Investment Banking Final (Chapter Q's, Notes, Case Studies, Too Big to Fail)

How is derivatives settlement different from securities settlement?

Derivatives often remain outstanding for months or years while securities are generally cleared and settled in 3 days. Securities are simultaneously delivered and paid in full while a derivative represents an obligation or an option to buy or sell an asset at a future date. This exposes the buyer or seller to financial risk for an extended period of time, meaning derivatives require more complex risk management systems than securities.

A goal of many parts of U.S. regulatory legislation has been to eliminate/minimize conflicts of interest between issuers, investment banks, and investors. Provide examples of conflicts of interest in the U.S. investment banking industry and the corresponding regulations that attempted to resolve those issues.

Example 1: Investment banking divisions and equity research groups within the same bank, resolved by the Global Research Settlement in 2003. Example 2: Fraudulent information about sale of securities between investment banks and issuers and investors, Securities Act of 1933 required information be released about securities

What is the difference between business risk and financial risk?

Financial risk is the risk that a business's cash flows are not enough to pay creditors and fulfill other financial responsibilities. The level of financial risk, therefore, relates less to the business's operations themselves and more to the amount of debt a business incurs to finance those operations. Taking on higher levels of debt or financial liability therefore increases a business's level of financial risk. Business risk refers to the chance a business's cash flows are not enough to cover its operating expenses like cost of goods sold, rent and wages. Unlike financial risk, business risk is independent of the amount of debt a business owes.

FICC is one of the main Divisions in an Investment Bank. What does FICC stand for? Other than during 2007 and 2008, how does this division typically rank from a profitability point of view, compared to other Divisions? What happened during these two years and which part of the FICC Division was most responsible for this outcome?

Fixed Income, Currencies, and Commodities - "Has historically been the most profitable division in most of the large investment banks". - "During 2007 and 2008, investment banks recorded significant losses on their structured credit positions because of the credit crisis.." The Structured Credit (CDO, MBS, CBO, CLO, etc.) business was most responsible for this outcome.

How have recent modernizations by the NYSE helped eliminate the problem of front running?

Front running is when a trader uses knowledge of a customers incoming large order to place his or her own order ahead of it to benefit from a change in market directions that a large order pay induce. The NYSE helped eliminate this problem by replacing these specialists with designated market makers (DMMs). A key difference between the DMMs and the specialists are that DMMs no longer get the first look at electronic orders. In addition, some of the privileges enjoyed by specialists are no longer available and some restrictions under the specialist format have been removed to allow greater flexibility. In general, the new structure is designed to modernize the market-making function and make it more competitive and effective.

Describe the function of the equity capital markets group, including the two major divisions they directly work with and the two types of clients they indirectly work with.

Function: Equity Capital Markets Groups help private companies determine if an IPO of stock is a logical decision based on an analysis of benefits and disadvantages. Then, determines if there is sufficient investor demand to purchase new equity securities offered by the company. Then, the investment bank determines the expected value of the company based on comparisons with publicly traded comparable companies or values derived through other methods. Major divisions (directly): Major divisions (indirectly): They indirectly work with institutional clients as well as the issuing companies themselves.

Following the 1929 Stock market crash, Congress passed a series of Acts to regulate the securities industries. Name four of these Acts and briefly describe their purpose.

Glass-Steagall Act 1933 - separated commercial and investment banks; created the Federal Deposit Insurance Corporation (FDIC) which insured depositors assets in the event of a bank default. Securities Exchange Act of 1934 - supervision of new security offerings, ongoing reporting requirements for these offerings, and the conduct of exchanges. hanged secondary market for securities by requiring minimal reporting standards and codifying rules for transactions. Public Utility Holding Company Act 1935- allowed the SEC to supervise the relationship between utility holding companies and investment banks. The Act restricted investment banks from owning these utility companies on the belief that the banks would limit competition and engage in monopolistic behavior. The Chandler Act 1938 - added chapter X bankruptcies to the National Bankruptcy Act. Before this act, corporate bankruptcies had limited government involvement and were largely run by private companies. The Chandler Act gave the SEC the authority to be a party to all corporate restructuring activity, giving investors additional protection against inequitable restructuring plans.

