Chapter 24
Securities Operations
Financial Markets and Institutions, 7e, Jeff Madura
Copyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved.
1
Chapter Outline









Investment banking services
Brokerage services
Sources of income
Regulation of securities firms
Risks of securities firms
Valuation of a securities firm
Interaction with other financial institutions
Participation in financial markets
Globalization of securities firms
2
Investment Banking Services

One of the main functions of investment banking
firms (IBFs) is raising capital for corporations
 IBFs
originate, structure, and place securities in the
capital markets
 They serve as an intermediary rather than a lender or
investor
 Their compensation is typically in the form of fees
3
Investment Banking Services
(cont’d)

How IBFs facilitate new stock offerings
 An
IBF acts as an intermediary between a
corporation and investors
 Origination


IBFs recommend the appropriate amount of stock to issue
IBFs evaluate the corporation’s financial condition to
determine the appropriate stock price
4
Investment Banking Services
(cont’d)

How IBFs facilitate new stock offerings (cont’d)
 Origination

The issuing corporation registers with the SEC



(cont’d)
The registration statement is intended to ensure that
accurate information is disclosed by the issuing corporation
Included in the registration information is the prospectus,
disclosing relevant financial data on the firm and provision
applicable to the security
The IBF and the issuing firm may engage in a road show to
meet with institutional investors
5
Investment Banking Services
(cont’d)

How IBFs facilitate new stock offerings (cont’d)
 Underwriting
 The IBF may form an underwriting syndicate and ask
other IBFs to underwrite a portion of the stock
 In a best-efforts agreement, the IBF does not guarantee a
price to the issuing corporation
 During IPOs:



IBFs want to set the price high so that the issuing corporation
receives higher proceeds
IBFs do not want to set the price too high in order to place the
entire issue
IBFs tend to underprice IPOs
6
Investment Banking Services
(cont’d)

How IBFs facilitate new stock offerings (cont’d)
 Distribution




of stock
The prospectus is distributed to all potential purchasers of
the stock
The issue is advertised to the public
Some IBFs have brokerage subsidiaries that can sell stock
on a retail level
The corporation incurs two types of flotation costs:


Fees paid to the underwriters
Issue costs, including printing, legal, registration, and
accounting expenses
7
Investment Banking Services
(cont’d)

How IBFs facilitate new stock offerings (cont’d)
 Advising

The IBF acts as an adviser during the origination stage and
may provide advice after the stock is issued
 Private




placement of stocks
IBFs may be able to place an entire offering with a small set
of institutional investors
Rule 144A allows firms to engage in private placement
without the registration statement
An underwriting syndicate may not be necessary
The issuing firm’s costs are lower
8
Investment Banking Services
(cont’d)

How IBFs facilitate new bond offerings
 Origination




The IBF may suggest a maximum amount of bonds based
on existing debt levels
The coupon rate, maturity, and other provisions are decided
The asking price on the bonds will be determined by
evaluating market prices of existing bonds
Issuers of bonds must register with the SEC and a
registration statement must be filed
9
Investment Banking Services
(cont’d)

How IBFs facilitate new bond offerings (cont’d)

Underwriting bonds





Some issuers may solicit competitive bids on the price of bonds
from various IBFs
IBFs provide several services to the issuer
Underwriting spreads on newly issued bonds are normally lower
than on newly issued stock
The IBF may organize an underwriting syndicate to participate in
placing the bonds
Distribution of bonds




A prospectus is distributed to all potential purchasers
The issue is advertised to the public
The asking price is normally set to ensure a sale of the entire issue
Flotation costs range from 0.5 to 3 percent of the value of the
bonds
10
Investment Banking Services
(cont’d)

How IBFs facilitate new bond offerings (cont’d)
 Advising

IBFs may serve as advisers even after the placement is
completed
 Private

In a private placement, the issuing corporation sells the
issue to a purchaser of the entire issue


placement of bonds
Avoids underwriting fees
Private placements are more common for bonds than for
stocks
11
Investment Banking Services
(cont’d)

