Investment Banking WBL – Flashcards

The original and primary function of investment banking is the raising of funds, both in the form of debt and as equity. Governments and companies hire banks to help them issue debt (usually as either bonds or loans) or equity (shares) to investors. The bank assists in structuring the issue, finding potential investors, and, usually by itself or with other banks, underwriting or guaranteeing the issue. Banks also help advice companies on other major corporate financial transactions, including mergers with and acquisitions of other companies. During recent years, investment banks were seen to be taking on more risk exposure. This was due partly to the markets becoming more complex, with a menu of financial structures available. However, the primary reason for the increased assumption of risk was the increased revenue-generating potential. Many investment banks were also perceived as buying companies and investments that were indirectly related to the banking industry; for example, Goldman Sachs acquired a series of electric power plants. Following the credit and liquidity crises of 2007 through 2009, investment banking activity is now typically a part of organizations with wider banking activities. Some, such as Goldman Sachs, are more specialized with investment banking and asset management activity as key lines of business. Most others, such as UBS and Citigroup, are banks with investment banking divisions, but they also provide other types of banking services, including retail banking and asset management. Generally, banks will seek to identify and build upon potential synergies between their different banking divisions. The leading providers of investment banking services include Goldman Sachs, Morgan Stanley, and JPMorgan Chase, in the United States. In Europe UBS, Credit Suisse, Deutsche Bank, BNP Paribas, and Societe Generale are significant providers of investment banking services.

Retail Banking vs. Investment Banking Retail banks and other types of retail banking institutions cater to the needs of the individual consumer and small- and middle-market businesses. Retail banks and banking institutions can take a number of different legal forms, including commercial, savings banks and cooperatives, building societies, credit unions, and captive nonfinancial. Although investment banks' primary focus is on activity with other banks and major corporations, products can be structured that eventually might be sold in the retail market (for example, equities, bonds, or certificates), through their retail banking activities.

Commercial/Corporate Banking vs. Investment Banking Commercial/corporate banking relates to banking services provided to any type of business or company. The range and complexity of services offered by corporate banks increase or decrease based on the size of the client being served. Common commercial/corporate banking products include finance products, transaction-based products, and advisory products such as insurance and wealth management. The distinction between commercial/corporate banking and investment banking can be vague, often because the same institutions providing corporate banking services also will have an investment banking arm (such as Barclays and its investment bank BarCap).

Private Banking vs. Investment Banking Private banking exists to provide the highest-quality services and products to individuals and families often referred to as high net-worth individuals (HNWIs). The offerings of a private bank provide clients with a combination of the products and services offered by a typical retail bank with upscale investment services. Exclusivity and a commitment to outstanding service are hallmarks of private banking institutions. Major private banking products include investment management products; structured products, such as premium and equity-linked products; alternative investments; investment funds; precious metals and commodities; and financial planning. Investment banks usually will generate the products, such as equity-linked notes, that then are sold by the private banks to HNWIs.

Includes institutional client flow activities, prime brokerage, research, securitization, and secondary-trading and financing activities in fixed income and equity products. These products include a wide range of cash, derivative, secured financing, and structured instruments and investments. Global finance serves capital-raising needs through underwriting, private placements, leveraged finance, and other activities associated with debt and equity products.

Includes advisory services, global finance activities serving corporate and government clients, and activity related to mergers and acquisitions (M&A). The business line often is organized into global industry groups — communications, consumer/retailing, financial institutions, financial sponsors, health care, hedge funds, industrial, insurance solutions, media, natural resources, pension solutions, power, real estate, and technology — that include bankers who deliver industry knowledge and expertise to meet clients' objectives. Specialized product groups within advisory services include M&A and restructuring.

Includes asset management and private investment management. Asset management generates fee-based revenues from customized investment management services, as well as fees from mutual funds and other small- and middle-market institutional investors. Asset management also generates management and incentive fees from the bank's role as general partner for private equity and other alternative investment partnerships. Private investment management provides comprehensive investment, wealth advisory, and capital markets execution services to high-net-worth and institutional clients.

Due to the diversity of its activities, there is no one standard model as to how investment banking is structured. However, broadly, investment banking can be examined within three areas: --Front office: executing the business --Middle office: verifying and managing the business --Back office: accounting for the business This basic front-middle-back office split is the most meaningful breakdown of the structure of investment banking. Keep in mind, several service departments go across these organizational divides, such as IT, HR, and risk management. There are also business streams, particularly fee-based business, which do not fully use all the different functions listed. It also should be noted that the split between these categories may differ among banks for historical and cultural reasons.

The front office of investment banking comprises sales, traders, and trade support. --Sales: Receives inquiries or orders from customers and passes them to the trader for execution; Maintains the relationship with the customers; ovides a point of contact if any problems with any particular customers arise; ovides business development and engages new customers --Traders: Executes customer trade orders and/or trades for the bank's own positions Governed by trading limits established for individual traders and monitored by risk management office of the bank; trading limits include limits by product, portfolio, position, and various other factors Required to enter all trades in an electronic trade blotter --Trade Support: Provides administrative support to the traders; for example, entering the trade details into the system and helping resolve disputes

The definition of what is within the middle office as opposed to the back office differs from bank to bank; however, the middle office typically performs trade operations/constituent management and risk management. Let's begin by examining the operations management aspect of the middle office. Operations are responsible for the verification of trades and then the management of the constituents of a trade through its life. Click each graphic below to learn about the main functions of the middle office. Mid office performs Reconciliations, confirmations and settlements The bank's middle office is responsible for monitoring the bank's risk exposure, including setting limits and authorizing new trades and valuation models.

