She has spent a number of years designing and developing global
graduate training programs for leading global investment banks.
Her key training areas are the core skills required of an investment banker – accounting,
financial statement analysis, financial modeling and valuation. She has used her experience
of what graduate entrants into the field need to know about financial mathematics to develop
a focused section on the key questions you need to be able to answer.
Statistics and Financial Math Q&A
Where the financial maths and statistical knowledge become more relevant is in the fixed
income and more quantitative areas of the investment bank. Pricing derivatives and
understanding interest rate sensitivities through duration and convexity calculations require
a good level of mathematical and statistical ability.
135
Statistical and Financial Math Q&A
What are the common measures of central
tendency and dispersion?
Central tendency (typical values)
Measures of dispersion
Mean
Standard deviation
Mode
Range
Median
Inter-quartile range
The mean
The mean, also known as the 'simple arithmetic mean', is calculated as the average of a set of
values.
For example, should five funds achieve returns of 10%, 12%, 12%, 15%, and 18%, then the mean
return is calculated as:
(10% + 12% + 12% + 15% + 18%) / 5 = 13.4%.
The mode and range
The mode is the most frequently occurring number in a set of data. The range is calculated as the
difference between the highest and lowest values in a set of data.
7 3 14 6 10 9 16 19 2 4 15 11 9 23 27
Mode = 9 (there are two of them
and only one of everything else)
Range = 27 – 2
= 25
Problems with the mode and range:
As a measure of central tendency, the most obvious problem with the mode is that a set of data
may not contain a mode at all. Alternatively, there may be more than one mode in a data set, i.e.
'bi-modal' (two modes) or 'tri-modal' (three modes).
The main problem with using the range as a measure of dispersion is that it is distorted by extreme
values.
For example, if the (extreme) value of 1002 is added to the previous set of data, the range
increases from 25 to 1000 – even though most of the numbers are 'clustered' at the lower end of
the scale.
136
Statistical and Financial Math Q&A
The median
The median is the value of the middle item in a set of data arranged in chronological order.
For example:
2 3 4 6 7 9 9 10 11 14 15 16 19 23 27
7 numbers
7 numbers
The median
If the data set has an even number of values, then the median is equal to the average of the two
middle items:
The inter-quartile range
The median is also known as the 'second quartile'. The middle item between the start of a series of
numbers and the median is known as the 'first quartile'. The middle item between the median and
the end of a series of numbers is known as the 'third quartile'.
2 3 4 6 7 9 9 10 11 14 15 16 19 23 27
1st Quartile 2nd Quartile
(The median)
3rd Quartile
The inter-quartile range is the third quartile, minus the first quartile
2 3 4 6 7 9 9 10 11 14 15 16 19 23 27
1st Quartile
Inter quartile range
16 – 6 = 10
3rd Quartile
The inter-quartile range, therefore, is the 'spread' of the middle 50% of items in a data set. As such,
it is not distorted by extreme values.
137
Statistical and Financial Math Q&A
What is standard deviation?
The standard deviation (which is often referred to as the Greek letter 'Sigma') measures the level
of distribution, i.e. dispersion, around the mean of a set of data.
The formula for the standard deviation is:
138
Statistical and Financial Math Q&A
What is a geometric mean?
The geometric mean measures the average rate of change over a given period. It is particularly
useful when looking at compound changes, such as changes in a share price or changes in
portfolio returns.
The geometric mean is defined as the nth root of the product of n numbers.
For instance, consider a deposit of $5,000 over three consecutive years at rates of 6% p.a.,
5% p.a., and 4% p.a. respectively. The geometric mean rate of return is calculated as:
3 1.06 x 1.05 x 1.04 = 0.049968253 (or 4.9968253%)
This means that the deposit's average rate of return over the three year period is equal to 4.9968%
per year. The proof of this is shown below:
$5,000
6% pa
$300 interest
$5,300
$5,565
5% pa
$265 interest
$5,787.60
4% pa
$222.60 interest
Which gives exactly the same answer as:
5000 x (1.049968253)3 = $5787.60
139
Statistical and Financial Math Q&A
What is a correlation coefficient?
The correlation coefficient measures the strength of the relationship between two variables, for
example, the strength of the relationship between two share prices.
It is a useful tool when analyzing the association between two variables in a scattergram.
Correlation coefficient is calculated by dividing the covariance with the product of the two standard
deviations. By virtue of its calculation, correlation will always be between +1 and -1.
The correlation coefficient uses the covariance in its calculation. The covariance (cov) is a
statistical measure of the relationship between two variables, e.g. two share prices.
If the variables tend to move in the same direction, the covariance is positive. If the variables tend
to move in opposite directions, their covariance is negative. If the two variables are independent of
each other, the covariance is zero.
Positive correlation describes a relationship where an increase in one variable is associated with
an increase in another, e.g. advertising and sales. If both variables increase together, the
variables have a perfect positive correlation. Such a relationship is described by a correlation
coefficient of +1, e.g. demand for strawberries and demand for cream.
Negative correlation describes a relationship where an increase in one variable is associated with
a decrease in another, e.g. umbrellas and suntan lotion. If one variable decreases as the other
increases, the variables have a perfect negative correlation. Such a relationship is described by a
correlation coefficient of - 1, e.g. nights staying in and nights going out.
Perfect correlation describes a relationship where a change in one variable is exactly matched
by a change in another.
Note: when there is no relationship between two variables, the correlation coefficient is zero,
e.g. TV viewing habits and sunshine in Canada.
How can correlation be used to diversify risk?
Diversification, and an associated risk reduction of a portfolio of securities, is achieved by
combining securities which are not perfectly positively correlated.
Risk reduction through diversification is therefore achieved by combining assets with a low
(or negative) correlation of returns. The lower the correlation of returns, the greater the fund's
diversification and the lower the risk associated with an expected level of return. The only instance
when diversification benefits are not achieved is when there is a perfect positive correlation of
returns.
140
Statistical and Financial Math Q&A
What is a normal distribution?
Should a large number of histograms be drawn from a wide range of data, a familiar pattern
emerges. This pattern results in a high column in the centre of the histogram, with decreasing
columns spread symmetrically on either side.
If the class intervals are small enough, the resultant frequency distribution curve will look like a
cross-section of a bell, i.e. a 'bell-shaped' curve.
The bell-shape curve is called the 'normal curve of distributions'. (Note: the standard deviation
forms part of the normal curve of distributions. This is the reason why the standard deviation is so
important in statistical analysis).
A normal frequency distribution curve is one where the mean, median and mode all have the same
value.
Data does not always conform to a normal and expected pattern. In such cases, the frequency
distribution curves will be 'skewed'. If the peak of the curve lies to the left of centre, it is said to be
positively skewed. If the peak of the curve lies to the right of centre, it is said to be negatively
skewed.
Kurtosis tells us whether the distribution is more or less peaked than normal.
The distribution could be:
 Leptokurtic
 Platykurtic
 Mesokurtic
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Statistical and Financial Math Q&A
Leptokurtic
This describes the distribution as being more peaked than normal, and has a further feature that is
‘fatter tails’. Fatter tails show greater frequency of extreme values. The impact of this is that the
probability of extreme returns is greater than a normal distribution would assume.
Platykurtic
This describes the distribution being flatter than normal. This shows that the frequency of returns
are less concentrated at the mean.
Mesokurtic
This is the description of a normal distribution.
What is the difference between simple and
compound interest?
Interest represents the cost of borrowing money over a period of time. As such, it is often referred
to as the 'cost of capital' or the 'time value of money'.
Whether it is paid or received, interest can be calculated on either a simple or compound basis.
Simple interest
If interest is withdrawn at the end of each period and not aggregated to the principal – it is called
'simple interest'. Simple interest is calculated on the original principal amount only.
It assumes that at the end of each period, earned interest is not summed together with the
principal. For example, a $1,000 deposit placed at 5% per annum (p.a.) for three years will earn
$150 worth of interest, i.e. 3 x $50 p.a.
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Statistical and Financial Math Q&A
The terminal or final value (TV) of a lump sum invested at a rate of interest (r) over a given number
of years (n) on a simple interest basis is calculated as:
TV = Original principal amount x [1 + (r x n)]
Using the numbers in the above example:
TV = $1000 x [1 + (0.05 x 3)] = $1,150
Compound interest
Interest is usually paid/received at periodic intervals and is expressed as a percentage of the
principal borrowed. If interest is permitted to accumulate on top of the principal borrowed in order
to earn interest itself, it is called 'compound interest'.
Compound interest assumes that interest earned for one period is 'rolled-over' into subsequent
periods. The interest rate applies to the principal plus accrued interest.
When applying compound interest it is assumed that interest earned is re-invested, i.e. earning
interest on interest. Interest payments will therefore increase exponentially over time.
For example, a three year deposit of $1,000 at 5% p.a. would accrue to $1,050 at the start of the
second year. This amount earns interest of $52.5 ($1,050 x 0.05) which itself is rolled over into the
third year.
The process can be summarized as:
143
Statistical and Financial Math Q&A
The terminal or final value (TV) of a lump sum invested at a rate of interest (r) over a given number
of years (n) on a compound interest basis is calculated as:
Using the numbers from the previous example:
Calculate the terminal value of $1,000 invested for three years at a compound interest rate 5% p.a.
Therefore:
PV
r
n
= $1,000
= 5%
=3
TV
= $1,000 (1+0.05)3
= $1,000 x 1.157625
= $1,157.625
Therefore:
144
Statistical and Financial Math Q&A
What is discounting?
Discounting is the exact opposite of compounding. Compounding is concerned with determining
the terminal/future value of a principal sum given a rate of interest and frequency of payment.
Discounting is concerned with determining how much to invest today, given a rate of interest (the
'discount rate') and frequency of payment, in order to achieve a required terminal value in the
future.
The methods used to calculate the present value of future cash flows are known as discounted
cash flow (DCF) techniques.
These techniques are extensively used in accounting, equity, and bond valuation.
The present value of a single lump sum due to be received on a future date, at a given level of
interest, is calculated by re-arranging the compounding equation to make PV (present value) the
subject of the formula.
In other words:
For example, calculate how much is required to be invested today at an annual interest rate of 5%
p.a., in order to achieve a value of $1,000 in three years’ time:
Example:
Calculate the present value of $1,000 to be receive in three years’ time with interest rate of 5% p.a.
TV
r
n
= $1,000
= 0.05
= 3
PV =
$1,000
Therefore:
(1.05)3
= $863.84
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Statistical and Financial Math Q&A
What is an annuity?
An annuity is a series of equal payments received at the end of each period for a fixed number of
periods:
Formula for present valuing an annuity:
Where PV is the present value of an annuity paying $x each year at the end of the year for n
periods at an interest rate of r per period
What is a perpetuity?
A perpetuity is a series of regular cash flows paid or received indefinitely.
The formula to calculate the present value of a perpetuity is given as:
For example, assuming the first payment is made in one year's time, the present value of a $500
perpetuity at an interest rate of 10% is equal to $5,000 ($500 / 0.1).
The perpetuity formula can be used to value those investments that have fixed periodic cash flows
that are paid indefinitely. One such security is a standard preference share.
146
Statistical and Financial Math Q&A
How is discounting used?
The principle of discounting may be used to:
 Test the viability of a project, such as the construction of a building
 Value a company – an equity valuation
 Value a bond
There are two main discounted cash flow (DCF) techniques used for project appraisal purposes:
 Net present value approach (NPV)
 Internal rate of return approach (IRR)
When using discounted cash techniques for investment appraisal purposes, a range of
considerations must be taken into account:
 Risk. The risk of the project affects the cost of capital and subsequently the discount rate.
The more risk associated to a project, the higher the cost of capital, which in turn leads to
using a higher discount rate for cash flow analysis.
 Forecasting errors. DCF techniques rely on accurate predictions of future cash flows.
The longer the life of the project, the more difficult it is to forecast the future.
 Inflation. Inflation will have an impact on future cash flows and must be accounted for in the
relevant analysis.
 Government policy. Although in simple analysis the government's role is often ignored, a
change in, say, tax legislation can have a big impact on the viability of a particular project.
What is net present value?
The NPV technique of investment appraisal measures the present value of the project's cash
inflows, against the present value of the project's cash outflows, in order to determine the viability
of a project and/or investment.
The difference between the present value of the inflows and the present value of the outflows is
known as the Net Present Value (NPV) of the project:
If the NPV is equal to, or greater than zero, the project is viable and is worth carrying out, i.e. the
present value of the project's cash inflows are equal to, or greater than, the present value of the
project's cash outflows. A negative NPV, however, indicates the project should not be attempted,
as the present value of the project's cash outflows are greater than the present value of the
project's cash inflows.
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Statistical and Financial Math Q&A
What is the internal rate of return (IRR)?
The IRR is defined as the discount rate, that when applied to the cash flows of a project, will
equate the present value of the cash inflows with the present values of the cash outflows.
In other words, it is the discount rate that will calculate the net present value of a project as zero.
The internal rate of return is therefore the discount rate where the present value of the inflows
equals the present value of the outflows.
When evaluating a project's viability using the IRR technique, the IRR of the project must be
compared to the company's cost of capital.
If the company's cost of capital is less than the project's internal rate of return, the project should
be accepted. However, if the company's cost of capital is more than the project's internal rate of
return, the project should be rejected.
For example, if a project has an internal rate of return of 15% and the company's cost of capital
was only 10%, then the project would be worth proceeding with.
What is a CAGR?
Funds sometimes have their returns expressed as a compound annual growth rate.
Below are the values of a fund at the end of each year:
148
Equities Q&A
Introduction
This equities section focuses on cash equities business, its associated products and how
these products are brought to market. The Q&A will address such issues of how an IPO
works, what is an ADR, what is the difference between a bookbuild and underwriting.
9
This knowledge will be relevant for interns working in:
 Equities
 Fixed income
 Derivatives
 M&A
 Research
 Corporate banking
Marta Stojanova
Marta has over nine years experience working in the
financial sector. She spent seven years with WestLB
Panmure and Citigroup, working in equity and debt capital
markets as well as in the investment banking advisory
group.
Throughout her career she has gained vast transactional
experience in structuring and financing private and public
equity transactions, venture capital fundraising, private
equity financed LBOs, leverage finance, and buy-side M&A transactions. In addition, she
spent two years at Citi Private Equity and was responsible for sourcing, executing and
monitoring private equity co-investments, mezzanine and fund-of-funds investments across
Europe and North America.
Equities Q&A
Her wide ranging experience has been invaluable in compiling the interview questions for
Navigating the Maze, as she has been able to identify key questions that she would ask new
Analysts, as well as pinpoint the type of answers that would really impress her.
149
Equities Q&A
What are the basic characteristics of common
stock or ordinary shares?
Common stock is the most common form of equity. Outside the US, this type of equity is often
called ordinary shares.
Right to vote
Common stocks usually grant the right to vote in general meetings (although non-voting common
stock/ordinary shares exist).
Right to a dividend
A dividend is a share in the profits of the underlying company. Dividends payable to ordinary
stockholders are made after all other payments, such as interest and preference dividends, have
been satisfied.
So, if a company is unprofitable, it is the ordinary stockholders who are most likely to lose out.
On the flip side, should the company generate profits, the ordinary stockholders can expect a good
return in order to compensate for this risk.
Right to a surplus on winding up
In the event of a bankruptcy, ordinary stockholders are entitled to a share of the remaining assets
of the company, but only after all other liabilities have been settled.
How do preferred stocks differ from common stocks?
Preferred stocks do not normally carry the right to vote in general meetings or to participate in
decision-making. But, unlike ordinary stocks, preferred stocks carry an expectation of a fixed rate
dividend, which is payable after interest, but before common dividends. Preferred stock is referred
to as such because a company cannot pay common dividends without paying off any preferred
dividends due first. The stockholders of preferred stocks get preferential treatment.
Companies can issue different types of preferred stocks:
Cumulative preferred stock
Cumulative preferred stock differs from preferred stock in that it has a cumulative dividend,
meaning that, should the company not pay a dividend, (because, for example, of a lack of
profitability) the right to receive that dividend is rolled over into the next period. This is in contrast to
common stockholders, who will lose the right to receive an annual dividend if the directors do not
declare one.
All arrears of cumulative preferred dividends must be paid before the common stockholders
receive any dividend.
Participating preferred stock
Most preferred stockholders are limited to receiving a fixed rate dividend. For example, a 5% $1
preferred share will entitle the shareholder to a 5c dividend each year for every share held.
However, companies may confer participating rights. This means that if the company is
particularly profitable, an additional dividend may be paid.
You would calculate the participating preference dividends according to a profit-related formula.
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Equities Q&A
Convertible preferred stock
A convertible preferred stock is a preferred share with conversion rights that allows the holder of
the share to convert their investment into ordinary stock in the future.
Redeemable preferred stock
While most stocks have an indefinite life, redeemable preferred stocks carry a specified
redemption date, on which date the corporation would have to pay back the initial investment.
This type of preferred stock is similar to a loan in that a corporation receives cash with the
understanding that it has to pay it back in the future.
What is an ADR?
An ADR, or American Depository Receipt, represents a shareholding in a non-US corporation.
Because US investors like to buy stocks that are denominated in dollars and pay dollar dividends,
non-US corporations often face the problem that their stocks are unattractive to US investors.
Therefore, unless a non-US company issues dollar denominated shares, it may lose out on the
potential US investor base. In order to attract US investors to buy an equity stake in their
businesses, non-US corporations issue American Depository Receipts (ADRs) as a solution to this
problem.
The following description explains how a fictional UK company, Brit plc, issues ADRs for
sterling-denominated shares:
 Step 1: Brit plc issues sterling stocks to a UK branch of an American bank. The bank will pay
Brit plc for these stocks in sterling.
 Step 2: The bank will keep the sterling stocks in a safe place by acting as a depository.
 Step 3: The bank then issues ADRs denominated in dollars to US investors.
Usually, one ADR represents several underlying securities. For example, one ADR may represent
100 shares in Brit plc. ADR holders receive most privileges of the underlying stocks, including
voting rights and dividends. The benefit for US investors is that they will receive their dividends in
dollars.
ADRs are not restricted to trading in the US; they are also traded in the UK and elsewhere. Global
Depositary Receipts (GDRs) work in the same way.
US depository banks issue ADRs. The major depository banks are:
 JP Morgan
 Citi
 Deutsche Bank
 Bank of New York Mellon
JP Morgan first introduced ADRs in 1927 in order to encourage investors to buy shares of the UK
retailer, Selfridges.
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Equities Q&A
Why would a corporation choose to raise finance
via an equity issue as opposed to a debt issue?
Corporations can raise capital either by issuing equities to investors or by taking out a loan from a
finance provider. The managers of a company will have a lot of things to consider when they are
raising capital, for example, whether that finance is available, how quickly they can get their hands
on the cash and how the financing might affect the corporation taxes that they pay.
Equity has two great advantages over debt as a source of finance:
 It is permanent capital – it never has to be repaid to the investors
 The corporation has no legal obligation to make regular payments to ordinary stockholders
What are the advantages and disadvantages of
being a publicly listed corporation?
The decision to go public is one of the most important decisions a corporation can make and is
both a strategic and fund-raising decision. Therefore, when making this decision, it is vitally
important to appreciate the advantages and disadvantages of being a publicly listed entity.
Advantages
Disadvantages
Increased stock price because
it is easier for investors to
buy and sell the stocks
Increased public profile
and prestige
High cost – initial fees,
ongoing costs to maintain listing, investors
require high return
Potential loss of control for
pre-listing stockholders
Access to alternative
sources of capital
Public pressure on management
– meeting investor expectations
Offer employees stock options
as incentives
Regulatory requirements and
increased disclosures
Facilitate acquisitions (use stocks
as a form of currency)
What does ex-div mean?
The ex-dividend (or ex-div) date is the date from which all transfers of the security are contracted
excluding the right to receive the dividend. The period from the ex-div date is called the ex-div
period. The period before the ex-div date is called the cum-div period.
Any transfers of the security during the cum-div period are contracted with the right to receive the
next dividend payment.
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Equities Q&A
What is the difference between primary and
secondary markets?
The primary market is the market on which securities are sold for the first time. Companies use
the primary market as a means of raising new long-term capital (for both equity and debt).
The secondary market on the other hand, is the market on which existing securities are traded.
The secondary market exists to support the primary market. It provides subscribers to shares in the
primary market with a place to sell them on again, and also acts as a benchmark for primary
market pricing decisions. Secondary market activity does not raise new capital for the company.
Many international stock exchanges fulfil the role of both primary and secondary markets.
An initial public offer (IPO) is the first sale of stock by a private company to the public. In an IPO,
the issuer obtains the assistance of an underwriting firm (typically an investment bank), which
helps it determine what type of security to issue, best offering price and time to bring it to the
market and acts as sponsor
How can new equity be issued?
New equity can be issued via a number of different mechanisms:
 Offer for subscription
 Offer for sale
 A placing
 Using intermediaries
 A vendor placing
Offer for subscription
An offer for subscription involves a company issuing shares directly to the general public.
Offer for sale
An offer for sale is not restricted to the issue of new securities. It can also be used for a large
shareholding being sold into the market place, e.g. government privatizations. An offer for sale is
similar to an offer for subscription.
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Equities Q&A
However, in this case, the issuing house (or lead manager), initially may buy up new shares from
the issuing company before re-selling them to the investing bookrunner (underwritten) or the
issuing house may sell the stock to investors without taking pricing risk (bookbuild).
A placing
A placing is similar to an offer for sale; however, the lead manager does not offer to resell the
shares to the investing community at large.
Instead, the shares are only offered to selected investors such as pension funds and wealthy
individuals. For this reason, a placing is sometimes referred to as selective marketing.
An intermediary offer
An intermediary offer involves making a placing through several lead managers (brokers).
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Equities Q&A
A vendor placing
A vendor placing can occur as part of an acquisition. It is used when the buyer wants to pay for the
acquisition by issuing shares in itself, but the vendors want to sell for cash. In these circumstances,
to enable the deal to go ahead, the following procedure will take place:
 The buyer will issue shares in itself to the vendors
 The vendors will give up their shares in the company being sold to the buyer
 The vendors will then sell on the shares given to them by the buyer straightaway, in a deal
arranged beforehand. They will therefore ultimately receive cash in return for giving up their
shares.
What is stabilization?
Stabilization is the process where a lead manager in an issue purchases stock in the secondary
market in order to support the price of the issue. The market is made aware that stabilization is
taking place by the letter 'S' being displayed on trading screens.
What is ‘book-building’?
Book-building is the process by which an investment bank will try to determine the IPO price for the
stocks of a corporation, for example. The investment bank(s) driving the IPO contact major
institutional investors who will bid for the shares. The investment bank then sorts the investors’
orders according to price, quantity and other factors such as ‘firmness’ of bid. The bankers use the
data to establish a price for the issue and the allocation of shares.
The book-built IPO tends to result in a higher issue price as the investment bank will aim to
generate competition from the investors in an attempt to gain the best price for the issuer. The
downside of the process is that the proceeds are less certain as the price is not set until the end of
the process.
Today, most investment banks price IPO stocks using a book-building process.
What is underwriting?
One risk of trying to raise capital through issuing equities is that the corporation may offer stocks to
the public, but they may not want them. In this case, the equity issue would fail, resulting in wasted
time, effort and money.
Underwriting is where the investment bank guarantees to buy the stocks from the issuing
corporation. This gives the issuer certainty with respect to the final proceeds.
There are two types of underwriting – hard and soft.
Hard underwriting
This takes place very early on in the equity issue process. The investment bank guarantees the
stock price upfront, before they have contacted investors to gauge what the demand is likely to be.
This is the riskiest form of underwriting and hence the bank will charge a higher fee to compensate
for this risk.
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Equities Q&A
Soft underwriting
This takes place much later on in the process, typically after the book-building stage has happened.
At this point, the bank has received all the orders and has calculated the final IPO price. At this late
stage, all the issuer is really protecting against is settlement risk. Settlement risk is the risk that an
investor who has put in an order fails to settle the trade and pay the cash in which case the
investment bank will buy the shares. This is much less risky for the bank and so they will charge a
lower fee.
Generally, the later underwriting takes place, the cheaper it is.
What are the key stages in an IPO process?
The process can be broken down into a number of phases as far as a bank is concerned:
 Winning the mandate
 Positioning and preparation
 Marketing and investor education
 Roadshow and allocation
 Aftermarket
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Equities Q&A
Winning the mandate
The issuer will have a ‘beauty parade’ where they invite banks to pitch for the right to lead the IPO.
The first step for the bank will be to get an invite to pitch for the business. It is easier to get an
invite if the bank has a key relationship with the corporation and has provided loan finance for the
issuer in the past. Participation in the IPO is a reward for this support.
Another factor that would increase the likelihood of an invite is if the bank is one of the most prolific
lead managers in IPOs in the issuer’s sector or region. This will give the issuer comfort that the
bank has a relationship with potential investors and therefore has the ability to sell the shares.
Once invited to the pitch, the bank must convince the issuer that it is fundamental to the success of
the IPO, and the listed company thereafter.
Important elements of the pitch would be:
 Distribution network (League tables)
 The Equity Capital Markets (ECM) team who will work on the deal
 Analyst coverage after IPO
 Fees
 Anticipated IPO price
The key role that the banks will be pitching for is that of Lead Manager (US) or Global Coordinator
(UK). The bank that takes on this role has primary responsibility for the whole IPO process
including:
 Providing advice on optimal transaction structure
 Developing the ‘equity story’
 Determining the timing of the issue
 Supervising and performing due diligence
 Appointing and managing the syndicate
 Dealing with documentation (listing particulars, prospectus, underwriting agreement)
 Dealing with the other advisors – auditors, lawyers, public, investor relations specialists etc.
 Dealing with regulators and the exchange
The Lead Manager will most likely also act as a bookrunner which involves:
 Identifying and accessing key investors to generate demand for shares
 Advising on final pricing and allocation
Positioning and preparation
Very early on in the process, the investment bank will undertake due diligence. The objective of
due diligence is to identify and gain comfort as to the validity of the issuer’s information. This will
involve reviewing the issuer’s financial accounts, legal documentation and business plan.
During this stage, the investment bank will also be drafting the prospectus, which is the document
distributed to potential investors that should tell them everything they need to know in order to
make an informed investment decision.
The research Analysts will meet with the management team and will begin to write their
pre-marketing research report.
