INTRODUCTION TO INVESTMENT BANKING

Introduction to Investment Banking

TABLE OF CONTENTS
Introduction ............................................................................................................................................. 3
Course Objectives ....................................................................................................................................... 3
List of Chapters ........................................................................................................................................... 3
Chapter 1: Investment Banking Basics ..................................................................................................... 5
Chapter Objectives ..................................................................................................................................... 5
Introduction to Investment Banking Basics ................................................................................................ 5
Case Study .................................................................................................................................................. 6
Introduction to Securities ........................................................................................................................... 8
What is an Investment Bank? ..................................................................................................................... 9
Summary of Investment Banking Structure ............................................................................................. 13
Chapter Summary ..................................................................................................................................... 13
Chapter 2: Investment Banking Products and Services ........................................................................... 15
Chapter Objectives ................................................................................................................................... 15
Introduction .............................................................................................................................................. 15
Investment Banking Overview .................................................................................................................. 16
Equity Investments ................................................................................................................................... 16
Fixed Income ............................................................................................................................................ 17
Derivatives ................................................................................................................................................ 20
Prime Brokerage ....................................................................................................................................... 22
Foreign Exchange...................................................................................................................................... 25
Investment Management ......................................................................................................................... 27
Summary................................................................................................................................................... 27
Chapter 3: Lifecycle of a Trade ............................................................................................................... 29
Chapter Objectives ................................................................................................................................... 29
Introduction .............................................................................................................................................. 29
Trading Risks ............................................................................................................................................. 31
Trade Lifecycle Overview .......................................................................................................................... 32
Trade Execution ........................................................................................................................................ 33
Confirmation ............................................................................................................................................. 35
Settlement ................................................................................................................................................ 36
Reconciliation ........................................................................................................................................... 37
Accounting ................................................................................................................................................ 38
Chapter Summary ..................................................................................................................................... 40
Course Summary ...................................................................................................................................... 40

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Introduction to Investment Banking

Introduction
This e-book contains all the content covered in the Introduction to Investment
Banking course. You may choose to use this e-book as a reference document.

Course Objectives
The objectives of the course are:
 Define investment banking
 Describe investment banking products and services
 List the stages in the lifecycle of a trade

List of Chapters
This course comprises three chapters:
 Chapter 1: Investment Banking Basics
 Chapter 2: Investment Banking Products and Services
 Chapter 3: Investment Banking Processes

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 CHAPTER 1

INVESTMENT BANKING BASICS

Chapter 1: Investment Banking Basics

Chapter 1: Investment Banking Basics

Chapter Objectives
Welcome to Chapter 1: Investment Banking
Basics. At the end of the chapter, you will
be able to:
 Define investment banking
 Describe the role of an investment
bank
 Distinguish between investment and
retail banks
 Describe the typical structure of an investment bank

Introduction to Investment Banking Basics

"Lack of money is the root of all evil." – George Bernard Shaw

We need money to buy a house, plan a vacation, or just

pay bills. For some things, your savings might be enough.
For others such as buying a house, you may have to take
a loan from a bank or sell some personal possessions.
Have you ever wondered how large organizations and
companies raise capital? A lot of them take the help of
investment banks. Let‘s look at a scenario to understand
how investment banks help companies raise funds.

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Case Study
Shane, an employee at a top investment bank, was sipping coffee at his desk when
the phone rang. On the call was his client, John, the CEO of ABC Steel.

Shane, Investment Banker John, CEO of ABC Steel

Shane: Hey John, how are you?