The back office of an investment bank generally includes the accounting, finance, compliance, and auditing functions of the bank. --Product control:provides the link between trade execution/management and trade accounting. It irresponsible for generating and checking the trading-related data before it is put through the financial statement close process (FSCP). --Finance:is responsible for producing the management and financial accounts. Some Finance staff members will sit in the middle office to provide management information to front-office staff. However, the majority sits within the back office, and their responsibilities include: --Compliance:has the responsibility for oversight of the entity's compliance to the rules set by the regulator, such as FSA (UK) and FINRA (United States). --Internal audit: provides an independent, professional service to review, monitor, assess, and report on the effectiveness of internal controls in place for the safeguarding of assets against loss from unauthorized use or disposition

A bank uses the front-middle-back office structure to ensure segregation of duties. The basic control principle within a bank is that an action is reviewed by an individual who is independent of the person performing that action. (Click here for an example of this action/review process flow.) Segregation also will exist within departments, especially with regard to cash movements. Many of the worst frauds suffered by banks occurred when this segregation of duties was not in place. Even with such segregation of duties, there is one major fraud potential that cannot be mitigated directly: the bonus culture for front and middle office. Salaries and, historically bonuses, have been relatively high in banks, and their level is directly linked to the performance of the bank. There is, therefore, an inherent risk that staff members will make up profits or hide losses, since this has a direct impact on how much they are paid. Therefore, as well as good segregation of duties, it is important that the back-office functions such as internal audit, risk management, and compliance have strong profiles within the bank and that there is an effective management structure overlaying the front-middle-back office structure outlined above

Traditionally, the primary revenue streams and sources for investment banking activities are fee-based and commission-based business services, principal transactions (margin and/or trading revenues), and interest-based products. In recent years, the revenue streams have become more diverse, with banks taking on more risk and a wider investment base. For example, Goldman Sachs now manages one of the world's largest hedge funds and also has a range of investments in other banks (such as in emerging markets like China) and industrial investments (through private equity structures). In addition, the geographical spread of revenue streams also has grown. Many of the major US banks now earn a significant part of their investment banking-related revenue from outside the United States. This trend reflects the growing global nature of the capital markets and the growth in emerging market economies and wealth, especially in Asia, the Middle East, and BRIC (Brazil/Russia/India/China).

Investment banking revenues represent fees and commissions received for underwriting public and private offerings of fixed income and equity securities, fees, other revenues associated with advising clients on M&A activities, and other corporate financing activities. Often investment banks are hired to raise capital on debt and equity markets or provide services related to M&A. You will learn about specific examples of these in the next lesson. Fees can be fixed but are usually contingent on the deal succeeding or completing (for example, the debt issue being launched). However, normally, banks also will add other services, such as providing hedging or finance, through which they earn revenue. Banks can work alone in providing these services but usually, and especially for the large deals, will work in syndicates with other banks. When raising capital on debt or equity, the bank has to create a market (for instance, the bank buys shares from the client and then sells shares to the bank's customer base, with the risk that the bank will be unable to sell all shares). Typically, if the bank has failed to sell all of the shares or debt, it is likely that customers think the security is overpriced or too risky, and therefore, the bank is left with assets that it must write down to current market prices. In addition, there is the reputational risk of a bank being involved in an issue or M&A deal that does not succeed. League tables are produced by financial information providers that rank banks according to deal volume for each type of fee-based business. Within the industry, these are important and there are strong reputational and future revenue benefits from being near or at the top of the league tables.

Commissions primarily include fees charged to customers from executing and clearing client transactions on stocks, options, and futures markets worldwide. Commission revenues are highly volume-sensitive and fluctuate based on the number of shares that the bank is executing on behalf of its customers. Being a low-risk activity for the bank, commission revenues are fairly benign to market movements and are more sensitive to trading activity, as commissions are charged on both the buy and sell side, through both good and bad times. The bank's strategy is to grow its customer base and thereby further create opportunities to generate fees. Often, a key contributor to success in expanding commission fees is efficiency in IT systems that speed up transaction times.

The fee- and commission-based business described thus far indirectly involves banks trading in the capital markets (though trades usually occur in association with this business). In effect, in fee- and commission-based business, the bank acts as an agent. Banks will trade in securities and derivatives (such as becoming the principal in a transaction) either because their client has asked them to (market making) or because they want to make favor of expected market changes (proprietary). By trading as a principal rather than an agent, the bank will be exposed to market risk, meaning the market moves for or against them. Principal transaction activity can be divided further into flow business (simple trades) and structured business (more complex trades). As was highlighted in the introduction, market-making is when a bank is providing a market to a client; for instance, the client wants to do a trade (such as a hedging risk) and the bank provides that client someone to trade with. The bank usually will then enter into an equivalent transaction with another counterparty to offset the risk (called going "back-to-back"). For a structured trade, this offset might need to be done on an individual risk basis because the original trade is so complicated and bespoke to the original counterparty. Market-making becomes risky in illiquid markets (where there is little activity), because a bank may be unable to offset the risk or only do so at additional risk.