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Equities Q&A
Marketing and investor education
The aim of this process is to assess reaction to the selling story, identify and address any areas of
concern, and elicit feedback on the possible pricing of the stock issue. It also increases the
investors’ awareness of the issuer prior to the roadshow (which is the next stage in the process,
below). This should ensure the roadshow runs as smoothly as possible. To this end, the bank
needs to provide potential investors with enough information to whet their appetite and be willing to
take part when the books open during the roadshow.
The investment bank should now have enough information from the pre-marketing to investors and
the management presentations in order to set an initial price range. The initial range will start off
quite wide, narrowing as the process progresses.
The aim of activity at this stage of the process is that there is an aura within the investment
community that this is a ‘must have’ stock, even at the top-end of the pricing range.
Roadshow
The roadshow is when the senior management of the issuer and the investment bank visit the
major investors. Institutional investors, Analysts and money managers attend by invitation only.
This may take place over a one or two week period depending on the size of the issue and the
location of listing.
Throughout the roadshow, the bookrunner’s sales team builds a book of demand. This book will list
the Indications of Interest (IOI) from investors, which will give an indication of demand for the stock
over a range of potential prices.
Banks show the orders from investors either in terms of the number of shares (e.g. 100,000
shares) or as an amount of money (e.g. $1m worth of shares). An investor may also specify a
maximum price they are willing to pay.
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Equities Q&A
There are three different types of bids:
 Strike order – bidder is willing to accept shares at whatever the final price is
 Limit order – the bidder specifies a maximum price which they are prepared to pay for the
shares
 Step bid – the bidder submits the number of shares he wishes to buy at various price limits
(e.g. 500,000 @ $40.00, 750,000 @ $30.80, 1,000,000 @ $30.50 and so on)
Bidders can revise their bids at any time, and the orders are not final until the books close at the
end of the bookbuilding process.
At the end of the roadshow, once all of the orders are in and the books are closed, the bookrunner
will need to price the IPO. The decision on pricing is usually determined as a result of discussions
and negotiations between the bookrunner and the issuer.
In reality, the bookrunner will deliberately under-price the issue by about 10% to ensure it is
oversubscribed and the shares trend upwards in the aftermarket. This bodes well for the future
investor relationship with the company and makes it easier for the company to come back to the
markets with follow-on offerings.
The bookrunner will then need to allocate the shares. Ideally, corporations want the shares to end
up in the hands of high quality, long-term institutional investors.
What is a dual track process?
A corporation engaging in a spin-off or a private equity firm monetizing its equity may be unsure
whether an IPO or a trade sale will give the best price for the entity that they are selling.
In this case, corporations or private equity firms can start both processes, choosing their preferred
method of sale part-way through the process when they have a better idea about which option will
be more lucrative.
What is a syndicate?
A syndicate is a group of investment banks that work together in an IPO (for example) to sell the
shares to the public. Headed by the Lead Manager (US) or Global Coordinator (UK), this group
disbands as soon as the IPO is completed.
What is a prospectus?
When a corporation wants to raise capital through an equity issue, they prepare a prospectus.
The prospectus is a document that explains all aspects of a company's business, including
financial results, growth strategy, and risk factors. This is the key document used by investors
when considering the risks and potential rewards associated with investing in the issuer.
In the US, the preliminary prospectus is called a Red Herring because of the red ink used on the
front page, which indicates that some information such as the price and number of shares is
subject to change. In the UK, the preliminary prospectus is called the Pathfinder.
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Equities Q&A
The following extract shows the contents page of a prospectus:
What is a pilot fishing exercise?
Prior to the IPO being made public and whilst the equity research Analysts are writing their report,
the bookrunners may invite a number of key investors ‘over the wall’ in order to gauge demand and
price expectations, which is particularly beneficial in uncertain market conditions. The chosen
investors will not be able to trade any stock affected by the potential IPO, as they will have inside
information.
The pilot fishing exercise will help:
 Identify target investors to meet during the roadshow
 Fine-tune the equity story
 Identify key investment highlights and key weaknesses for investors
 Key points to be addressed by management during the roadshow
 Obtain feedback on the valuation and assess key valuation metrics investors will be focusing on
The regulators’ view on pilot fishing differs across the globe. In the US, restrictions on ‘gun
jumping’ prevent pre-marketing of IPOs before the regulator approves the prospectus. This
effectively outlaws both pilot fishing and anchor marketing.
Even where pilot fishing happens, there is controversy. Critics ask questions like ‘Why pay the
bank to run the IPO when they let the market value the company?’ Detractors also criticize the
banks for ‘baiting and switching’ on their clients. This is where a bank promises a high IPO price
at the beauty parade but then uses pilot fishing to lower the issuer’s expectations.
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Equities Q&A
Anchor marketing is similar to pilot fishing, but differs in that the banks will gain commitment from
the cornerstone investors. Banks believe that if the investors meet the management very early on
in the process, it increases the chance of investment even in volatile markets.
Following publication of the research report, the IPO is ‘live’ or ‘public’. As soon as the IPO
becomes public the ‘quiet period’ or ‘blackout period’ begins.
What is a Greenshoe option?
This is part of the stabilization process which allows the underwriters to buy more shares from the
issuer – typically 15% of an IPO. It happens if a deal is extremely popular, or if the underwriters
overbook the issue. The Greenshoe option is also called the over-allotment option.
During the allocation process, the bank will typically over-allocate the stock by up to 15% of the
IPO. The bank, therefore, has a short position of 15% (i.e. they have sold shares they don’t have).
If the price falls, the bookrunner covers the short position by buying shares in the market, thus
stabilizing the price.
If the share price increases, the bookrunner exercises the Greenshoe option and purchases shares
from the issuer at the original IPO price to cover the short position.
For a limited period of time, the bookrunner may stabilize the share price in the aftermarket; for
example, if the shares start to fall, the bookrunner may step in and start buying shares in order to
provide support to the share price. The bank does this to try and smooth the volatility caused by
the high volume of shares traded in a short period of time.
The bookrunner does this by using the ‘over-allotment’ or the ‘Greenshoe’ option (named after the
first company which did this – The Green Shoe Manufacturing Company in 1963). The Greenshoe
gives the bookrunner the right to buy additional shares at the IPO price from the issuer.
161
Equities Q&A
What is a secondary offering?
A follow-on, or secondary offering, is an issuance of stock subsequent to the company’s IPO.
Technically, a follow-on offering is an issue of ‘new’ shares, i.e. cash goes to the company and a
secondary offering is defined as existing shareholders monetizing their equity, i.e. cash goes to
selling shareholders. In reality, these terms are used interchangeably in the markets.
There are a number of ways in which a company may return to the equity markets (depending on
which jurisdiction the issuer operates in):
 Fully marketed book-built offering
 Accelerated book-built offering
 Bought deal
 Placing
What are the advantages and disadvantages of a
fully marketed book-built offering?
This is a similar process to an IPO. The issuer will appoint an investment bank, lawyers and
accountants. The professional advisers are required because this process involves carrying out
due diligence, completing research, producing a prospectus, holding a roadshow, book-building
etc.
Advantages:
 Good if targeting investors in a new market
 Helpful if the investing community does not understand your equity story
Disadvantages:
 Cost and time
 Lack of price certainty
 Does not fulfill pre-emption rights
What is an accelerated book-built offering (ABB)
or a placing?
An ABB is like a fast-track book-build. It is a sale of shares directly to institutional investors,
typically within a 24-hour period. The investment bank will build a book of demand and the issue
price and quantity will be determined at the end of the process.
Advantages:
 Quick – good for well-known issuers with a good equity story
 Price tension benefits of book-build process
 Limited documentation
Disadvantages:
 Lack of price certainty
 Does not fulfill pre-emption rights
162
Equities Q&A
What is a rights issue?
A rights issue is an invitation to current stockholders to buy new stocks in direct proportion to their
existing stockholding. Pre-emption rights ensure existing stockholders get first refusal on new
stocks, which protects the investors from directors seeking to dilute a stockholder’s control of a
company.
Rights issues are described using a ratio of the new and existing stocks. For example, with a 1 for
5 (1:5) rights issue, stockholders have the right to buy one new share for every five they already
hold.
In a rights issue, the stocks are offered at a discount to the prevailing market price of the shares.
This is both to encourage investors to take up their rights and to act as a safeguard should the
market price of the shares fall before the issue is completed.
If the market price of the shares were to fall below the rights issue price, the issue is unlikely to be
a success because shareholders would simply buy new shares for a lower price in the market.
When the market price is trading at less than the rights price, the shares are termed ‘underwater’.
Deep discounts of 40-50% are more common in volatile markets where there is a higher risk of this
happening. Most of the capital raising done by European banks in the middle of the credit crunch
was at deep discounted prices.
What is TERP?
TERP, or the theoretical ex-rights price, is the price of the shares after the rights issue has taken
place. Because the shares are issued at a discount to the current market price, the effect of a
rights issue will be to dilute the share price in the market.
The formula for calculating the theoretical ex-rights price is as follows:
(Number of new shares x Issue price) + (Number of existing shares x Market price)
Total number of shares post-issue
Note that the calculation does not take account of market sentiment before, during or after the
rights issue. Consequently, the value calculated is only a theoretical price. In reality, the price may
differ from the theoretical price.
An example of a right issue
A company undergoes a 1:4 rights issue. The subscription price is $1.50. The stock price of the
existing stock before the rights issue is $1.75 (commonly known as the 'cum rights' price).
Before the rights issue:
4 shares @ $1.75 each
= $7.00
During rights issue:
1 share @ $1.50 each
= $1.50
After rights issue:
5 shares
= $8.50
So, after the rights issue each share is worth
$8.50
= $1.70
5 shares
The theoretical ex-rights price = $1.70 per share.
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Equities Q&A
Investors may have insufficient funds available to take up the rights offered. If they are still keen to
take up stock, they can sell some rights to fund the taking up of others. This is known as splitting
rights or ‘tail-swallowing’. If an investor wishes to sell the rights, they will need to value the rights.
The price that an investor would (theoretically) pay for the right to subscribe for a discounted share
in a rights issue is the nil-paid price.
To illustrate how to calculate the nil-paid price, let’s use the previous example. The nil-paid price is
simply the difference between the theoretical ex-rights price (TERP) and the rights issue price, as
shown below:
Theoretical ex-rights price
$1.70
Less subscription price
$1.50
Theoretical nil paid price
$0.20
This is the maximum price someone would (theoretically)
pay for the right to buy the share at $1.50
The formula to find out how many rights an investor needs to sell in order to take up as many
possible rights with the proceeds is:
Number of rights to be sold
= Number of rights available x Subscription price
Theoretical ex-rights price
If an investor owns 1,000 shares, he will receive the right to purchase an additional 250.
Using the formula above, to take up as many rights as possible, it will be necessary to sell the
following number:
No. of rights sold:
250 ×
$1.50
= 220.6 (221 rights - always round up)
$1.70
The investor will sell 221 rights and take-up 29 rights.
Proof:
Sell:
221 rights @ $0.20 each
= $44.20
Take up:
29 rights @ $1.50 each
= $43.50
250
$0.70
If the investor sells less, he will have insufficient proceeds to take up more. The maximum
subscription at nil cost is therefore 29 shares.
164
Equities Q&A
What is an index?
An index is a number that gives the value of something (e.g. shares in a stock market) relative to
its value at some other point in time.
When an index starts, it is assigned a value of, say, 1,000 (the base value).
Any movement in the index measures the change in value of the constituents of the index. If, in our
example, the index rises to 1,100, then we know that the constituents of the index have risen in
value by 10%. All major stock exchanges calculate indices based on the shares traded on that
exchange.
An index is a simple way of summarizing what has been going on in the marketplace as a whole.
The press constantly refers to stock exchange indices in describing the general mood of the
market.
What is the difference between a market
capitalization weighted index and an unweighted
index?
Most indices are weighted towards the market capitalization of their constituent companies.
Therefore not all constituent companies are treated equally by the index.
For example, consider the FTSE 100 index. Royal Dutch Shell is one of the largest companies by
market capitalization currently listed on the LSE. The FTSE 100 index is weighted to market
capitalisation. Therefore, a 1% movement in the share price of Royal Dutch Shell will have a
greater impact on the FTSE 100 index, than a 1% movement in the share price of another FTSE
100 constituent, e.g. Next Group.
Not all indices are calculated in this way. For example, the Dow Jones Industrial Average used by
the New York Stock Exchange is weighted towards the price of a share in a company, rather than
the full market capitalization. Price weighted indices are often termed unweighted, as weighting to
market capitalization is the norm.
What is the Dow Jones Industrial Average (DJIA)?
This is the oldest continuing US index (it was first compiled in 1896) based on the 30 largest and
most widely held US companies. The reference to 'industrial' is based on the historic construction
of the index, as today most of the companies are not industrial in their nature. For instance, two of
the largest companies are the technology companies, Intel and Microsoft.
The DJIA is often referred to as 'the Dow'. It is probably the most quoted and widely recognized
index in the US, despite only containing 30 constituent companies. The index is maintained by the
editors of the 'Wall Street Journal'.
The DJIA is a price-weighted or unweighted index, as the index is calculated based on the
movement in a company's share price rather than its market capitalization.
165
Equities Q&A
What is the Nasdaq?
The National Association of Securities Dealers Automated Quotations (Nasdaq) composite index
is a market-capitalization weighted index based on the Nasdaq stock market. There are
approximately 3,200 companies trading on the Nasdaq market, of which approximately 300 are
non-US stocks. Therefore it is not strictly a US only index.
It is often used as a benchmark index to measure the performance of technology and growth
stocks.
What is the S&P 500?
The Standard & Poor's 500 is a free-float capitalization-weighted index, published since 1957 of
the prices of 500 large-cap common stocks actively traded in the United States.
What is the FTSE 100?
The 'Financial Times', together with the London Stock Exchange (LSE), is responsible for
calculating the 'FTSE' series of indices.
The FTSE 100 index is a market-capitalization weighted index based on the performance of the
100 largest UK-domiciled companies. The index is weighted by 'free-float' market capitalization.
The free float of a company is the proportion of shares that are held by investors who are likely to
be willing to trade. Free-float shares do not include the holdings of directors or the founders of the
company for instance. So, not all shares are included in the valuation of a company in the FTSE
100.
In the UK, the FTSE 100 is also referred to by the nickname 'Footsie'.
The FTSE All-Share contains the FTSE 100 and the FTSE 250 – the performance of the 101-350
largest domiciled UK companies. These two constitute the FTSE Large Cap Index. The FTSE
All-Share also includes the FTSE SmallCap Index, which is an index of small market capitalization
companies consisting of the 351st to approximately the 621st largest listed companies and it aims
to represent at least 98% of the full capital value of all UK companies.
166
Money Markets Q&A
Introduction
Money markets is a general term for the part of the financial system concerned with
short-term borrowing and lending. This is as opposed to capital markets whose products
have longer, if not infinite maturities, such as bonds and equities.
10
Money market products typically have a maturity of less than 12 months, although slightly
longer products do exist. The shortest period of time for a money market product is overnight
lending and borrowing.
The majority of money market products are inter-bank, i.e. banks borrowing and lending for
a short period of time from and to each other. The simplest example of a money market
product is a basic short-term loan. We know the rate of interest at which the banks are
conducting these loans, as it is published on a daily basis in the form of LIBOR (London
Inter-Bank Offered Rate). As London is the world’s largest centre for Foreign Exchange, the
LIBOR rates are published for 10 different currencies. Because banks will charge each other
a different rate for different time periods, there are also 15 different LIBOR maturities ranging
from overnight to 12 months. This means 150 different LIBOR figures are published each
day, for example, USD 6-month LIBOR = 0.79%.
This knowledge will be relevant for interns working in:
 Corporate banking
 Fixed income

Equities as well as
Peter has worked with and trained investment bankers,
corporate bankers and global markets for over 14 years.
His focus within the training arena is equity and debt capital
markets, money markets, derivatives and hedging the risks
associated with M&A and financing.
He has worked with major global investment banks designing and running programs for
Analysts, Associates and capital markets teams. His training commitments have taken
him to the US, Europe, Middle and the Far East.
The recent graduate season saw him successfully deliver capital markets and
derivative training to Analysts and Associate classes attended by geographically
diverse professionals with varying knowledge and experience. The client base ranged
from US and Asian owned global banks to a boutique European investment bank.
He worked with the derivatives team designing and delivering a course attended by all
members of a global DCM team. The training was implemented and sponsored by the
Head of DCM. Over a period of two months, using both internal and external collateral,
the training covered pre and post-issuance hedging, as well as sessions covering
hybrids, securitization and accounting for derivatives.
Money Markets Q&A
Peter Scollen
 Derivatives
167
Money Markets Q&A
What are the money markets?
The money markets are the market for short-term credit, loans and deposits with an original
maturity of less than one year. Institutions can borrow funds if they have a cash flow problem, or
deposit funds if they have a surplus. Deposits range from overnight to twelve months. These funds
may either be in the form of a straightforward cash deposit or loan, or an instrument such as a bill
or a Certificate of Deposit.
Companies continually borrow or lend money. Each day different companies (and other customers)
approach the banks wanting to borrow or lend different amounts of cash for different terms (i.e.
periods of time).
The banks' net position in each term is never likely to be even, (the money market jargon for this is
square, or flat). If the bank is not square it is either short which means it has over-lent in that period,
or long, which means it has over-borrowed.
What is the inter-bank market?
In order to resolve any shortages or surpluses of cash that arise, the banks have a borrowing/
lending market amongst themselves called the inter-bank market. Here they raise the shortfalls
and lay off the surpluses generated in each period by their customers' activities.
For example:
168
Money Markets Q&A
How are inter-bank rates quoted?
The inter-bank market is a quote-driven market where two way prices are made between
participating banks. All money market rates are expressed in annual terms.
This means a three month deposit rate of 6% would actually pay interest at 1.5%.
The two way price will be made up of a bid rate (the rate the bank will pay for deposits received),
and an offer rate, (the rate the bank charges for loans made). The bid rate is always lower than
the offer. The difference between the two is called the spread.
The rates on the inter-bank markets are better than those offered by the banks to their customers,
i.e. the spread is narrower. The ebb and flow of funds through the money markets due to the
customers’ changing appetite for funds means that the inter-bank rates are constantly changing.
They change on a minute-to-minute basis.
At 11.00am GMT each day, a snapshot is taken of the prevailing offer rate in the London
inter-bank market for each term to be used as a reference. This snapshot is called the 11.00am
LIBOR (London Inter-bank Offered Rate).
What is commercial paper?
Just as governments issue short-dated money market instruments – so do companies. Corporate
issued, unsecured short-dated debt is called Commercial Paper (CP).
When corporates issue commercial paper investors need to take into account the risk of default
(government debt is zero risk of default). In order to determine the relative risk of a company’s
commercial paper, credit agencies such as Standard & Poor's and Moody's grade the paper,
assessing its creditworthiness.
Like T-bills, CPs carry no coupon; they are issued at a discount and redeemed in full. CPs may
have maturities of between 7 days and 12 months.
169
Money Markets Q&A
What is a certificate of deposit?
A CD is issued when an investor places some money for a given term with a bank at an agreed
interest rate. To be permitted to accept the deposit, the bank (or building society) would need a
banking licence. The bank may draw up a CD representing the deposit. This is freely tradable.
CDs are different from other money market instruments in the following respects:

CDs represent a deposit and not a loan

CDs pay interest, whereas bills of exchange, T-bills and CPs do not

CDs may be issued with a life of up to five years, but it is only those with a remaining
maturity of one year or less that are classed as money market instruments
$5m on deposit for 3 months at 6%pa
Investor
170
Certificate of deposit
$5m deposit deposited at Bank X
for 3 months at 6%
Bank XYZ
Fixed Income Q&A
Introduction
Debt is the second pillar of a company’s capital structure. A good banker has a well-rounded
theoretical and practical knowledge of the various instruments in his or her ‘financing
toolbox’.
11
Research and practice have demonstrated that a little bit of debt (and sometimes a lot of it,
as in the case of leveraged buyouts) is a good thing – for the company and for its investors.
In general, you need to know the difference between bonds and loans (i.e. public market
debt vs. private market debt). You also need to be familiar with the following debt aspects:
pricing; seniority and security; maturity and repayment profile; size and flexibility; and during
which corporate event it would make sense to use which debt instrument(s).
Questions on types of debt may arise in interviews. Bond math questions – yield curve, price
vs. yield relationship and credit premiums – will crop up within capital markets.
Harry Cross
Harry is Fitch Learning’s Head of Investment Management Certificate
training and has over 20 years’ experience in the capital markets. Prior to
joining Fitch Learning in 2007, he specialized in the fixed income markets,
working as a trader and market maker, building an extensive knowledge of
European, UK gilt and US bond markets. He has a strong background in
formulating strategy and developing ideas for active trading and risk
Harry also excels in delivering training programs covering trading, sales, asset and wealth
management. During his time at Fitch Learning, he has delivered graduate programs to
clients as diverse as investment banks, global asset managers, inter-dealer brokers and a
prominent cash and derivatives broker-dealer.
His training involves developing materials and delivering courses on a wide array of market
related subjects and his background assists in making his courses relevant to the ‘real world’
practitioner. He has also published several works: The German Pfandbriefe and European
Covered Bonds Market, in Fabozzi, F., (Editor), The Handbook of Finance, John Wiley &
Sons Ltd (2008), The Gilt-Edged Market, with Moorad Choudhry, Butterworth-Heinemann
(2003), Implications of e-Trading in Financial Markets, Journal of Bond Trading and
Management, Volume 1 Issue 2, ( 2002).
Fixed Income Q&A
management.
171
Fixed Income Q&A
Why would a corporate choose to raise finance via
a debt issue as opposed to an equity issue?
Debt has a number of advantages over equity as a source of finance:
 There is no dilution of shareholder control (debt holders have no voting rights)
 Debt finance is a cheaper source of finance compared to equity finance
 Debt holders face less risk than equity investors do and so require a lower rate of return. This
is because interest is paid before dividends and the investors must be repaid at maturity. If the
firm goes into liquidation, debt holders are paid before the shareholders receive anything.
 In most jurisdictions, interest is a tax-deductible expense (dividends are not)
 Issuance costs tend to be cheaper
Because of these advantages, most corporations tend to have some debt as a form of permanent
capital, refinancing their debt obligations as opposed to paying them off.
What are the two main types of debt finance and
what are their key features?
The two main types of debt finance are:
1. Loans
2. Bonds
When a company decides to go down the debt route, it must decide whether to access the loan
markets (borrow directly from the banks) or the bond markets (borrow from the institutional investor
base). In making this decision, an investment grade issuer will need to consider the characteristics
of each market.
The table below shows the typical characteristics the issuer would need to consider:
172
Typical loan
Typical bond
Size
Any
$250m +
Maturity
3-5 years
3-50 years
Interest
Floating
Fixed
Repayment
Flexible
Bullet
Ratings
No
Yes
Regulation
No
Yes
Disclosure
Private
Public
Fixed Income Q&A
What is a bilateral loan/syndicated loan/club deal?
A bilateral loan is simply where a company borrows money from a single bank. This is a very
quick and simple process and is often a company’s first foray into the debt market.
A syndicated loan is a loan provided by a group of banks. From the company’s point of view, the
obvious advantage of a syndicated loan is it can borrow much larger amounts.
From the bank’s point of view, syndicating a loan reduces the bank’s risk exposure whilst retaining
a relationship with the client. The lead bank or banks that arrange and structure the loan are the
Mandated Lead Arrangers (MLAs). The MLA(s) will agree on the terms and conditions of the loan,
i.e. amount, maturity, margin, fees, any covenants etc. They will also invite the other banks to
participate in the loan. The participating banks do not get much say in the terms or pricing of the
loan – the MLA simply offers them the opportunity to participate in the loan on the terms negotiated
by the MLA.
A club deal is similar to a syndicated loan in that a group of banks come together to lend the
money. However, in this case it tends to be a much smaller group of existing relationship banks
and they will work together when agreeing on the terms and conditions of the loan. There is no one
bank acting as the MLA in a club deal. The banks that club together are of equal status.
What are the advantages and disadvantages of
loan finance?
Advantages of loans
 Speed – key terms of a bank loan are set quickly and the funding facility can be in place within
a matter of hours
 Administrative and legal costs are low – avoids marketing, arrangement and regulatory
expenses involved in a bond issue
 There is no need to obtain a credit rating
 Flexible with regards to currencies, repayment and drawdown
 Confidential – private arrangement between lenders and borrower
 Relationship – easier for the borrower to negotiate a waiver or amendment with a syndicate of
bankers than try to alter the terms of a bond
 Available to small firms
 Acquisition finance – flexibility good for the bid stage of an acquisition when price and timing
may still be uncertain
Disadvantages of loans
 Loan documentation can be more restrictive than in the bond market
 Maturities are typically limited to 3-5 years
173
Fixed Income Q&A
What is a term loan?
A term loan:
 May be drawn down in a single advance, or may be drawn in a number of separate advances
during the availability period (usually 30 days).
 Any unused commitment at the end of the availability period is lost and is not available for
drawing.
 Repayment of the loan happens in one of two ways. The first option is that repayment
happens at maturity (called a bullet repayment), the second is that repayment is continuousbased on an agreed amortization schedule.
 As the loan is repaid, the commitment reduces and the funds cannot be redrawn.
Bullet term loan borrowing structure
Commitment
$
Availability
period
Maturity
Time
Amount available
Loan outstanding
Uses of term loans
Term loans are typically used for permanent capital requirements such as long-term financing of
acquisitions or capital assets, such as property or equipment.
174
Fixed Income Q&A
What is a revolving credit facility?
 Commitment made available for a fixed period and does not reduce until the final date.
 During the period, the facility can be fully or partly
 Drawn
 Repaid and/or
 Drawn again
 Commitment fees payable on un-drawn portion of revolving credit facility.
Revolving credit facility borrowing structure
Maturity
Commitment
$
Time
Amount available
Loan outstanding
Uses of revolving credit facilities
The nature of the revolving credit facility makes it highly flexible and therefore it is most useful
when the timing and/or the amount of financing needed is uncertain. Revolving credit facilities are
frequently used to fund working capital and as a backstop/standby facility for capital markets
issuances. Revolving credit facilities are commonly used in acquisition finance as a bridge to more
permanent finance, such as a term loan or a capital markets issue.