John: I‘m fine, thank you. How are you?
Shane: I‘m doing good. I hear things are going great for ABC Steel.
John: Oh yeah, things are great – the economy is booming and there‘s a lot of
demand for our products.
Shane: Wow! That‘s nice to hear. I also hear you bagged a big contract.
John: Yeah, and we need to build a new production facility soon. But we have a
problem…
Shane: Tell me about it.
John: Well, we need $200 million dollars to fund this new project…
Shane: And you want to know how you can raise this money, right?
John: Right. We spoke to the bank, but man those interest rates are ridiculous!
Shane: I know. But there are other options you know.
John: That‘s why I called. I was wondering if you could help us.
Shane: Sure, John. Let me do some homework and get back to you. I‘ll call you
tomorrow morning?
John: Sounds perfect. Thanks Shane!

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Shane’s Options

Shane thought about John‘s funding requirements. He made a

list of all funding options for John‘s company and filtered the
list down to three.

Taking a Loan
ABC Steel has a good credit rating. So getting a loan
from any bank would be easy. But the rates of
interest are quite high. Also, the new plant will
generate revenue only after a few years. This would
make immediate repayment difficult, adding to the
debt burden.

Saving Money
ABC could save a percentage of the profits and build a
plant after few years. However, John couldn‘t wait that
long because this would make it difficult for ABC Steel to
meet the demand for steel in the near future.

Selling Stocks
John could raise capital by offering company stocks to
the public. Since the steel market is booming, a lot of
investors would buy ABC‘s shares. But the challenge is
to manage the risks and complications involved in the
IPO process, government regulations and market
uncertainties.

If you were in Shane‘s shoes, what option would you consider and why?

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Shane’s Advice
Shane carefully evaluated the options and advised John
to sell company stocks through an initial public offering
(IPO). John was apprehensive about the technicalities
and risks involved with launching an IPO. This is where
Shane‘s investment banking expertise was crucial. He
helped John decide the offer price and guided him on
government regulations and the requisite documentation.
Shane also used his contacts with different large
investors to generate interest in ABC Steel.

Thanks to Shane, the IPO was a success, ABC raised the capital it needed, and
investors were happy about buying stocks of a company with good fundamentals.

Introduction to Securities
You just saw how ABC raised money by selling their
stocks. But what exactly is a stock? A stock or share or
equity literally means a share or stake in the company.
If you owned 100% stock of a company, it would
mean that you are the only owner of the company!

Another option for raising money is a bond, which is essentially a loan to a company.
The key difference between stocks and bonds is that buying a bond does not mean
that you own a share in the company. Bond-holders are paid the principal along with
the interest, but are not entitled to the profits made by the company. On the other
hand, a company doesn‘t have to ―repay‖ its shareholders. Instead, it simply shares
its future profits with them.

Both stocks and bonds are examples of securities. This means that you can trade
stocks and bonds for money.

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What is an Investment Bank?

Believe it or not, even investment bankers find it
difficult to describe what exactly investment banks do!
This has to do with the sheer complexity and enormity
of the financial transactions involved.

In simple words, an investment bank is an

intermediary between organizations such as ABC Steel
that need money and individuals and institutions that
need to invest. Broadly speaking, an investment bank
is an institution that:
 Helps organizations or governments raise money by issuing and selling
securities such as stocks and bonds
 Provides a range of advisory services on complex transactions such as
mergers and acquisitions
 Offers a range of structured products and services to institutional and
individual investors to help them manage their assets and wealth

Role of an Investment Bank

Investment banks could play different roles in a
financial transaction. Some of the most common
roles played by them are:
 Underwriter
 Principal Trader
 Broker or Agent
 Prime Broker
 Advisor

Underwriter
As an underwriter, an investment bank purchases all
new securities of a company and resells them to the
public. For example, ABC issues 20,000,000 shares for
$10 each. An investment bank directly purchases all
these shares from ABC and sells it to the public at a

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higher price, say $15 each. The investment bank also bears the cost of the sale.

Principal Trader

As a principal trader, an investment bank buys shares

from other investment banks and investors and keeps
them in its inventory. It may sell these shares at a
higher price in the future. The term ‗principal trading‘
simply means that the trader of securities is also its
owner or principal.

For example, after ABC Steel‘s shares are sold to the public, an investment bank
may purchase some of these shares from the market. It may sell these shares later
when the price rises.