When providing market-making services, the bank does not charge a fee or concession, but rather charges a "mark-up." In dealings, the bank provides a "bid" and "ask" quote. The bid is what the bank is willing to pay to buy a bond; the ask is what it requires in order to sell a bond. The difference between the bid and the ask is called the "spread" or mark-up. The bank earns revenue for trading with its investor customers by means of the spread, or difference, between the price at which the dealer buys a bond from one investor — the bid price — and the price at which he or she sells the same bond to another investor — the bid or "offer" price. The bid/offer spread represents the total transaction cost associated with transferring a bond from one investor to another. The spread will be wider for more risky products or due to illiquidity of the market.

Proprietary trading is when the bank will deliberately take on risk in the markets; in other words, it is betting its own money. Sometimes this is achieved by not offsetting the risk from a market-making trade or by doing a new trade based on the bank's view of how the markets will perform. As with any bet, there is the potential to lose money if the market behaves differently from how it is expected to behave. Most proprietary trading takes the form of directional bets (that the market will go up or down) or quantitative bets (betting that one market factor will move differently from another market factor). When a bank performs proprietary trading, the bank's traders will be actively trading stocks, bonds, options, commodities, or other items with its own money instead of its customers' money, making a profit for itself as opposed to earning a spread

Flow trading involves simple or "vanilla" products, such as cash products like bonds or shares, or simple derivatives, such as swaps. The margin for this business is small; therefore, being efficient, minimizing costs, and generating as much volume as possible are keys to success.

Structured trading occurs in more complex or "exotic" derivatives. They are exotic either because they are more complex and less standard, or the underlying asset is exotic (such as weather derivatives). These transactions occur less frequently because they take more time to structure and will be more specific to individual clients' needs. Margins will be much higher than with the flow trading. The key to success is to be innovative in the market, structure the trade so it exactly meets the client's requirements but minimizes the residual risk to the bank, and to ensure that all the legal documentation is completed and accurate. Successful structured trade types eventually will be copied by other banks, thereby reducing margins. If the trade type becomes popular and standardized, then it might become a flow-trading product (for example, credit default swaps).

Interest and dividend revenue and interest expense are functions of the level and mix of total assets and liabilities (primarily financial instruments owned and sold but not yet purchased, and collateralized borrowing and lending activities), the prevailing level of interest rates, and the term structure of the financings. Interest and dividend revenue and interest expense are integral components of our evaluation of the bank's overall capital markets activities. Keep in mind that every asset on the asset side of the balance sheet creates a revenue stream, while those on the liability side create interest expense. The more effectively the bank increases interest and dividend revenue while lessening its cost of funds, the more profitable the bank will be. Interest-based revenue is a key component in the overall revenue of a bank.

M&A is one of the core investment banking functions, advising client companies on whether to: Add businesses to their portfolio of assets Sell divisions or subsidiaries they no longer want to own Merge themselves entirely with another company, either by acquiring the target firm or selling themselves to it As a result, it would be more accurate to talk about mergers, acquisitions, and divestitures, since there are clearly two sides to every deal, and M&A advisors are employed on both sides of a transaction. In some mergers, the two companies involved join as equals. In other cases, M&A bankers help their clients find buyers or sellers for businesses that are of interest. In addition, companies are increasingly being taken private in buyouts by private equity firms. Traditionally, M&A bankers advise clients on all aspects of buying, selling, and merging with other companies. They're typically part of a broader corporate finance advisory team, which also advises firms on how to raise the money needed to finance a transaction. Among large banks, a recent trend in financial sponsor/private equity transactions is for a separate unit (usually an investment fund) to participate directly in the deal alongside the client. Mergers and acquisitions is principally an advisory role for the investment bank. When public companies announce they're "exploring strategic opportunities," this typically indicates that they have hired a bank to advise them on a merger or acquisition.

Primary equity issues are originated and traded by the equity capital markets (ECM) division of a bank. Likewise, debt issuances are originated and traded by the debt capital markets (DCM) division of a bank. The ECM division of a bank will help clients structure, buy, and sell primary equity (this includes private placements as well as organized markets and exchanges). For equity, this may be in the form of capital it needs through the shares' initial public offering (IPO) or rights issue (a secondary public offering). For debt, the bank's DCM division may act as the underwriter to create bonds and bring them to market. Capital markets divisions also issue more complex products, such as equity-linked securities — or bonds that can be converted into equities at a pre-arranged price — and derivatives.. Banks act as "underwriters" on behalf of the company issuing equity. They assume the risk of issuing the equity or debt and do the work necessary to bring it to market, in return for a fee known as the underwriting spread. Direct responsibilities in an underwriting include registering the new securities with the exchange regulator — such as the Securities and Exchange Commission (SEC) in the United States — setting the offering price, possibly forming and managing a syndicate to help sell the new securities, and to peg the price of the new issue by buying in the open market, if necessary. The underwriting firm frequently becomes a market maker in the new security by keeping an inventory and providing a firm bid and offer price. This provides liquidity via a secondary market, which allows investors to buy or sell the new securities after the primary sale.

Prime brokerage is the name given to the package of services that investment banks offer to hedge funds. A hedge fund is a private investment fund that charges an administration fee (normally 1 to 2 percent of assets) and a performance fee (generally 20 percent and higher), and typically is open to only a very limited range of qualified investors. In the United States, hedge funds are open to accredited investors only. Because of this restriction, they usually are exempt from any direct regulation by the SEC, FINRA, and other regulatory bodies. In most countries, hedge funds are prohibited from marketing to non-accredited investors, unlike regulated retail investment funds such as mutual funds and pension funds. Since hedge funds are essentially a private pool of managed assets, and since their public access is commonly restricted by the government, they have little or no incentive to release their private information to the public. The prime broker provides a centralized securities clearing facility for the hedge fund, and the hedge fund's collateral requirements are netted across all the deals handled by the prime broker. The prime broker will earn fees (referred to as spreads) on financing the client's long and short cash and security positions and, in some cases, by charging fees for clearing and other services.