175
Fixed Income Q&A
What is the interest rate on a loan based on?
LIBOR + margin
The pricing of a loan, i.e. the interest rate paid by the borrower, depends on interest rates and
credit risk. The borrower will pay a spread or margin above a benchmark rate, typically LIBOR or
EURIBOR. The margin depends mainly on credit quality and it is quite common for the loan
agreement to include a grid which states the margin for various levels of credit quality.
Rating
AA
A
BBB
BB
Margin (bps)
35-55
60-90
100-200
250-400
Other key drivers influencing the size of the margin include:
 Tenor, i.e. duration of the loan
 Terms and conditions of the loan
 Existence of collateral
 Purpose of the loan
 Industry sector
 Seniority, i.e. the order of repayment in the event of bankruptcy
 State of the bank market
 Relationship – amount of ancillary business
176
Fixed Income Q&A
What is LIBOR?
LIBOR stands for the London Inter-Bank Offered Rate. This is the rate at which leading banks lend
money to each other for a specified period in the London wholesale market. LIBOR is the primary
benchmark for interest rates around the world and is a key reference rate for other loans. There is
a LIBOR rate for ten currencies with 15 maturities quoted for each, ranging from overnight to 12
months.
LIBOR is set at 11.00am London-time every business day by the British Bankers Association
(BBA). The BBA will take the quotes submitted by a panel of 16 banks, remove the top four and
bottom four values (to remove any outliers), and take an arithmetic average of the middle eight
quotes. This creates the BBA LIBOR quote. Key rates include US dollar LIBOR and Euro LIBOR.
What is EURIBOR?
Euro Inter-Bank Offered Rate (EURIBOR) is a LIBOR rival, referring to the Euro LIBOR. The
European Banking Federation in Brussels calculates this rate from spot lending rates in the Euro
posted by a panel of the 57 most active banks in the Euro zone. The top and bottom 15% are
eliminated and an average taken of the remaining quotes. The rate is set at 11.00am (CET) every
business day.
What is a covenant?
Covenants are promises made by the borrower to the bank. The borrower may promise to do or
not do certain things, and therefore covenants give comfort to the lender (i.e. bank) by imposing a
discipline on the borrower. They:
 Enable the bank to monitor the borrower’s position
 Provide an early warning of financial difficulty and protect against deteriorating credit quality
177
Fixed Income Q&A
 Define the parameters within which the borrower may operate its business
 Preserve the ranking of the lender
 Manage the conflict between shareholders and creditors
If the lender breaches its covenants, this would be a technical default and the bank may accelerate
the loan (ask for their money back).
Maintenance and incurrence covenants
Financial covenants may be maintenance covenants or incurrence covenants.
 Maintenance – so-called because the issuer must maintain quarterly compliance or suffer
technical default on the loan agreement.
 Incurrence – criteria must be met at the time of a pre-specified event, such as an acquisition,
raising additional debt, paying a dividend etc.
Who are the main credit rating agencies?
The major credit rating agencies are:
 Standard & Poor’s
 Moody’s
 Fitch
A credit rating is an independent opinion on the general creditworthiness of a borrower and their
ability to service their debt obligations.
Measuring credit risk is fundamental in the debt capital markets as the risk should determine the
return that the lenders require on their investment. The higher the risk of default, the higher the
interest the lender demands to compensate them for that risk.
Why are credit ratings more important for bonds
than for loans?
In the loan markets, banks loan the cash and tend to perform their own risk analysis as opposed to
relying on a public credit rating. This is because the banks have a relationship with the borrower
and therefore have access to management and to internal information, accounts and forecasts so
they are in a position to assess the risk of default.
Bond investors do not have such a relationship with the borrower or access to internal information.
They may not have the time to undertake extensive credit analysis every time they buy a bond.
This is where the external ratings agencies come in – they will perform an independent
assessment of the credit risk of a borrower. By assigning internationally recognized ratings to
companies and to individual debt instruments, bond investors can understand the risk of default
and compare the credit quality of borrowers from different sectors and from all around the world.
Ratings are therefore more important in the bond markets than the loan markets, and there are
many fund managers who cannot invest in non-rated bonds because of the risks that this poses.
178
Fixed Income Q&A
What is the lowest investment-grade rating?
The lowest rating for an investment grade bond is BBB-/Baa3.
Moody’s
S&P
Fitch
Description
Investment grade
Aaa
AAA
AAA
Aa1
Aa2
Aa3
AA+
AA
AA-
AA+
AA
AA-
High quality. Strong capacity to service debt and repay principal
A1
A2
A3
A+
A
A-
A+
A
A-
Strong payment capacity but susceptible to adverse changes in
circumstances and economic conditions
Baa1
Baa2
Baa3
BBB+
BBB
BBB-
BBB+
BBB
BBB-
Adequate payment capacity but this capacity could be weakened
by adverse changes in circumstances
Highest quality. Extremely strong capacity to make interest
payments and repay principal
Non-investment grade (‘Junk’ or High Yield)
Ba1
Ba2
Ba3
BB+
BB
BB-
BB+
BB
BB-
Likely to fulfil obligations but major ongoing uncertainties or
exposure to adverse changes in conditions could affect issuer’s
ability to make timely payments of interest and principal
B1
B2
B3
B+
B
B-
B+
B
B-
High-risk obligations. Greater vulnerability to default
Caa
CCC+
CCC
CCC-
CCC
CC
CC
Highly speculative
C
C
Highly speculative. No interest being paid or situation where
bankruptcy petition filed but debt still being serviced
D
DDD
DD
D
Ca
D
Currently identified vulnerability of default
Default
179
Fixed Income Q&A
What is a bond?
A bond is simply an IOU – a piece of paper or contract declaring the borrower will pay back the
principal on a specified future date (bullet repayment) or on a number of possible future dates.
In the meantime, the borrower promises to pay a specified rate of interest which is typically a fixed
rate.
Hence, from an investor’s point of view, bonds are termed ‘fixed income’ investments.
Historically, bonds were issued in ‘bearer’ form, i.e. the investor would receive a physical certificate
similar to the one pictured below. Attached to the bond would be a number of detachable coupons.
These coupons relate to a particular interest payment and hence, the interest on a bond is termed
the ‘coupon rate’. The holder of the bond would submit the relevant coupon on the payment date
and in return would receive the interest. These days, most bonds are registered in ‘book-entry’
form and merely exist as electronic entries on computers.
Bond
NV $1m
Coupons
(interest)
A bond security differs from a loan in that it is a tradable instrument. The loan amount is broken
down into smaller pieces and issued to a large number of investors who can then trade or sell on
the bond to other investors. Also with a loan, the bank tends to maintain a relationship with the
company it has lent to whereas in the bond market the company has no relationship with its
investors (and if the bond is in bearer form the corporate may not even know who the investors
are!). The investors in the bond markets tend to be domestic and foreign institutional investors
such as pension funds, mutual funds and insurance companies, as opposed to banks.
180
Fixed Income Q&A
What are the key features of a vanilla bond?
Issuer
The issuer of the bond is the entity borrowing the money. The interest rate the issuer will have to
pay will depend on the creditworthiness of the issuer, as well as the structuring and terms of the
bond.
Nominal value
Each bond has a fixed face value or nominal value. This is also referred to as the par value. This is
the amount that the company promises to repay at maturity. The price an investor will pay for a
bond is not necessarily the par value.
In the example above, Toys R Us Inc. have a total bond issuance of $350m where each bond is for
a nominal value of $1,000. Debt is often expressed relative to a par value of 100%. You can see in
the Bloomberg screenshot that the issue price is 100. This indicates that the bond was issued for
100% of its par value, i.e. $1,000. If the issue price had been 98, this would imply the bond had
been issued at 98% of its par value, i.e. at $980.
Most bonds are structured such that they are issued at, or very close, to par. Whether the bond is
issued at, or traded at a discount or a premium, will depend on how close the coupon rate is to
current market rates and the investor’s required rate of return.
Coupon
As already mentioned, the coupon rate is the interest rate on the bond. The coupon is typically paid
every six months (US markets) or twelve months (Eurobonds and some European markets), and is
calculated as a fixed percentage of the nominal value. Hence, on the Toys R Us bond, the coupon
would be 7.375% of $1,000, i.e. $73.75.
181
Fixed Income Q&A
Maturity
This is the date the bond will be repaid, i.e. when you will receive the par value.
Typical cash flow profile of a bond
The majority of bonds are of this type, with a fixed coupon and the principal paid entirely at maturity
(bullet maturity). The advantage to a company of issuing a fixed coupon bond is they have
eliminated interest rate risk. They know exactly what they will have to pay and when. They do not
have to worry about what might happen to interest rates going forward and thus they can budget
and prepare their cash flow forecasts accordingly.
From an investor’s point of view, fixed income investments are attractive as they provide a steady
stream of income and a known lump sum when the bond matures.
What are the advantages and disadvantages of
bonds?
Advantages of issuing bonds
 Longer term maturities – 5-10 years easily placed, and up to 50 year maturities available
 Fixed interest payments – issuer knows the exact cost across the debt’s lifetime and can
budget accordingly for the interest and principal repayments
 Fewer and less restrictive covenants than in the loan market
 Alternative investor base to banks
Disadvantages of issuing bonds
 Minimum issue size of approximately $250m
 Public – increased market regulation and disclosure of information
 Issue costs more expensive than loan issue
 Can be a lengthy issue process
182
Fixed Income Q&A
What is a floating rate note?
These bonds pay interest at a variable rate and are known as floating rate notes (FRNs). The
coupon tends to vary with some sort of benchmark rate, typically LIBOR.
The rate of interest payable varies from one payment date to the next because of changes in the
benchmark rate of interest. The Citigroup bond delivers cash flows quarterly and has a coupon
formula equal to the three month LIBOR + 20bps (0.20%).
Banks and other financial institutions typically issue FRNs to bring their funding in line with their
assets (floating rate loans). This is known as asset-liability matching.
183
Fixed Income Q&A
What is an index-linked bond?
Similar to floating-rate notes, the coupon on an index-linked bond varies over time. In this case, the
coupons are linked to some sort of price index such as the Retail Price Index (RPI) or Consumer
Price Index (CPI). From an investor’s point of view this builds in a form of protection against
inflation risk as the bond’s cash flows are adjusted to ensure the holder receives a real rate of
return. Index-linked bonds are usually associated with longer dated securities.
Typical issuers:
 Governments
 Utilities sector – whose revenues may be contractually linked to inflation
What is a callable bond?
A callable bond is one which gives the issuer the right to buy the bond back prior to its stated
maturity date, i.e. redeem the bond early.
Why would an issuer choose to repay a bond early? They would typically do so if interest rates
have fallen or their credit rating has improved and they can refinance at a lower coupon rate. This
is advantageous for the issuer and therefore a callable bond will typically carry a higher coupon
rate to compensate the investor for the possibility of early redemption of their bond.
Typically, when bonds are called, they are redeemed at a premium to par.
What is a putable bond?
A corporate bond may be issued with a put provision. In this case, it is the bondholder who has the
right to sell the bond back to the issuer at a specified price, i.e. ask for early redemption. Why
would a bondholder choose to redeem their investment earlier than at maturity? They would do so
if interest rates have risen or the credit spread widened and the investor can use the money to
invest in new bonds yielding a higher rate. As this is to the investor’s advantage, a putable bond
should offer a lower coupon rate than a straight bond without the put feature.
What is a convertible bond?
A convertible bond is a bond where the investor can either receive their principal or instead receive
a specified number of shares. From an investor’s point of view, this is an attractive investment as it
allows investors to benefit if the equity price of the company rises. From the company’s point of
view, convertible bonds are attractive as investors value the conversion right and so the company
can pay a much lower coupon on the bond. The more valuable the conversion option, the lower the
coupon rate.
184
Fixed Income Q&A
What is a Eurobond?
An international bond/Eurobond is a bond issued in a non-domestic currency. For example, any
non-sterling denominated bond issued in London, or any non-dollar bond issued in the US is an
international bond.
A dollar borrowed outside the US is commonly known as a Eurodollar. Yen borrowed outside of
Japan is called Euroyen borrowings. The term Eurobond is historical and has nothing to do with the
Euro currency or Europe. Confusingly, Eurobonds do not have to be denominated in Euros and
syndicates of dealers in several countries all around the world often issue and trade in them.
Commonly, Eurobonds are issued in the currency and country where the issuer finds it cheapest to
raise the finance. They are then swapped into the currency the issuer wants.
How would you determine the coupon on a bond?
At issue, bonds will typically be priced close to par and therefore pay a coupon rate which reflects
the yield required by investors under current market conditions.
The coupon on the bond is set by reference to a government bond of the same maturity at the time
of issue and then adding a spread to take into account the additional credit risk (risk of default) of a
corporate bond vs. a government bond. The general market conditions and the liquidity of the issue
will have an influence on the spread.
What is a high yield bond?
High yield bonds are bonds that have a credit rating below BBB-/Baa3. As there is a higher risk of
default, these bonds will typically pay higher interest to compensate investors for the increased
credit risk. Investors will also demand protection in the form of more restrictive covenants relative
to the investment-grade market.
The table shows typical features of the high-yield loan and bond markets:
All in cost (market
dependant)
Flexibility
Minimum amount
Term/maturity
Public rating
Ranking
Covenants
HY loans
HY bonds
L + 350bps
Mid-swaps + 450bps
Ability to delay drawdown and repay
None
Max amount limited by EBITDA multiple
3-10 years
None needed
Senior secured
Onerous financial
Maintenance
Incurrence
Non-financial
Information covenants
Negative pledge
Cross default
Restriction on indebtedness
Quarterly covenant testing
Low (call protection common)
$100m
5-10 years
Yes
Subordinated unsecured
Financial
Incurrence
Non-financial
Negative pledge
Restrictions on indebtedness
185
Fixed Income Q&A
What is PIK?
Most bonds pay a coupon during the life of the bond and the nominal value is repaid at redemption.
Zero-coupon bonds are issued at a discount to the nominal or par value. No interest is paid during
the life of the bond, but it is paid at redemption when the bond is redeemed at par.
PIK bonds are similar to zero-coupon bonds; however, they are not normally issued at a discount.
Instead the interest (or part of the interest) due on the bond, accrues over the life of the bond and
is paid at redemption along with the nominal value.
What is the Yield to Maturity (YTM)?
This is also called the gross redemption yield and is also the IRR (internal rate of return.)
The YTM represents the total return achieved from a bond assuming it is held to redemption.
It therefore takes account of:
 Coupons received
 Coupons re-invested (assuming no re-investment rate risk)
 Capital gain/loss on redemption
The YTM is simply the discount rate that equates the price of a bond to the present value of its
future cash flows.
YTM is the return the investor receives if they:
 Buy the bond at its current price and hold it until redemption
 Invest all of the coupons at the same rate
It is a weighted average of the spot rates applied to each cash flow.
In the example below (9% coupon, redeemable in three years, current price 93.35) the yield to
maturity of the three year bond is 11.76% p.a.
Coupon
Value = 93.35
9
(1.1176)
= 8.05
Coupon
9
(1.1176)2
= 7.22
Interest/flat/income yield
The return the holder receives on their investment in terms of coupons only:
Flat yield =
186
Coupon amount
Clean price
Coupon + Par
109
(1.1176)3
= 78.08
Fixed Income Q&A
Simple or Japanese yield
This is a naïve version of YTM; it ignores the time value of money:
Coupon +
(Nominal value - Clean price)
Time to redemption
Clean price
Simple YTM =
What is the difference between a clean and dirty
price?
Bond prices in the market are calculated using the assumption that there is a whole number of
coupon payment periods remaining.
When the bond trade is settled, the additional amount added for accrued interest is calculated by
dividing the coupon payment period as follows:
Next
coupon
Last
coupon
Whole coupon period
Fractional period (w) = 1 - AI
Interest earned by seller
Interest earned by buyer
Where: AI = Accrued interest
No. of days from last coupon to settlement date
No .of days in the coupon period
187
Fixed Income Q&A
What is duration?
Duration is a measure that reveals how sensitive a bond is to interest rate changes. Duration (also
known as Macaulay duration or the economic life of a bond) is the weighted average maturity of a
bond, where the weights are the relative discounted cash flows in each period.
In other words:
Duration
=
∑ Present value of cash flow x time to cash flow
∑ Present value of cash flow
Duration is expressed in years. The higher the duration, the more sensitive the bond’s price.
Duration is a relative measure. It enables us to determine the riskiest bond from a list of bonds,
i.e. a bond with a duration of 4.37 years will be more sensitive to changes in interest rates than a
bond with a duration of three years.
However, it does not quantify the sensitivity. To achieve this, Modified duration is required. The
modified duration of a bond estimates how much a bond’s price will change if there is a change in
interest rates/yields.
Modified duration can be calculated using the following formula:
Modified duration =
D
(1 + r)
Where D is the bond’s duration and r is the present yield.
188
Fixed Income Q&A
Applying the formula to the example considered earlier:
The modified duration of a bond with a duration of 4.37, and a yield of 8pct:
Modified duration =
D
(1 + r)
=
4.37
1.08
=
4.05
This is how much the bond’s price will change for a 1% change in interest rates.
What is a yield curve?
The spot rate is the current interest rate for a given maturity. The yield (spot rate) offered by bonds
varies according to their maturity dates.
The yield curve (or ‘term structure of interest rates’) illustrates the relationship between maturity
dates and yields. The yield curve for a particular bond market is the result of plotting the yields
offered on varying bonds against the maturities of those bonds.
There are three theories that attempt to justify the shape of the yield curve:
Liquidity preference theory – this only explains upward or normal yield curves. It is based on the
assumption that longer dated bonds are more risky than near dated bonds. For this reason
investors will require a higher rate of interest for a longer loan. If the market believes that
short-term rates are due to rise, one would expect the curve to assume an upward slope.
Market segmentation theory – the premise here is that the market is made up of many different
components. Each component is a market in its own right with its own supply and demand forces.
The yield curve's overall shape is the sum of the different conditions in each segment.
Pure expectations theory – this states that 'the long-term rate is a geometric average of expected
future short-term rates (forward rates)'. A forward rate is an expected future interest rate, i.e. the
six months rate in a year from now. It can be seen as the future interest rate inferred from the term
structure of the yield curve. In other words, if the market thinks short-term rates are going to
increase, long-term rates will increase. Alternatively, if the view is that short-term rates will fall,
longer-dated yields will come down.
189
Fixed Income Q&A
What is an assetbacked security?
An asset-backed security (ABS) is a financial instrument secured by a pool of underlying assets
such as property, loans or credit-card receivables. They are often issued by companies specially
created for the purpose called Special Purpose Vehicles (SPVs). This enables the issuing
company to be a separate legal entity from the original owner of the underlying assets, leaving the
SPV unaffected by any bankruptcy risk in the original owner.
These instruments are often called ‘pass-through securities’ as the cash flows from the pool of
underlying assets, e.g. rental income on property or interest on loans, pass through the SPV and
are distributed on a pro-rata basis to the holders of the ABS. In other words, the cash flows from
the underlying assets have been securitized.
Where the cash flows from the pool of underlying assets is distributed between several varying
classes of bonds, each class of bond is known as a tranche. This process of 'tranching' has the
effect of spreading the prepayment risk (the risk of early redemption). An additional tranche, known
as a 'Z bond', pays no interest in the early years and has a long average life.
The most common types of ABSs are:




190
Collateralized bond obligations (CBOs)
Collateralized debt obligations (CDOs)
Mortgage-backed securities (MBSs)
Collateralized loan obligations (CLOs)
Fixed Income Q&A
Collateralized bond obligations (CBOs)
A collateralized bond obligation (CBO) is an investment-grade bond (i.e. highly rated bond) backed
by a pool of high yielding bonds (i.e. ‘junk’ bonds). High yield bonds are usually not investment
grade, but because several types of credit quality bonds are pooled together, the risk is managed
to ensure the majority of the CBO securities are ‘investment grade’. (Well, that’s the theory
anyway!)
Collateralized loan obligations (CLOs)
A collateralized loan obligation (CLO) is similar in structure to a CBO, except that the pool of
underlying assets are corporate and bank loans rather than bonds.
Mortgage-backed securities (MBSs)
A mortgage-backed security (MBS) is, simpler in structure to a CBO except that the pool of
underlying assets are home loans. They are used by retail banks to securitize the cash flows from
mortgages that would otherwise be receivable over normally, a 25 year term.
Collateralized debt obligations (CDOs)
A collateralized debt obligation (CDO) is a security secured by the cash flows from a pool of bonds,
loans, and other assets. CDOs do not specialize in one type of debt. CDOs are similar in structure
to a CBO and CLO but unique in that CDOs represent different types of debt and credit risk.
191
Fixed Income Q&A
192
Derivatives Q&A
Introduction
Clients are exposed to risk. Bankers can provide advisory services to hedge out this risk.
Client-facing bankers such as corporate bankers, equities and fixed income specialists will
need a keen understanding of the key derivative products – how these products work and
what drives their pricing.
12
You should have a working knowledge of the key derivative products (options, futures,
forwards and swaps), how they price and how clients can use them.
This knowledge will be relevant if you are working in:
 Fixed income
 Equities
 Derivatives
 Corporate banking
Investment bankers should have sufficient knowledge so that they can recognize
cross-selling opportunities within the bank. Many M&A transactions will introduce significant
risk to the client. Some of these risks could be effectively hedged through the use of
derivatives.
Derivatives can also be used for speculation and arbitrage.
Rob has been working as a financial trainer for the last 13
years and has developed and delivered innovative,
participative and enjoyable training courses predominantly to
the investment banking, markets and wealth management
communities. His role as a trainer has enabled him to travel
the world teaching in all of the world’s major financial centers.
He is considered a pre-eminent practitioner with the ability to
design and execute programs for every audience – from new
industry joiners to top-level management.
Rob’s subject portfolio encompasses equity and debt products, derivatives, investment
management, valuation and financial modeling.
At Fitch Learning, Rob is responsible for developing and implementing a range of training
courses particularly with an investment banking and sales and trading focus. This includes
leading graduate programs for our investment banking clients and blue chip organizations.
Before becoming a financial tutor Rob studied computing science at college and joined
Cargill plc as a trainee accountant.
After qualifying as an accountant, he held various positions within Cargill and was the
Financial Accountant for the UK when he left to start working in the training sector.
Derivatives Q&A
Rob Woods
193
Derivatives Q&A
What is the difference between cash and
derivatives securities?
Equities and bonds are cash securities, i.e. tradable pieces of paper. Derivatives are agreements
in which price and value are derived from something else (a cash security or otherwise).
Instruments
Derivatives
Cash securities
Equities
Bonds
Futures
“I will”
Options
“I may”
Swaps
“Let’s swap
cash flows”
What is the difference between OTC and
H[FKDQJHtraded?
Exchange
Standardized
Liquid
Centrally cleared
Heavily regulated
Few products
Volumes known
Professional and retail market
194
OTC
Generally bespoke
Generally less liquid
Generally no clearing house
(but changing)
Lightly regulated
Product proliferation
Volumes not known aside from surveys
(e.g. BIS)
Professional market
Derivatives Q&A
What is a future?
A future is simply an agreement (or contract) between two parties, where one party agrees to buy
something in the future, and the other party agrees to do the opposite and sell.
The terms and conditions of the future transaction (i.e. price, size, quality etc.) are agreed now.
Note that in futures contracts nothing is bought (or sold) today. It is the terms and conditions that
are fixed today regarding a transaction to be completed in the future.
Futures jargon
The underlying asset
The underlying asset drives the value of the future. It is often referred to as simply the underlying
or cash asset. Futures are derived from numerous assets. For example, an investor can trade
futures on such diverse cash assets as gilts, currencies and orange juice.
The long
The long position with a future is the future buyer of the underlying asset. The long has agreed to
buy the underlying asset on a future date.
For example, if an investor is long June bond futures at $98, he has agreed to buy bonds in June
for $98 each.
With a future this is a binding contract. Once agreed, the long has an obligation to meet the terms
set out in the contract, i.e. he must buy the bonds for $98 in June.
The short
The short position with a future is the future seller of the underlying asset. The short has agreed to
sell the underlying asset on a future date.
For example, if an investor is short June bond futures at $98, he has agreed to sell bonds in June
for $98 each. Again with a future this is a binding contract. Once agreed, the short has an
obligation to meet the terms set out in the contract, i.e. he must sell the bonds for $98 in June.
Price agreed today
By fixing the price, the instrument provides certainty about prices in the future. The long knows
how much he will pay for the underlying asset, and the short knows how much they will receive for
the underlying asset. Remember, once the contract is made, it is binding on the parties. It no
longer matters what happens to the price of the underlying asset, the price at which delivery will be
taken or made is set in the terms of the contract.
195
Derivatives Q&A
Note the future is a contract. No money is paid on the agreement; it is only paid on the future
delivery date.
Delivery date
This is the date on which the agreed transaction takes place. It represents the end of the future's
life.
Fair value
The fair value of a future is a theoretical value of the future. It is based on the theory that if you
were to enter into a long future position on wheat for delivery in three months, there is always
another alternative. That alternative to entering into a future contract is to buy the wheat today and
hold it in a warehouse for three months.
However, buying the wheat today incurs extra costs above the price of the asset. These costs are
referred to as the cost of carry. The cost of carry is comprised of the following:
 Interest rate cost
 Storage
 Insurance
Interest rates
Buying the wheat today means spending money today. Remember, with a future you do not have
to pay until the future date. By buying the wheat today you need to borrow money (paying extra in
interest) or spend your own money (losing the interest on your deposits).
For this reason, we have to add the cost of interest to the price of the asset on the market.
Storage and insurance
Once we have bought the asset, assuming that the asset is a physical asset such as wheat, we will
need somewhere to store it until the future date. This adds to the cost of buying the asset today.
We also need to protect it from harm, so insurance adds further to the cost.
To demonstrate how fair value is calculated; consider a three month future on one tonne of wheat.
Assume that interest rates are currently 6% and storage and insurance costs amount to 80c per
tonne, per month.
 The price of wheat today (cash or spot) $65 / tonne
 Delivery date three months
Fair value of future = Cash price of the underlying + Costs of carry
Cost of 3
month’s
foregone
interest
($65x6%x3/
12) = $0.97
Buy wheat
today at $65
per tonne
Theoretical fair value = $65 + $0.97 +
for 3 month delivery
$2.40
= $68.37
196
Storage and
insurance cost
for 3 months
80c x 3
months =
$2.40
Derivatives Q&A
How are futures used in practice?