Broker or Agent
As an agent or broker, an investment bank buys and
sells securities on behalf of a company. The key here is
that the investment bank does not own these securities.
It only trades in them for a commission.

The important thing to remember here is that the brokerage or agency represents
buyers or sellers who are the principals or owners of the securities.

Prime Broker
A prime broker offers a range of services to professional
investors, including:
 Administrative and operational support for
trading
 Lending of securities
 Management and safeguarding of securities
 Financing

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Without a prime broker, it would be difficult for professional investors to trade with
several different brokers and manage their cash and securities from one centralized
account.

Advisor
Investment banks provide a range of advisory services
on complex transactions such as mergers and
acquisitions. They also advise companies on the
different options to raise capital. They provide high
net-worth individuals with customized wealth
management services.

Why an Investment Bank

So why do companies require an investment bank?
Can‘t they raise funds on their own? Yes, companies
can sell shares or bonds directly to investors. But
most don‘t because they simply don‘t have the
expertise. Without professional help, companies
would end up violating rules and regulations that
they didn‘t even know existed.

Investment banks have a large pool of experts who are well versed with market
regulations and conditions. Moreover, they are more cost effective due to their scale
of operation and optimal use of technology. Considering all this, it would be too
expensive and time consuming to not use an investment bank.

Investment ‘Banks’
Have you wondered why investment banks are called
‗banks‘? After all, they do not provide home loans or car
loans to customers. Nor do they provide savings accounts.

The reason investment banks are also considered ‗banks‘

is that they help to finance an organization‘s capital needs
by taking money from investors. This is similar to how a regular bank lends money
deposited with it by customers to businesses and individuals.

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Investment Banking Structure

Let‘s now take a look at what a typical investment bank is structured like. Usually, all
investment banks consist of three units—front office, middle office and back office.

Front Office
The front office refers to the sales, marketing, trading and other divisions that
involve customer interaction and revenue generation. The front office of an
investment bank typically handles the following functions:
 Investment management
 Investment banking
 Research
 Strategy
 Trading and sales
 Structuring of complex financial instruments such as derivatives

Middle Office
The middle office of an investment bank manages risk. For an investment bank, risk
can be of two types:
 Market risk – the risk of decrease in value of investments due to market
fluctuations
 Credit risk – the risk of loss due to non-payment of a loan

The middle office calculates profits and losses. It also analyzes the risk of trading
portfolios and ensures compliance with regulations. It works closely with both the
front and back office.

Back Office
The back office consists of the operational and administrative functions of the
investment bank. Typically, the back office handles the following functions:
 Clearing
 Settlement
 Regulatory compliance
 Record-keeping
 Reporting of transactions

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The back office may also consist of a technology division that creates software tools
that automate processes and integrate different systems.

Summary of Investment Banking Structure

Here‘s a quick summary of what you learned in the

previous pages:
 The front office interacts with customers, trades
in securities, and researches the market.
 The middle office calculates the risk, profit, and
loss associated with trading.
 The back office is the administrative and
operational backbone.

Chapter Summary
You have completed Chapter 1: Investment
Banking Basics.

You should be able to:

 Define investment banking
 Describe the role of an investment bank
 Differentiate investment banking from
retail banking
 Describe the typical investment banking structure

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 CHAPTER 2

INVESTMENT BANKING PRODUCTS

& SERVICES
Chapter 2: Investment Banking Products and Services

Chapter 2: Investment Banking Products and

Services

Chapter Objectives
Welcome to Chapter 2: Investment Banking Products and
Services.