How IBFs facilitate leveraged buyouts




IBFs assess the market value of the firm
IBFs arrange financing, which involves raising funds and
purchasing any common stock outstanding that is held by the
public
IBFs may be retained in an advisory capacity
IBFs may purchase a portion of the firm’s assets to provide
financial support


Exposes the IBF to a high degree of risk
Merrill Lynch has designed a mutual fund that finances LBOs


Purchase junk bonds of firms that went private
Provides bridge loans that offer temporary financing to firms until
junk bonds can be issued
12
Investment Banking Services
(cont’d)

How IBFs facilitate arbitrage
 Arbitrage
activity involves the purchasing of
undervalued shares and the resale of those shares
for a higher profit
 Arbitrage firms search for undervalued firms and
IBFs raise funds for these firms
 Asset stripping involves acquiring the firm and
selling its individual divisions off

The sum of the parts is greater than the whole
13
Investment Banking Services
(cont’d)

How IBFs facilitate arbitrage (cont’d)





IBFs generate fee income from advising arbitrage firms and
receive a commission on the bonds issued to support the
arbitrage activity
IBFs receive fees from divestitures of divisions
IBFs may provide bridge loans if additional financing is needed
IBFs may provide advise on defense takeover tactics and
finance takeovers
Some arbitrage firms take positions in hostile takeover targets to
benefit from the expected takeover by another group

Some attempts at arbitrage fail because target firms are successful
at defending against a takeover
14
Investment Banking Services
(cont’d)

How IBFs facilitate arbitrage (cont’d)
 History

Sometimes arbitrage firms have accumulated shares of
targets with the expectation that targets will buy back the
shares at a premium



of arbitrage activity
Greenmail
Some IBFs helped to finance greenmail
Arbitrage activity has been criticized because:


It often results in excessive financial leverage and risk for
corporations
The restructuring of divisions after acquisitions results in
layoffs
15
Investment Banking Services
(cont’d)

How IBFs facilitate corporate restructuring
 IBFs

provide advice on corporate restructuring
IBFs assess potential synergies that might result from the
combination of two businesses


The sum of the whole is greater than the sum of the parts
IBFs may suggest a carve-out in which the firm sells a unit of
the firm to new shareholders through an IPO by the unit


The sum of the parts is greater than the sum of the whole
The unit may also be spun off, where new shares of the unit
are created and distributed to existing shareholders
16
Investment Banking Services
(cont’d)

How IBFs facilitate corporate restructuring
(cont’d)
 IBFs



provide advice on mergers and acquisitions
IBFs are critical in the valuation of the business
IBFs have loaned out their funds to companies involved in
mergers and acquisitions or even provided equity financing
The IBF can help finance an acquisition by:



Providing loans to the acquirer
Underwriting bonds or stock for the acquirer
Investing their own equity in the acquirer’s purchase of the
target
17
Brokerage Services


Market orders are requests by customers to purchase
or sell securities at the market price existing when the
order reaches the exchange floor
Limit orders are requests by customers to purchase or
sell securities at a specified price or better


Specialists monitor limit orders and execute transactions in
accordance with the limits specified
If investors order a sale of securities when the price reaches a
specified minimum, it is a stop-loss order
18
Brokerage Services (cont’d)

Short selling involves the sale of securities investors do
not own



Used to speculate on expectations of a decline in securities
prices
Short sellers are required to reimburse the owners of the stock
for any missed dividends
Full-service versus discount brokerage services


Full-service brokerage firms provide information and advice
as well as executing transactions
Discount brokerage firms only execute transactions upon
requests and do not provide advice


The required minimum opening balance is typically between $1000
and $3,000
Most discount brokers offer some degree of research on a website
19
Brokerage Services (cont’d)

Online orders
 The
implementation of an online order system has
reduced costs of brokerage firms
 Online trading has become very competitive

Prices charged are low, typically $25 or less for 100 shares
of stock
20
Sources of Income (cont’d)

Income allocation among securities firms

The proportion of income derived from each source varies
among securities firms in any particular year