There are three main uses of futures contracts:
 Speculation
 Hedging
 Arbitrage
Speculation
Speculation means taking on risk in order to make a profit. Unfortunately, by taking on risk, there is
also the potential to lose money as well.
Speculation is, essentially, like gambling. Futures are used by investors to speculate on the price
movements of the underlying asset.
Example:
An investor has decided to stake some money on a speculative futures position. A news report has
suggested that there may be a shortage of wheat in months to come. She therefore decides to
place an 'up bet' on the price of wheat. She does this by buying a wheat future at $100 per tonne.
She is said to be bullish as she is expecting prices to rise.
The next day, she hears that the price of wheat (in the cash market) has risen. This has the effect
of increasing the price of wheat futures to $120 per tonne. The investor has the choice of keeping
her position open in the hope the price will rise even further, or closing out her position, by selling
wheat futures at $120 and thus realizing a profit of $20 per tonne.
Note that, if the price of the wheat futures had fallen to $60 when she closed out, she would have
lost $40 per tonne. Had she thought prices would fall (i.e. had she been bearish), she would have
placed an opening trade of selling the future, making profits as prices fell.
Speculation is done by investors who have no real interest in the underlying asset. Speculators are
taking a position on the price of an underlying asset and hope that their belief as to whether the
price will rise, or fall is proved correct.
Hedging
Unlike speculation, hedging is not a money-making exercise. Hedging is used by people who have
a genuine interest in the underlying asset but want to remove the uncertainty (risk) of potential
price movements.
A short hedge is used to remove the uncertainty of owning an asset, i.e. being long the underlying.
The risk associated with owning an asset is that by the time you want to sell it the price will
have fallen.
Example:
A farmer produces barley at a cost of $60 per tonne. By the time he comes to sell it, the price of
barley may have decreased (or increased). If the farmer can sell barley at more than $60 per tonne,
a profit is made. If the price drops below $60, a loss is incurred.
197
Derivatives Q&A
Profit
60
Purchase price per
tonne $60
Loss
Prices falling
Prices rising
Notice that the profit profile of being long the cash asset is the same as the profile for a long
futures position, i.e. the farmer will make a profit if the price of barley increases above $60 per
tonne but make a loss if it falls below.
The risk of falling barley prices can be offset by taking an opposite position in the futures market,
i.e. long cash barley, short barley futures. For example, if the farmer sells barley futures (available
on NYSE.liffe) at, say, $75 per tonne, any losses made on the cash barley should the price drop
will be offset by profits made on the short futures position.
Short future at $75
per tonne
Long cash at $60
per tonne
Overall profit of
$15 per tonne
Profit
Loss
60
75
Eg 1
Eg 3
Prices falling
Prices rising
Eg 3
Regardless of the price of barley when the farmer comes to sell it, he will make a profit of $15 per
tonne.
Example 1: If the price of barley were to be $60 per tonne on sale day, $nil will be made on the
underlying but $15 will be made on the short future.
Example 2: If the price of barley were $70 on sale day, $10 profit would be made on the cash
asset and $5 on the short future. A total of $15.
Example 3: If the price of barley were $75 on sale day, $15 profit would be made on the cash
asset and $nil on the future.
No matter what happens to the price of barley in the cash market, the farmer has locked-in a profit
of $15.
A person who is long the underlying is concerned about prices falling.
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Derivatives Q&A
Long underlying/Short futures = Short hedge
Selling futures on the underlying asset protects against falling prices.
The hedge takes its name from the futures position.
Arbitrage
Arbitrage is the process whereby an investor (usually a market professional) makes a risk-free
profit by exploiting anomalies and inconsistencies in the prices between two related but different
markets.
For example, as cars are (allegedly) cheaper in the rest of Europe than in the UK, someone can
buy a car in France and sell it immediately in the UK for a profit.
By exploiting the inconsistencies between motor car prices in different markets, a quick profit can
be made. The same principle is used when arbitraging between a cash asset and its derivative. Of
course, when arbitraging financial instruments, only the fastest will be able to exploit the arbitrage
opportunity. It does not take long for everyone in the market to spot the arbitrage opportunity and
the two prices are very quickly brought back into line with one another again.
What is basis?
Basis quantifies the difference between the cash price of the underlying asset and the futures
price.
What is the difference between contango and
backwardation?
Contango means that basis is negative, i.e. the cash price is less than the price of the future.
As the future's price indicates the costs of carry, basis is usually negative and the market is
described as contango. Negative basis is the norm when there is adequate supply, i.e. 'far' prices
(future prices) are higher than 'near' prices (spot prices).
Another term for contango is premium.
Backwardation means that basis is positive, i.e. the cash price is greater than the price of the
future. This might occur for example, if there were a temporary shortage of the underlying, which
would push up the cash/spot price today and produce a back market.
Backwardation can also occur where there is an overall benefit of carry rather than a cost of carry.
This could arise where the dividend yield on an equity or equity index is above interest rates.
Another term for backwardation is discount.
199
Derivatives Q&A
What is a forward contract?
A 'forward' is a deal between two parties not dealt on an exchange (i.e. an over the counter or OTC
transaction).
Futures and forwards are therefore similar products in that both enable something to happen at
some time in the future on terms agreed today. The key difference is that futures contracts are
exchange- traded.
The main advantage of forwards (over futures) is that they offer a high degree of flexibility to the
parties involved, allowing them to set any contract specifications that are mutually acceptable.
The main disadvantage of forwards is direct counterparty risk with the opposite side of the trade.
There is no central counterparty or collateral payment, so the credit worthiness of both
counterparties is extremely important. A second problem is that they are not tradable, so it is
difficult to value them and price information is not always available.
Common examples of OTC deals include:
 Forward rate agreements: a forward applied to interest rates
 Swaps: a forward applied to the exchange of one series of future cash flows for another
What is a futures contract?
A futures contract is an agreement to buy or sell a specified quantity of a specified asset on a
specified future date at a price agreed today.
The terms and conditions of a futures contract are specified/standardized. This is because futures
are traded on derivative exchanges around the world. Standardizing the terms and conditions of a
contract allows a person to sell their future on to someone else, and hence provides liquidity to the
market. Standardized terms are known as contract specifications. The price of the future is never
standardized. The price does however form part of the total agreement and so is a feature or
component of a futures contract.
What is a long position on a future?
The long position describes the buyer of a future.
Note that the buyer of a future is not buying anything now. Instead, they agree to buy the
underlying asset in the future. In other words, the long agrees to take delivery of the underlying
asset in the future.
The long hopes that the price of the underlying asset will rise.
The long futures position makes money in a rising market but loses money in a falling market.
200
Derivatives Q&A
What is a short position on a future?
The short position describes the seller of the future.
Note that the seller of a future is not selling anything now. Instead, they have agreed to sell the
underlying asset in the future.
In other words, the seller has agreed to make delivery of the underlying asset in the future.
The short hopes that the price of the underlying asset will fall.
The short position makes money in a falling market.
Profit
500
Loss
Prices falling
Prices rising
How does a future settle?
The buyer of a futures contract has two choices:

To old the future to expiry and then take delivery of the underlying (if physically deliverable)

To sell the future before the expiry date. This is known as the closing out position
Closing out is achieved by entering into a second equal, but opposite contract in order to offset the
terms and conditions of the first. Hence, a buyer of a future who has made an opening purchase
(created an obligation to take delivery of an asset at a future date), closes out by making a closing
sale (creating an obligation to make delivery of an identical asset at the same future date). Equally,
an opening sale is closed out by a closing purchase.
201
Derivatives Q&A
How can a future be used to hedge?
Futures, like the S&P 500 future, can be used to hedge portfolios of US equities against adverse
market movements. The number of contracts required is known as the hedging ratio.
Example:
A fund manager has a portfolio of major US stocks worth $200m and is worried that the market
may fall and reduce its value:
Portfolio (extract)
GE
Microsoft
Exxon Mobil
Pfizer
val $200m
120,000
100,000
130,000
150,000
In order to gain some protection, the fund manager constructs a short hedge, by selling S&P 500
futures.
Profit
500
Loss
S&P 500 falling
S&P 500 rising
So as the S&P falls, the loss in value of the portfolio is off-set or hedged against the gains arising
from the short position of the future. There are two questions:
Which delivery month?
Generally speaking the most liquid month is the nearest delivery date. So if it were November
when the fund manager decided to construct the hedge, the December future would be used.
How many contracts?
The contract size of the S&P 500 future is $25 per point. This means that if the December future
were trading at 1,300.00, then its equivalent would be $325,000.00 worth of the S&P 500
constituent shares.
The number of contracts the fund manager’s hedge needs is:
202
Derivatives Q&A
What is an option?
An option gives the buyer the right (not the obligation) to buy or sell an underlying asset at a fixed
price on, or before, a given date in the future.
Only the seller of an option has a potential obligation while the buyer has a choice. With futures,
both the buyer and seller have an obligation.
The buyer of an option pays a premium to the seller. There is no premium paid when buying
futures.
Confers rights
Pays premium
Buyer
Holder
Long
Has rights
Seller
Writer
Short
Has obligations (if the buyer
exercises their rights)
Option jargon
Call option – an option that gives the holder the right to buy the underlying asset.
Put option – an option that gives the holder the right to sell the underlying asset.
Exercise (or strike) price – the price at which the option specifies the underlying asset may be
bought (or sold).
Atthemoney (ATM) – a call option whose strike price is the same as the underlying's current
trading price.
Inthemoney (ITM) – a call option whose strike price is below the underlying's current trading
price.
Outofthemoney (OTM) – a call option whose strike price is above the underlying's current
trading price.
Premium – options are not free, they must be paid for. The price paid for an option is called the
premium.
The holder – the term used to describe the buyer of an option – also referred to as the long
position.
The writer – the term used to describe the seller of an option – also called the short position.
Expiry date – the rights granted by an option do not last forever. The expiry date is the last day of
the option's life.
European style – options that may be exercised on their expiry date only.
American style – options that may be exercised at any time during their lives, up to and including
the expiry date.
Gearing – the extent to which an investment's value can move relative to a percentage change in
the underlying. Options are highly geared.
203
Derivatives Q&A
What are the basic option positions?
There are four basic option positions:
 Long a call option – the right to buy the underlying
 Short a call option – a potential obligation to sell the underlying
 Long a put option – the right to sell the underlying
 Short a put option – a potential obligation to buy the underlying
It is important to note that the following profit and loss profiles all represent uncovered (or naked)
positions. In other words, the holder or writer in question does not actually own the underlying
asset.
For the sake of simplicity, in considering profit and loss profiles, assume that the options are all
European style and therefore can only be exercised on the expiry date.
A long call
In this situation, the buyer pays a premium and is granted the right to buy the underlying asset on
expiry if they wish.
The higher the price of the underlying, the more profit the buyer will make.
Buying call options is a bullish strategy.
The maximum profit for the buyer is unlimited. The maximum loss for the buyer is the premium.
Example:
An investor buys a 100 (The strike price) call (the right to buy) paying a 10p premium. A long call
position is a bullish strategy. It makes money in a rising market. The breakeven point on the option
is when the underlying share price has rising sufficiently above the strike price to cover the
premium cost.
Strike price = 100
Underlying
share price at
expiry
Profit
110
Premium
Loss
100
10
Option abandoned
Breakeven =
strike (100) +
premium (10)
Option exercised
A short call
In this situation, the seller receives a premium and is required to sell the underlying asset on expiry
if the buyer requires.
The higher the price of the underlying, the more loss the seller will make.
Writing call options is a bearish strategy.
The maximum profit for the seller is the premium. The maximum loss for the seller is unlimited.
204
Derivatives Q&A
Example:
An investor sells a 100 call option receiving a premium of 10p. A short call position is a
bearish/neutral strategy. The writer keeps the premium if the market falls.
Strike price = 100
Premium
Breakeven =
strike (100) +
premium (10)
Profit
10
100
Underlying
share price at
expiry
110
Loss
Option abandoned
Option exercised
A long put
In this situation, the buyer pays a premium and is granted the right to sell the underlying asset on
expiry if they wish.
The lower the price of the underlying, the more profit the buyer will make.
Buying put options is a bearish strategy.
The maximum profit for the buyer is the strike price less the premium paid. The maximum loss for
the buyer is the premium
Example:
An investor buys a 200 put paying a premium of 60p. A long put option is a bearish strategy.
You make money in a falling market.
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Derivatives Q&A
A short put
In this situation, the seller receives a premium and is required to buy the underlying asset on expiry
if the buyer requires.
The lower the price of the underlying, the more loss the seller will make.
Writing put options is a bullish strategy.
The maximum profit for the seller is the premium. The maximum loss for the seller is the strike
price less the premium.
What drives the price of an option?
The price of an option, the premium, is the amount the holder pays to the writer for the option.
For some types of option the premium is paid when the option is purchased, this is described as
'upfront'. For other options, the premium is paid on expiry or exercise – this is described as
'on-close'.
The premium of an option is made up of intrinsic value and time value:
Intrinsic value
The intrinsic value is the obvious value of the option. It is the inherent value a particular option has,
were it to be exercised now.
For a call option this would be the price of the share, less the strike price. The logic being, if the
share price (the price you can sell for) is above the strike price (the price you can buy for), the
option has intrinsic value.
206
Derivatives Q&A
For a put option this would be the strike price less the price of the share. The logic is the same but
now the strike price is the price you sell for and the share price is the price you buy for.
It is important to point out that intrinsic value can never be less than zero.
Time value
Time value is the amount over and above the intrinsic value that an investor will pay, to buy an
option because of what might happen to the price of the underlying between now, and the end of
the life of the option.
An option with a long time to expiry will have a considerable element of time value incorporated
into its price. The longer the period, the higher the time value, as the more time there is for the
price of the underlying to change.
If an option was trading at a premium of 25 cents, and the intrinsic value was 15 cents (in the
money), then the time value would be 10 cents.
What factors influence the time value of an
option?
Examples of factors that impact on option premiums include:




Volatility of the price of the underlying asset
Interest rates
Dividend yields
The remaining life of the option
Each of these also has a sensitivity measure – referred to as the option Greeks – that tells us by
how much the option's premium will be affected by a movement in these factors:
Volatility of the price of the underlying asset
The more volatile the price of the underlying asset, the higher the time value (and therefore
premiums) of a call and put option. Vega measures the sensitivity of an option premium relative to
a change in the volatility of the price of the underlying.
Interest rates (equity options only)
Movements in interest rates will have different effects on call and put options. The following effects
are most apparent for options with premiums paid upfront.
207
Derivatives Q&A
Call options
If interest rates rise, the time value of call options will increase and the premium will rise.
Consider a call option as a deferred/delayed purchase of the underlying. When interest rates rise,
investors will be keen to defer the purchase of the underlying, and instead put their money in the
bank to earn a high rate of interest. As a result, call options become more attractive to investors
who wish to expose themselves to rising prices without actually having to buy the underlying asset.
Time value therefore increases and the premium on the call option rises.
The opposite is true when interest rates fall.
Put options
When interest rates rise, the time value of put options decreases. Consider a put option as a
deferred/delayed sale of the underlying. If interest rates go up, investors are less likely to want to
delay the sale of the underlying asset as this delays paying the cash into the bank and earning a
high rate of interest. Put options therefore become less attractive when interest rates rise and so
time value decreases and the option premium falls.
The opposite is true when interest rates fall.
Rho measures the sensitivity of an option premium relative to a change in the interest rate.
Dividends (equity options only)
Changes to a company's dividend policy will have different effects on calls and puts.
Call options
If dividends increase, the time value of equity call options will decrease (and vice versa).
The holder of a call will not receive the dividends on the shares. If dividends rise it becomes more
attractive to buy the share than to delay the purchase. Call options, therefore, fall in value when
dividends rise.
Put options
If dividends increase, the time value of put options will rise.
As put options defer the sale of a share, when a company announces an increase in dividends, put
options become more attractive (as the holder can retain the share and receive the increased
dividends) and therefore the premium increases.
Remaining life of the option
The longer an option has to expiry, the higher the time value of the option.
This is because there will be more time for the price of the underlying to change. As the life of an
option passes, therefore, its time value decreases. However, time value does not decrease in a
linear fashion. The closer the option is to expiry, the faster the time value will decay.
This can be illustrated graphically:
208
Derivatives Q&A
As a consequence of time value decay, we would expect longer-dated options to be higher priced
than shorter-dated options (assuming the same underlying with the same strike). Note: time decay
works against the holder and therefore operates to the advantage of the writer. That is, if all other
things remain stable, a writer of a call/put will be able to close their position out by buying at a
lower price than they originally sold for.
Theta measures the sensitivity of an option premium relative to a change in the remaining life of
the option.
What is an interest rate swap?
Interest rate swaps (IRSs) are agreements between two people to exchange or swap payments on
loans. They are sometimes described as 'agreements to swap cash flows' or coupon swaps.
A specific example of a coupon swap is a vanilla swap, which is created where two parties swap a
fixed rate of interest and a floating rate.
It is because of the different methods of borrowing that IRSs are useful. A company may either
borrow money at fixed or variable rates; it would borrow fixed if it thought rates were going up and
variable if it thought they were about to fall. An interest rate swap will allow the company to change
borrowing styles part way through the term of the original loan. The standard form of an interest
rate swap is BBAIRS (British Bankers' Association Interest Rate Swap).
Example: Consider a five year, three month borrowing facility.
The five years are split into three month periods – at the beginning of each period, the LIBOR rate
for three months is set and applied to the loan. At the end of each period, the interest is paid and a
new LIBOR rate is set for the next three month period. This is known as the reset date. The term
of the swap is defined by two dates, the effective date (the date from which interest starts to
accrue), and the termination date (the end of the swap).
A company with such a facility may approach another institution and arrange an interest rate swap.
The institution would agree to pay LIBOR to the company at the end of each three month period, in
exchange for interest payments from the company at a fixed rate.
209
Derivatives Q&A
In the diagram you can see the company has swapped three month LIBOR payments for a fixed
rate of 6.32% pa, say. The company's net outgoings are simply 6.32 pct over the year, as the
LIBORs cancel out. The swap institution will bear the risk of the company not honoring its
obligations.
What is a cross currency swap?
Currency swaps allow a company to raise funds in one currency and convert them into another
currency. Unlike an interest rate swap in a currency swap, the notional principal actually changes
hands at the beginning of the swap and payments are made without netting.
Example:
The company then
approaches a swap bank and
swaps the $1.5m (at an
exchange rate of $1.5:£1 and
receives £1m for three years
at an interest rate of 6%.
2
Company
A
3
4
1
A company raises
$1.5m from a third
party. This loan will
pay a fixed rate of
5% over three
years
Over the next three years,
Company A pays the swap
institution 6% x £1m and
receives 5% x $1.5m from the
swap institution. This amount
is then used to service the
interest to the third party
Swap
Institution
Interest
payments
made at 5% x
$1.5m
5
The overall impact on
the company is that it
has raised £1m over
three years at a rate
of 6%
Third
party
investor
A company raises $1.5m from a third party, paying a fixed rate of 5% p.a. over a three year term.
The company then approaches a swap bank and swaps the $1.5m (at an exchange rate of
$1.5:£1), receiving £1m for three years at a rate of 6%. Over the following three years, the
company pays the swap institution 6% x £1m and receives 5% x $1.5m. At the end of the three
year period, the swap is reversed and the company uses the $1.5m from the swap bank to repay
the third party. The overall effect on the company is that it has raised £1m sterling over three years
at a rate of 6%.
210
Derivatives Q&A
What is an equity swap?
Entering into the equity market comes with various additional costs, such as commissions, charges
and tax. An investor can gain exposure to the returns on the equity markets without incurring these
additional costs by entering into an equity swap. The swap would work as follows…
…if for example, an investor has a certain amount of money that she wishes to use to gain equity
exposure, she could place the money on deposit and enter into an equity swap. Essentially she will
forgo the interest on the deposit and in return, get the return on an equity (or basket of equities).
Equity leg
Index
basket/
individual
equities
Equity return
LIBOR +
Bank XYZ
payer
Interest leg
Investor
The swap will involve the investor paying a rate of return, usually linked to LIBOR, on the deposit in
exchange for the percentage change in the chosen equity. The chosen equity could be an
individual share, a basket of shares put together specifically for the swap, or shares representing
an established index.
What is a credit default swap?
Credit default swaps have the same effect as shorting a bond. The buyer (investor) of the swap
gains if the bond decreases in value, but if the bond increases in value, the buyer must pay the
increase to the swap bank.
The buyer of a credit default swap pays a premium to the swap bank and in return will receive a
cash payment, should a default event occur. For all practical purposes, credit default swaps are
regarded as option contracts.
211
Derivatives Q&A
What is a structured product?
Structured products are a combination of a security and a derivative – typically an option. They
have a fixed life at the end of which payments to the investor will be made.
The most common structured products are:

Callable/putable bonds

Convertible bonds

Index linked bonds

Commodity linked bonds
Callable/putable bonds
A callable bond is a standard bond issued by a company or investment bank with a call provision
attached to it. The call provision entitles the issuer to buy back the bond (repay the loan) early.
Like any call option, the exercise price and the date will be specified in the investment.
A putable bond is a very similar investment. However, a put provision entitles the holder of the
bond to sell back the bond (demand repayment) early.
Convertible bonds
With convertible bonds, the bond effectively becomes an option on shares as soon as the share
price rises above the conversion price.
For example, assume a convertible has a nominal value of $1,000, a coupon of 2.5% and a
conversion ratio of 35 shares. This gives a conversion price of $1,000 / 35 shares = $28.57. If the
share price is currently below $28.57, it is unlikely that the bond will be converted. Therefore, the
value of the bond will be based on the discounting of cash flows, plus a small amount for the value
of the option to convert should prices rise.
If the share price is currently above $28.57, it is likely that the bond will be converted. All of a
sudden, the bond is no longer valued on the discounting of cash flows basis, but instead on the
value of equity it can be converted into, plus, of course, the value of the option.
Investing in convertibles is often seen as a low risk way of gaining exposure to an equity price
increase.
Index-linked notes
Indexation is where the coupon on the bond is variable and moves in line with a specified inflation
index. This is often described as a bond with an inflation swap packaged together, where the fixed
coupon of the bond is swapped for a floating inflation index.
Commodity linked bonds
This could take many forms. One example could be a bond with a commodity index swap attached
to it, allowing the fixed coupon on the bond to be replaced with a floating rate based on the return
of a specified commodity index. Another example could allow the investor to convert the bond into
a specified quantity of an asset on redemption. Alternatively, the bond could feature both of these
elements.
212
Derivatives Q&A
What is arbitrage?
Arbitrage is the process whereby an investor (usually a market professional) makes a risk-free
profit by exploiting anomalies and inconsistencies in the prices between two related but different
markets.
For example, as cars are (allegedly) cheaper in the US than in the UK, someone can buy a car in
the US, pay the additional import fees, and sell it immediately in the UK for a profit. By exploiting
the inconsistencies between motor car prices in different markets a quick profit can be made.
The same principle is used when arbitraging between a cash asset and its derivative. If an investor
can buy an asset and pay the cost of carry for less than the price on the futures contract, there is
an inconsistency in pricing.
An investor alerted to this inconsistency, and able to exploit it, can make a profit through buying the
asset and holding (cheap) and shorting the future (agreeing to sell at a higher price).
Of course, when performing arbitrage on financial instruments, only the fastest will be able to
exploit the arbitrage opportunity. It does not take long for everyone in the market to spot the
arbitrage opportunity and the two prices are very quickly brought back into line with one another
again.
213
Derivatives Q&A
214
Foreign Exchange Q&A
Introduction
Many banking clients will have a need for foreign exchange services – whether it is how to
operate and transact in a foreign currency, as well as how to hedge out these risks. Foreign
exchange can be a difficult subject to ‘pick up’ for the uninitiated.
13
You should know how these rates are quoted, what drives movements in exchange rates, as
well as how these risk can be hedged.
This knowledge will be relevant for interns working in:
 M&A
 Research
 Fixed income
 Equities
 Derivatives
 Corporate banking
Neil Graham
Neil has been working in financial markets for 25 years. He began
working in the operations and settlement division at a large UK
clearing bank, before moving into the trading room where, over
the course of ten years, he held various sales and trading
positions in spot and forward FX, money markets and derivatives. After leaving the bank he
spent two years trading his own account as a proprietary Local at the London International
Financial Futures Exchange (LIFFE).
NeiI began his training career in 1997 teaching competency exam courses but now spends
his time entirely on building and delivering academies’ curricula, graduate programs and
one-off courses in the global markets area of investment banking. Within these courses he
uses his market experience to highlight the commercial and practical elements of financial
markets, as well as the technical concepts.
Foreign Exchange Q&A
Neil is Head of Global Markets at Fitch Learning, meaning he is
responsible for developing and producing courses which focus on
institutions’ sales, trading and structuring activities.
215
Foreign Exchange Q&A
How are foreign exchange rates expressed?
Each currency is represented by a three-letter code called an ISO code. Generally speaking, the
first two letters denote the country and the last letter denotes the currency.
For example, sterling’s ISO code is GBP: Great Britain Pound.
The rate is generally quoted to five significant figures; the first three are referred to as the big
figure and the last two as pips or ticks.
GBP: USD 1.5104 1.5112
The first currency quoted is the base currency (GBP) with the second currency being the quoted
variable currency (USD).
What is a cross rate?
A cross rate in foreign exchange is the price of one currency, in terms of another currency in the
market of a third country. For example, the exchange rate between Japanese Yen and Euros
would be considered a cross rate in the US market. In this case we look at the rate of exchange
between the Yen and the Euro, not directly, but via the US dollar.
For example, given the following spot rates, calculate the cross rate for the Euro: Yen where the
USD is the base currency:
1USD : 0.7500EUR
1USD : 120.00JPY
The cross rate can be calculated using the following equation:
USD/EUR X JPY/USD
The first part of the equation looks at the base currency (USD) in terms of one unit of the variable,
EUR. In this case, €1 is equal to 1/0.75 = 1.3333USD. This effectively resets the base currency to
EUR, but expresses it in terms of USD.