Suppose you are a wealth advisor and a client has asked for your recommendation on which of the BRIC countries poses the least risk and most opportunity for investment growth. Briefly compare the perceived risks and benefits of each of the countries and provide support for your selection.

Global IPO financings raised nearly $300 billion in proceeds, with Brazil, Russia, India, and China ("BRIC" countries) accounting for $105 billion (or 35%) of this volume. Three years earlier, in 2004, this same group of countries comprised just 11% of total global IPO proceeds. BRIC's share of the global IPO market temporarily decreased to 22% in 2008, mostly stemming from the ongoing uncertainty and market turmoil caused by the global credit crisis. China would be considered the best country to invest in. China has the largest growth opportunity. There is a bigger opportunity for gains as they are newly developing, but at the same time IPOs will be more volatile for that reason as well.

Why did the SEC delay declaring Google's IPO registration effective?

Google had violated "quiet-period" rules, in which the SEC allows a company to disclose their interest in offering IPO shares to investors only by means preliminary, red herring prospectus, when Google's founders discussed Google's IPO in a magazine interview with Playboy. This riled the SEC, causing the delay in declaring the IPO's registration effective.

Describe the unique process utilized by Google in its IPO, intended advantages and potential disadvantages.

Google was determined to IPO using a Dutch Auction, in which potential investors weigh in with bids, listing the number of shares they want and how much they are willing to pay for those shares. Bids are then ranked with the highest price at the top. And then, going from the highest price down, the market price is established in which all the shares that can be sold will be sold at the lowest price offered. The advantages of a Dutch auction are that it guarantees the greatest distribution to retail investors. The auction would allow Google to avoid some of the excesses that can occur in large IPOs, particularly the large first-day pop in a stock's price. Disadvantages would include the alienation of large institutional clients since it disenfranchises those clients' pricing input and also removes the opportunity to receive large allocation directed by the book-runner. The commissions received in the underwriting would also be considerably less for the investment bankers.

What are core differences between Investment Banking and Sales & Trading career paths?

Have same titles - IBD has consistent promotion schedule, S&T has more flexibility if you're good - Compensation initially lower in S&T but evens out at higher levels and may even surpass due to high performers ability to generate more revenue for the firm. - S&T hours are shorter (50-60 vs 70-100) but can be more intense on trading floor

What is the tradeoff for having a stabilizing green shoe option in a common equity offering?

Having a green shoe offering means that the board must give approval for an issuing a range of shares that is 100% - 115% of the original shares intended to be issued, Meaning that the company must accept the negative earnings per share consequences of issuing more shares. The cost of mitigating the potential downside risk of a share price decrease is the negative earnings per share impact of issuing more shares.

Assume Hedge Fund A purchases a portion of Company B's convertible and will execute a delta hedge strategy. Describe the steps Hedge Fund A will take in the event the price of Company B's shares fall, and explain the reasoning behind each action.

Hedge Fund A will buy Company B's stock at the market price in order to maintain an acceptable hedge ratio. The hedge ratio is a representation of the number of shares sold short to the amount of common stock due through a convertible security. When the price drops, the hedge ratio will drop as well. To cover their short position, Hedge Fund A will buy shares at the new lower price and return them to the parties that loaned the securities. See the example in Q1 for a more in depth overview.

When a company has agreed to a green shoe, who does the underwriter buy shares from if the share price drops? Who do they buy shares from if the share price increases?

If the share price drops, then the investment bank will buy shares in the market at the prevailing market price in order to generate demand and support the stock. If the share price increases, then the bank will buy shares from the issuer at the offering price. "Underwriters use greenshoe options in one of two ways. First, if the IPO is a success and stock prices surge, the underwriters exercise the option, buy the extra stock from the company at the predetermined price, and send those extra shares, at a profit, to whoever bought them. Contrastingly, if the price starts to fall, they buy back the shares from the market instead of the company to cover their short position, supporting the price of the stock."

When might an investment bank decline participation in an underwriting and why?

