IB - Knowledge Bank

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Investment BankingKnowledge Bank

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


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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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Securities Underwriting

In securities underwriting the investment banker raise capital for

corporations through the structuring and sale of securities suchas 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 stocksor bonds, to investors.

A syndicate of banks (the lead-managers) underwrites thetransaction, which means they have taken on the risk of

distributing the securities. Should they not be able to find enoughinvestors, 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 directcompetition and share the same product lines and markets.

Vertical merger - A customer and company or a supplierand company. Think of a cone supplier merging with an icecream maker.

Market - extension merger - Two companies that sell thesame products in different markets.

Product - extension merger - Two companies selling different but related products in thesame 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 targetcompany's ownership stakes in order to assume control of thetarget firm. Acquisitions are often paid in cash, the acquiringcompany's stock or a combination of both. Acquisition can be :

Congenial

Hostile

Reverse Take Over (RTO) Private Company becomes publicwithout IPO.

Difference between Merger and Acquisition

Though the two words mergers and acquisitions are often spoken in the same breath andare also used in such a way as if they are synonymous, however, there are certaindifferences between mergers and acquisitions

Merger Acquisition

The case when two companies (often of samesize) decide to move forward as a single newcompany instead of operating business separately.

The case when one company takesover another and establishes itself asthe new owner of the business.

The stocks of both the companies are surrendered,while new stocks are issued afresh.

The buyer company swallows thebusiness of the target company, whichceases to exist.

For example, Glaxo Wellcome and SmithKlineBeehcam ceased to exist and merged to become anew company, known as Glaxo SmithKline.

Dr. Reddy's Labs acquired Betapharmthrough an agreement amounting $597million.

Role of Investment Banks in Merger and Acquisitions

Identify potential investors for the clientGain 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 asresidential mortgages, commercial mortgages, auto loans or credit card debt obligations andselling 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 receivablesare called mortgage-backed securities (MBS), while those backed by other types ofreceivables are asset-backed securities (ABS).

The granularity of pools of securitized assets is a mitigant to the credit risk of individualborrowers. Unlike general corporate debt, the credit quality of securitised debt is non-stationary 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 alltranches of structured debt improves; if improperly structured, the affected tranches mayexperience 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 assets including equity, fixed-income and foreignexchange products, as well as options, swaps, warrants, futures and other derivatives

It integrates the entire trade cycle, preventing the inconsistencies arising due to dealingwith 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 whocan allow the investment bank to lend out their shares to otherpeople. This is often done to investors of all sizes who have pledgedtheir shares to borrow money to buy more shares, but largeinvestors like pension funds often choose to do this to theirunpledged shares because they will receive interest income. Inthese types of agreements, the investor still receives any dividendsas normal, the only thing they cannot generally do is to vote theirshares.

Institutional Investment Management

Research

Conducting research of different industries by looking ateconomy, interest rates and company data

Providing analysis and rating of securities such ashold , add and reduce to various clients

Investment Banks Asset Management (funds)

Institutional and RetailInvestors Equity and Fixed IncomeFunds Hedge Funds


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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 forthemselves through the revenue lines.

Principal Transaction

A transaction in which the counterparty acts as a principal, i.e., carries some or all of therisk associated with the change in the instrument value

Example:Client : I want to buy 1,000,000 shares of Reliance at the price of XPrincipal : Agrees to the price with clientClient : Receives share at the pricePrincipal : May transfer his / her own shares to the client, or buy them in themarket, therefore carrying the risk executing the transaction at a price differentfrom X

Agency Transaction

A transaction in which the executing brokerage firm acts as an agent and usuallycharges a commission for its services

Example:Client : Buy 100 shares of Reliance at the current market priceAgent : Executes trade in the marketClient : 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) andgovernments can raise long-term funds. It is defined as amarket in which money is provided for periods longerthan a year, as the raising of short-term funds takes

place on other markets (e.g., the money market). Thecapital market includes the stock market (equitysecurities) and the bond market (debt).

Financial regulators, such as the UK's Financial ServicesAuthority (FSA) or the U.S. Securities and ExchangeCommission (SEC), oversee the capital markets in theirdesignated jurisdictions to ensure that investors areprotected against fraud, among other duties.

The capital markets consist of the primary market, where newly issued securities aredistributed to investors, and the secondary market, where existing securities are traded.

The capital market includes:Stock marketBond 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) andderivatives at an agreed price; these are securities listed on a stock exchange as well asthose only traded privately.

The stocks are listed and traded on stock exchanges which are entities of a corporation ormutual organization specialized in the business of bringing buyers and sellers of theorganizations 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 marketwhere 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, arelisted on exchanges.