The second part of the equation looks at the variable currency (JPY) in terms of one unit of the
base, USD. In this case, $1 is equal to 120/1 = 120.
We now have the desired base rate, EUR, expressed in USD (1.3333USD), and the USD/JPY
exchange rate (1USD: 120JPY).
If 1USD will buy you 120JPY, then 1EUR (1.3333USD) will buy you 1.333 x 120 = 160JPY.
More simply expressed:
1USD/0.75EUR X 120JPY/1USD = 160JPY
The cross rates would be 1EUR : 160JPY
216
Foreign Exchange Q&A
How is foreign exchange quoted?
The market is quote-driven. The major banks will quote two-way FX prices in any of the major
currency pairs.
If Bank A asks Bank B for a sterling vs. US dollar quote, the price received would look like this:
Bank B buys GBP at 1.5010; this is the bid rate.
Bank B sells GBP at 1.5015; this is the offer rate.
The bank making the quote always buys the base currency at the rate on the left (the bid) and sells
it at the rate on the right (the offer). The difference between the bid and offer rate is called the
spread; here it is 5 pips.
A would lose money on B’s quote if they were to deal on the bid and the offer; they (A) would pay
$1.5015 for sterling, and could only sell it back at $1.5010, making a loss of $0.0005 (or 0.05 cent)
per pound.
In reality, the quote that B would give to A would be very much shortened. Every dealer knows that
the big figure on the rate is 1.50 and would not bother to mention it; the quote would be reduced to
10/15. The FX market's term for the GBP vs. USD exchange rate is cable.
So the quoting process would probably look more like this:
217
Foreign Exchange Q&A
What is a forward forex deal?
FX deals for settlement other than spot (up to 12 months) are known as forward deals. Forward
deals are possible, provided that both parties agree and that the date in question is a good day for
both currencies.
Different countries have different public holidays; therefore a good day in one currency is not
guaranteed to be a good day for another.
It is also possible to deal pre-spot (e.g. T0 or T+1), however the time difference must be
considered. For instance you cannot do a deal for T0 settlement in sterling/yen if it is noon in
London, because Tokyo’s business day would have already finished.
Sometimes deals are executed consisting of a purchase or a sale on a near date, and an opposite
deal on another, later date. These are known as FX swaps. If the first (near) leg of the FX swap is
itself in the future, it is called a forward forward swap.
A forward forward with a purchase in two months' time and a sale in five months' time would be
referred to as a 2s vs. 5s or 2 x 5 forward forward. Here the dealer is in effect, borrowing the
currency for a three month period starting in two months' time
How are forward rates quoted?
In order to agree a forward FX deal, the spot rate needs to be adjusted. This adjustment can either
be positive or negative.
If the adjustment is positive, pips are added on and the forward rate is known as a discount.
For example:
A bank quotes a spot rate of 1.5020 and a forward adjustment of +15 pips (i.e. a 15 pip discount).
The forward rate is calculated as follows:
Spot rate
Forward
adjustment
Forward rate
GBP 1 = 1.5020 USD
Plus 15 pips
GBP 1 = 1.5035 USD
It is referred to as a discount because dollars are cheaper for forward delivery (there are more
dollars to one pound).
Alternatively the adjustment could be negative; pips are subtracted from the spot rate. This is
known as a premium.
For example:
A bank quotes a spot rate of 1.5020 and a forward adjustment of -10 pips (i.e. a 10 pip premium).
The forward rate is calculated as follows:
Spot rate
Forward
adjustment
Forward rate
218
GBP 1 = 1.5020 USD
Minus 10 pips
GBP 1 = 1.5010 USD
Foreign Exchange Q&A
It is referred to as a premium because dollars are more expensive for forward delivery (there are
less dollars to one pound). The premium arises because the dollars are more expensive forward
than the spot.
It is also possible to have a situation where no adjustment is necessary. In this instance the
forward rate is said to be at PAR.
How are forward exchange rates determined?
A number of theories seek to explain the relationship between current and future exchange rates.
These theories focus on relative movements in interest rates and inflation.
Purchasing Power Parity (PPP)
The theory of PPP states that the exchange rates between two countries’ currencies will adjust
automatically, in order to take into account their respective inflation rates. The rationale behind this
is that a good (e.g. kilo of sugar or a tonne of potatoes) ought to cost the same regardless of which
country it is bought in.
This is known as the law of one price.
Thus the ‘law of one price’ suggests, that should a good be cheaper in one country than anywhere
else, the demand for that country’s currency would appreciate, as consumers buy up the currency
in order to buy the cheaper good.
This would continue until the cost of the currency outweighed the benefit of the good being
cheaper.
This can be summarized in a formula:
F (1 + IVariable )
=
S
(1 + I Base )
Where:
F
= Forward rate
S
= Spot rate
Ivariable Ibase = Inflation rates for each currency, variable and base
219
Foreign Exchange Q&A
For example:
If sterling (GBP) inflation is at 2.5% p.a., US (USD) inflation 3% p.a. and the spot rate is GBP1 =
USD 1.5000 (Note: GBP is base and USD is variable), the 12 month forward rate may be
calculated as follows:
F (1 + IVariable )
=
S
(1 + IBase )
F
(1 + 0.03)
=
1.5000 (1 + 0.025)
F=
(1 + 0.03)
× 1.5000
(1 + 0.025 )
F = 1.5073
Where:
F
= Forward rate (unknown)
S
= $1.50
Ivariable
= 3% US inflation
Ibase
= 2.5% UK inflation
Interest Rate Parity (IRP)
IRP suggests that the exchange rate between two currencies for a given date in the future will take
account of the difference in their interest rates over the period up to the future date.
So, for example, if spot GBP – USD is currently 1.5000 and we are trying to calculate the 12 month
forward rate, we would need the one year interest rates for GBP and USD which are, say, 5% and
7% respectively.
The forward exchange rate is the ratio of the two currencies inflated by their own interest rates, as
shown below:
220
Foreign Exchange Q&A
This may be summarized in the formula:
F (1 + RVariable )
=
S
(1 + R Base )
Where:
F
= Forward rate
S
= Spot rate
Rvariable Rbase= Interest rates for each currency, variable and base
If the information in the above example is inserted into the formula, we can use it to check the
forward rate.
If sterling vs. the US dollar is currently trading at £1 = $1.5000, sterling interest rates are 5% p.a.
and US interest rates are 7% p.a. the IRP may be used to calculate the forward rate:
F (1 + RVariable )
=
S
(1 + RBase )
F
(1 + 0.07 )
=
1.5000 (1 + 0.05 )
Solve for the
forward rate
F=
Apply the known
variables to the IRP
equation
Make sure interest rates
are correctly expressed
as decimals
(1 + 0.07 )
× 1.5000
(1 + 0.05 )
F = 1.5286
Make the forward rate
the object of the
equation by multiplying
both side of the
equation by the spot
rate of 1.5000
What is the Fisher effect?
The international Fisher effect states that in a global market with free capital flows the real
interest rate (the interest rate less an adjustment for inflation) will be equal in all countries.
F (1 + RVariable )
=
S
(1 + RBase )
F (1 + IVariable )
=
S
(1 + IBase )
F (1 + IVariable ) (1 + RVariable )
=
=
S
(1 + IBase )
(1 + RBase )
This has the overall effect of bringing together PPP and IRP.
221
Foreign Exchange Q&A
222
Asset Management Q&A
Introduction
The asset management business relies on knowledge pulled across the full spectrum of
finance. Interns and Analysts will have to command a confident knowledge of accounting,
valuation and products as well as portfolio management theories.
14
There are a variety of areas of this manual that will be relevant to asset management interns
and Analysts. Without this firm foundation of knowledge, the more advanced skills will suffer.
Bob Wieczorek
Bob is the Head of Asset Management at Fitch Learning.
He has designed, led and taught many of Fitch Learning’s
marquee training programs as well as developed our
business activities in the asset management sector.
He has over 20 years' experience working in asset
management, capital markets and corporate finance.
Bob began his career at Chase Manhattan Bank and also worked for West LB and
Credit Research and Trading before joining Credit Lyonnais (now Credit Agricole).
Before leaving to develop STORM, he was Managing Director and Head of North
American Corporate Finance at Credit Lyonnais.
Bob has extensive distressed, workout and reorganization experience from the
distressed private desk at Credit Research and Trading (CRT) as well as the workout
group at Credit Lyonnais.
Bob holds a BSM from the A.B. Freeman School of Business at Tulane University.
He is a CFA charterholder and a member of the CFA Institute and the New York Society
of Securities Analysts.
Asset Management Q&A
Before joining Fitch Learning, he launched STORM Capital Partners, a market neutral
hedge fund that remains an active participant in today's derivative markets.
223
Asset Management Q&A
What is asset management?
A fund/portfolio manager working on behalf of a financial institution, such as a mutual fund, unit
trust or pension fund, is responsible for ensuring the fund is managed in the best interests of the
underlying investors. To this end, the fund/portfolio manager takes into account the investment
objectives and manages the portfolio accordingly.
A fund's investment objectives are determined by the needs of the underlying investors, i.e. the
beneficial investors, and are set out in the trust deed (also known as the 'indenture') of the fund.
The following factors are taken into account when determining the most suitable asset mix of the
fund:
 Risk
 Liquidity
 Growth
Risk
Different investors are prepared to take on different levels of risk. The role of the fund manager is
to attempt to diversify risk to an acceptable level. The aim of diversification is to optimize the
risk/reward trade-off.
Liquidity
Some investors require the ability to convert their investment into cash at very short notice. These
funds will consequently invest more heavily in short-term instruments, such as Treasury bills and
short-term deposits.
Growth
Funds investing for future gains rather than immediate returns will have a higher proportion of their
capital tied up in equity securities rather than bonds. In particular, equities in companies that
reinvest profits, rather than pay out dividends, will be attractive to a fund with growth objectives.
224
Asset Management Q&A
What is portfolio construction?
Portfolio construction refers to the activity of collating and managing a collection of different assets,
e.g. shares, bonds or real estate.
There are certain stages in ensuring a portfolio is managed efficiently:
Asset
allocation
Tactical
allocation
Stock
selection
The first decision the fund manager makes is with respect to the asset mix of the portfolio, (i.e.
shares vs. bonds). For example, income-seeking portfolios invest more heavily in bonds, whilst
growth-seeking portfolios invest a higher proportion of the fund in equities. This process is known
as asset allocation (or strategic allocation). Studies suggest that the asset allocation is the
single most important influencing factor on a fund's performance.
Once the strategic allocation has been set (e.g. fixed interest 80%), the next stage is the tactical
allocation where ranges are specified around the strategic level to enable market timing
adjustments to be made by the manager (e.g. fixed interest 70-90%).
Once the asset mix has been decided, the manager must choose the individual securities within
each class of asset.
For instance, the asset mix may have been determined as 50% equity, 50% bonds, i.e. the asset
allocation decision. The next step is to determine whether the fund invests in, say, Microsoft rather
eBay shares. This process is known as stock selection.
What is the efficient market hypothesis?
A hypothesis is a theory; an idea of how something works. In this case it is an idea or hypothesis
about how stock markets work in relation to new and existing information.
If a stock market is perfectly efficient, it has certain properties:
 All investors and market participants will have perfect information about each company in the
market
225
Asset Management Q&A
 There will be no point in carrying out research on a company because everyone else will
already know this information and it will already be priced in by the market
 In a perfectly efficient market, there would be no transaction costs
 In a perfectly efficient market there would be no earnings surprises, because investors would
know the information already
The question is…are our real life stock markets perfectly efficient? The answer is most probably
no.
The Efficient Market Hypothesis has three forms:
 The Weak Form
 The Semi-Strong Form
 The Strong Form
Each form has its own definition of an efficient market.
The Weak Form of the EMH
The weak form states that the current market price already reflects all historic share price
information. If this is true, there is no benefit in looking at historic stock price charts and graphs as
everyone else already knows this information.
So the weak form contradicts technical analysis – it says looking at past prices for patterns won’t
work. The fact that people use technical analysis may indicate that in real life our markets are not
perfectly efficient – even at the weak form of the EMH.
The Semi-Strong Form of the EMH
The semi-strong form states that the current market price already reflects not only all historic share
price information but also all other publicly available information.
This means that carrying out research about a company’s activities and its products will also be of
no use as all other market participants already know the information.
The Strong Form of the EMH
The strong form states that the current market price already reflects not only all historic share price
information and all publicly available information but also all private information. Private information
is ‘insider’ information, i.e. information known only within the company that is likely to be material
(would affect the share price), but not yet released to the markets. The EMH is very bold to
suggest that the market has already priced in this private information when the market won’t be
aware of it yet.
So it is very unlikely that the strong form of the EMH holds, as material insider information is not
known to the market and is not likely to be currently priced into the share.
EMH conclusions
The main conclusion is that real life markets are not perfectly efficient. There is some evidence that
some aspects of the EMH do hold, but also some counter examples as well.
We could also conclude that real life markets vary in their efficiency. The larger and more liquid the
market, the more efficient it is, e.g. the FTSE 100 or the S&P 500 should be fairly efficient. This is
because larger markets have so many Analysts following the larger companies that there are fewer
surprises (of course these still do happen).
On the other hand, fewer Analysts follow the smaller less well-known companies, especially those
based in lesser followed markets around the world. These markets are often less efficient but at
the same time also carry their own specific risks.
226
Asset Management Q&A
What is passive fund management?
A passive style means that the fund manager attempts to replicate the returns of a pre-determined
benchmark, such as a market index, e.g. FTSE 100 or S&P 500.
Managers of passive funds subscribe to the Efficient Market Hypothesis (EMH). EMH states that
the market price of a security is correctly priced and will have already discounted all available
market information.
If the EMH is true, then it is not possible to identify mis-priced securities in order to outperform the
market.
The rationale therefore, behind passive management is 'if you can't beat them, join them'. Instead
of wasting time looking for mis-priced stocks to beat the market return, a fund manager should
replicate the market in their portfolio. A portfolio that replicates the market is known as a tracker
fund.
What is active fund management?
The aim of an active fund is to outperform a chosen benchmark, i.e. 'beat the market', and achieve
excess returns for investors. Actively managed portfolios can be constructed on either a top-down
or bottom-up basis.
Top-down
Top-down management involves three stages:
 Asset allocation
 Sector selection
 Stock selection
Asset allocation
The manager will choose what investment mix will be included in the portfolio. This was discussed
earlier. In essence, the manager will look at the proportion of cash, equity, debt and other asset
classes within the portfolio. Some of the extra returns by the active manager may be achieved
through tactical asset allocation (also called market timing). Here the fund manager uses their
discretion to make small changes to the asset allocation of the fund, in order to take advantage of
short-term market shifts.
For example, the fund may have an asset allocation of 50% equities and 50% bonds. If the fund
manager felt that an equity bear market was imminent they may decide to alter the allocation to
45% equities and 55% bonds. The fund manager's discretion will be constrained within limits
agreed initially and reviewed periodically.
Sector selection
Some sectors, such as the technology markets and financial markets, are more sensitive than the
markets as a whole. They have high betas and are considered aggressive stocks that perform well
in a rising market. Utility companies tend to be less sensitive than the markets. They have low
betas and are considered defensive stocks performing less badly in falling markets. The manager
will need to construct a weighting that he believes will take the best advantage of the current
environment.
227
Asset Management Q&A
Stock selection
This involves seeking out mis-priced securities in order to buy undervalued and sell overvalued
stock. Stock selection and market timing are therefore particularly important when an active
strategy is adopted
Bottom-up
A bottom-up approach to management focuses on the attractions of individual stocks. Specific
company factors such as whether the company is a takeover target or about to launch an
innovative product are important.
This in effect, removes the asset allocation and sector selection as primary factors and focuses
instead on stock selection, often from an event-driven or tactical trading basis.
Summary
Achieving excess returns however, is difficult to achieve as the relatively high costs of managing
an active fund often corrode the extra return achieved by the fund itself. Various studies suggest
that, in the long-term, around 80% of active managers tend to under-perform the market.
How can portfolio performance be measured?
It is important that investors, and other interested parties (e.g. trustees of pension funds/unit trusts),
are able to monitor the performance of a fund in order to evaluate the manager's performance.
Assessing performance requires the ability to measure the return that a fund has achieved for its
clients.
There is a number of performance metrics associated with assessing portfolio performance – we
will focus on three different methods used to measure portfolio performance:
 The Holding Period Yield (HPY) – sometimes referred to as 'total return'
 The Money Weighted Rate of Return (MWRR).
 The Time Weighted Rate of Return (TWRR).
Holding period yield
The holding period yield (HPY) measures how much the portfolio has increased in value over a
particular time horizon. The HPY identifies the change in value of the fund as a percentage of the
start value.
In other words:
Although the holding period yield is a relatively simple measure to understand, it does suffer from
the limitation of not taking into account the timing of cash flows in, and out of the fund, i.e.
withdrawals and deposits.
Consequently, it is not a particularly useful measure for assessing the returns achieved from
open-ended funds, such as mutual funds or pension funds where regular cash flows in/out of the
fund are a major feature.
228
Asset Management Q&A
Money weighted rate of return (MWRR)
The MWRR is used to measure the performance of a fund that has experienced deposits and
withdrawals during the period being measured. It is also sometimes referred to as the internal rate
of return (IRR) of the fund.
For example, assume a fund starts the period with a value of $97.5m that grows to $98m in three
months. At this time, a further cash injection of $5m is deposited. At the end of the six month
period, the value of the fund has grown to $104.5m.
Therefore, the total return over the six month period is the rate at which $97.5m for six months,
plus $5m for three months has grown to $104.5m.
The money weighted rate of return (r) may be calculated using the equation below either by:
 Solving for r
 Using Excel and goal seeking the r
 Trial and error
The $5m was only in
the fund for 6 months
or half the period –
therefore it is only
raised (or discounted)
to the power of 0.5
$97.5m x (1+r) + $5m x (1+r)0.5 = $104.5m
$97.5m x (1+0.02) + $5m x (1+0.02)0.5 = $104.5m
As a method of comparing one portfolio's performance against another, the money weighted rate
of return is only valid if both portfolios received/withdrew cash at the same time, because the
timing and the size of the flows will affect the rate of return.
For example, if a client injects cash into the fund at an unfavorable time, the MWRR will tend to be
depressed. However, if cash is injected into the fund at a favorable time, it will have the effect of
boosting the MWRR.
The MWRR should therefore be used with caution when comparing one fund manager's
performance with another.
229
Asset Management Q&A
Time weighted rate of return (TWRR)
The time weighted rate of return gets around the problem of the money weighted rate of return
because it is unaffected by the timing of cash flows into (or out of) the fund.
It is calculated by measuring the change in the value of the fund before the cash injection (or
withdrawal), and multiplying this by the change in value after the injection (or withdrawal). This
means that the TWRR gives equal weighting to the timing of the cash flows.
In the example below, the increase in the fund's value before the cash injection is 0.51% (i.e. the
fund is 1.0051 times its original value) and after the injection it has increased by 1.46% (1.0146
times its original value) giving an overall increase of 1.98%:
Time period
0
Time period
3 months
Time period
6 months
Value of the fund
97.5
98
104.5
New Money injected
0
5
Total
97.5
103
Three assumptions underlie the use of the TWRR:
 The portfolio contains enough liquid resources such that a large cash flow will not distort its
performance (e.g. a withdrawal of cash forcing a sale of investments).
 The fund manager does not control the cash flows. A pension fund manager for example,
cannot dictate when money will enter into, or leave the fund.
 The investments can be priced at the same time as the cash flow, so for the example above it
is necessary to say that just before the cash was added to the fund its value is $98m. This can
be a drawback in that pricing may need to be done on a daily basis.
The fact that the time weighted rate of return is not influenced by the timing of cash deposits and
withdrawals makes it a preferred measure of fund performance compared to the money weighted
rate of return.
230
Asset Management Q&A
What is risk?
There are many definitions of what constitutes risk, financial as well as non-financial. Risk is part of
the human existence – we take risks in everything we do on a day-to-day basis. Some risk are
involuntary, some are calculated and voluntary. There is also a distinction between what
constitutes risk vs. what constitutes uncertainty. In 1921, Frank Knight summarized the essential
difference between the two:
"…Uncertainty must be taken in a sense radically distinct from the familiar notion of
Risk, from which it has never been properly separated…The essential fact is that ‘risk’
means in some cases, a quantity susceptible of measurement, while at other times it is
something distinctly not of this character; and there are far-reaching and crucial
differences in the bearings of the phenomena, depending on which of the two is really
present and operating…It will appear that a measurable uncertainty, or ‘risk’ proper, as
we shall use the term, is so far different from an unmeasurable one that it is not in
effect an uncertainty at all."
Knight essentially concludes that only a quantifiable uncertainty can be viewed as a risk.
Another way to think of risk is opportunity with a potential downside. This idea is very neatly
summed up with the Chinese symbol for risk:
The symbol is the combination of danger and opportunity – thus reflecting both the upsides and
downsides of risk.
In the investment world it is important to see the connection between risk and reward. The concept
of taking risk with the potential to reap rewards is at the heart of all investing.
Taking on a higher level of risk may have the potential for greater rewards, but also the potential
for greater losses. Higher risk investments normally have higher volatility, i.e. a wider range of
returns, some of them very good and some of them very bad.
But what if we are not prepared to take a risk? We need to clearly define which risks are
acceptable to investors and the degree of volatility that an investor is prepared to accept.
If an investor wishes to avoid market risk, they need to scale down their return expectations to that
of the risk-free return. Such investors should also bear in mind that inflation is a hidden risk that
erodes the value of their investment.
231
Asset Management Q&A
What is a risk premium?
A risk premium is the additional return over a risk-free return needed to compensate an investor for
taking on the risk of an investment.
For example, an equity risk premium needs to compensate equity investors for:
 The potential variability of stock returns. While we hope there are upside profits there could
also be downside losses
 The potential variability of income in terms of dividends
 Giving up immediate access to the funds invested
A fundamental concept in investing is that the riskier the investment, the higher the risk premium
demanded from investors. For example, venture capital is a particularly risky alternative investment
as money is invested in new start-up companies. Therefore the risk premium for venture capital is
higher than for more traditional established equities.
What is the difference between systematic and
non-systematic risk?
Systematic risks are risks that affect the financial system as a whole. Because these risk factors
affect the whole financial markets, they are also sometimes collectively referred to as market risk.
It is very difficult for investors to accurately predict the nature of systematic risks over the
short-term, medium-term and long-term.
However some investments are more sensitive to the following systematic risks than others:




Interest rates
Inflation
Liquidity
Currency
Whereas systematic risks are risks that affect the financial system as a whole, non-systematic risks
are risks specific to a particular business. All businesses are unique and have their own specific
risk factors such as:
Business risks
What are the elements that contribute to a successful business? Good products and services,
skilled and committed staff, the right location, successful ideas, manageable costs, financial
strength in difficult times and a strong market for the company’s products and services. Business
risk is the risk that any of these elements become unfavorable and uncompetitive, leading to
reduced profits.
Industry risks
Each industry carries its own specific risks that affect all companies in the industry. For example, in
the airline industry, health and safety issues are paramount and are quite different to health and
safety issues in the banking industry.
Management risks
When a company performs well, growing its profits, increasing its market share and creating happy
customers, it says a lot about how it is being managed – the management must be doing
something right. However management mistakes can cost the company dearly.
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Asset Management Q&A
How can risk be measured?
The risk of a fund's constituents is a key consideration when constructing a portfolio of assets. The
higher the return the fund manager is seeking to achieve, the greater the risk he or she must be
prepared to take.
Risk is measured as the variability of returns around an expected level. If the expected level of
return is calculated as the average return (i.e. the mean), then the risk is measured as the standard
deviation of returns over time. Because it measures the level of dispersion from an
expected/average value, the standard deviation is a measure of the total risk.
A security with low risk will have returns that do not fluctuate significantly around its mean
(average) return, and will consequently have a small standard deviation. Alternatively, a security
with high risk will have returns that do fluctuate significantly around its mean (average) return, and
will therefore have a large standard deviation.
Stock J
Returns
Time
Stock K
Returns
Time
Stock J is clearly more risky than Stock K. The standard deviation around the mean will be larger
for Stock J. Standard deviation (σ) is used to measure the comparative risk of stocks.
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Asset Management Q&A
What is the Sharpe ratio?
The Sharpe measure (or reward to variability) uses the standard deviation of portfolio returns as
an estimate of risk in order to calculate excess reward or return to volatility.
Because the standard deviation is used to measure risk, the Sharpe measure is best suited for
measuring the performance of a non-diversified fund, as such a fund is exposed to total risk (i.e.
specific and systematic risk). Remember, standard deviation is a measure of total risk.
The Sharpe measure calculates the excess return achieved by a fund (i.e. the return over and
above the risk-free rate) for each unit of total risk, (i.e. standard deviation), taken on.
In other words:
=
R p - Rf
σp
Where:
Rp = Return to the portfolio
Rf = Risk-free return
σp = Standard deviation of the portfolio
For example, assume two fund managers both achieve an average return over one year of 12% on
their respective portfolios. Fund A has a standard deviation of 6% and Fund B has a standard
deviation of 8%. If the risk-free rate of return is 6%, the Sharpe measures for both portfolios are:
Fund A
Sharpe = (12% - 6%) / 6% = 1
Fund B
Sharpe = (12% - 6%) / 8% = 0.75
Fund A has therefore given better value than Fund B on a risk-adjusted basis.
Another way to describe this is to say that Fund A has less dominance over Fund B.
Dominance is where one fund achieves a better return than another for the same risk. Alternatively,
the dominant fund could achieve the same return as another for less risk. A fund that achieves
better return for lower risk than another fund, would also clearly, be a dominant fund.
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Preparing for Work
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Introduction
A successful internship will result in a full-time Analyst job offer, so it is in your best interests
that having secured an internship, you are able to impress. In this section, we offer our tips
on what life as an intern will be like. All of the advice in this section is applicable, in the most
part, to life as an Analyst too. We’ve also included some information from Bloomberg,
FactSet and Thomson Reuters which should prove a useful reference tool as you work on
the desk.
In our experience, there are always a number of things that interns say they wish they had
known at the start of their internship. Similarly, Analysts often report that there are things that
they really should have known before starting their roles. Very often, this extra information
would have been useful to help with technical areas of banking, but interns and Analysts also
find things that they wish they had known about office politics and how to best climb the
career ladder.