At the end of the chapter, you will be able to:

 List the important types of investment banking
services and products
 Define important investment banking terms
 Describe investment banking products, services and related terms

Introduction
"Finance is the art of passing currency from hand to hand until it finally disappears."
– Robert W. Sarnoff

Mention ‗investment banking‘ and most

people think of pinstriped suits, power
lunches, and complicated jargon such as
‗collateralized debt obligation‘ or ‗credit
default swaps.‘ If you are the kind who
gets jittery when someone uses a big
word, do not worry. Even experts can
get confused! Things are so complicated
because investment banks have to constantly innovate and create new products and
services. This way, they can demand higher margins and attract new investors.

This chapter will introduce you to common investment banking services and products.
But don‘t expect to become an investment banker by just reading this! To get a more

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detailed understanding of the subject, speak to experts in the field and refer to
books and websites on investment banking.

Investment Banking Overview

In the past, investment banking meant helping
companies raise capital or take strategic decisions on
mergers or acquisitions. Today‘s investment banks
have expanded and consolidated with several other
industries such as brokers and commercial banks.
They offer an overwhelming range of investing and
financing services that can be roughly classified into
the following categories:
 Equity investments
 Fixed income
 Derivatives
 Prime brokerage services
 Foreign exchange
 Investment management

Equity Investments
A wise man once said about the share market that every
time somebody buys, another sells, and both think that
they are smart! The market for shares, or the equity
market, is an excellent way for companies to raise
money and for investors to make money by buying and
selling shares. The difference between the cost price and
selling price is known as capital gain.

Investment banks trade in the market either on behalf of their clients or for their
own portfolios using a variety of strategies. They conduct extensive equity research
and analysis and provide reports to their clients. Equity investments have the
potential to give higher returns but at a higher risk.

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Fixed Income
Let‘s say you want to use your savings to generate
regular income to pay your bills. You don‘t want to
invest in the equity market because you know it is
too risky. What would you do? One option you could
consider is fixed income.

Fixed income refers to an investment where

investors ―loan‖ their money to obtain a fixed periodic return. For example, say you
lent $1,000 to your friend at an interest rate of 10% with a period of five years.
Every year, this would generate a fixed income of $100. At the end of five years,
your friend agrees to return the $1,000. In short, not only do you get your money
back, but you also get the interest on your loan as a regular income. This interest
paid to you is called a coupon.

More About Fixed Income

The most common type of a fixed income instrument
is a bond. This is an excellent option for companies
that want to raise money though at a slightly high
cost. Moreover, investors are assured regular returns
for a certain period. Other types of fixed income
instruments include government-issued treasury bills,
municipal bonds, and certificates of deposit.

Investment banks provide a range of structured fixed income instruments. A

collateralized debt obligation is one such instrument. It is a way of raising money
through bonds and then investing that money typically in other fixed income
instruments such as mortgages. Buyers of such bonds are paid a regular coupon.

Just like stocks, fixed income securities are traded in the market. You may wonder
why anyone would trade in fixed income securities when other instruments provide
higher returns. To understand this, let‘s look at a simple scenario.

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Scenario: Risk and Return

Amanda has two friends, Rachel, and Sophie. Both need
$10,000 for their personal needs.

Rachel
Rachel has a poultry business that has been adversely
affected by the bird flu panic. Since the price of eggs is at its
lowest, she plans to borrow $10,000 to buy large quantities
of eggs from a wholesaler and stock them for the next few
months. As the prices rise by 200% in the next three
months, she plans to sell her stock at a higher rate. Rachel
is willing to pay Amanda $14,000 at the end of the year.

Sophie
Sophie has a low-paying job at a government bank. She needs
$10,000 to buy a new car. This would reduce her commuting
cost by $400 a month. Sophie promises Amanda that she‘ll
pay her $12,000 at the end of two years.

If you were Amanda, whom would you lend to?

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Analysis

There is no right or wrong answer for Amanda.

The final choice depends on her ability to take
risks and her need for returns. While Rachel is
ready to pay a higher rate of interest, the
volatile egg business makes the loan very risky.
On the other hand, Sophie‘s bank job makes it
easy for her to repay the money along with the
interest. Still, the risk of default still exists.
Moreover, Amanda‘s money would be ―tied up‖ for two years, earning a low interest.

