Investment Banking

Knowledge Bank

Designed and Developed by: Finance Learning and Development Team (FLAD)

Table of Contents

Introduction to Investment Banking ....................................................................... 4

Introduction ..................................................................................................................... 4 Role of Investment Bank ................................................................................................. 4
Role of Investment Banking Capital Providers............................................................................. 4 Role of Investment Banking Capital Users .................................................................................. 5

Investment Bank and its Services .................................................................................. 5

Investment Banking ......................................................................................................................... 5 Securities......................................................................................................................................... 8 Institutional Investment Management ............................................................................................. 9 Research ......................................................................................................................................... 9

Typical Investment Bank Structure .............................................................................. 10

Principal Transaction ..................................................................................................................... 10 Agency Transaction ...................................................................................................................... 10

Investment Bank Operating Structure ......................................................................... 11 Key Products ................................................................................................................. 11

Capital and Capital Markets .................................................................................. 12

Introduction to Capital Market ...................................................................................... 12
Stock Market ................................................................................................................................. 12 Bond Market .................................................................................................................................. 13

Market Scenario in Capital Market ............................................................................... 13 Market Participants ....................................................................................................... 14

Market Participants Individual Investors .................................................................................... 14 Market Participants Institutional Investors ................................................................................. 15 Market Participants Issuer.......................................................................................................... 17 Market Participants Custodian ................................................................................................... 17 Market Participants Securities Trading Organization (STO) ...................................................... 18 Market Participants Regulators .................................................................................................. 18

Market & Stock Exchange ............................................................................................. 19

Introduction to Derivative Market ......................................................................... 20

Introduction ................................................................................................................... 20 Major Players in Derivative Market ............................................................................... 21 Major Participants In Derivatives Market ..................................................................... 21 Trading Underlying Vs Trading Stock Futures ............................................................ 21
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Exchange Traded Vs OTC Derivatives Market ............................................................. 22

Features of OTC compared to ET Derivatives .............................................................................. 22

Derivative Spread .......................................................................................................... 23

Forwards ....................................................................................................................................... 23 Futures .......................................................................................................................................... 23 Options .......................................................................................................................................... 23 Warrants ........................................................................................................................................ 23 Swaps ............................................................................................................................................ 23 Swaptions ...................................................................................................................................... 23

Equity Derivatives Market ............................................................................................. 24

Future and Option Market Instruments ......................................................................................... 24 Contract Specifications for Index Futures ..................................................................................... 24 Trading Mechanism ....................................................................................................................... 25 Forward Contracts ......................................................................................................................... 25 Futures .......................................................................................................................................... 26 Options .......................................................................................................................................... 26

Payoff for Futures and Options .................................................................................... 26

Payoff for Futures .......................................................................................................................... 26 Payoff of Options ........................................................................................................................... 28

Applications of F&O ...................................................................................................... 30

Applications of Futures .................................................................................................................. 30 Application of Options ................................................................................................................... 30

Overview of Nomura Finance Processes ............................................................. 31

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Introduction to Investment Banking

Introduction
An investment bank is a financial institution that assists individuals, corporations and governments in raising capital by underwriting and/or acting as the client's agent in the issuance of securities.

Role of Investment Bank

Investment banks provide four primary types of services: raising capital, advising in mergers and acquisitions, executing securities sales and trading, and performing general advisory services. Most of the major Wall Street firms are active in each of these categories. Smaller investment banks may specialize in two or three of these categories.

Role of Investment Banking Capital Providers

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Role of Investment Banking Capital Users

Investment Bank and its Services

1. 2. 3. 4. Investment banking Securities Institutional Investment Management Research

Investment Banking

Underwriting

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Securities Underwriting In securities underwriting the investment banker raise capital for corporations through the structuring and sale of securities such as bonds and stocks. Municipal finance is securities underwriting (strictly bonds) on behalf of government entities such as states, counties, municipalities and public authorities. This is a way of selling a newly issued security, such as stocks or bonds, to investors. A syndicate of banks (the lead-managers) underwrites the transaction, which means they have taken on the risk of distributing the securities. Should they not be able to find enough investors, they will have to hold some securities themselves.