The author of this section, Rebekah Irion, has used her experience in banking to give you a
no-nonsense guide to life as an intern. This is an invaluable guide for how to behave, what to
watch out for, and what others will expect of you day-to-day.
Many tasks within a bank involve using information from one of the leading information
providers. These companies offer services which range from up-to-the-minute financial
information on stocks, exchange rates, historic information about companies’ annual filings
through to general news items. Navigating these systems can be a challenge for interns and
new Analysts as there is often a lot more information available than is necessary to do your
job.
Rebekah Irion
Rebekah Irion is a financial instructor at Fitch Learning, where she
specializes in corporate finance. Her work experience as both an
investment banker and Human Resource Manager with
Rothschild Inc. enables her to bring a well-rounded perspective
and real world examples to the classroom.
Rebekah began her investment banking career with Rothschild
Inc. after graduating from Babson College with a BA in Business
Management. As an investment banking Analyst within the Restructuring Advisory group,
she gained extensive transactional experience and specialized in company restructurings,
financial planning and analysis, and recapitalizations. During her time as Human Resource
Manager for the Investment Banking department, she oversaw all recruiting efforts and
managed on-boarding training programs for investment banking Analysts and Associates.
Rebekah’s practical investment banking know-how, coupled with her demonstrated ability to
create and implement successful training programs, has equipped her with invaluable
experience that she is able to transfer to her students.
Preparing for Work
We’ve included information from Bloomberg and FactSet, two such information providers, so
that you can get a feel for the type of information gathering you might need to do as an intern.
This information is also likely to be of use during your internship and after when you secure
your full-time job.
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Preparing for Work
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Life as an Intern
Life as an intern
As an intern, you should have one goal in mind, and that is to receive a full-time offer at the
end of the summer. Even if you are unsure as to whether or not you would take it, you want
the decision to be yours. Below are some tips that should guide you through the internship
process and help you accomplish your goal.
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Be a sponge – suck it up!
This can be taken two ways: first, use your internship as an opportunity to learn and take in
as much as you can from others. Second, you will have plenty of ‘bad’ days where you will
be tired, frustrated, cranky, and irritated – suck it up! A positive attitude will go a long way.
Perception is everything
Completing your work quickly and accurately is a great skill to have, but leaving early every
day is not always viewed as positive. Work ethic, dedication, intellectual curiosity and
flexibility are critical characteristics/attributes to portray during your internship.
Build relationships
While you may not realize it now, networking and establishing substantial relationships with
others will prove invaluable throughout your career. Therefore, before you run out of the door
at 11.00pm, spend ten minutes catching up with another Analyst or Associate in your division.
The more people you have pulling for you at the end of your internship, the more the
likelihood of an offer.
Identify decision makers early
The internship is basically one long interview for a full-time offer. Similar to your on-campus
interviews, there will be a select group of people who make the final decision as to whether
or not they want you to come back. Therefore, it is important to be aware of the decision
makers and those who are influential in the offer decision.
At some point throughout the summer, you will likely be asked to provide a list of all of the
people you have worked with who will review your performance. While senior bankers will
likely be on the list, the ones with whom you will have worked the closest will be second and
third year Analysts and Associates. They will be likely to look back and say, ‘Did this intern
make my life easier, and if so, how?’ You want them to be able to highlight specific examples
where you added value to the team (which can be as simple as coming in on a Sunday to
print books).
Learn to talk the talk
If someone asks you what you are working on, it’s important to be able to quickly articulate
it. (Think big picture – demonstrate that you understand what you are working on).
Honesty is not always the best policy.
Senior bankers will often ask, “How is it going?” Although it may be tempting to answer with,
“Right now, horrible. I haven’t slept in two days, and the deal I’m working on is awful,” I would
avoid this answer at all costs! A simple, “things are going well, thanks, and you?” will usually
be sufficient. If it goes deeper than that, just try to keep a smile on your face and be
positive. Remember – they were once in your position, so they are aware of what you are
going through.
Life as an Intern
Think about reviews
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Life as an Intern
Patience is critical
There will be many instances where you will be waiting throughout your internship – waiting for a
Managing Director to get back with comments, waiting for printing to be completed, waiting for the
Associate to check the model. Be patient! There is no point in getting frustrated, and if anything, it
makes you look inflexible.
I find that the best way to be patient is to never make plans ahead of time. If you avoid making
plans, you feel much less anxiety about getting out of the office and are better at ‘going with the
flow’.
Ask questions!
If you do not understand what is being asked of you, ask your Associate to clarify! Never be afraid
to ask questions – no question is stupid. The worst scenario would be for you to spend a full day
working on an assignment that you ‘think is right’, and then to find out that you misunderstood what
your manager was asking for. Not only will you feel like you completely wasted your time, but your
Associate will be frustrated that work did not get done. Get it right the first time!!
Keep track of your projects
Remember, this is a resume building opportunity, and you will be updating your resume upon
completion. You want to be able to reiterate and articulate what you have worked on. Think big
picture – what have you done, and how can you talk about it?
It’s all in the approach
You get more with honey than you do with vinegar. Everyone needs a day or weekend off every
now and then, but asking for it can be a challenge. The way you are viewed and the response you
receive will result from your approach to the situation. Instead of telling your Associate that you
cannot work on Saturday, politely ask him/her if it is okay if you take Saturday off because of…..,
and then offer to stay later on Friday if he/she needs you to complete something. Always offer an
alternative solution.
Don’t expect a thank you
If you cancelled your Friday night to get a presentation done for your Associate so that he could go
to a movie, a thank you or pat on the back might take some of the pain away. Let’s be honest, this
does not happen and here’s why: it’s your job! Similar to you, many of your managing Analysts and
Associates recently went through the same experience and therefore have little sympathy for
newbies. My advice would be to set your expectations low, and then if you receive a ‘great job’ or
pat on the back, you’ll be ecstatic!
What will your typical day be like?
You will likely begin your internship program with a 2-4 week training program. The training will
typically run from 8.30am or so, to 6.00pm, with plenty of homework. It is important to take training
very seriously – it is the company’s first chance to observe you. Therefore, your classroom
participation, timeliness, attitude, and overall performance will be monitored – be on your best
behavior!
In many banks, you are often considered a generalist and are not hired into a specific sector, such
as retail, or specific group, such as M&A. Therefore, I encourage you to introduce yourselves to
senior Analysts and Associates to try to get as much insight into the possible opportunities. While
you’re not likely to have a choice of which group you work in during your internship, it is a good
idea to be aware of what’s out there, and build a network in the event that you receive a full-time
offer to join the firm.
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Life as an Intern
One important thing to keep in mind is that each of you will have a different, unique experience.
Although you will likely think that some projects are ‘better’ or ‘cooler’ than others, you will be
evaluated on your specific experience and your contribution to the projects that you work on. So,
keep a positive attitude, work hard, and stay open-minded – it will take you a long way!
An example day as an intern
I arrive at the office at 8.30am, get breakfast and coffee, and head to my desk. Although I am
running on three hours sleep, I feel relieved to wake up to an email from my Managing Director
saying that he received the pitch books for his meeting and was en route. Hoping that I don’t get
staffed on a new project until tomorrow, I spend twenty minutes or so surfing the internet and
reading the Journal. Then, around 10.00am, I get an email from the staffer letting me know that I’ve
been put on an existing M&A deal as an added resource. This email is followed by another email
from the Analyst stating, “Attached is a retail comps file containing ten companies that needs to be
updated for the most recent filings. Can you please complete these by this evening so that I can
check them tomorrow? Thanks!”
I spend the rest of the morning and early afternoon printing all of the filings and pulling research
reports. After grabbing a quick lunch and another coffee, I start spreading the comps. Given that
this is only my second time, it takes me 45 minutes to an hour for each company. As I go through
each filing, I flag and highlight every number as I enter them in Excel and then scan the MD&A
section to see if there are any adjustments or non-recurring items to be added back. To make it
easy for the Analyst to check the numbers, I insert notes in Excel with the detailed support.
By 10.00pm, I complete the comps and email them to the Analyst. With the hope of going home, I
stop by his desk, drop off all of the back-up files (flagged and marked), and ask him if he needs
anything else. When he says no, I gladly leave to get some sleep. Tomorrow is a whole new day!
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The Internship
Rachel Anderson
Rachel is one of Fitch Learning’s Management and Personal
Development instructors. She has been facilitating courses in London for
eight years, firstly in her role at Goldman Sachs and then as a full-time
instructor at Fitch Learning.
At Goldman Sachs, Rachel worked in the Human Capital Management
Division where she was involved in attracting and recruiting graduates into the Analyst
and Associate programs and working on the summer Analyst and Associate learning
initiatives.
16
16
Rachel uses her experience in recruiting graduates to great effect to be able to offer some
first-hand advice about what recruiters are looking for.
One of her main focuses as a trainer is in consulting, developing and delivering graduate
programs. She has been involved in a whole range of programs, delivering everything
from traditional courses on basic communication skills, to ‘fused courses’ which blend
technical skills with soft skills using case studies and simulations.
The internship
Training
It’s likely that at least part of your internship will include some type of training – whether that
be in the form of formal classroom learning, seminars or interactive workshops. Here’s where
a lot of interns get it wrong. Your internship is essentially a ten-week interview – behavior you
can get away with at college really isn’t going to cut it during these training sessions. You
won’t be under constant surveillance, but be aware that any undesirable behavior is highly
likely to be noted.
Here’s how to make the best impression:
Aim to be ten minutes early for any training sessions. It’s probable that anyone who is asked
to speak during a training session is either pretty senior, or a stakeholder in graduate
recruiting. Either way, these are people who you want to make a good first impression with.
I was once present at a training session for summer Analysts. The session featured an MD
from Fixed Income. Clearly his time was precious; he’d had this time reserved in his diary for
months to secure his presence. Despite working long hours and having a family, the MD
turned up ready to present on time. Ten minutes into his presentation, a couple of late
comers shuffled into the back of the room, obviously hoping that they could creep in
unnoticed. One of the pair had wet hair and both were carrying cups of coffee.
Sadly for them, they were noticed. The MD asked me to find out who they were, remarking
“the wet hair shows they didn’t get up on time, and those coffee cups show that they
prioritized going to Starbucks over getting to my presentation on time.” He then made it clear
that if those interns were on his desk, they wouldn’t have an internship anymore.
Always remember that you’re at work. You are being paid to be where your schedule dictates.
Your hard work and intellect have secured your place on an internship, but something as
simple as poor punctuality can thwart your chances of a full-time analyst position.
The Internship
Punctuality
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The Internship
During training events
If you’ve ever given a presentation or led a seminar at college, you’ll know how distracting it can be
if just one person isn’t paying attention. You could have an audience of 50, with 49 people locked
on to every word that you are saying. Instead of noticing these people however, your eyes will be
drawn to the one person who is daydreaming, staring out of the window or checking their phone.
The people who lead your training will be exactly the same. So if you’re that person doodling or
checking Facebook on your phone, the presenter’s eyes will be drawn to you.
Even if you are reading the Financial Times or checking work-related emails, the person who is
running the training session will judge your behavior to be rude and inappropriate. A lot of these
speakers will be asked for feedback on the group, so you don’t want to give them reasons to
remember you for negative reasons.
Thus always be aware of your behavior and body language, even if you are completely focused on
the training and the learning. I recently watched an intern draw (a very nice) picture of a garden
while he sat meters away from a director in M&A who was giving a presentation. I asked that intern
if he’d enjoyed the presentation and he enthusiastically replied that he had. To the outside eye
however, he looked totally disengaged. I’m guessing if I’d asked that director for feedback on the
group that he would have mentioned the ‘garden artist’ in a not very complimentary way.
Don’t let your body language and behavior let you down. You may be engrossed in what the
presenter or trainer is saying, but you also need to convince the people observing you of this.
Dealing with work/training conflicts
It may be that you have training which happens midway through your internship program, when
you’ve already been with your team for a few weeks. In this case, it may be hard for you to extract
yourself from the desk for the duration of the training – communication with your line manager and
the person leading the training is key.
Ensure that your line manager is aware of your training schedule in advance. Your schedule
should be made available to your manager but you may need to highlight conflicts. Try to be
released from your daily responsibilities if you can be. It’s highly likely that if you’ve only been on
your team for a few weeks, that they’ll be able to cope without you, as long as you give them time
to prepare.
If your team is in the middle of a pitch or a deal, and they have to call you away from training, try to
make provisions to allow you to do this without disturbing the training. Let your team know your
schedule, including breaks and lunch times. That way they can try to keep any phone calls to the
breaks that you have. If you suspect that your team will have to call you midway through a session,
sit next to the door so that you can excuse yourself causing minimum disruption. Also have a quiet
word with the person leading the training before the session commences. Let them know that you
may have to leave early to assist your team. They’ll appreciate that you’ve made the effort to be
upfront.
I once had an intern spend half a session on her phone, texting frantically. I politely asked if she
could refrain from texting until the imminent break. She barked back at me “It’s my Associate!”
Had she been upfront with me, I’d have told her from the start to step outside, sort out whatever
needed doing and to come back when she was able to commit to the training session. That way
she could have attended to her responsibilities on her team, take more away from the training
session and also make a better impression on me!
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The Internship
“But I’m already advanced on Excel…”
Your training schedule will be designed to bring every summer Analyst up to speed on the things
they need to operate as an intern. It may be that some of the things that are on the schedule are
things that you’re already familiar with. For example, if you are studying Finance, you may be very
comfortable with a Discounted Cash Flow analysis, or if you’re studying Maths you’re likely to be a
whiz on Excel already.
Always remember that the schedule is designed for an audience wider than yourself, so you may
have to go through training sessions which seem like a waste of time to you.
Be mindful of the way that you deal with this. If you stamp your feet and make a big deal of how
much of an expert you are, you’re likely to cause damage to your reputation. Those around you
may only take note of your bad attitude rather than the skill or knowledge that you’re shouting
about.
Also recognize that the sessions are likely to be way more pragmatic and less theoretical than
classes you may have at college. So rather than openly talk about how much of an expert you are,
yawn openly and catch up on your emails, get involved, ask questions and help others learn. You
may well be an expert, but if you demonstrate a bad attitude in the classroom, there’s a high
likelihood that this will be fed back to your line manager or divisional recruiter.
Personal skills training
Additionally you may have courses around communication, business etiquette or presentation skills.
These are commonly known as soft skills sessions. To discount these sessions would do you a
great disservice.
When I was involved in running internship programs, I would collate and review feedback on
interns from their line managers and colleagues. More often than not, criticism was focused on an
intern’s interpersonal skills, rather than their technical skills. Some couldn’t manage their time,
others lacked the confidence to ask questions and others asked too many.
Interestingly, I found that it was often a person’s technical skill that would get them hired as
an intern, but their interpersonal skills which would ensure them an offer of a full-time
Analyst position at the end of the summer.
So any interpersonal training sessions should be jumped on and taken advantage of. Do
acknowledge that while new technical skills can be difficult to understand but then easy to put into
practice, interpersonal training is the exact opposite. For example, understanding how to make a
great first impression can seem very simplistic. To put that into practice can seem like the most
difficult thing in the world.
Top tip: When you attend an interpersonal skills course, try to take away just one or two
things which you really think could impact your effectiveness. This will be far more useful
than trying to implement everything you’ve learned in the session and then very possibly
failing miserably.
A lot of these sessions will involve active learning rather than passive learning. Therefore you will
be required to get involved with the class. In my experience, the more people put into these
classes the more that they take away. Therefore do get involved, ask questions, be open to
challenging existing behaviors and trying to do something different.
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The Internship
Work/life balance
Chances are, if you’ve applied to work in a bank, you’re well aware that this isn’t a 9-5 industry.
Far from it. I worked in a non-revenue producing area of the firm, where you might expect less
demanding hours. However I regularly worked until 9 or 10pm, occasionally working until after
midnight. As well as working long hours, you’ll have to maintain a dynamic working pace and
execute your tasks flawlessly.
For interns this can be a huge shock to the system. You therefore need to have a strategy to allow
you to survive your internship, perform well, and to not hate banking by the end of the internship!
Here are some ways to get into the flow of working long hours:
Know that it will get easier
Recognize that your timetable has totally changed. Initially the hours will seem brutal and pretty
painful – but just like when you start a new exercise routine, your body will get used to the long
hours if you look after yourself.
Take breaks when you can
Throughout your working day, try to get away from your desk, stretch your legs and if you can, get
some fresh air. This will not only give you an energy boost, but will allow you to approach your
work with fresh eyes upon your return.
Only work the hours that you need to
A common thing you’ll see in banks is people hanging back at work longer than they need to just
so it looks like they are more productive and busy than they actually are. This is commonly referred
to as ‘face time’. Most line managers see through face time and would rather you went home, got
yourself refreshed and rested, returning the next day ready to be productive.
If you think that you’ve completed your work, check with your team to see if there is anything that
you can do for them. If the answer is no, bid them farewell and leave the office.
Get a routine
As boring as this sounds, you need to establish an efficient routine which will make the most of
your time. If time is a tight commodity you need to make sure that you use every second well.
This will mean different things to different people. Whether you are bulk-buying snacks to store at
your desk, listening to Bloomberg while getting ready for work or tidying your desk at the end of
every day – make your routine work for you.
Diet
You may not be able to control how much sleep your body gets. Neither can you control the stress
levels which you will be exposed to and the various chemical reactions that your body will be at the
mercy of. What you can control is what you put into your body.
If your diet is usually far from perfect, now is the time to make some positive changes. And let’s
face it, if you’re denying your body the required amount of rest, the least you can do is give it the
nutrients that it needs to help you perform.
Poor diet choices can increase irritability, cause volatile energy flows and a deterioration of
concentration. Clearly none of these things are desirable when you’re trying to win a full-time
Analyst or Associate position!
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The Internship
A few simple things that you can do:
 Drink lots of water, have a large bottle on your desk and work your way through it each day
 Eat little and often, huge meals are fine for Sunday afternoons when you have the time for a
nap afterwards
 Eat breakfast within a couple of hours of rising
 Stock up on healthy snacks to keep in the office
 Go easy on the sugar
Exercise
For many people, exercise is a healthy and positive way to manage stress and anxiety which can
come from working long hours.
When you’re stressed your body will produce more adrenaline than usual. This can be helpful in
the short-term, helping you deal with tight deadlines, and difficult tasks. In the long-term however,
adrenaline can cause a whole host of negative side-effects. These side-effects can include health
problems as well as behavioral problems such as lack of concentration and mood swings. Exercise
releases (gets rid of) the natural chemicals such as adrenalin that accumulate during stress.
As well as releasing adrenaline, exercise stimulates the production of endorphins. Endorphins will
increase alertness and concentration, a welcome feeling if you’re surviving on little sleep.
Therefore try to take advantage of your firm’s gym or the gyms in the area. Take your cue from the
other Analysts around ‘gym etiquette’. For example do they disappear for 45 minutes
mid-afternoon to go to the gym? Or do they squeeze in the gym, early in the evening before eating
dinner?
It may be of course that visiting the gym isn’t for you. If this is the case, try to work exercise into
your daily routine. This may include a brisk walk into the office or cycling home. However you are
able to exercise, you’ll feel the benefit.
Joining your team
Introducing yourself
You may or may not know your team already. Even if you do, it’s inevitable that you will be meeting
new people, so it’s a good idea that you consider how best to do this. And do make sure that you
introduce yourself! All too often interns sit in an open plan office and never take the initiative to
introduce themselves and find out who they are working alongside. The more people you know, the
easier your internship will be. Once you’re allocated a desk, look around you and make sure you
take the initiative to introduce yourself to your neighbours as soon as possible.
Making the best first impression
For many people, making a positive first impression involves a firm handshake, polished shoes, a
freshly laundered suit and a confident stance. Of course these things are important and are not to
be overlooked. However, most interns on your intern program are highly likely to get these things
right.
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To stand out from the crowd, you need to go one further than ticking off the usual, fairly superficial
list of first impression must-haves. Making a good first impression isn’t always about boasting
about how great you are. Rather it is about making a person feel good about themselves.
It’s very easy to make a fantastic first impression by simply being genuinely interested in a person,
asking questions and being responsive to the answers. Your goal should be to make them feel
important rather than to big yourself up.
Here are some key ways that you can make a positive impression in the first interaction. Of course,
these tips can be employed in all situations, but the first is irrefutably the most important to get
right.
Remember names
When you introduce yourself, people will inevitably introduce themselves in return. Ensure that you
remember their name. Making an effort to remember a person’s name is a great place to start
when it comes to making them feel important. Conversely, forgetting a person’s name is an
excellent way to offend.
The easiest way to remember anything is by repetition. This is probably the way you learnt your
alphabet or times tables for example. The same can be said for learning names. Clearly it would be
weird for you to immediately repeat a persons name back at them. So instead just try to use their
name a few times during that initial conversation.
Even if you currently deem yourself to be bad at remembering names, if you enter a conversation
consciously trying to memorize a person’s name, your recall will dramatically increase.
Show genuine interest
When you have swapped names with a person, if they look like they have time, ask them a
question about themselves. Ensure the question is a ‘Who? What? Why? Where? When? How?’
question as this will encourage more than a ‘yes’ or a ‘no’ answer.
For example:
 Who do you work with?
 What products do you work with?
 Where are your clients based?
 How long have you been in this team?
When you get an answer, demonstrate that you are listening using your body language and
paraphrasing what has been said to you in follow-up questions.
For example a colleague may say:
“I’ve been in the TMT team for two years. Before that I was in the Italian coverage team.”
“I met Allesandro from the Italian team. What inspired you to move teams?”
Remember, people love talking about themselves. If you give people this opportunity, you won’t go
wrong when it comes to making a great first impression.
Look for clues
If you are in a person’s working space, it may be that they have pictures, mementos or
possessions which can give you a hook to start an informal conversation. They may have a picture
of a skiing trip, a bike helmet, or a screensaver of their favorite football team.
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Use these clues to engage your new colleagues beyond the usual formal chit-chat. I used to work
alongside a very senior member of the HR team. Our relationship was very much a functional one
for a long time. We would usually meet in his office, which was adorned with pretty impressive
landscape photographs. During one meeting I happened to ask about the photographs. His face lit
up and his whole manner totally changed. It turned out that he was something of an amateur
photographer and he was very keen to talk about something he was obviously very passionate
about. From then on, I made sure to periodically ask about how his photography was progressing.
People like to talk about themselves and the things that are important to them. If you can work out
what people are passionate about, it becomes incredibly easy to engage them.
Often people are more influenced by how they feel about you than what you actually say, so
engaging people in informal and enjoyable conversations is an invaluable skill for an intern.
Though do always ensure that people have time to chat!
Getting to grips with how your team works
Every team works slightly differently. The sooner you can be familiar with the idiosyncrasies of your
team, the better. Therefore be prepared to ask how things work.
The types of questions to ask include:
 “How should I ask questions? As and when I think of them? Via email? Should I book half an
hour in your diary to talk through a list of questions I’ve accumulated?”
 “What are the most commonly used acronyms I should get my head around?”
 “What’s the policy on answering the other team member’s phones and taking messages?”
 “Who are the key contacts outside of the team that I’ll be interacting with?”
 “What are the main deadlines that the team work to?”
 “How should I prioritize my work?”
 “What are the hours that the team typically work?”
 “How often should I give you status updates?”
Clearly there will be questions which will be uniquely specific to each team. Whatever your team
does, ensure that you try to find out as much about the modus operandi as possible.
Understanding tasks given to you
It’s highly probable that you’ll be quickly given real responsibility. In this case it’s essential that you
ask questions in order to understand exactly what is required of you.
One of the most common pieces of feedback that interns receive is that they don’t ask enough
questions. Typically an intern will be given a task, it may be that the task isn’t communicated in a
particularly clear way. The intern will nod their head earnestly and imply that they understand
exactly what is required….even if their understanding is sketchy at best.
The intern will go back to their desk, procrastinate for a while, Google some of the unfamiliar terms
that they’ve just heard, try to make sense of their notes, search on the shared drives and through
its folders to find some clues and generally get stressed.
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The Internship
It does take confidence to ask questions. Recognize that everyone knows that you are an intern
and that you’ll be doing many things for the first time, so it would be weird if you didn’t ask
questions. Also, asking questions will actually make others more confident of your ability and give
them a sense of comfort that you’ll get the task right. I’d go as far as saying that asking good
questions can help you to look like a star performer.
Be aware that your line managers will want you to succeed and will also want to do a good job in
managing you. Occasionally for various reasons, their objective setting may be a little vague – you
can help them to manage more effectively by asking good questions.
However, there are right ways and wrongs way to ask questions:
So if I have this correct…
A great way to check your understanding of a task is to repeat back to your line manager your
understanding of the task. Paraphrase exactly what has been said to you and then check in to see
if your understanding is accurate.
If you’ve got it wrong, your line manager is likely to fill in the gaps, expanding on what has already
been said.
When you really have no idea: Look for questions not answers
Let’s imagine that a VP mentions in passing that he’d like you to pull together a WGL. You have no
idea what a ‘WGL’ is, nevermind how you would pull one together.
Here you need to ask the right types of questions. Asking the correct type and style of question
makes it easier for the people around you to provide the appropriate answer.
Always start out with open-ended questions – these are essentially questions that require more
than a ‘yes’ or a ‘no’ answer. You will need to think harder about the questions that you are asking,
as people seem to be programmed to automatically ask closed questions. However, open-ended
questions invite others to engage in conversation meaning you’ll receive far richer and expansive
answers.
So instead of asking:
“Will this be used in tomorrows meeting?”
Ask:
“How will this be used by the team?”
There are different areas that you can focus your questions on.
Output questions: “What exactly am I trying to achieve?”
Here you ask questions about the end product of the results desired. You want to gain as clear a
picture as possible about the end product. You want your line manager to give you a very specific
target for which to aim.
For example:
“What should it look like?”
“Can this be measured?”
“How do I know I’ve completed this successfully?”
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The Internship
Action-orientated questions: “How should I achieve this task?”
These questions are all about the ‘how’ – as in how you will achieve the desired result.
For example:
“Where can I find existing templates?”
“How long should this take me?”
“What is the first step to getting this done?”
“Who can I ask for help with this?”
Context questions: “Why does this task need to be done?”
