SECURITIES FIRMS
FINANCIAL INSTITUTIONS & SERVICES
How Investment Banking firms
Facilitate New Stock Issues
• Origination
• Underwriting Stock
• Distribution of stock
• Advising
Origination:
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When a corporation decides to
publicly issue additional stock, it may
contact an IBF.
The IBF can recommend the
appropriate amount of stock to issue,
since it can anticipate the amount of
stock the market can likely absorb
without causing a reduction in the
stock price.
Whether the stock to be issued
should be preferred or common.
The
IBF
will
evaluate
the
corporation’s financial condition to
determine the appropriate price for
the newly issued stock.
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The issuing corporation then registers
with the SEC. all information relevant
to the security, as well as the
agreement between itself and the IBF
must be provided within the
registration statement, which is
intended to assure that accurate
information is disclosed by the
issuing corporation.
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SEC approval does not guarantee the
quality or safety of the securities to
be issued; it simply acknowledges
that a firm is disclosing accurate
information about itself.
Underwriting Stock:
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As a result of negotiations between the IBF and an issuing corporation, an
underwriting spread is determined, the difference between the price the IBF is
willing to pay for stock and the price at which it expects to sell the securities.
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The underwriting spread represents a commission to the IBF for selling the stock.
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The original IBF may form an underwriting syndicate of IBF’s which are requested
to underwrite a portion of the stock.
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IBF’s may not be willing to act as underwriters for securities issued by relatively
risky corporations.
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Instead, they may offer their best efforts in selling the stock. This result is bestefforts agreement; Whereby the IBF does not guarantee a price to the issuing
corporation.
Distribution of Stock
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Once all agreements between the issuing firm, the originating IBF, and other
participating IBF’s are complete and the registration is approved by the SEC, the
stock may be sold.
The prospectus is distributed to all potential purchasers of the stock, and the issue
is advertised to the public.
Some IBF’s participating in a syndicate has brokerage subsidiaries that can sell
stock on a retail level.
When a corporation publicly places stock, it incurs to types of floatation costs, or
costs of placing the securities.
First, the underwriting spread is paid to the underwriters, who guarantee the
issuing firm a set price for the stock.
Second, issue costs from issuing stock include printing, legal, registration and the
accounting expenses.
Advising
• The IBF acts as an advisor throughout the
origination stage as to the various terms of
the stock.
• Even after the stock is issued, the IBF may
continue to provide advice on the timing,
amount and the terms of future financing.
How Investment Banking Firms
Facilitate New Bond Issues
• 1. Origination:
• The IBF may suggest a maximum amount of bonds that
should be issued, based on the issuer’s characteristics.
• The bonds would need to offer a relatively high yield,
which reflects a high cost of borrowing to the issuer.
• Next, the coupon rate, the maturity, and other
provisions are decided, based on the characteristics of
the issuing firm. Issuers of bonds must register with the
SEC.
How Investment Banking Firms
Facilitate New Bond Issues
• 2. Underwriting Bonds:
• Underwriting spreads on
newly issued bonds are
normally lower than on
newly issued stock, because
bonds can often be placed
in large blocks to financial
institutions.
• The IBF may organize an
underwriting syndicate of
IBFs to participate in the
placement of the bonds.
• 3. Distribution of Bonds:
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• Upon SEC approval of
registration, a prospectus is
distributed to all potential
purchasers of the bonds,
and the issue is advertised
to the public.
• 4.
Advising
How Investment Banking Firms
Facilitate Private Placements
• If an issuing corporation knows of a potential
purchaser for its entire issue, it might be able to sell its
securities directly without offering the bonds to the
general public.
• This private placement avoids the underwriting fee.
• The price paid for privately placed securities is
determined by negotiations between the issuing
corporation and the purchaser.
How Investment Banking Firms
Facilitate Leveraged buyouts
• Investment Banking Firms Facilitate Leveraged buyouts in
three ways:
1. They assess the market value of the firm of concern so
that the participants planning to purchase the firm do not
pay more than the firms value.
2. They arrange financing, which involves raising funds and
purchasing any common stock outstanding that is held by
the public.
3. They may be retained in an advisory capacity.
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– A group may not be able to afford an LBO because of constraints
on the amount of funds it can borrow.
How Investment Banking Firms
Facilitate Leveraged buyouts
– The IBF may therefore consider purchasing a portion of the firms assets, which
provides the group with some financial support.
– It will either search for an immediate buyer of these assets or maintain the
assets over a period of time
– If it chooses, the latter alternative, it may finance the purchase by issuing
bonds. Its return on this deal is based on the difference between the net cash
inflows generated by the assets and the cash outflows resulting from the bond
issue.