As a rule, higher the risks, higher the returns, and vice versa. Typically, most
investors reduce their risks by ‗diversification‘ or investing in diverse instruments. To
offset the risk of volatile equity investments, investors often allocate a certain
percentage of their portfolio to fixed income. There are other ways to reduce risks,
as we shall see in the next few topics.

Reducing Risk
How does one reduce risk? Like Amanda, companies and
banks spend sleepless nights pondering over this question.
Bad weather, credit default, demand slump, and other
unexpected events can wreck any business. This need to
reduce risks led to the creation of derivatives.

A derivative is a kind of insurance against something going

wrong. For example, in the previous example, Rachel would have suffered heavy
losses if the expected price rise of eggs did not happen. Amanda would have lost
money if Rachel did not repay her loan. Purchasing the right derivative in their case
would have protected them in the case of an adverse event.

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Derivatives
So what are derivatives really? A derivative is a
financial instrument whose value depends on the
value of one or more financial instruments or the
‗underlying.‘ These instruments could be interest
rates, foreign exchange rates, or even the price
of commodities such as coffee or wheat.

The advantage of derivatives is that they can be

bought or sold without having to deal with the underlying asset. For example, you
can trade in derivative contracts for the price of cotton without actually dealing in
cotton. Moreover, just like stocks, derivatives can also be traded on an exchange or
sold over the counter. New derivatives are constantly being invented. For example,
now you can even buy earthquake derivatives!

Let‘s take a look at the different types of derivatives contracts.

Futures and Forwards

A future or forward is a contract to buy a
specified quantity of a financial instrument at a
certain price and time. For example, if you were
afraid that the price of coffee would rise in
three months, you could buy a future contract.
This gives you the right to buy or sell, say
10,000 kilos of coffee at the price you want
after three months.

The difference between a future and forward is that in a future, a clearing house that
operates an exchange writes the contract while forward contracts are written by both
the parties themselves. In short, futures are traded on the stock exchange while a
forward is sold over the counter.

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Options
As the name suggests, an option provides you the ‗option‘ or
right to buy or sell at a specific time in the future. Buying a
call option gives you the right to buy a specified quantity of a
security at a certain price. Buying a put option gives you the
right to sell.

How is an option different from a future? Well, a future

contract makes it obligatory for you to perform the transaction
while option does not. For example, say you bought a derivative to sell a company
share at $100 after six months. After six months, however, the market price of the
share has shot up to $150.

If you had bought a:

 future contract, you would have to sell it at $100.
 put option, you could exercise the right to sell it at $150 and not $100.

Swaps
A swap means an exchange of something. You could have swaps
for several things including interest rates, cash flows, and
currencies.

A common type of swap is a credit default swap. For example,

Sam borrows $100 from Anita. Anita is not sure if Sam will repay
her. Therefore, she buys a swap from Mike for protection against default. As per the
swap agreement, Anita agrees to pay Mike $10. In case Sam does not pay Anita,
Mike will pay Anita the full amount. How does Mike benefit? For sharing Anita‘s risk,
he gets a small payment. Moreover, Mike would have agreed to share Anita‘s risk
only after researching Sam‘s creditworthiness and his ability to repay.

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Prime Brokerage
A hedge fund, as the name suggests, is a fund
that aims to protect against potential losses using
a combination of trading strategies including
derivative contracts. Such funds are open only to
a few professional or wealthy investors.

Investment banks provide specialized services

known as prime brokerage to professional investors such as hedge funds. These
services include administrative and operational support, financing, and advisory
services. Prime brokerage allows hedge funds to work with multiple brokers and
manage their cash and securities from a single account. Investment banks benefit by
charging fees for their various services.

Hedge Fund Strategies

Someone once said that you could easily recognize

a hedge fund manager at a bar. He‘s the person
holding a drink with the least transparency and
liquidity!