Some securities firms emphasize investment banking and
therefore generate a high proportion of income from
underwriting and advising fees


e.g., Goldman Sachs
Some firms emphasize brokerage and generate a higher
proportion of income from trading commissions


e.g., when IPOs are hot, income from underwriting fees will be high
e.g., Charles Schwab
Many securities firms attempt to diversify their services so that
they can capitalize on economies of scope
21
Regulation of Securities Firms




Securities firms are subject to a variety of
regulations
The SEC attempts to ensure that investors have
access to financial information
The SEC has power to ensure that publiclytraded companies provide sufficient financial
information to existing or prospective investors
The SEC tends to establish general guidelines
that can affect trading on security exchanges
22
Regulation of Securities Firms
(cont’d)

Rules regarding analyst compensation and
ratings
 When
firms need underwriting or advisory services,
they are more likely to hire a securities firm whose
analyst would rate the stock highly
 The compensation of some analysts in the 2001–
2002 period was sometimes aligned with the new
business they brought in
 Analysts were tempted to inflate the ratings of stocks
and investors were misled
23
Risks of Securities Firms

Market risk


When stock prices are rising there is a greater volume of stock
offerings and secondary market transactions
Securities firms benefit from a bullish stock market




Some take equity positions in the stocks they underwrite
Some take a partial equity interest in target firms
Acquisitions tend to be more common in bullish markets
Interest rate risk


The market values of bonds held as investment by securities
firms increase as interest rates decline
Lower interest rates can encourage investors to withdraw
deposits from banks and invest in the stock market
24
Risks of Securities Firms (cont’d)

Credit risk



Securities firms offer bridge loans and other types of credit to
corporations
Default risk increases during periods when economic conditions
deteriorate
Exchange rate risk



Many securities firms have operations in foreign countries
Earnings remitted by foreign subsidiaries are reduced when the
foreign currencies weaken against the parent firm’s home
currency
Market values of foreign investments decline as the currencies
weaken against the parent firm’s home currency
25
Valuation of a Securities Firm

The value of a securities firm is the present
value of its future cash flows
 The
value should change in response to changes in
expected cash flows and the required rate of return:
V  f E (CF ), k 

-

Factors that affect cash flows:
E (CF )  f ( ECON, Rf , INDUS, MANAB)

-
?

26
Valuation of a Securities Firm
(cont’d)

Economic growth

Economic growth increases the level of income of firms and
households and can increase the demand for the firm’s services





The volume of brokerage activity increases
Business expansion increases
Debt securities are less likely to default
Equity securities should perform well
Change in the risk-free interest rate

The valuation of a securities firm is inversely related to interest
rate movements

Assets are adversely affected by rising interest rates
27
Valuation of a Securities Firm
(cont’d)

Change in industry conditions




Affected by regulations, technology, and competition
Reduced regulations may increase expected cash flows
Increased competition from reduced regulations may reduce
expected cash flows
Change in management abilities


Managers can attempt to make decisions that will capitalize on
external forces the firm cannot control
Securities firms need skillful management to create new
financial services that may complement the brokerage services
they already offer
28
Valuation of a Securities Firm
(cont’d)

Factors that affect the required rate of return by
investors:
k  f ( R , RP )
f






The risk-free rate is positively related to inflation, economic
growth, and the budget deficit level, but inversely related to
money supply growth
The risk premium is inversely related to economic growth and
the company’s management skills
Regulatory constraints may discourage firms from taking
excessive risk
Loosening of regulatory barriers to entry may increase the risk
of securities firms
29
Participation in Financial Markets
(cont’d)

Competition between securities firms and
commercial banks
 Commercial
banks can offer discount brokerage
services at lower fees than full-service fees


Commercial banks compete with discount brokers
Commercial banks must either establish a brokerage
subsidiary or acquire a brokerage firm
 Recently,
some securities firms have provided loans
to businesses
30
Globalization of Securities Firms
(cont’d)

Growth in international joint ventures

Securities firms have expanded internationally by engaging in
joint ventures



Allows foreign market penetration with a limited stake
Securities firms facilitate privatizations of firms in foreign
markets such as Latin America and Europe
Growth in international securities transactions

The growth in international securities transactions has created
more business for the larger securities firms


Growth in Latin America
Growth in Japan
31