Merger and Acquisitions Mergers A merger refers to a combination of two or more companies, usually of not greatly disparate size, into one company. Horizontal merger - Two companies that are in direct competition and share the same product lines and markets. Vertical merger - A customer and company or a supplier and company. Think of a cone supplier merging with an ice cream maker. Market - extension merger - Two companies that sell the same products in different markets. Product - extension merger - Two companies selling different but related products in the same market. Conglomeration - Two companies that have no common business areas.

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Acquisitions An action in which a company buys most, if not all, of the target company's ownership stakes in order to assume control of the target firm. Acquisitions are often paid in cash, the acquiring company's stock or a combination of both. Acquisition can be: Congenial Hostile Reverse Take Over (RTO) Private Company becomes public without IPO.

Difference between Merger and Acquisition Though the two words mergers and acquisitions are often spoken in the same breath and are also used in such a way as if they are synonymous, however, there are certain differences between mergers and acquisitions Merger Acquisition

The case when two companies (often of same The case when one company takes size) decide to move forward as a single new over another and establishes itself as company instead of operating business separately. the new owner of the business. The buyer company swallows the The stocks of both the companies are surrendered, business of the target company, which while new stocks are issued afresh. ceases to exist. For example, Glaxo Wellcome and SmithKline Dr. Reddy's Labs acquired Betapharm Beehcam ceased to exist and merged to become a through an agreement amounting $597 new company, known as Glaxo SmithKline. million.

Role of Investment Banks in Merger and Acquisitions Identify potential investors for the client Gain attention of these investors Pitch Book. Reviews financial statements of the target companies/industries

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Securitized Products

Securitization is the financial practice of pooling various types of contractual debt such as residential mortgages, commercial mortgages, auto loans or credit card debt obligations and selling said debt as bonds, pass-through securities, or Collateralized mortgage obligation (CMOs), to various investors. The principal and interest on the debt, underlying the security, is paid back to the various investors regularly. Securities backed by mortgage receivables are called mortgage-backed securities (MBS), while those backed by other types of receivables are asset-backed securities (ABS). The granularity of pools of securitized assets is a mitigant to the credit risk of individual borrowers. Unlike general corporate debt, the credit quality of securitised debt is nonstationary due to changes in volatility that are time- and structure-dependent. If the transaction is properly structured and the pool performs as expected, the credit risk of all tranches of structured debt improves; if improperly structured, the affected tranches may experience dramatic credit deterioration and loss.

Securities
Custody and Clearance Investment bank provides timely, consistent and accurate information of trades to the participants for efficient clearing It can support custody of a variety of assetsincluding equity, fixed-income and foreign exchange products, as well as options, swaps, warrants, futures and other derivatives

It integrates the entire trade cycle, preventing the inconsistencies arising due to dealing with different market practices, accounting standards and time zones

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Lending and Financing It is a service provided by investment banks to large investors who can allow the investment bank to lend out their shares to other people. This is often done to investors of all sizes who have pledged their shares to borrow money to buy more shares, but large investors like pension funds often choose to do this to their unpledged shares because they will receive interest income. In these types of agreements, the investor still receives any dividends as normal, the only thing they cannot generally do is to vote their shares.

Institutional Investment Management Investment Banks Asset Management (funds)

Institutional and Retail Investors

Equity and Fixed Income Funds

Hedge Funds

Research
Conducting research of different industries by looking at economy, interest rates and company data Providing analysis and rating of securities such as hold, add and reduce to various clients

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Typical Investment Bank Structure

Investment banks through their various business divisions with the help of support & control divisions provide their clients an array of services and generate revenues for themselves through the revenue lines.