Financial and organizational restructurings provide another source of fee-based business for banks. When a company cannot pay its cash obligations — for example, when it cannot meet its bond payments or its payments to other creditors (such as vendors) — it goes bankrupt. On the other hand, the company also can restructure and remain in business. The restructuring process can be thought of as twofold: financial restructuring and organizational restructuring. --Financial restructuring involves renegotiating payment terms on debt obligations, issuing new debt, and restructuring payables to vendors. Bankers provide guidance to the firm by recommending the sale of assets, issuing special securities such as convertible stock and bonds, or even selling the company entirely. --Organizational restructuring can involve a change in management, strategy, and focus. Bankers with expertise in "reorgs" can facilitate and ease the transition from bankruptcy to viability.

In many western countries, the size of companies' pension plan deficits has increased significantly in recent years as employees live longer and low interest rates have reduced the discounting impact on future liabilities. In addition, recent accounting changes often force the recognition of these deficits as liabilities on companies' balance sheets. Therefore, how to manage the pension deficit has become a focal point for many corporate management teams. While some companies have responded by closing or changing their pension schemes, others have used investment banking advisory teams to restructure the way either the assets or liabilities are managed. The most common is called "Liability-Led Investment Strategies," whereby banks will structure investments to match the long-term profile of the pension plan liabilities.

Equities, or shares in the ownership of a company, have a variety of names across the world: equity, shares, and stock are the three most popular. A company whose equity is owned (in part or in whole) by the public is called a listed company. The initial sale of equity would be done through an initial public offering (IPO) that is managed by a bank that guarantees the sale. Further sales of equity can occur to the general public again or just to existing equity holders. Investors buy equity because they think the equity price will rise and be worth more in the future, because the dividend yield is attractive (historically, an average dividend yield has been around 5 percent per year), or both. Click the graphics below to learn more about the history, function, and trading markets of equities.

The first company to issue equity was the Dutch East India Company in 1606. Previously, enterprises were founded by very rich individuals, governments, or both. The creation of an equity holding group allowed funding to be raised more easily and the risk on the deal to be spread more widely. The development of this equity market was one of the drivers of Europe's economic acceleration compared to the rest of the world during the following centuries. Specifically for the Dutch East India Company, it allowed the company to build ships and become the first global corporation

This basic function of equity — the raising of funds in return for a partial share of the company's profits — remains true today, although the range of different types of equity has increased. "Ordinary" shares (also called common stock) remain the most common and allow the equity holder to vote on key decisions and to receive a share of the company's profits (dividend). Another types of equity is preference equity, which offers no voting rights but has priority over ordinary equity holders in the distribution of dividends and assets. Often, this preference (sometimes called preferred) equity can be structured to be akin to debt with a fixed dividend repayment and repayment period. All these types of equity are called cash equities in the capital markets

Equities are traded on stock exchanges such as the New York Stock Exchange (which has merged with Euronext), NASDAQ, the London Stock Exchange, and the Tokyo Stock Exchange. Trading on an exchange is done by brokers who either introduce a buyer and seller (called name give-up broking) or match buyers and sellers by transacting with both sides (called matched principal broking). Investment banks often act as the broker, although specialized brokerage companies exist. Equities also may be dual listed

Since raising new equity can take a long time, be relatively expensive, and also dilute the ownership rights of existing equity holders, most companies raise funds through debt, either through loans directly with banks or through the bond market. To be successful, companies need to maintain the right balance between debt and equity: Too much debt may strain a company because interest has to be paid and the debt ultimately repaid; too little debt and a company could have insufficient funding to expand or meet cash flow needs.

One of the most significant developments in the last five to 10 years has been the development of the credit derivative market and, in particular, the credit default swap (CDS). We will go into more detail in the next lesson on how a swap works, but a CDS allows a trader to take a view on the creditworthiness of a company without buying an actual bond. This type of trading allows the trader to choose whether to take a position against a company's creditworthiness. In addition, it allows the CDS trader to take multiple positions on the same bond issue. The development of ABSs and CDS has allowed banks to hedge their credit risk, thereby allowing them to do more business and to spread credit risk throughout the market. However, as seen during the credit and liquidity crises that began in 2007 and the related economic downturn that followed, the potential downside to this is that the impact of an individual default can be more severe and affect more people than before

Government bonds are one of the most basic products in the interest rate market. Just like companies, governments also need to raise finance through debt and, therefore, issue bonds to the market. The names of government bonds vary between countries; for example, in the United States they are called "treasuries," in the UK "gilts," and in Japan "JGBs." A government bond works in much the same way as a corporate bond, with interest/coupon payments and then repayment of the notional at maturity.

Interest rates usually are set by the national bodies that set monetary policy. There are many types of interest rates, but the basic rate is the one at which these central banks lend money to the market (normally commercial banks). That "base rate" then will be used to determine the interest rates charged to customers (such as through company loans or mortgages) and also the rate of interest banks charge each other (in London this called the London Inter Bank Offered Rate, or LIBOR). For example, when the base rate is cut, commercial banks usually will cut their mortgage lending rate. This is because their funding costs are now less and they can afford to pass some of those savings to their customers.