Context questions require you to ask about the bigger picture. These questions are less necessary
in allowing you to achieve the task, but they will give you perspective about what you are doing.
Additionally this will demonstrate to your manager that you can think above and beyond the
individual task that you are working one.
For example:
“How will this impact the wider project?”
“Where does this need come from?”
“How will this feed into the overall deal?”
By asking output, action and context questions you should be able to feel comfortable about
delivering the desired task.
Building confidence
During your internship you will be communicating your level of confidence constantly, even if you
are not actually speaking. You may find that you attend a lot of meetings and simply observe,
taking notes. Although you may not say anything more than your name as you introduce yourself,
your behavior will give people an impression of how confident you are.
It’s vital to look confident because people assume that your level of competence is directly linked
to your level of confidence. If a colleague views you to be confident, they will automatically
assume that you are competent.
Imagine you’re in a meeting. If you have sat, listened and taken notes and have appeared
comfortable and confident during the meeting, attendees are far more likely to allocate one of the
action points to you. This is because of the competence they have assumed that you have.
If you have sat slumped in your chair, fidgeting and avoiding eye contact with others, it’s highly
unlikely that you’d be trusted with any of the action points.
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The Internship
There is something of a virtuous cycle between confidence and competence:
Which can allow
you to increase
your level of…
Competence
Confident
Which helps
you to feel
even more…
…and makes
you feel…
Confident
Competent
Which makes
others assume
that you are…
This cycle can either be a positive one which allows you to perform to your optimum, or it can be a
negative cycle which can cause you to chronically under-perform.
Which further
causes a…
Lack of
confidence
Competence
Competence
Which can have
a detrimental effect
to your…
…and makes others
question your…
Lack
confidence
Which can cause
you to further…
So you could be the most technically competent intern of the summer – however if your confidence
is shaky, it will be your competence which is questioned. Your level of confidence therefore cannot
be left to chance.
Many times I’ve heard line managers say of an intern “he knows what he’s talking about, but no
way would I let him in front of a client!”
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The Internship
How do I raise my confidence?
The simple answer here is to change your body language.
Most people think that body language is like a billboard, advertising how a person feels. So if I’m
feeling nervous, I’ll display nervous body language, or if I’m feeling relaxed, I’ll look relaxed. For
many people this is very true; their internal state dictates how their external state appears.
However, this process can be reversed. So if you want to feel more confident, you simply act as if
you are already confident. Your body will then trick your brain into believing that you are confident.
This is a tried and tested method that many people call ‘fake it ‘til you make it.’ As cheesy as this
method sounds, it does work. Research shows that confident, upright body language, actually
causes hormonal shifts. Testosterone (the hormone linked to power and dominance) levels go up,
whilst cortisol (the stress hormone) levels go down.
Conversely, passive body language will cause cortisol levels to increase while testosterone levels
decrease. So if you were to sit slumped at your desk, eyes downcast with your arms folded
protectively across your chest, you would start to feel pretty nervous very quickly.
You need to start paying attention to your non-verbal communication as your physiology has a
powerful impact on your psychology. Some people find it overwhelming to start changing their body
language and don’t really know where to start.
Here are a few simple things to think about:
Your shoulders
Shoulders say a lot about how you’re feeling. For example when you are tense, your shoulders
tend to head north and when you are feeling passive, your shoulders slump downwards as you
attempt to make yourself smaller. Confident people hold their shoulders back, but not so far back
that they are puffing out their chest.
Take up space
The amount of space you inhabit, whether in a meeting, at your desk, or in the staff restaurant
reflects how confident and comfortable you are feeling. Therefore ensure you are taking up an
appropriate amount of room. Too little and you will appear lacking in confidence. Whereas taking
up too much space would make you look arrogant.
Control your hands
Fidgety, shaking hands are a classic sign of nervousness. When we are in extremely pressurised
situations our bodies trigger the production of adrenaline. This was a useful thing back in
prehistoric times because this ‘fight or flight’ response helped us either escape or fight off
dangerous animals. In the 21st century, this physiological response isn’t so helpful because we
lack a release of this huge burst of adrenaline that our body has produced – clearly to attempt to
fight or run away in the face of stressful situations will not be well received during an internship!
If you know that your hands shake, try not to use them in gesturing. Keep them folded and static in
front of you. Avoid holding paper as this will only serve to highlight your shaking hands, as the
whole piece of paper will shake and potentially rustle.
If you don’t shake, you may still find that your hands become extra animated when you are nervous.
As you talk, they fly about, making weird and wonderful shapes, almost taking on a life of their own.
These types of hand gestures will make you look slightly hyper and may distract from what you are
saying.
If this is you, try to take control of your hands gestures. Rein them in. A simple, effective way to do
this is to centralize your hand gestures. Instead of gesticulating outwards (which can look like
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The Internship
you’re throwing your words away), bring your hands inwards. This simple trick can make you look
much more stable, grounded and confident.
Your voice
Most of us have (or will) find ourselves in a meeting or presentation where we’re not 100%
confident of the subject matter and we feel quite comfortable in sitting back and letting others lead
proceedings. Then all of a sudden, eyes turn to us and we’re asked: “So what would your
recommendation be?”
Shocked and slightly panicked, we open our mouths to answer. The voice that then comes out of
our mouth is totally different to our usual voice. It may be high, breathy, weak and thin sounding,
but it’s definitely not the voice that we’re used to using. This happens because stressful situations
affect your voice as much as they do your body language.
Your voice and your body language are interconnected. This is because your posture impacts your
breathing and your breathing impacts your voice.
There are a few simple steps you can take to allow you to project confidence with your voice:
 Breathe from your stomach not your chest. This will allow a greater intake of air, and stop any
shallow gasps mid-sentence.
 Control your pitch. Confident people use the lower part of their voice.
 Vary the pace of your voice slightly to avoid sounding robotic.
 Avoid going up in pitch at the end of your sentences. This will make a statement sound like a
question.
 Use pauses to pace your speech and allow yourself to take a deep break.
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Bloomberg for Analysts
Introduction
Analysts need to have a wide variety of skills. They are expected to have excellent technical
knowledge, be efficient financial modelers, creative at PowerPoint as well as being adept at
finding, extracting and recording data.
Bloomberg is a huge database of information. Analysts are not expected to know everything
about Bloomberg and its contents. However, you should be able to find the key information
quickly. Sourcing a beta on Bloomberg is a 60 second exercise, not a 20 minute ‘hit a
Bloomberg key and hope’ exercise.
The best way to learn about Bloomberg is to try using it. This section of the manual covers
the key Bloomberg screens an Analyst will use. This list is not exhaustive, but it concentrates
on the areas you are most likely to meet.
Bloomberg skills coverage
The chapter covers:
 The Bloomberg keyboard
 Using Launchpad
 Exporting data from Bloomberg
 Finding a company ticker
 The Equity screen
 Accessing shareholder data
 Getting NOSH via the DES screen
 Accessing company filing data
 Finding company news for normalization purposes
 Picking a relevant broker report
 What are the current Analyst recommendations?
 Getting share price data
 Annotating Bloomberg share price graphs
 Creating a relative share price graph
 Importing Bloomberg share price data into Excel
 Getting a Hoovers profile
 Accessing the related securities screen
 Accessing the issuer description screen
 Creating government (international) yield curves
 Creating a yield curve analysis
 Credit profile summary
 Creating a Bloomberg beta profile
Appendix 1– Bloomberg for Analysts
Knowing how to use the Bloomberg Terminal is another skill Analysts should work to
enhance. Bloomberg is an excellent source of data that will be used by Analysts on a day to
day basis.
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Bloomberg for Analysts
 Accessing the WACC profile
 Accessing the new issues monitor
 Accessing the debt term sheets
 Creating debt maturity profiles
 Accessing money market rates
 Accessing forex rates
 Accessing the world equity indices
 Accessing economic data
 Using the Bloomberg MA search functionality
 Creating league tables
 Bloomberg news codes
The Bloomberg keyboard
Key rules:
Yellow keys are market sectors:
 <GOVT> = Securities issued by national governments and quasi-governmental agencies
 <CORP> = Corporate bonds
 <MTGE> = Mortgages and collateralized mortgage obligations
 <M-MKT> = Money market information
 <MUNI> = Trading, descriptive and settlement information on municipal and state bonds
 <PFD> = Preferred stock of public companies
 <EQUITY> = Historical and intraday price record for common stock, options and SEC filings
 <CMDTY> = Commodities and their futures and options
 <INDEX> = Generic interest rates and economic indices
Green keys are actions:
 <GO> = Activate a function
 <NEWS> = News
 <HELP> = Define terms, formulas and applications
 <MENU> = Back up to previous menu
 <PAGE UP> = Move forward one page
 <PAGE DOWN> = Move back one page
 <PRINT> = Print screen
Red keys are stop and abort:
 <CONN/DFLT> = Log on/off
 <CANCEL> = Abort function/reset screen
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Bloomberg for Analysts
Blue keys
 <PANEL> = Move back and forth between screens
 LAST = Type LAST to review that last eight functions used
 CU = Call up retrieves the last security or ticker used
 EASY = Calls up the Bloomberg shortcut menu
After pressing Bloomberg function keys, you must press Enter. The <GO> button will activate the
function.
Using Launchpad
Launchpad provides Analysts the ability to run a number of Bloomberg screens from a customized
Bloomberg desktop. It is a very useful tool that allows the Analysts to view multiple sources of
information at the same time.
Launchpad is used to view screens such as:
 New monitors
 Charts
 Betas
 Calendars
 Quotes
 Comps
The simplest use of Launchpad is to run a Bloomberg screen that is kept open and visual while
completing others within Bloomberg.
For instance, an Analyst is working on a WACC calculation and needs to source data to support
the inputs. They access a Bloomberg beta and now wish to find equity market risk premiums for
the stock in question. However, they still want to view the beta.
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Bloomberg for Analysts
The Bloomberg beta screen can be exported into Launchpad by clicking on the export dropdown
menu and selecting the ‘Export to Launchpad’. This will initiate the Launchpad window that will
hold the Beta screen:
If the analyst then navigates away from the main Bloomberg screen, the Launchpad will remain
visible displaying the Beta screen.
The screenshots below illustrate how the Launchpad will look. If a second screen has been setup,
the Launchpad view can be dragged onto the second screen.
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Bloomberg for Analysts
Launchpad can also be used to setup customized Bloomberg desktops. This allows the user to set
up multiple Bloomberg views.
Launchpad is initiated by either:
 Key stroke : BLP <GO> or
 Pressing the Green Launchpad button
The Launchpad toolbar below can then be customized to the user’s own requirements.
Exporting Data from
Bloomberg
Bloomberg provides a number of exporting options:
 Emailing a screen grab
 To email an image of a screen, type GRAB<GO>
 Follow the steps to enter your email address and a subject line,
followed by <GO>
 To send the email, when prompted, type 1<GO>
 Printing – via the Green Print button or the export menu
 Exporting to Launchpad – see previous notes
 Upload as a file
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Bloomberg for Analysts
Using a company ticker allows the use of Bloomberg shortcuts. If you do
not know the company ticker, then find it by entering the company name
into Bloomberg.
Finding a Company Ticker
The following screen will appear if we type ‘Hershey’.
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Bloomberg for Analysts
Select the appropriate company listing from the securities section (note the
ticker symbol ‘HSY US’ in white).
The Equity Screen
This will bring up the full equity screen below:
Note if the company ticker is known, simply enter the following key strokes
to pull up the same equity screen.
Key strokes:
For Hershey this would be:
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Bloomberg for Analysts
Shareholder data provides useful information for:
 Pitch book presentations
 Company profiles
 Shareholder analysis
Accessing Shareholder Data
(Holders)
Key stroke:
262
Further detail on the shareholding can be accessed by clicking on the
holder name.
Bloomberg for Analysts
Key pricing and NOSH information can be accessed through the
Bloomberg company description screen.
Getting NOSH via the Description (DES)
Screen
Key strokes:
Type <Number> <GO>
1 – link through to share price chart
2 – link through to financial analysis screen
3 – link through to total return analysis
4 – link through to options
5 – link through to dividend analysis
6 – link through to earnings summary
7 – link through to earnings estimates menu
8 – link through to multiple shares
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Bloomberg for Analysts
Company filings can be found on:
 Company websites
 Perfect information
 Bloomberg company filing page
Accessing Company Filing
Data
Key stroke:
264
Clicking on the document type will download the supporting documentation.
Bloomberg for Analysts
Information for normalization adjustments can be found on the Bloomberg
corporate actions calendar. The corporate actions calendar provides
information such as:
 Meeting announcements
Finding Company News (and
Research) for Normalization
Purposes (Corporate Actions)
 Changes in borrowings
 Acquisitions
 Divestitures
 Dividend payments
 Ticker symbol changes
The CACS page links through to company news (Type 21 <GO>) and
research (Type 22 <GO>).
Key strokes:
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Bloomberg for Analysts
Picking a Relevant Broker Report
(Company Research)
Broker research is available through Bloomberg – key stroke:
266
A BRC screen will produce a search list that will include an extensive list of
research notes. The search can be further filtered or expanded by using the
data fields at the top of the screen.
Many of these notes will be one page flash notes that contain new flash
information.
Bloomberg will not provide access to all available research on a particular
company. If a particular research piece is required, a charge may be levied.
Research can be expensive. It is important that you are confident you are
buying relevant and useful research.
The research can be previewed by clicking on the magnify icon. It can be
downloaded by clicking on the page icon.
Bloomberg for Analysts
Current Analyst recommendations can be reviewed through Bloomberg.
The ANR screen provides information on:
What are the Current Analyst
Recommendations (Analyst Recs)?
 Consensus ratings
 Individual ratings overviews
 BARR (Bloomberg Absolute Return Rank) – Analyst rankings
 Rank (Portfolio BARR ranking) – analyst rankings
 Annotated share price chart links
Key strokes:
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Bloomberg for Analysts
Analysts should know how to access share price data from Bloomberg.
This data is often used in pitch books and company profiles. The share
price graph for Cadbury plc is:
Key stroke:
This Bloomberg screen allows the Analysts to alter the share price graph
data sets:
 Share price ranges
Getting Share Price Data
(Graph Price)
 Frequency of observations
268
 Moving averages
 Trading volume graphs
Bloomberg for Analysts
Annotating Bloomberg
Share Price Graphs
The Bloomberg GP screen allows the Analysts to annotate the share price
graphs using the sub-menu ‘Annotations’ below, e.g. the date that
Kraft/Cadbury deal was announced.
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Bloomberg for Analysts
Key stroke:
The relative share price graph is used to graphically compare securities
and indices against each other. It is a useful function to allow Analysts to
benchmark performance and share price return.
The Bloomberg default graph will produce a monthly five year graph.
The frequency and range of observation can be changed.
Creating a Relative Share Price Graph
Up to three securities or indices can be plotted on the graph. An additional
security can be added by:
270
Enter
Ticker.Exchange
code in security
field
Equity
GO
Question (Help)
to find exchange
codes
For instance to add Hershey as an additional security – the ticker code
would be HSY US Equity:
Importing Bloomberg Share Price
Data into Excel
Bloomberg for Analysts
Share price data can be imported directly into Excel. Bloomberg offers an
add-on Excel menu. The menu (see below) is a menu driven import wizard.
This is a useful function for pitch book presentations and company profiles
as the graphs can be built in accordance with the IBD presentation
protocols, rather than relying on Bloomberg screen dumps. A Bloomberg
screen dump in an IBD pitch book will look unprofessional.
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Bloomberg for Analysts
The Hoover’s profile provides company background information such as:
 Company profile
 Company history
 Board members
 Location
 Competitors
 Brands
Getting a Hoover’s Profile
 Financials
272
This screen is very useful for company profiles as well as initial comparable
universe identification.
Key strokes:
Bloomberg for Analysts
The RELS screen is a menu-driven page that provides company
information about:
Accessing the Related Securities
Screen
 Key people
 Brands
 Company news
 Equity securities
 Debt securities
Key stroke:
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Bloomberg for Analysts
The issuer description screen provides a quick overview of the key credit
and capital structure ratios for an issuer. The screen also provides
additional menu links into company fundamentals, credit profile, corporate
actions screen etc. It is a useful cornerstone screen for Analysts to gain
quick information about an issuer.
Accessing the Issuer
Description Screen
Key stroke:
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Bloomberg for Analysts
Benchmark yield curves are used:
 In DCF valuation for benchmark risk-free rates for cost of debt and
equity.
 For LBO benchmark rates.
Creating Government (International)
Yield Curves
Key stroke:
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Bloomberg for Analysts
The Bloomberg yield curve analysis tool allows up to four yield curves to be
plotted on the same graph. This is useful to analyze the impact of credit
ratings on the yield curve spreads.
Creating Yield Curve Analysis
(‘Yield Curve Relative’)
Key stroke:
276
The yield curve analysis allows the user to choose which yield curves to
plot. The example above has chosen corporate UK yield curves for different
credit ratings. The graph can be extended to a full-screen version by
clicking on the ’expand graph’ button. The template can also be saved.
Bloomberg for Analysts
The Bloomberg credit profile summary is a useful source of information for
cost of debt benchmarking as well as merger modelling analysis
(post-transaction credit rating analysis).
Credit Profile Summary
Key stroke:
Clicking through the numbered options will take the Analysts through to the
detail of historic rating changes.
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Bloomberg for Analysts
The Bloomberg beta profile is an Analysts primary source for beta inputs for
the CAPM cost of equity calculation. The beta is a levered beta. Raw and
adjusted betas are provided.
Creating a Bloomberg Beta Profile
The beta parameters can be altered for:
278
 Frequency of observation
 Time range of observation
 Market index
 Currency
Key stroke:
Bloomberg for Analysts
The Bloomberg WACC profile should not be relied on without further
investigation into the inputs that drive the calculation. The WACC profile
does provide a source to cross-check Analyst estimates.
Accessing the WACC Profile
Key stroke:
Further breakdowns of the WACC calculation components can be
accessed by clicking on the numbered references.
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Bloomberg for Analysts
The new issues monitor is a news ticker for new issues. The monitor will
allow Analysts to dig into the detail of the issue and the deal tear sheets.
Accessing the New Issues
Monitor
Key stroke:
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Bloomberg for Analysts
A debt term sheet will disclose information such as:
 Issuer
 Currency
 Issue sizes and price
 Coupon rate
 Ratings
 Collateral type
Key stroke:
CORP
TK
Accessing Debt Term Sheets
GO
Enter company
ticker
GO
Choose bond
from bond list
DES
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Bloomberg for Analysts
Debt maturity profiles are used to examine the refinancing options open to
an entity as well as examining what the transaction finance availability is
within the gaps in the maturity profiles.
Key stroke:
Creating Debt Maturity Profiles
CORP
282
TK
GO
Enter company
ticker
GO
Choose bond
from bond list
DDIS
Bloomberg for Analysts
Money market rates, particulary swap rates, are used as benchmark rates
in a number of IBD models such as an LBO.
Accessing Money
Market Rates
Key stroke:
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Bloomberg for Analysts
Forex rates are used extensively in modelling.
Examples of forex use are:
 Merger modeling
 DCF modeling
 Comps earnings and EV metric translation
Accessing Forex Rates
Key stroke:
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Bloomberg for Analysts
Snapshot screen overview for current world indices performance.
Accessing World Equity
Indices
Key stroke:
285
Bloomberg for Analysts
Bloomberg has a large database of economic statistics. The database is a
useful support for valuation and forecasting assumptions.
Accessing Economic Data
Key stroke:
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Bloomberg includs a strong M&A search function.
Key stroke:
Using the Bloomberg M&A Search
Functionality
Equity
MA
GO
Advanced
search
The Bloomberg screenshot below illustrates the various search criteria
available to Analysts. The key when using these databases is to use these
criteria precisely. A failure to do this will result in an M&A deal search that
produces a list that runs into hundreds of transactions.
Narrow your search definitions (this applies to all M&A databases):
 Narrow range of recent dates.
 Pick narrow industry codes.
 Narrow the deal size to be in line with the target deal.
 Use only pending and completed deals.
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Bloomberg for Analysts
League tables often form part of company profiles and pitch book
presentations. They are often used by Analysts to promote the bank’s
standing within different specialists and markets.
Creating League Tables
Key stroke:
288
Click on the firm name to access the deals they advised.
Bloomberg for Analysts
Analysts must keep up-to-date with the news in their particular sector as
well as key news for the industry. This can be a tough ask given the sheer
volume of information available. Bloomberg has a number of news codes
that can filter this information into a format that is more accessible.
N – Main news menu
TOP – Today’s top news headlines
TOP DEAL – Today’s top M&A news headlines
Bloomberg News Codes
NI READ – Weekly news summaries of the most read stories on Bloomberg
NI WIN – Summary of news exclusive to Bloomberg
NI HOT – Hot news
NI WNEWS – A summary of who’s who people news
LIVE – Live broadcast and interviews
News can be further filtered by company specific news stories.
Using Cadbury as an example:
CDBY LN Equity CN <Go> – Company specific news for Cadbury
CDBY LN Equity CN 01/01/2010 <Go> – Company specific news for
Cadbury from a specific date
CDBY LN Equity BN <Go> – Company specific Bloomberg news for
Cadbury
News stories can be emailed using the short key stroke:
289
Bloomberg for Analysts
290
Excel Shortcuts
Movement/selection
SHIFT + arrow
SHIFT + CTRL + arrow
CTRL + arrow
CTRL + Home
CTRL + End
CTRL + PgUp
CTRL + PgDn
CTRL + Tab (or F6)
SHIFT + Spacebar
CTRL + Spacebar
Alt + PgUp
Alt + PgDn
Select cell(s)
Select range
Go to start/end of range
Go to start of sheet
Go to last row/column junction
Go to previous sheet
Go to next sheet
Go to next model
Select row(s)
Select column(s)
Go left one screen
Go right one screen
CTRL + C
CTRL + X
CTRL + V
CTRL + R
CTRL + D
CTRL + Z
CTRL + Y (or F4)
CTRL + F
CTRL + H
CTRL + S
CTRL + W
Alt +
Alt + =
CTRL + 1
Alt + '
Alt + down arrow
Copy
Cut
Paste
Copy/fill right
Copy/fill down
Undo
Redo/repeat
Find
Find and replace
Save
Save and close
Access ribbon/menu
Autosum
Format cells
Style
Drop-down menu
Auditing
CTRL + `
F2
Auditing toolbar
CTRL + [
CTRL + SHIFT + [
CTRL + ]
CTRL + SHIFT + ]
F2 then F5
F2 then F9
Toggle formula view
Highlight precedents
Trace precedents
Go to direct precedents
Go to all precedents
Go to direct dependents
Go to all dependents
Go to selected reference
Turn references into values
Names
CTRL + SHIFT + F3
CTRL + F3
F3
Create name
Edit/delete name
Use name
Appendix 2– Excel Shortcuts
The basics
291
Excel Shortcuts
Used with SHIFT
Function key
On its own
Used with CTRL
F1
Help
Closes/reopens
current task pane
F2
Edit
In Excel 2007,
brings up
Print Preview
Insert/edit
a comment
F3
Names
Name Manager
Insert
function wizard
F4
Dollars/repeat
Closes workbook
F5 (+
Special)
Go to
(special options)
F6
Switches to next
pane in a worksheet
(where worksheet
has been split)
Toggle between
open workbooks
F7
Spell check
Performs the
Move command
on the workbook
window
F8
Extend selection
(as if holding
SHIFT down)
F9
Calculate
Minimizes a
workbook
Calculates the active
worksheet
F10
Accesses the menu
(like pressing Alt key)
Maximizes/
restores the
selected
workbook window
Displays the
right-mouse menu
F11
Graph/chart
Beware – adds
a Macro sheet
Inserts a new
worksheet
F12
Save as
292
Find
Switches to previous
pane in worksheet
(where worksheet
has been split)
Enables selection
of non-adjacent
cells, (without using
the mouse)
Excel Shortcuts
CTRL+
What it does
A
If the worksheet contains data, CTRL+A selects the region.
Pressing CTRL+A a second time selects the entire worksheet
B
Bold
C
Copy
D
Copy/fill down
F
Find
G
Go to
H
Find and replace
I
Italic
K
Insert hyperlink
L
Selects data/creates a table
N
New workbook
O
Open a document
P
Print
R
Copy/fill right
S
Save
T
Selects data/creates a table
U
Underline
V
Paste
W
Close workbook (save dialogue will appear)
X
Cut
Y
Redo/repeat
Z
Undo
293
Excel Shortcuts
294
FactSet
Introduction
FactSet provides in-depth company and industry insight with integrated data and investment
analytics tools designed specifically for a banker’s workflow.
The aim of this document is for you to master the essential skills you need during your
internship, such as:
 Store lists of comparable companies; and research and analyze those companies in
depth
 Updating and maintaining custom template models, reports, and presentations in
Microsoft Excel, Word and PowerPoint
 Apply techniques for updating comp models, pitchbooks and research reports with a
click of a button
 Improve efficiency and productivity in everyday tasks
Appendix 3 – FactSet
Advice: We have a 24/7 Helpdesk staffed by experienced consultants who are on hand to
answer any queries you have related to FactSet. This service is part of your FactSet
subscription and any calls you make to FactSet are confidential and will not be disclosed to
your company. You can find Helpdesk, Consultant and Support Mail details by clicking on the
phone book icon in FactSet.
295
FactSet
FactSet Application
When you first launch FactSet you’ll find a predefined Corporate Finance workspace consisting of
several tabs and sub tabs that provide access to all displays, reports and applications. Your
workspace will be stored online and can be updated and accessed from multiple locations if you
have FactSet installed on a work, home and/or laptop computer.
Here are some helpful tips:
FactSearch! Type a company name,
index, bond, person or even country
to jump to relevant reports. Entering
a company into this box will blast the
identifier to all relevant reports.
Begin customizing your
workspace! Click on the F
icon to insert different
components into each
window.
296
These are shortcuts, allowing you
to open commonly used components
such as a news or full quote window.
You can customize these shortcuts
via the +/- Icon.
Access Online Assistant, which is
like the encyclopaedia of FactSet.
Phone Book: Contact our 24-7
Helpdesk to ask questions.
Tabs make up a workspace and consist of components such as
reports, displays, and applications. A tab can be used in multiple
workspaces. The arrow to the right of each tab allows you to close
the tab, rename, export, print, or display outside of FactSet.