Principal Transaction
A transaction in which the counterparty acts as a principal, i.e., carries some or all of the risk associated with the change in the instrument value Example: Client : I want to buy 1,000,000 shares of Reliance at the price of X Principal : Agrees to the price with client Client : Receives share at the price Principal : May transfer his / her own shares to the client, or buy them in the market, therefore carrying the risk executing the transaction at a price different from X

Agency Transaction
A transaction in which the executing brokerage firm acts as an agent and usually charges a commission for its services Example: Client : Buy 100 shares of Reliance at the current market price Agent : Executes trade in the market Client : Does not know exact price he will receive (depends on timing) Agent : Receives commission (~ 0.25 - 0.5 % of the total value of the purchase)

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Investment Bank Operating Structure

Key Products

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Capital and Capital Markets

Introduction to Capital Market

Capital market is a market for securities (debt or equity), where business enterprises (companies) and governments can raise long-term funds. It is defined as a market in which money is provided for periods longer than a year, as the raising of short-term funds takes place on other markets (e.g., the money market). The capital market includes the stock market (equity securities) and the bond market (debt). Financial regulators, such as the UK's Financial Services Authority (FSA) or the U.S. Securities and Exchange Commission (SEC), oversee the capital markets in their designated jurisdictions to ensure that investors are protected against fraud, among other duties. The capital markets consist of the primary market, where newly issued securities are distributed to investors, and the secondary market, where existing securities are traded. The capital market includes: Stock market Bond market

Stock Market
A stock market or equity market is a public entity (a loose network of economic transactions, not a physical facility or discrete entity) for the trading of company stock (shares) and derivatives at an agreed price; these are securities listed on a stock exchange as well as those only traded privately. The stocks are listed and traded on stock exchanges which are entities of a corporation or mutual organization specialized in the business of bringing buyers and sellers of the organizations to a listing of stocks and securities together.

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Bond Market
The bond market (also known as the credit, or fixed income market) is a financial market where participants buy and sell debt securities, usually in the form of bonds. Bond market takes place between broker-dealers and large institutions in a decentralized, over-the-counter (OTC) market. However, a small number of bonds, primarily corporate, are listed on exchanges.

Market Scenario in Capital Market

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Market Participants
1. 2. 3. 4. 5. Investors: Issuers Custodians Security Trading Organizations Regulators

Market Participants Individual Investors

Individuals who invest in securities for their personal gain, their focus being capital growth through an increase in the market value of their investment or regular income through the receipt of dividends on shares Individual Investors visit the marketplace via agents through whom the buying & selling of securities is effected To buy or sell securities, an individual usually places a request with an agent commonly known as an order

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Market Participants Institutional Investors

The term Institutional Investor or Institutional client are collective terms used to describe companies that visit the securities marketplace and invest in securities Institutional Investors place orders with an agent or they may also access markets directly The type of organization that constitutes an Institutional Investor includes companies in the capacity of: Mutual Fund Managers Pension Funds Insurance Companies Hedge Funds

Institutional Investors Mutual Funds

An investment vehicle that is made up of a pool of funds collected from many investors for the purpose of investing in securities such as stocks, bonds, money market instruments and similar assets Mutual funds are operated by money / fund managers, who invest the fund's capital and attempt to produce capital gains and income for the fund's investors A mutual fund's portfolio is structured and maintained to match the investment objectives stated in its prospectus Examples of Money Managers : Fidelity, Reliance MF, HDFC MF

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Institutional Investors Hedge Funds An aggressively managed portfolio of investments that uses advanced investment strategies in both domestic and international markets with the goal of generating high returns (either in an absolute sense or over a specified market benchmark) Legally, hedge funds are most often set up as private investment partnerships that are open to a limited number of investors and require a very large initial minimum investment Investments in hedge funds are illiquid as they often require investors keep their money in the fund for at least one year Examples : Julius Baer, Marble Bar Asset Management Institutional Investors Pension Funds

A pension fund is a pool of assets forming an independent legal entity that are bought with the contributions to a pension plan for the exclusive purpose of financing pension plan benefits Example : AMP, State Pension Funds

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Market Participants Issuer

Organizations who need to raise capital can use the capital market by: Selling part ownership issuing shares or equity Borrowing cash from investors issuing debt in the form of bonds There are many reasons why capital is needed, for example: Geographical Expansion, Business Expansion, Infrastructure Investments, Acquisitions, etc

Type of Issuer Corporations Sovereign Entities Local Governments Government Agencies Supranational Organisations

Example Vodafone (UK) Kingdom of Denmark City of London Federal National Mortgage Association International Bank for Reconstruction & Development (World Bank IBRD)