As well as different types of interest rates, you also will see interest rates quoted over time. Such are the range of maturities on offers that you can plot a curve showing how the interest rate changes against maturity; this is called the yield curve. Normally, the yield curve goes upward; that is, interest rates for short maturities are lower than those for long maturities. This is because the opportunity cost of investing your money for a longer period is greater because your money is tied up for longer and, more importantly, inflation erodes the value of your money over time. However, the market can reflect an inverted yield curve; that is, the short-term rates are higher than the longer-term rates. This is mainly due to expectations that inflation is low and interest rates already have risen significantly. Therefore, future interest rates are expected to be lower.

Like the equity and credit markets, banks are involved in the different sections of the interest rate market. They help governments issue debt (or at least provide a secondary market in it), they make markets for their customers, and they develop derivative products that are based on interest rates. They also use interest rate derivatives to help hedge out or mitigate their interest rate exposure that arises in the normal course of their business. Some interest rate products (for example, futures) are exchange-traded, but the majority of them are traded over the counter or via broker-facilitated platforms such as MTS for Eurobonds.

Note that for developed countries and regions, such as the United States, Western Europe, and Japan, government bonds are considered "risk-free," since there is no expectation of default. Therefore, the price of government bonds varies due to other issues than credit: primarily the level of interest rates, foreign exchange (FX) rates, and inflation. It is worth highlighting that these three factors are heavily interdependent; for example, FX rates often move because of interest rate movements and vice versa. We will go into more detail about the FX markets after this section. Investors will buy these government bonds as a "safe" investment when other markets fluctuate or have problems. Click Next to continue. This type of "risk-free" government debt applies only to the most-developed countries. Other countries with less-developed economies also have to raise debt, but investors have some fears of default. The price for this type of government bond, often referred to as emerging market debt, is driven not just by interest rates or inflation levels, but also by expectations of default (similar to corporate bonds). Like corporate bonds, their price often is quoted as the "spread" to the risk-free government bonds (the difference in interest rate payable on emerging market bonds as compared to US treasuries). In recent years, because of the growth in the global economy, the spread between this emerging market debt and the risk-free government debt has narrowed because investors have lower expectations that emerging market economies will collapse, their governments will default on their debt, or both. This is because the global economy has strengthened due to a combination of high commodity prices (the main export for many emerging market countries), stronger capital markets in those countries, and the shifting of manufacturing capacity from developed countries like France to cheaper emerging market countries like those in Eastern Europe.

The FX market is the largest financial market and exists wherever one currency is traded for another. The reason the market is so large is that any company, bank, or individual that operates in countries other than its own will usually need to transfer its home money into foreign money and vice versa. The creation of the Eurozone and the de facto adoption of the US dollar by many Latin American countries have reduced the amount of FX transactions, but the volumes are still considerable. They will include companies that buy or sell from foreign markets, tourists on holiday overseas, and traders who will take bets on how different currencies change price compared to each other. Banks are mainly involved in the first and third of these activities. As with the other markets, they make markets for corporate clients that want to hedge out or manage their FX risk and also take on proprietary trades as they attempt to make money on market movements. FX rates are traded and priced in pairs; for example, when we talk about how much a US dollar is worth, we will do so in terms of how many British pounds or Japanese yen it is worth. Obviously then, the US dollar-yen rate is not just driven by facts influencing the former, but also the latter

The commodity markets are slightly different from the markets we have already discussed. The modern commodity markets started with the trading of agricultural products in the 17th century. As the world economy became more industrialized, the market branched out into other types of commodities, such as metals and energy. Today, there is a broad range of commodities traded, and they can be split into the following categories: --Metals - base metals such as copper and precious metals such as gold --Power and Energy - oil, gas, and electricity --Softs - agricultural products such as coffee and sugar --Grains - other agricultural products such as wheat

Trading is split into two types: physical trading (the actual commodity will change hands) and paper trading (derivatives based on commodity prices but for which delivery of the commodity is unlikely). Paper trading is done via commodity exchanges, with the most common contracts being futures and forwards (trading now for a future sale date). Although these contracts include a technical provision for physical delivery, in reality they are settled by difference account (in basic terms, the P&L movement between the price you executed at and the price you later settle at). This means the same underlying commodity (be it a bag of coffee or a barrel of oil) can be traded many times over. Commodity trading, however, is done in a global market and there will be different prices for commodities in the world driven by local demand and supply as well as the quoted exchange commodity "price." For example, for oil you will get prices for West Texas Intermediate (WTI) in the United States, Brent Crude in Europe and Africa, Dubai in the Middle East, and Tapis in Asia.

There are several different types of users of the commodity markets: --Producers (such as oil companies and mining companies) - those who supply and refine commodities and will use the market to optimize their business and also to hedge market risk --Consumers (such as retail energy companies) - those who buy from the market and supply to retail customers; they also will use the markets to optimize their business and hedge market risk --Traders (such as banks or physical merchants) - they will trade commodities either in an attempt to make speculative gains on their proprietary book or to market make between producers and consumers --Investment Funds - they make investments in commodities as they would in any other asset class like equities or credit. Traditionally, the market has been dominated by producers and consumers, with physical traders and banks sitting in the middle. However, after the equity market downturn and low interest rates of the early 2000s, more speculators and investment funds looked to the commodity markets to provide an asset class that could offer higher returns. In addition, they believed, the commodity markets were largely independent of the other markets (like equities) and therefore, would help diversify their investment strategies. This has meant that volumes in the commodity markets (particularly the paper trading market) have grown significantly but also that the market has become a lot more volatile (the prices move up and down more frequently and significantly).