Jokes apart, hedge funds have received a lot of

bad press in the last few years primarily because of
their secretiveness about their trading strategies.
Also, such funds are not subject to the same regulations as other institutions. Let‘s
take a quick look at some of their strategies and how investment banks help them.

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Short selling and Long Selling

Most people buy shares expecting price to rise in the future. Selling shares that you
own is known as long selling. If the price were to fall and not rise, you would make
a loss if you were to sell.

Short selling is just the opposite of long selling. If you believed that the share price
of a company would fall tomorrow, you could borrow shares from a broker and sell it
in the market today at a higher price. When the price falls, you would buy the shares
again at a lower price and return them to the broker.

Hedge funds often borrow securities from their partner investment banks for short
selling.

Derivatives
Investment bankers offer a range of derivative
products to hedge funds along with futures clearing
and execution services. Hedge funds use
derivatives for hedging against possible market

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risks. For example, hedge funds may buy or sell credit default swaps (CDS), which
protect against possible defaults on a loan.

Arbitrage
Arbitrage refers to taking advantage of
differences in prices of the same
quantity between two or more markets.
Suppose the price of a share of a
company is $10 in one stock exchange
and $11 in another. Here arbitrage
would mean purchasing the cheaper
share and selling it in the other exchange for a profit.

Leverage
Leveraging refers to using somebody
else‘s funds to amplify your earnings.
Investment banks provide equity and
debt financing services to hedge funds
for leveraging. While leveraging has
the power to magnify your gains, it
also substantially increases your risk.

A simple example of leverage would be

buying a house. Say the cost of buying
a house is $100,000. You pay $20,000 in cash and borrow the rest from a bank. In
this case, a bank loan is the leverage, as it makes your $20,000 more productive.
How does it amplify your earnings? The following two cases are possible:
 Suppose the price of the house rises to $110,000. By investing only $20,000,
you earned $10,000—a 50% growth!
 If the value of the house decreases to $90,000, your initial investment of
$20,000 has made a loss of $10,000.

Of course, there is a cost for the leverage. In the above example, it would be the
interest rate paid to the bank.

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Foreign Exchange
If you were travelling out of the
country, you would need the local
currency—to shop or to pay your bills.
After all, most businesses prefer being
paid in their own currency. You would
need to buy foreign currencies or the
U.S. dollar in what is known as the
foreign exchange market (currency
or forex or FX). To know what the FX
market looks like, imagine a huge
network of people across the world connected by telephones and computers.

Participants

The foreign exchange market consists of the following

participants:
 Banks and other financial institutions earn profits by
buying and selling currencies in huge volumes.
 Brokers act as the ‗middlemen‘ between banks. They
usually charge a commission on each transaction.
 Customers are organizations or individuals who require
foreign currency for their own businesses or personal
needs.
 Central banks such as the Reserve Bank of India (RBI) manage the value of
their currencies to avoid disastrous effects of currency fluctuations on their
country‘s economy.

Reasons for Trading

Why do people trade in the foreign exchange

market—the largest and most volatile market in the
world? Let‘s understand with the help of simplified
examples.
 Profit: The fluctuations in exchange rates

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make it profitable for traders who buy currencies in large volumes. For
example, say you bought a pound for $1.25 and sold it for $1.30. If $0.05
seems too less, imagine a transaction of thousands or millions of dollars. The
sheer volumes make forex a highly lucrative but also volatile business.

 Protection: A small fluctuation in the exchange rate can make the difference
between profit and loss for a business. If you were an exporter who earned in
dollars and spent in rupees, the fluctuation in the exchange rates would affect
you. If the dollar became more expensive, you would make more money. But
if the dollar became cheaper, it would reduce your earnings.

 Usage: Businesses and countries need foreign currency to buy goods and
services from other countries. For example, India imports huge quantities of
oil with the help of dollars. A stronger dollar will make oil more expensive,
which can have a negative effect on the economy.