Market Scenario in Capital Market


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Market Participants Institutional Investors

The term Institutional Investor or Institutional client arecollective terms used to describe companies that visit thesecurities marketplace and invest in securities

Institutional Investors place orders with an agent or theymay also access markets directly

The type of organization that constitutes an InstitutionalInvestor includes companies in the capacity of:

Mutual Fund ManagersPension FundsInsurance CompaniesHedge Funds

Institutional Investors Mutual Funds

An investment vehicle that is made up of a pool of funds collected from many investorsfor the purpose of investing in securities such as stocks, bonds, money marketinstruments and similar assets

Mutual funds are operated by money / fund managers, who invest the fund's capital andattempt to produce capital gains and income for the fund's investors

A mutual fund's portfolio is structured and maintained to match the investment objectivesstated 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 investmentstrategies in both domestic and international markets with the goal of generating highreturns (either in an absolute sense or over a specified market benchmark)

Legally, hedge funds are most often set up as private investment partnerships that areopen 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 moneyin 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 boughtwith the contributions to a pension plan for the exclusive purpose of financing pensionplan 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 equityBorrowing 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 Example

Corporations Vodafone (UK)Sovereign Entities Kingdom of DenmarkLocal Governments City of LondonGovernment Agencies Federal National Mortgage AssociationSupranationalOrganisations

International Bank for Reconstruction &Development (World Bank IBRD)

Market Participants Custodian

Custodian An organization that holds securities and cash on its clients behalf and mayaffect 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 inrelation to trade settlement and the holding of securities in safe custody on behalf of theowner

When securities are bought or sold, it is normal for institutional clients, agents andinvestors to utilize the services of their specific custodian in the financial centre relatingto 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 whoreside within the securities marketplace, namely traders and market makers who sellsecurities to or buy securities from :

o Agents acting on behalf of individuals or institutional investorso 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 betweentrader and market maker being that trader may or may not trade at the price counterpartywishes 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 thetype 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 thepower to admonish and accept undertakings from delinquent market participants tocorrect their behaviour, up to the ability to impose fines (often very large) and to initiatecriminal proceedings against companies and their officers

Examples : Americas SEC Services and Exchange Commission , Europe FSAFinancial 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 stockmarket is the Stock Exchange

Trades executed over an Exchange are executed On -Exchange or Exchange Traded

Other trades executed between the parties directly , not v ia 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 Country Financial Centre Stock ExchangeEurope UK London London Stock Exchange (LSE)

London International Financial Futures& Option Exchange (LIFFE)

Germany Frankfurt Deutsche BourseSpain Madrid Bolsa de Madrid

AsiaPacific

China Hong Kong Stock Exchange of Hong KongHong Kong Futures Exchange

China Shenzhen

Shanghai

Shenzhen Stock Exchange

Shanghai Stock ExchangeJapan Tokyo Tokyo Stock ExchangeTokyo International Financial FuturesExchange (TIFFE)

Singapore Singapore Stock Exchange of SingaporeSingapore International MonetaryExchange (SIMEX)

Australia Sydney Australian Stock Exchange (ASX)India Mumbai Bombay Stock Exchange

America USA New YorkChicago

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 thatspecifies conditions in particular, dates and the resultingvalues of the underlying variables under which payments, orpayoffs, 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. Andhence becomes a part owner of the company

To trade futures, a customer must open a futures tradingaccount with a derivative broker

Buying future means putting in margin money

With a purchase of future, holder essential makes alegally binding promise or an obligation to buy thesecurity 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 Derivativeswhereas 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 ofcustomization

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 decentralizedand located within individual institutions

There are no formal centralized limits on individualpositions, leverage or margining

There are no formal rules for risk and burden-sharing

There are no formal rules or mechanisms for ensuringmarket stability and integrity

The OTC contracts are generally not regulated by aregulatory organization, although they are affected indirectlyby national legal systems, banking supervision and marketsurveillance.


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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 forthe trading day and the final settlement price shall be the closing value of the underlyingindex on the last trading day.

Trading Mechanism

The futures and options trading system ofthe respective exchange

Generally provides fully automated screen-based trading for equity futures & options

Online monitoring and surveillancemechanism

Support order- driven market , providescomplete transparency of tradingoperations, operate on strict price-timepriority basis

Forward Contracts

Salient features of Forward Contracts:

They are bilateral contracts and hence exposed tocounter party risk

Each contract is custom designed and hence is uniquein terms of Contract size, expiry date and asset type and

quality

The contract price is generally not available in publicdomain

On expiry, contract has to be settled by delivery of theasset

If the party wishes to reverse the contract it has to becompulsorily go to the same counterparty, which oftenresults in high prices being charged


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Futures

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

The standardized items in a future contract are:Quantity of the underlyingQuality of underlyingThe date and the month of deliveryThe unit of price quotation and minimum price changeLocation of settlement

Options

Options are derivative instruments where one party has a right to buy/sell the underlyingwhile 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 obligationis 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 Seller of Call Option

Payoff for Buyer of Put Option


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Overview of Nomura Finance Processes


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