As the capital markets become more complex and diverse, new asset categories and markets are created. These can be subsets of existing markets (for example, trading inflation indices rather than interest rates), new commodities (such as the weather), or new ways to trade existing financial assets (for example, derivatives on hedge fund investments and on insurance policies). A whole new market, hybrids, has arisen to trade cross-asset class. Some of these markets have not developed well. For example, general weather derivatives have not proved popular because it is difficult to use them as a hedge, since weather is a localized phenomenon. Other markets — for example, fund derivatives — have become popular and could become the next big new market

As discussed in the previous lesson, a cash equity is a share in a listed (public) company. Cash equities will be listed on an exchange, and that exchange will provide a quote. Therefore, no specific valuation technique is required. The market capitalization of a company (the equity price times the number of shares) is the most common measurement for valuing public and private companies. This is because the equity price is influenced by the market's expectation for future performance, not just current or past performance There are several alternative valuation methods for valuing companies: Net asset basis - balance sheet value of the company less preference shares (Note that this is not used in the United States.) Earning basis - future maintainable earnings (post-tax) multiplied by the P/E ratio Dividend yield basis: (dividend percent / dividend yield) x (nominal value) Discounted cash flow basis - uses future cash flow projections and discounts them (most often using the weighted average cost of capital) to arrive at a present value, which is used to evaluate the potential for investment The value of a share/stock multiplied by the number of shares equals the market capitalization

Again as discussed in the previous lesson, bonds are one of the most commonly used and popular financial instruments. Once issued, bonds are actively traded in the secondary markets. Valuation of bonds: --The value of a bond is the sum of the present values of all the expected coupon payments plus the present value (PV) of the par value at maturity. To calculate PV, a suitable discount factor has to be determined, usually the required yield. --Using PV incorporates the time value of money into the valuation. --Time value of money is the premise that, due to factors such as inflation and interest rates, money will depreciate in value over time relative to its value today. --Long positions are valued at the bid price. --Short positions are valued at ask (sometimes called "offer") price.

Asset-backed securities (ABS) are bonds or notes backed by financial assets. Typically, these assets consist of receivables other than mortgage loans, such as credit card receivables, auto loans, manufactured-housing contracts, and home-equity loans. ABS differ from most other kinds of bonds in that their creditworthiness (which is at the triple-A level for more than 90 percent of outstanding issues) derives from sources other than the paying ability of the originator of the underlying assets. Note that financial institutions that originate loans, including banks, credit card providers, auto finance companies, and consumer finance companies, turn their loans into marketable securities through a process known as securitization. The loan originators are commonly referred to as the issuers of ABS, but in fact they are the sponsors, not the direct issuers, of these securities. A significant advantage of ABSs is that they bring together a pool of financial assets that otherwise could not easily be traded in their existing form. By pooling together a large portfolio of these illiquid assets, they can be converted into instruments that may be offered and sold freely in the capital markets. Converting these securities into instruments with different risk/return profiles (called tranching) facilitates marketing of the bonds to investors with different risk appetites and investing time horizons

ABSs enable the originators of the loans to enjoy most of the benefits of lending money without bearing the risks involved. ABSs advantages include: Selling ABSs to pools allows originators to reduce their risk-weighted assets and thereby free up capital, enabling them to originate still more loans. ABSs lower the originator's risk. In a worst-case scenario where the pool of assets performs poorly, the owner of ABSs would pay the price of bankruptcy rather than the originator. The originators earn fees from originating the loans, as well as from servicing the assets throughout their life.

Forwards and futures are two of the most widely used and popular financial products. They represent an agreement between two counterparties to buy or sell an asset at a pre-agreed future point in time at a pre-determined price. Recent trading has found futures to be a lot more popular than forwards. Futures and forwards are often used for hedging purposes because they can be used to address market risk such as interest rate risk, credit risk, price risk, and volatility risk faced in the normal course of business. They also can be used for speculative trading and can be a cheaper means of trading than trading the underlying asset outright. This allows the investor to speculate on the price movement of an asset without purchasing the actual asset (only price movements are paid or received rather than for the whole asset value).

--Characteristics of forwards include: Trade over-the-counter Nonstandardized Subject to counterparty credit risk No cash flows until delivery (for instance, these are settled at the end of the period of the contract) --

--Characteristics of futures include: Exchange-traded Standardized No exposure to counterparty credit risk because through an exchange Daily mark to market creates a variation margin, requiring daily cash settlement with the clearing house --Standardization - All the terms of a futures contract are standardized. The terms below are typical agreements in the majority of futures contracts and cannot be changed by counterparties: Underlying asset - could be crude oil, gold, the US dollar, or interest rate Notional of the underlying - notional of the above assets are also fixed (such as notional US dollars, number of barrels of oil, or units of currencies for an interest rate future contract) Currency - currency in which the contract is quoted and the trade is fixed Delivery - the delivery date and month Type of settlement - physical or cash; grade and quality of the underlying (such as the quality of crude oil) -- Futures trades are executed on futures exchanges --Settlement and valuation of all futures contracts are settled through a clearinghouse, which acts as a buyer, seller, and guarantor to every clearing member, thus eliminating the credit risk from the transaction. Initial margin requirements Maintenance margin (sometimes called the variation margin) requirements Valuation