Types of Transactions

Fluctuations in foreign exchange can be costly for

businesses, such as exporters and importers. That
explains the popularity of foreign exchange derivatives.
There are four types of foreign exchange transactions:
 Spot – A spot transaction refers to a two-day
delivery transaction.
 Forward or future – In a forward transaction, both parties agree to
exchange a fixed quantity of currency at a specified time in the future.
Forwards are traded in the over-the-counter market. A future is a type of
forward transaction that is traded on the exchange.
 Swap – In a swap, both parties exchange currencies and agree to reverse the
transaction in the future.
 Option – An option provides its owner with the right but no obligation to
exchange currencies at a predetermined rate in the future.

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Investment Management
Investment management is a term for an array
of services offered by investment banks to
large investors such as institutions or very
wealthy individuals to manage their wealth,
securities, or assets such as real estate. The
services include:
 Providing investment and financial
advisory services
 Ensuring compliance with regulations
 Managing assets for large funds

An example of investment management would be a mutual fund that pools in money

from several small and large investors and invests it in shares, bonds, and other
securities.

Summary
You have completed Chapter 2: Investment Banking Products
and Services

You should be able to:

 List the important types of investment banking services
and products
 Define important investment banking terms
 Describe investment banking products and services and related terms

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CHAPTER 3

Lifecycle of a Trade
Chapter 3: Lifecycle of a Trade

Chapter 3: Lifecycle of a Trade

Chapter Objectives
Welcome to Chapter 3: Lifecycle of a Trade.

At the end of the course, you will be able to:

 List the stages in the lifecycle of a trade
 Describe each stage in the lifecycle of a trade

Introduction

"The market can remain irrational longer than you can remain solvent." - John
Maynard Keynes

What would happen if there was no stock

exchange? You would probably have to
place an ad in the newspaper to buy or sell
a share or a commodity like coffee!

Even after stock exchanges were invented,

trading simply meant shouting out loud in a
crowded chaotic room along with several
other traders. Thankfully, technology has made trading as easy as clicking a mouse
or making a phone call. But what happens behind the scenes is still quite a
complicated process. It involves thousands of people and an astonishing use of
technology.

If you are a beginner in investment banking, this chapter will provide a basic
understanding of the trade lifecycle.

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Trade Definition
What is a trade really? It is the exchange
of a commodity for money or other
commodities. A simple example is buying
fruits. To buy apples, you would go to the
market and pay the vendor. In the
securities market, you would trade in the
stock exchange through a broker. Large
clients typically use the services of investment banks which act as brokers and
execute large orders on their behalf.

Formally speaking, a trade is a legal contract between a buyer and a seller. As per
this contract:
 The seller must provide the commodity that has been sold to the buyer.
 The buyer must pay the purchase price on the date agreed upon by both
parties.

Types of Trade
An investment bank trades in two ways:
 Client trading
 Principal trading

Client trading
Client trades are trades done for a client such as a
hedge fund. Investment banks earn a commission on each transaction. While
representing their clients, investment banks may need to trade and negotiate with
other entities known as counterparties.

Principal trading
Principal or proprietary trading refers to buying and selling of securities for the
investment bank‘s own portfolio. At times, traders have the leeway to buy or sell the
securities they want using the bank‘s capital. Using a variety of strategies and
cutting-edge technology, traders constantly make bets on the market.

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The profit from principal trading stems from buying securities at a low price and
selling at a higher price later. This difference is known as the bid-ask spread.

Trading Risks
In 1995, Barings Bank of London collapsed due to
unauthorized trading by a rogue trader who lost $1.4
billion in derivative contracts. There are several other
cases of rogue trading. The kind of money and stocks
that investment banks handle makes it critical to
prevent any possible errors, human or otherwise.

At every stage of the trade lifecycle, necessary checks

are kept in place. For example, traders are prevented from influencing the
confirmation and settlement processes. Advanced strategies using computer
modeling and well-defined rules are used to eliminate the emotional aspect of
trading.