Market Participants Custodian

Custodian An organization that holds securities and cash on its clients behalf and may affect settlement of trades With much of todays securities trading being executed in securities originating overseas, the services offered by custodians are used to provide greater efficiency and less risk in relation to trade settlement and the holding of securities in safe custody on behalf of the owner When securities are bought or sold, it is normal for institutional clients, agents and investors to utilize the services of their specific custodian in the financial centre relating to the traded market makers Custodians are also referred as local agents, depots and nostros Examples : JP Morgan, Mellon Bank, State Street Bank

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Market Participants Securities Trading Organization (STO)

The term securities trading organization is a collective term that describes those who reside within the securities marketplace, namely traders and market makers who sell securities to or buy securities from : o Agents acting on behalf of individuals or institutional investors o Individuals (usually of high net worth) and institutional investors who have opted not to use an agent Traders execute orders on the exchange, typically in the equity markets Market maker acts in similar fashion as trader. The fundamental difference between trader and market maker being that trader may or may not trade at the price counterparty wishes to trade, where as market maker publicizes the prices (bid price and offer price) at which he is prepared specific securities typically via computer screens Investment Banks act as traders or market makers depending on the security and the type of activity they engage in on behalf of the client

Market Participants Regulators

Regulators are usually the agencies established by central governments for the control of or intervention in the operation of markets, according to public interest principles Sanctions available to economic regulators are often considerable, ranging from the power to admonish and accept undertakings from delinquent market participants to correct their behaviour, up to the ability to impose fines (often very large) and to initiate criminal proceedings against companies and their officers Examples : Americas SEC Services and Exchange Commission, Europe FSA Financial services Authority, India SEBI Securities and Exchange Board of India

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Market & Stock Exchange

A Market is an environment in which securities are bought and sold. Central to the stock market is the Stock Exchange Trades executed over an Exchange are executed On-Exchange or Exchange Traded Other trades executed between the parties directly , not via an Exchange, are OTC (Over the Counter) or Non-Exchange Traded Each securities market has an associated and recognizable place to effect settlement E.g. French Government Bonds traded on the Paris Bourse settle in Euroclear

Region Europe

Country UK

Financial Centre London

Asia Pacific

Germany Spain China China Japan

Frankfurt Madrid Hong Kong Shenzhen Shanghai Tokyo

Singapore

Singapore

America

Australia India USA

Sydney Mumbai New York Chicago

Stock Exchange London Stock Exchange (LSE) London International Financial Futures & Option Exchange (LIFFE) Deutsche Bourse Bolsa de Madrid Stock Exchange of Hong Kong Hong Kong Futures Exchange Shenzhen Stock Exchange Shanghai Stock Exchange Tokyo Stock Exchange Tokyo International Financial Futures Exchange (TIFFE) Stock Exchange of Singapore Singapore International Monetary Exchange (SIMEX) Australian Stock Exchange (ASX) Bombay Stock Exchange New York Stock Exchange (NYSE) Chicago Stock Exchange

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Introduction to Derivative Market

Introduction
A derivative instrument is a contract between two parties that specifies conditionsin particular, dates and the resulting values of the underlying variablesunder which payments, or payoffs, are to be made between the parties. Derivatives can be used for speculating purposes ("bets") or to hedge ("insurance").

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Major Players in Derivative Market

Clients Agents/Brokers Exchange

Major Participants In Derivatives Market

Hedgers Speculators Arbitrageurs

Trading Underlying Vs Trading Stock Futures

Buying security involves putting all money in front. And hence becomes a part owner of the company To trade futures, a customer must open a futures trading account with a derivative broker Buying future means putting in margin money With a purchase of future, holder essential makes a legally binding promise or an obligation to buy the security at some point in the future It doesnt represent ownership

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Exchange Traded Vs OTC Derivatives Market

Derivatives that are traded on the Exchange are called Exchange Traded Derivatives whereas privately negotiated derivative contracts are called OTC contracts. Some features of OTC derivatives: The bilateral forward transactions of the OTC market allow a high degree of customization Information Asymmetries The high concentration of OTC derivatives activities in major institutions

Features of OTC compared to ET Derivatives

The management of counterparty (credit) risk is decentralized and located within individual institutions There are no formal centralized limits on individual positions, leverage or margining There are no formal rules for risk and burden-sharing There are no formal rules or mechanisms for ensuring market stability and integrity The OTC contracts are generally not regulated by a regulatory organization, although they are affected indirectly by national legal systems, banking supervision and market surveillance.