– IBF’s initially borrow short term until bonds are issued. If interest rates rise
prior to the issue date, the cost of long-term financing may be much higher
than the IBF’s had anticipated.
• The investment in the mutual fund is used mostly to purchase junk bonds
of firms that went private.
How Investment Banking Firms
Facilitate Arbitrage
• Some IBF’s also facilitate arbitrage activity, which in the
securities industry refers to the purchasing of
undervalued shares and the resale of these shares for a
higher profit.
• One common form of arbitrage would be acquiring a
firm and then selling off individual divisions of the firm.
This action is called asset stripping.
• IBF’s would generate fee income from their advising
arbitrage firms as well as receive a commission on the
bonds issued to support the arbitrage activity.
How Investment Banking Firms
Facilitate Arbitrage
• They would also receive fees from divestiture divisions.
When the raising of funds is not expected to be
complete before the acquisition is initiated, the IBF’s
provide bridge loans.
• The IBF’s can help finance acquisitions by:
1. Providing loans to the acquirer
2. Underwriting bonds or stocks for the acquirer
3. Investing their own equity in the acquirer’s purchase
of the target.
How Investment Banking Firms
Facilitate Arbitrage
• Some times, Arbitrage firms accumulate
shares of targets with the expectation that
target would be willing to purchase them back
at a premium. This tactic is known as Green
Mail.
• Final result of Green Mail is that target is not
acquired and incurs a large expense of buying
back shares held by arbitrage firms.
Brokerage Services
• 2.
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2.
3.
Market orders
Limit orders
Short-Selling
• 1.
Market Orders
• Requests by customers to
purchase or sell securities at
the market price existing when
the order reaches the
exchange floor are called
market orders.
Limit Orders
• Requests by customers to
purchase or sell securities at a
specified price or better are
called limit orders.
• A more specific type of limit
order is Stop-Loss order. An
investor specifies a selling
price below the current
market price. When the price
drops to specified level, stoploss order becomes market
order.
3. Short Selling
• Investors can speculate • Another type of order
on expectations of a
used in short selling is
decline in securities
Stop-Buy-Order.
prices by short selling or
Investor specifies a
selling securities that
purchase price above
they do not own.
the current market
price. When the price
• Short
sellers
are
rises to specified level,
required to reimburse
stop-Buy-order
the owners of the stock
becomes market order.
for
any
missed
dividends.
Sources of Income for Securities Firm
Investment Banking Services
Underwriting
Fees from underwriting stock offerings or bond offerings by
firms and Govt agencies
Advising
Fees for paying advice to firms about identifying targets,
valuing targets, identifying potential acquirers and protecting
against take overs
Restructuring
Fees for facilitating mergers, divestitures, carve-outs and spinoffs
Brokerage Services
Management Fees
Fees for managing individual’s or firm’s securities portfolio
Trading Commissions
Fees for executing securities trades requested by clients
Margin Interest
Interest charged to investors who buy securities on margin
Investing Its Own Funds
Investing
Profits from investing in securities
SECURITIES FIRM RISKS
1. Market risk
• Securities firm offer
many services linked to
stock
market
conditions.
• Rising stock prices
generate high volume of
business for securities
firm.
• They benefit from:
1. Greater volume of
stock offerings
2. Taking equity positions
in IPOs
3. Taking partial equity
stake in target firms
4. Generate
more
advising and financing
acquisitions business
SECURITIES FIRM RISKS
2. Interest rate Risk
Performance is sensitive to
interest rate movements:
1. Price of bonds held as
investments increases
when interest rates are
low
2. Low rates can encourage
investors to withdraw
deposits from commercial
banks and invest in stock
transactions.
3. Credit Risk
• Many Securities firms offer
bridge loans and other
credit services to firms.
• Under
unfavorable
economic conditions, firms
have higher probability of
default on their loans.
SECURITIES FIRM RISKS
• Exchange Rate Risk
• Due to depreciation of foreign currency
against home currency:
1. Earnings remitted by foreign subsidiaries
reduce.
2. Market value of foreign securities held as
investments decline.
Securities Firm Valuation
• Value of a Securities Firm changes in response
to change in expected cash flows in future and
to changes in required rate of return:
• ∆V = ƒ[∆E(CF), ∆ k]
• Factors affecting cash Flows:
• ∆E(CF) = ƒ[∆ECON, ∆ Rf, ∆INDUS, ∆ MANAB]
• Factors affecting Required rate of return:
• ∆ k = ƒ[∆ Rf, ∆ RP]