Swaps are OTC derivatives, traditionally defined as the exchange of one security for another to change the maturity (bonds), change the quality of issues (stocks or bonds), or because investment objectives have changed. Recently, swaps have grown to include most asset classes in the capital markets. In a financial swap, two counterparties exchange one stream of cash flows against another stream. These streams are called the legs of the swap. The cash flows are calculated over a notional principal amount.

contractual agreements entered into between two counterparties under which each party agrees to make periodic payment to the other for an agreed-on period of time based upon a notional amount of principal. Interest rate swaps are the most commonly used and popular form of a swap.

financial contracts in which two parties exchange a series of cash flows in one currency for a series of cash flows in another currency at an agreed-on rate for an agreed-on period of time.

swaps in which a set of future cash flows is exchanged between two counterparties, with one cash flow stream being based on the performance of a share of stock or stock market index, such as Nikkei or S&P 500, and the other based on a reference interest rate, such as LIBOR

swaps in which counterparties exchange cash flows, at least one of which is dependent on the price of an underlying commodity. Therefore, a commodity swap matches a commodity producer's desire to receive a fixed income for his product with the customer's need to lock in the price that is paid for the commodity.

contracts that provide protection against credit loss on an underlying reference asset as a result of a specific credit event. A credit event is usually a default of the asset issuer or, possibly, a credit downgrade. The reference asset may be a bond, a loan, a trade receivable, or some other type of liability. The buyer of a default swap/protection pays a premium to the writer or seller in exchange for the right to receive a payment should a credit event occur. In essence, the buyer is purchasing insurance.

swaps used to allow one party to derive the economic benefit of owning an asset but without actually having that asset on their balance sheet. Alternatively, this swap allows the asset owner to transfer risks and rewards without selling the asset. Hedge funds use total return swaps to gain leveraged exposure to assets. It is a similar in structure to other swaps, but can be applied to any type of asset and is not linked to a specific event (such as default for a credit default swap).

Swaps often are used in execution of hedge and risk management, arbitrage, investment, and trading in response to market movements. --Hedging/risk management: Cash flow modification: Changing from one form of cash stream to another more desirable form of cash stream Elimination of uncertainty: Elimination of or reduced exposure to market rates or prices --Arbitrage: Reduce cost or improve returns by taking advantage of a particular market in which the entity has relative advantage (capital market arbitrage) or taking advantage of an arbitrage that exists between two different markets (market arbitrage) --Investment: Create or reduce price exposure to a desired asset without buying or selling the asset --Trading: Speculation and execution of trades in reaction or anticipation of market conditions

Fair value of a swap is equal to the present values of its net future cash flows. In today's markets, most swaps are fairly liquid products, and their fair values can be obtained easily from various market sources such as broker quotes. It is possible to compute the fair values of swaps through simple valuation models using market inputs. Exchanges are developing exchange-traded swaps (for example, exchange-traded CDSs), which will help produce clearer pricing and more standardized products

The holder of an option has the right, but not the obligation, to sell a security at a specified price, called the "strike price." Every financial product can have options. The use of options is facilitated by contracts. --A call option is a contract giving its owner the right to buy a fixed amount of a specified underlying asset at a fixed price at any time or on or before a fixed date. For example, for an equity option, the underlying asset is the common stock. The fixed amount is 100 shares. The fixed price is called the exercise price or the strike price. The fixed date is called the expiration date. On the expiration date, the value of a call on a per-share basis will be the larger of the stock price minus the exercise price or zero. Click here for a detailed example of a call option. --A put option is a contract giving its owner the right to sell a fixed amount of a specified underlying asset at a fixed price at any time on or before a fixed date. On the expiration date, the value of the put on a per-share basis will be the larger of the exercise price minus the stock price or zero. Click here for a detailed example of a put option. --A European option is an option that can be exercised only at maturity. --An American option can be exercised at any time up to the maturity date.

When a bank values options, it often will use the terms "in the money" (the current market price is better than the strike price), "at the money" (the current price is the same as the strike price), or "out of the money" (the current price is worse than the strike price). Note that because the option may only be exercisable in the future, the option may move between these categories as the market price changes. Determinants of value for options include: --Current stock price - As the current stock price goes up, the higher the probability that the call will be in the money. As a result, the call price will increase. The effect will be in the opposite direction for a put. As the stock price goes up, there is a lower probability that the put will be in the money. Therefore, the put price will decrease. --Exercise price - The higher the exercise price, the lower the probability that the call will be in the money. --Volatility - Both the call and put will increase in price as the underlying asset becomes more volatile. Interest rates - The higher the interest rate, the lower the present value of the exercise price. As a result, the value of the call will increase. The opposite is true for puts. --Cash dividends - On ex-dividend dates, the stock price will fall by the amount of the dividend. So the higher the dividends, the lower the value of a call relative to the stock. This effect will work in the opposite direction for puts. --Time to expiration - Several effects are involved here. Generally, both calls and puts will benefit from increased time to expiration because there is more time for a big move in the stock price.