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Trade Lifecycle Overview

An investment bank consists of a
front office, middle office, and
back office. The front office initiates
the trade by negotiating with all
parties. The middle office calculates
the risks and suggests amendments
to the trade. The back office provides
the operational and technological
support to the entire trade.

The trade lifecycle consists of the

following stages:

 Trade Execution
 Trade Capture
 Confirmation
 Settlement
 Reconciliation
 Accounting

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Trade Execution
When both the buyer and
seller agree to a transaction,
the trade is executed. You
might be surprised to know
that most trades are executed
by a simple verbal agreement
between the client and the
front office of the investment
bank. After a trade is executed,
investment banks typically
hedge the trade to reduce the
risk associated with the trade.
This involves the buying or
selling of derivative contracts to offset any potential loss.

The business day on which the trade is executed on a securities exchange or market
is known as the trade date or simply as T.

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Trade Capture
A trade is captured in the
trading desk using a deal
capture system. The deal
capture system is simply
technology used by the trading
desk to validate and enter deal
information. More details are
added in a process known as
trade enrichment. These
details are important for the
completion and settlement of
the trade.

The middle office checks the basic details of a trade and reports any errors or issues
to the front office. If the front office accepts the request for amendment, it makes
changes in the source system. This ensures that all systems used by the front office
and the back office are updated. An acknowledgement may be sent to the
counterparty with the required trade details for confirmation.

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Confirmation
Confirmation involves sending
an electronic notification to all
the parties with important trade
details and obtaining a written
agreement. The trade details are
then entered into the clearing
systems of both the parties.

Most of the times, there is no

problem. However, sometimes
the details provided by both the
firms don‘t match. In such cases,
the system may report a
discrepancy to both parties so that they can rectify it.

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Settlement
In the securities market, if you
buy a share today, you do not
get actual possession on the
same day. Blame it on the
complex regulations and
procedures that govern this
market. Settlement essentially
refers to ensuring that the seller
has received payment and the
buyer the security or the
commodity. The time required
for buyer to pay and for the
seller to deliver the purchased
goods is known as settlement cycle.

This cycle differs from instrument to instrument. For example, it is usually three days
after the trade is executed or T + 3 for equity instruments.

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Reconciliation
The main objective of
reconciliation is to spot any
discrepancies in the trade—
either manually or with the help
of automated tools. For example,
cash reconciliation involves
checking if the flow of cash
occurs as predicted by the
trader.

Reconciliation also involves

reporting any open trades or
transaction differences between
systems.

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Accounting
After a trade has been
successfully executed, the details
of the transaction are recorded.
Why is this important? Trade
accounting helps the investment
bank determine the profit or loss
on each transaction. Also, due to
government regulations, firms
have to report several aspects of
the trade. Traders require a daily
profit and loss report so that
they can trade from the most
accurate position.

The sheer complexity and volume of transactions make trade accounting a

challenging job. Moreover, investment banks have to adhere to strict accounting
standards.

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Summary of Trade Cycle

Here‘s a quick summary of the trade lifecycle:
 After negotiating with the client, the front
office executes the trade.
 Trade capture involves entering the
transaction details in a computer system.
 Confirmation involves sending
electronically generated transaction details
to both parties of a deal. These details are
checked for any discrepancies.
 Settlement involves the actual exchange of cash for the purchased securities.
 Reconciliation involves checking the process to see if the transaction was
completed correctly.
 Accounting involves recording all the transaction details as per accounting
standards and calculating the profit and loss on the deal.

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Chapter Summary

You have completed Chapter 3: Lifecycle of a Trade

You should be able to:

 list the important stages in the lifecycle of a trade
 describe each stages in the lifecycle of a trade

Course Summary

You have completed Introduction to Investment Banking.

You should be able to:

 Define investment banking
 Describe investment banking products and services
 List the stages in the lifecycle of a trade

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