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Derivative Spread

FORWARDS

SWAPTIONS

FUTURES

Derivatives

WARRANTS

OPTIONS

SWAPS

Forwards
Customised contract between two entities Settlement takes place at a future date

Futures
Its an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price Its exchange traded contract

Options
Call and Put are the two types of Options Call gives the buyer the right but not the obligation to buy Put gives the buyer the right but not the obligation to sell

Warrants
Longer dated options are called Warrants Generally traded Over the Counter

Swaps
Its a private agreement between two parties to exchange cash flows in the future according to pre arranged formula Two commonly known Swaps are Interest Rate Swaps and Currency Swaps

Swaptions
Swaptions are options to Buy or Sell a Swap The Swaptions market has receiver swaptions and payer swaptions

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Equity Derivatives Market

Future and Option Market Instruments

Index Based futures Index Based Options Individual stock Options Individual stock futures

Contract Specifications for Index Futures

Future contracts having one-month, two month, three-month expiry cycles All contracts expiry on the last Thursday of every month in NSE and 2nd Friday at TSE

NSEs index options market, contracts at different strikes having one-month, two month, three-month expiry cycles o o Each with minimum seven price available for trading Hence at a given point of time there are minimum 42(3*7*2) options product available

TOPIX Options market contracts at different strikes having three-month, four month, five month expiry cycle The strike prices depends on the contract cycle-13(more than four months trading period),19 (with four months trading period)

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Settlement Basis: Mark to market and final settlement will be cash settled on T+1 basis. Settlement Price: Daily settlement price will be the closing price of the futures contracts for the trading day and the final settlement price shall be the closing value of the underlying index on the last trading day.

Trading Mechanism
The futures and options trading system of the respective exchange Generally provides fully automated screenbased trading for equity futures & options Online monitoring and surveillance mechanism Support order- driven market , provides complete transparency of trading operations, operate on strict price-time priority basis

Forward Contracts
Salient features of Forward Contracts: They are bilateral contracts and hence exposed to counter party risk Each contract is custom designed and hence is unique in terms of Contract size, expiry date and asset type and quality The contract price is generally not available in public domain On expiry, contract has to be settled by delivery of the asset If the party wishes to reverse the contract it has to be compulsorily go to the same counterparty, which often results in high prices being charged

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Futures
Its an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. Its an exchange traded contract. The standardized items in a future contract are: Quantity of the underlying Quality of underlying The date and the month of delivery The unit of price quotation and minimum price change Location of settlement

Options
Options are derivative instruments where one party has a right to buy/sell the underlying while the other party has an obligation to buy/sell The person with the right is called the buyer of the option. The person with the obligation is called the writer of the option

Types of Options Based on the right: Call option Put option

Payoff for Futures and Options

Payoff for Futures

Payoff for buyer of futures: Long Futures Payoff for seller of futures: Short futures
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Payoff for long TOPIX at 3000

Payoff for short TOPIX at 3000

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Payoff of Options
Non-linear payoffs Losses for the buyer are limited and profits are unlimited For the writer the payoff is exactly opposite Pricing of Options Price of option is called premium Theoretical value of premium can be calculated by option calculator on our site Market price, however, will be dependent on demand supply scenario Payoff for buyer of call option

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Payoff for Seller of Call Option

Payoff for Buyer of Put Option

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Payoff for the Writer of Put Option

Applications of F&O

Applications of Futures
Hedging: Long security , Sell futures Speculation: Bullish security , Buy futures Speculation: Bearish security , Sell futures Arbitrage: Overpriced futures : Buy spot , Sell futures Arbitrage: Underpriced futures : Buy futures, Sell spot

Application of Options
Hedging: Buying stock - Buy Put Speculation: Bullish security - Buy Call or Sell Put Speculation: Bearish security - Sell call or Buy Put

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Overview of Nomura Finance Processes

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*****************************************Thank You***************************************************

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