Entering a company into this box
will only change the current report.
All other reports would still be
driven from FactSearch!
FactSet
How to store a list of comparable companies on FactSet
You can perform comparable company analysis on FactSet which is a method used by investment
bankers to value a company. FactSet allows you to create your own list of comparable companies
which can be saved and stored online. You can then also view the performance of the group of
stocks using FactSet data. There are different options available to create and view a custom list on
FactSet:
Office applications
FactSet > Watchlist tab
Within Excel or PowerPoint navigate to the FactSet menu and select the magnifying glass to open
Identifier Lookup:
Choose your companies > Select ‘Save as Portfolio’ option (bottom left)
 Give the Portfolio a name and save.
Your new portfolio can be used in Active Graph Charts (See Active Graph section of this
document) or to return price performance data using formula Lookup (See Formula Lookup section
in this document), or FactSet Market Aggregates data. The FactSet Market Aggregates (FMA)
database can be used to derive ratios and per share values for your portfolio (Only subscribers to
FactSet Estimates or Fundamentals can access this database).
Within the FactSet Watchlist tab you can store a list of companies to track performance. The list
can be saved online and retrieved in various other FactSet applications.
From your Watchlist > right click and select ‘Save tickerlist’ > choose a name for your portfolio and
save the list.
297
FactSet
Research companies in depth
FactSet
Application reports
Start with the F icon
located at the top left of
the application
Description
F Icon > Company >
Overviews > Public
Company Snapshot
The Public Company Snapshot report is a
collection of business and financial information
that has been filtered to provide an overview of
a company's business and financial situation at
a point in time. The Snapshot report combines
summary information from the major information
sources on FactSet and serves as a launching
point to other datasets and reports.
Company financials
F Icon > Company >
Financials
The Financial reports allow you to view financial
statement information for a given company. You
can specify the financial report that you want to
see by selecting Key Items, Income Statement,
Balance Sheet, Cash Flow, Segments, Ratios,
Pension, Per Share, or Supplemental.
Company ownership
structure
F Icon > Company >
Ownership
FactSet's Ownership application provides
institutional, mutual fund, and insider/stake
holder ownership information.
F Icon > Company >
Estimates
FactSet's Estimate reports bring you a suite of
estimate data for reporting/charting, enabling
company analysis in easy-to-use reports. You
can view flexible, pre-made estimate
reports/charts, or build your own customized
report. The estimate data available includes:
EPS, Net Income, EBIT/EBITDA, PE, cash flow,
sales, surprise history, expected growth, per
share items, and more.
F Icon > Company >
Comps > Selected
Financials
The Deals report Company tab displays a
variety of deal data and sourcing information for
both public and private companies.
The following views are available: Summary, All
Deals, Buyer Deals, Seller Deals,
IPO/Follow-Ons, Private Placement Deals,
SharkRepellent, MergerMetrics, or Activism. By
default, the Summary report is displayed when
you choose the Deals.
Company snapshot
(Public and private
companies)
Company estimates
Company deals
298
Navigation
FactSet
F Icon > Company > Debt
The Debt Capital Structure database and
reports provide a standardized breakout of a
public or private company’s bank loan and/or
corporate bond financing activity at a specific
financial reporting point in time.
The issuer bond detail report provides a list of
company issued bonds along with the terms and
conditions of those bonds.
F Icon > Quotes/Prices >
Price Summary
The Price Summary report on FactSet displays
security price and return, corporate actions (e.g.
splits, dividends), volume and volatility statistics,
and related equities. Use the Price Summary
report to get a broad overview of a security’s
price performance.
F Icon > Company >
Filings
Use the Filings report to analyze both US and
non-US companies’ documents from EDGAR,
SEDAR, PDF annual reports, and
GlobalFilings.com
News
F Icon > News & Research
> News
The news display lets you view real-time,
scrolling financial news headlines for the current
day, for a specific company, and for a portfolio
of companies. In addition, you can search
through archived documents for news stories
with a specific date, source, or text.
Market indices
F Icon > Markets > Indices
The Market Indices reports let you view
real-time data for major indices, including Dow
Jones, S&P, AMEX, Russell, and FTSE.
F Icon > Markets > FX
FactSet offers over 158 currencies, covering
most of the world's currencies against the pound
sterling, US dollar, and Euro. FactSet uses
WM/Reuters daily (4.00 pm GMT) closing mid
spot rates as the primary source of exchange
rates, with history available back to 1994.
Prior to 1994 (including dates when WM/
Reuters does not calculate rates per their
methodology, e.g. New Year's Day), FactSet
uses the 10.30 am GMT Barclays Capital rates
via Exshare.
F Icon > Markets >
Economic
You can view economic reports for a variety of
countries. These reports let you view dozens of
important economic indicators with a single
mouse click.
Company debt
Company share price
(See company share
price section for further
information)
Company filings
(See global filings
section for further
information)
Exchange rates
Economic data
299
FactSet
Share price data
The Price Summary report on FactSet displays security price and return, corporate actions (e.g.
splits, dividends), volume and volatility statistics, and related equities. Use the Price Summary
report to get a broad overview of a security’s price performance.
Historical prices
You can also access historical price and return
data for a single security or multiple securities.
To view underlying data,
right click on the chart >
View Data > all.
Hover your mouse over data values in the
Return Analysis and Dividends and Splits
sections to view the underlying calculation.
300
FactSet
Company filings
Use this report to download documents such as Annual Reports, Interim Filings or Prospectuses in
PDF or HTML. The Filings Reports let you analyze both US and non-US companies’ documents
from EDGAR, SEDAR, PDF annual reports, and GlobalFilings.com.
Click the Filings Wizard
button to download
as-reported financials
into Microsoft Excel.
Perform advanced
searches, filtering
documents by date,
filing type, and text
string.
301
FactSet
Download multiple PDF TravelBooks
A TravelBook consolidates a company’s financial and operating metrics and the most recent 29
events into a presentation-ready company overview. You can enter multiple identifiers to create
multiple TravelBooks at the same time. The final document will contain all the TravelBooks in one
PDF file.
Within the Company Snapshot IB report, click on the ‘Build TravelBook’ link:
302
FactSet
Exporting data from FactSet
To extract data from FactSet, you can click on the download arrow on the menu bar:
Press download arrow and choose ‘download to new spreadsheet’
Tip: The Economic Reports allow you to export data as a template which can then be updated in
Excel:
Choose ‘New Spreadsheet’ option
and ‘Template’
303
FactSet
Updating and maintaining custom template models,
reports, and presentations in Microsoft Excel, Word,
and PowerPoint
During your internship you will be expected to maintain and update team Comps Models and
Pitchbook Presentations. FactSet has tools within Excel, PowerPoint and Word which enable you
to make Comps models or Pitchbooks dynamic, so your financial data can be automatically
updated with the latest information. These tools will save you time when searching through
documents such as Annual Reports (Financial data), Broker Research reports (Broker Estimates)
and other such source documents.
Excel tools
Updating team Comps Models
Formula Lookup – Import data directly into your Excel models
Formula Lookup contains formulas categorized into libraries based on various databases. You can
insert these formulas into your Comps model to make the data updatable. For example, the
formula =FDS("WMT-US","P_PRICE(0)") will return the latest closing price for Wal-Mart Stores Inc.
Favorites
Click on the star icon to add a
formula to your favorites library.
F icon
This means the formula is a
recommend FactSet formula
to use.
Step 1
The simplest way to find a formula is to type a keyword or phrase into the Search box and click the
Search button. By default, you will see a list of formula matches from all of the databases that you
have access to, in order by relevance.
Tip: If you are looking for a formula from a specific data source, you can narrow your search by
selecting the database from the Sources drop-down menu.
Step 2
Most formulas accept formula arguments that allow you to customize the data returned. The most
common formula arguments are dates and currency. Most formula arguments are optional and
there are some formulas that do not require any.
When you select a formula, formula arguments are displayed to the right side of Formula Lookup.
304
FactSet
Step 3
Once you've specified the formula arguments, click the Add Selected button. Click the Output
to output corresponding dates and column headers in your
Dates/Column Headers button
spreadsheet, along with your data. Then press OK.
Updating your model
Click the Refresh button
to generate your formula results. If your formula is correct, you will
see the resulting data. If there's an error in your formula, you will see a descriptive error message
to help you find the source of the problem (e.g. missing parentheses or an incorrect formula name).
You can then edit the item in the list and click the Refresh button again to see if you've fixed the
error.
=FDS Excel Error FAQs:
Calculation message: #Calc
The message #Calc is not a Microsoft Excel error message; it is
the value returned by FactSet when an =FDS code needs to be
recalculated.
Error code: #NAME?
The #NAME? error message displays when Microsoft Excel
doesn't understand the text used in an =FDS code.
Possible problem: Misspelling within the prefix.
Error code: #VALUE!
The #VALUE! error message displays when the wrong type of
argument is used in your =FDS code.
Error: You cannot change part of an array
Once you have entered an array formula in Excel, you must edit
the whole array if you want to change it. You cannot change part
of the array.
To edit an =FDS formula correctly within an array:
1. Edit any cell of the existing array.
2. When you have finished editing, press
CTRL+SHIFT+ENTER to re-enter the formula and change
the entire array.
305
FactSet
Downloading ‘Ready-made’ Models:
The Sample Models application contains a variety of FactSet templates that you can view in Excel.
These models are updated frequently and provide helpful building blocks for creating your own
custom models using =FDS codes. You can also upload your own proprietary models to store in a
central location and share across your company.
Examples of the type of models available would be:
 WACC
 Discounted Cash Flow
 Quick Comps
306
FactSet
Improve efficiency and productivity in everyday tasks
FactSet Hotkeys
FactSet has a variety of key combinations (HotKeys) designed to speed up your workflow within
Excel. You can use these to perform common Excel commands, for example, instead of creating
an ISERROR function manually, you could select the formula and use key combination Ctrl Shift E
to wrap an ISERROR around your formula.
Here are some common HotKeys:
Hotkey name
Hotkey
combination
Smart Precedents
CTRL+SHIFT+{
Smart Dependents
CTRL+SHIFT+}
Currency SmartCycle
CTRL+SHIFT+$
Cycles through customized currency styles
Date SmartCycle
CTRL+SHIFT+@
Cycles through customized date styles
Percent SmartCycle
CTRL+SHIFT+%
Cycles through customized percent styles
AutoColor Colors
CTRL+ALT+E
Cycles through customized font colors
AutoColor Selection
CTRL+ALT+A
AutoColors the current selection according to your
AutoColor settings
Increase Font Size
CTRL+SHIFT+F
Increases font size of the selected range
Decrease Font Size
CTRL+SHIFT+G
Decreases font size of the selected range
Smart Copy Right
CTRL+SHIFT+R
Smart Copy Down
CTRL+SHIFT+D
Check for Errors
CTRL+SHIFT+E
Inserts/removes formula adjustment to replace errors
with a custom message
Smart Fill Dates
CTRL+ALT+D
Fills in a series of dates by day, month or year
according to your preferences
Refresh All =FDS
ALT+SHIFT+A
Refreshes all cells that contain =FDS functions
Refresh Selected =FDS
ALT+SHIFT+S
Refreshes the currently selected cells that contain
=FDS functions
Formula Lookup
ALT+SHIFT+P
Builds Data Downloading formulas that begin with ^=
Filings Wizard
ALT+SHIFT+Z
Downloads financial statements and notes
Table Formatting wizard CTRL+ALT+SHIFT+T
Description
Identifies all cells and workbooks that the selected cell
references
Identifies all cells and workbooks that are dependent
on the selected
Copies a cell formula to the right intelligently according
to your preferences
Copies a cell formula down intelligently according to
your preferences
Custom Table Style SmartCycles make it easy to apply
custom table styles to a table.
Multiple SmartCycle
CTRL+SHIFT+*
Cycles through customized multiple styles
AutoColor Sheet
CTRL+ALT+S
AutoColors the current selection according to your
AutoColor settings
307
FactSet
Link Excel charts/tables to PowerPoint or Word
Presentation Linking and Formatting allows seamless interaction between Microsoft PowerPoint or
Word and Excel, making it easy to import and update data and charts in your documents. You can
update data and charts even if the cells and worksheets are rearranged or renamed, and even if
the source files are closed.
Presentation Linking and Formatting imports only the relevant data, keeping files small and stable.
Also, you retain control over whether and when to update some or all linked items and you can
audit back to the source data at any time.
Exporting data from Excel
To export data to PowerPoint, select the
PowerPoint drop-down menu from the Export
Data section of the FactSet ribbon in Excel
and select one of the following options:
 Table as Picture: Exports the active
selection to PowerPoint as a picture. The
picture will remain updatable through your
Excel spreadsheet, but you will not be
able to adjust any information manually.
The Productivity Suite has created hidden
defined names in your Excel workbook, so
be sure to save the file before you close it.
 Table as Word Table: Creates an
updatable Word table from the data,
where each cell of the table is updateable
by hand. Import settings for tables are
based on your user settings.
 Chart as Picture: Exports the active chart
to PowerPoint as a picture. The picture
will remain updatable through your Excel
spreadsheet, but you will not be able to
adjust any information manually. The
Productivity Suite has created hidden
defined names in your Excel workbook, so
be sure to save the file before you close it.
 Cell as Text: Exports active cell contents
to PowerPoint as updateable text.
 Table as Excel Sheet: Exports the table
as an embedded Excel Sheet.
 Table as Excel Chart: Exports the
table as an embedded Excel Chart.
 Table as MSGraph Chart: Exports
the table as an embedded MSGraph
Chart.
308
Update your data via Excel and
refresh your pitchbook charts to
reflect the new changes.
FactSet
Use ActiveGraph to create easy-to-update,
PitchBook-ready financial graphs using your firm’s
corporate colors, fonts, and standards
Available in Microsoft Word, PowerPoint, and Excel
Select Identifier
using Identifier
Lookup.
Click the Data button
to modify the data
behind the graph, or
to add your own
data to the graph.
Select
comparables
using Identifier
Lookup.
Add annotations
from a wide range
of captured events.
Select a graph category
and type (Price,
Valuation, Estimates,
etc.) by clicking the
Charts button.
A real-time preview of
your graph appears in the
top pane. Right-click and
select Format to change
the graph’s colors, titles,
legend, or axes.
To add an additional
series to your
ActiveGraph
e.g. statistical lines
like an average or
median, financial
items, or ratios click the Add Series
button.
Select a time period and
frequency for the graph.
(For some graphs, you
may also need to specify
additional options.)
Choose your company’s StyleSet.
309
FactSet
310
Index
About Fitch Learning ........................................................................................................... 3
Accelerated book-build offering (ABB) ............................................................................ 162
Accessing debt term sheets ............................................................................................ 281
Accessing company filing data ........................................................................................ 264
Accessing economic data................................................................................................ 286
Accessing forex rates ...................................................................................................... 284
Accessing money market rates ....................................................................................... 283
Accessing new issues monitor ........................................................................................ 280
Accessing shareholder data ............................................................................................ 262
Accessing the WACC profile ........................................................................................... 279
Accessing world equity indices........................................................................................ 285
Action-orientated questions ............................................................................................. 251
Active fund management................................................................................................. 227
ADR ................................................................................................................................. 151
Annuity ............................................................................................................................ 146
Arbitrage .................................................................................................................. 199, 213
Asset ................................................................................................................................. 64
Asset-backed security ..................................................................................................... 190
Asset management ........................................................................................................... 16
Balance sheet.............................................................................................................. 62, 98
Basic option .............................................................................................................. 204-206
Basis................................................................................................................................ 199
Beta ................................................................................................................................. 119
Bilateral loan/syndicated loan/club deal .......................................................................... 173
Bloomberg ....................................................................................................................... 255
Bloomberg beta profile .................................................................................................... 278
Bloomberg graphs ........................................................................................................... 269
Bloomberg keyboard ....................................................................................................... 256
Bloomberg MA search functionality ................................................................................. 287
Bloomberg news codes ................................................................................................... 289
Bond ................................................................................................................................ 180
Book-building................................................................................................................... 155
Building confidence ......................................................................................................... 251
Build up your resume ........................................................................................................ 41
Callable bond .................................................................................................................. 184
Capital (finance) leases ......................................................................................... 72, 73, 74
Cash flow growth perpetuity ............................................................................................ 116
Cash flow statement ............................................................................................... 63,93, 97
Certificate of deposit........................................................................................................ 170
Clean and dirty price ....................................................................................................... 187
Collaterized bond obligations (CBOs) ............................................................................. 191
Collaterized debt obligations (CDOs) .............................................................................. 191
Collaterized loan obligations (CLOs) ............................................................................... 191
Commercial paper ........................................................................................................... 169
Common stock or ordinary shares .................................................................................. 150
Company news for normalization purposes .................................................................... 265
Company profile .............................................................................................................. 133
Company takeover .......................................................................................................... 131
Company ticker ............................................................................................................... 260
Comparable company analysis ....................................................................................... 105
Comparable company valuation ...................................................................................... 122
Comparable transactions analysis .................................................................................. 105
Index
Index
311
Index
Competency questions ...................................................................................................... 51
Compound interest .................................................................................................. 142, 143
Contents .............................................................................................................................. 5
Context questions............................................................................................................ 251
Control premium .............................................................................................................. 127
Convertible bond ............................................................................................................. 184
Convertible preferred stock ............................................................................................. 151
Corporate banking ............................................................................................................. 20
Correlation coefficient...................................................................................................... 140
Cost of debt ..................................................................................................................... 115
Cost of equity .................................................................................................................. 115
Coupon ............................................................................................................................ 181
Covenant ......................................................................................................................... 177
Cover letter ........................................................................................................................ 46
Credit default swap.......................................................................................................... 211
Credit profile summary .................................................................................................... 277
Credit ratings ................................................................................................................... 178
Credit rating agencies ..................................................................................................... 178
Cross currency swap ....................................................................................................... 210
Cross rate ........................................................................................................................ 216
Cumulative preferred stock ............................................................................................. 150
Current analyst recommendations .................................................................................. 267
Deal ................................................................................................................................. 131
Deal-specific pitch book .................................................................................................. 134
Debt finance .................................................................................................................... 172
Debt maturity profiles ...................................................................................................... 282
Deferred tax..................................................................................................................... 100
De-lever a beta ................................................................................................................ 120
Derivatives and commodities ............................................................................................ 24
Discounted cash flow valuation ....................................................................................... 105
Discounting.............................................................................................................. 145, 147
Discount rate ................................................................................................................... 114
Discounted cash flow .............................................................................................. 110, 111
Dow Jones Industial Average (DJIA)............................................................................... 165
Dual track process........................................................................................................... 159
Duration ........................................................................................................................... 188
During the interview........................................................................................................... 50
Earnings dilution ................................................................................................................ 91
EBIT .................................................................................................................................. 84
EBITDA ............................................................................................................................. 85
Enterprise value .............................................................................................................. 109
EPS ............................................................................................................................. 89, 90
EPS accretive .................................................................................................................. 129
Equity ................................................................................................................................ 65
Equity dilution .................................................................................................................... 91
Equity screen................................................................................................................... 261
Equity swap ..................................................................................................................... 211
EURIBOR ........................................................................................................................ 177
Eurobond ......................................................................................................................... 185
EV multiple ...................................................................................................................... 123
EV/EBITDA...................................................................................................................... 124
Excel shortcuts ......................................................................................................... 291-293
Ex-div .............................................................................................................................. 152
Expenses........................................................................................................................... 66
Exporting data ................................................................................................................. 259
312
Index
Exporting data from FactSet............................................................................................ 303
FactSet ..................................................................................................................... 295-309
Financial statement integration ......................................................................................... 67
Financial statements ............................................................................................. 70, 71, 75
Fire sale........................................................................................................................... 132
First round interview .......................................................................................................... 48
Fisher effect..................................................................................................................... 221
Floating rate note ............................................................................................................ 183
Forecasting the FCFF drivers.......................................................................................... 113
Foreign exchange rate .................................................................................... 216, 217, 219
Forward contract ............................................................................................................. 200
Forward forex deal .......................................................................................................... 218
Free cash flow to firm ...................................................................................................... 110
FTSE 100 ........................................................................................................................ 166
Futures ...................................................................................................... 195-199, 200-202
Futures contract .............................................................................................................. 200
General pitch book .......................................................................................................... 118
Geometric mean .............................................................................................................. 139
Golden parachutes .......................................................................................................... 131
Government yield curves................................................................................................. 275
Greenshoe option ............................................................................................................ 161
Hedging ........................................................................................................................... 197
High growth period .......................................................................................................... 111
High yield bond................................................................................................................ 185
Historical betas ................................................................................................................ 119
Importing share price data............................................................................................... 271
Income............................................................................................................................... 66
Income statement .............................................................................................................. 63
Index................................................................................................................................ 165
Index-linked bond ............................................................................................................ 184
Inter-bank rates ............................................................................................................... 169
Internal rate of return (IRR) ............................................................................................. 148
Interest rate swap ............................................................................................................ 209
Inter-quartile range .......................................................................................................... 137
Interview ................................................................................................................ 48, 49, 50
Introducting yourself ........................................................................................................ 247
Investment banking blogs.................................................................................................. 58
Investment banking division ('IBD') ............................................................................. 24, 31
Investment grade rating................................................................................................... 179
IPO process..................................................................................................................... 156
Issuer............................................................................................................................... 181
Issuer description screen ................................................................................................ 274
Launchpad....................................................................................................................... 257
League tables .................................................................................................................. 288
Leptokurtic ....................................................................................................................... 142
Liabilities............................................................................................................................ 65
LIBOR.............................................................................................................................. 177
Life as an intern ............................................................................................................... 239
Litigation .......................................................................................................................... 132
Loan finance .................................................................................................................... 173
LTM ................................................................................................................................... 88
Making the best first impression ...................................................................................... 247
Markets.............................................................................................................................. 23
Market capitalization........................................................................................................ 109
313
Index
Maturity............................................................................................................................ 182
Menuing............................................................................................................................. 53
Merger model .................................................................................................................. 128
Mesokurtic ....................................................................................................................... 142
Minority interest ................................................................................................................. 83
Money markets and forex .................................................................................................. 24
Money weighted rate of return (MWRR).......................................................................... 229
Mortgage-backed securities (MBSs) ............................................................................... 191
Multiple approach ............................................................................................................ 116
Nasdaq ............................................................................................................................ 166
Net debt ........................................................................................................................ 78,79
Net debt 'net' ..................................................................................................................... 81
Net present value ............................................................................................................ 147
Nominal value.................................................................................................................. 181
Normal distribution .......................................................................................................... 141
Normalize a metric ............................................................................................................ 86
NOSH ................................................................................................................................ 84
NOSH via the description ................................................................................................ 263
Operating cash flow........................................................................................................... 94
Operating lease commitments........................................................................................... 80
Operating leases ............................................................................................................... 72
Operations ......................................................................................................................... 29
Options ............................................................................................................ 203, 206, 207
Output questions ............................................................................................................. 250
Pac man defense ............................................................................................................ 133
Passive fund management .............................................................................................. 227
Participating preferred stock............................................................................................ 150
Pension deficit ................................................................................................................... 81
Pension schemes .............................................................................................................. 99
Perpetuity ........................................................................................................................ 146
Personal skills training..................................................................................................... 245
PIK .................................................................................................................................. 186
Pilot fishing exercise........................................................................................................ 160
Pitch book........................................................................................................................ 133
Platykurtic ........................................................................................................................ 142
Poison pills ...................................................................................................................... 131
Portfolio construction ....................................................................................................... 225
Portfolio performance ...................................................................................................... 228
Preparation: The firm......................................................................................................... 49
Preparation: The industry .................................................................................................. 49
Preparing: Yourself............................................................................................................ 48
Private banking.................................................................................................................. 21
Pro-forma numbers ........................................................................................................... 88
Prospectus ...................................................................................................................... 159
Punctuality ....................................................................................................................... 243
Putable bond ................................................................................................................... 184
Recapitalizations ............................................................................................................. 132
Recruitment events ........................................................................................................... 39
Redeemable preferred stock ........................................................................................... 151
Related securities screen ................................................................................................ 273
Relative share price graph .............................................................................................. 270
Relevant broke report ...................................................................................................... 266
Research ........................................................................................................................... 24
Revolving credit facility .................................................................................................... 175
Rights issue ..................................................................................................................... 163
314
Index
Risk ......................................................................................................................... 231, 233
Risk premium .................................................................................................................. 232
Roadshow ....................................................................................................................... 158
Sales ................................................................................................................................. 23
Secondary offering .......................................................................................................... 162
Share price data .............................................................................................................. 268
Sharpe ratio ..................................................................................................................... 234
S&P 500 .......................................................................................................................... 166
Standard deviation .......................................................................................................... 138
Standstill agreements ...................................................................................................... 132
STAR technique ................................................................................................................ 52
Structuring ......................................................................................................................... 24
Syndicate......................................................................................................................... 159
Technology ........................................................................................................................ 28
Term loan ........................................................................................................................ 174
Terminal period ............................................................................................................... 112
Terminal value ................................................................................................................. 116
TERP ............................................................................................................................... 163
The mean ........................................................................................................................ 136
The median ..................................................................................................................... 137
The mode ........................................................................................................................ 136
Time weighted rate of return (TWRR) ............................................................................. 230
Trading .............................................................................................................................. 23
Training ........................................................................................................................... 243
Transaction finance ......................................................................................................... 130
Treasury method ............................................................................................................... 92
Understanding tasks........................................................................................................ 249
Underwriting .................................................................................................................... 155
Valuation ................................................................................................. 104, 106, 107, 117
Valuation football field ..................................................................................................... 108
Valuation methodologies ................................................................................................. 104
Vanilla bond..................................................................................................................... 181
Weighted average cost of capital (WACC) ...................................................................... 115
Weighted average number of shares ................................................................................ 91
What is a banking? ............................................................................................................ 17
What to expect as an Analyst within a bank ...................................................................... 33
What makes a complete Analyst ....................................................................................... 34
When to apply ................................................................................................................... 47
White knight..................................................................................................................... 132
Working capital .................................................................................................................. 77
Working capital adjustments ............................................................................................. 95
Writing your resume or application .................................................................................... 43
Yield curve....................................................................................................................... 189
Yield curve analysis......................................................................................................... 276
Yield to Maturity (YTM).................................................................................................... 186
315
Notes
316
Notes
317
Notes
318