There are many types of structured trades and derivatives. However, one of the more common and high-profile is the collateralized debt obligation (CDO). A CDO is a trade that builds up a pool of credit assets and then issues bonds linked to the credit performance of that pool of assets. Banks will structure these deals and use a special purpose vehicle (SPV) to house the reference pool and to issue the bonds. Key features of CDO include: Cash CDOs have pools of cash assets such as loans, corporate bonds, or ABSs that are physically owned by the SPV. A synthetic CDO does not actually own cash credit assets but, instead, gains exposure through derivatives such as a CDS. Rather than have a cash pool of assets, they, therefore, have a reference pool of assets. CDOs also: Facilitate the redistribution of credit risk Are effective in giving investors customized exposure to credit risk Transform a portfolio of debt assets into different investment tranches, each one having a different risk and return profile Are easy for issuers or investors to add a clause to in order to make the product suit a specific risk or return profile Provide a means to realize cash flows and mitigate credit risk for those that are selling their credit assets into the SPV (for example, a retail bank could sell part of its mortgage portfolio)

It is easiest to understand CDOs from their origins. In the late 1990s, several banks decided to dispose of their loan portfolios. Typically, an SPV was formed, which bought the loan portfolio from the bank. Investors in the CDO then were offered different levels of return depending on the risk they were willing to take The different levels of investment are referred to as tranches. If there is one default within the portfolio, the lowest tranche receives a reduced return, but no other tranches are affected. Only when further defaults occur do higher tranches begin to suffer. The lowest (and riskiest) tranche is referred to as the equity tranche; the name is a misnomer because it is not equity. This is followed by a mezzanine tranche and a senior tranche

The way in which CDOs are structured (assets are pooled together) allows ratings of assets to be enhanced. For example, a CDO portfolio may contain 25 loans, each one with a credit rating of CCC. While the chance that one loan may default in a year may be, say, 5 percent, the chance that several of the loans will default is extremely low. Consequently, the least risky tranche of the CDO can have a credit rating of AAA despite the poor quality of the underlying assets. Note that pension funds and insurance companies can invest only in extremely high-grade investments. Consequently, CDOs provided a new market in which these companies could invest (whereas before they typically were restricted to government bonds). Unlike the other forms of credit derivatives, CDOs are quite complex. For example, modern CDOs typically allow the sponsor to dynamically change the reference portfolio within limits. The inclusion of synthetic products such as CDS and other CDOs within a portfolio complicates matters still further

Valuing CDOs has always been challenging because, unlike shares or bonds, they are not listed on an exchange. In stable markets, a fair value can be estimated using models, but in turbulent times of high volatility, valuation becomes highly judgmental as liquidity in markets dries up. Valuation of CDOs key points --Since many CDOs are able to be customized, their price cannot be directly established from the market. Hence, a model generally is developed to value them, typically with the following inputs: Deal-specific static inputs Credit spreads of the underlying assets (default probabilities) Recovery rates Correlations between assets in the underlying pool --Some CDOs could be highly customized, and some of the inputs required may not be directly observable from the market. A basic principal of a CDO valuation remains to be the present value of the net future expected cash flows from the deal.

Repurchase agreements (called "repos") are a form of short-term borrowing for dealers in government securities. The dealer sells the government securities to investors, usually on an overnight basis, and buys them back the following day. For the party selling the security (and agreeing to repurchase it in the future), it is a repo; for the party on the other end of the transaction (buying the security and agreeing to sell in the future), it is a reverse repurchase agreement. Note: Repos, classified as money-market instruments, usually are used to raise short-term capital. A repo is economically similar to a secured loan, with the lender of money receiving securities as collateral to protect against default. Therefore, it is short-term and safer as a secured investment since the investor receives collateral. Examples: --Emerging market repos are repo transactions that use an emerging market bond as collateral. --Tri-party repos are transactions in which bonds lent/borrowed are not specified but are allocated by a tri-party agent based on a set criteria agreed on by both counterparties. Such tri-party agents are Euroclear and Clearstream. --Cross-currency repos are transactions in which the cash and assets/securities are not of the same currency.

How might banks, investors, and other parties use repos? Banks may use repos for short selling and financing long positions. Banks may use repos to obtain access to cheaper funding costs of other speculative investments and cover short positions in securities. For the cash investor, repos are opportunities to invest cash for a customized period of time. (Other investments typically have limited tenures.) Bond portfolio managers would use repos to enhance the yield of the portfolio for the investors. Hedge funds may use repos for financing purposes. Central banks use repos for liquidity management and monetary signaling policy.

Reverse repurchase agreements are the purchase of securities with the agreement to sell them at a higher price at a specific future date. For the party selling the security (and agreeing to repurchase it in the future), it is a repo; however, for the party on the other end of the transaction (buying the security and agreeing to sell in the future), it is a reverse repo agreement. Note: Repos, classified as money-market instruments, usually are used to raise short-term capital. In easier terms, a reverse repo is simply a repurchase agreement as described from the cash provider's, rather than security provider's, perspective. Hence, the cash receiver executing the transaction would describe it as a repo; the cash providers in the same transaction would describe themselves as executing a reverse repo. So, "repo" and "reverse repo" are exactly the same kind of transaction, just described from opposite viewpoints.

In investment banking, the term securities lending also is used to describe a service offered to large investors who can allow the bank to lend shares that they own to other people. This often is done to investors of all sizes who have pledged their shares to borrow money to buy more shares. Large investors such as 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 vote their shares.

Structured lending is a non-standard lending arrangement that is customized to the needs of specific clients. Note that such arrangements often are not transferable (interchangeable). Structured finance is a broad term used to describe a sector of finance that was created to help transfer risk by using complex legal and corporate entities.