If they are convinced the firm will lose money in the transaction or expose themselves to significant risks, they will oppose the transaction. Capital must be set aside to mitigate risks, this means that cash will be invested, and since this is a low return/scarce resource the bank cannot participate if the transaction is too risky.

How has recent legislation accelerated the development of the Japanese M&A market?

In 2003, a new law passed that permitted non-Japanese companies to use their own stock to acquire Japanese companies that were under Japanese bankruptcy court protection. This was followed by a 2007 law that further extended the ability of foreign companies to use their stock to acquire Japanese companies, as well as other laws that lowered the threshold shareholder approval requirement for an acquisition.

Describe the three principal businesses of an investment bank.

Investment Banking Business • Arranges financing for corporations and governments: debt; equity; convertibles. • Advises on M&A transactions. Trading Business • Sells and trades securities and other financial assets as an intermediary on behalf of institutional investing clients. • Operates in two business units: Equity and Fixed Income, Currency, and Commodities (FICC) 1. • Provides research to investing clients. Asset Management Business • Offers equity, fixed income, alternative investments, and money market investment products and services principally to individual investing clients. • For alternative investment products, the firm co-invests with clients in hedge funds, private equity, and real estate funds.

Calculate the investment bank's fees and profit for a 5 million share equity offering at $40/share, with a 15% green shoe option (fully exercised) assuming a 2% gross spread, assuming the issuer's share price decreases to $38/share after the offering.

Investment bank buys 5 mill*0.15 = 750,000 shares at $38 (750,000*38 = 28.5 million) to deliver to short sale buyers. Company receives proceeds of 5 mill*$40 = $200 mill and issues 5 million shares. Bank's Profit = (750,000*40) - (750,000*38) = 1.5 million. Fee = 0.02*($200 mill) = $4 million.

What are some methods used by investment banks to help equity issuers mitigate price risk during the marketing process?

Investment banks may use different distribution alternatives to help issuers mitigate price risk. This may include completing an accelerated offering with a shorter roadshow period of one or two days (red herring prospectus delivered), or by carrying out a block trade, in which the investment bank buys the securities without a road show and bears full price risk (red herring prospectus not delivered).

What are the objectives of Regulation FD? What are the concerns about this U.S.-based regulation?

It prohibits company's executives from selectively disclosing material information that could impact a company's share price. This means that prior to a discussing any potential "stock moving" information with research analysts, the company must disclose this information with a SEC filing. The benefit of this regulation is that it levels the playing field, enabling all investors to receive the same information at the same time. It is an attempt to bring better transparency and fairness to all investors. The concerns are that because companies must now be more careful in what they say to analysts and investors, and when they say it, less information is distributed in a less timely way. In addition, it is usually filtered through lawyers, causing a dilution in the quality of the information. Some investors feel that, as a result of FD, no one in the investment community, including retail investors, has the same quality or depth of information that they used to have

What are some securities regulations in place in the U.K., Japan and China that mirror U.S. regulations?

Japan- Similar to U.S. Glass-Steagall Act, Japanese regulators distinguished banks based on their business activities. Commercial banks were restricted from underwriting securities until 1999. In 2006, the Financial Instruments and Exchange Law which provides for registration and regulation of broker-dealers, disclosure obligations and internal controls in public companies. United Kingdom- Securities Investment Board (SIB) is similar to the SEC, financial firms have to register with the SIB. China- The Securities Law of 1998, there was a separation of banks engaging in deposit taking and securities activities.

Why was the Nikkei Put Warrant program so profitable for Goldman Sachs?

Japanese stock market crashed leading to gains on Nikkei Puts Met the requirements for all parties within the product (pg 186-192) Japanese Companies: Received high coupons bonds from AAA rated organizations Same level of risk from bond as from Japanese stock market Kingdom on Denmark Fully hedged position through Nikkei Put contract with Goldman Sachs Low-cost financing by using Nikkei Put sales proceeds to simultaneously issue fixed-rate Eurobonds High Rated Credit European Banks and sovereigns Hedged against exposure to Yen and high interest rate obligation of bond through sale of Nikkei Put Warrant to Goldman Sachs Payment from Goldman Sachs compensated for difference in high coupon rate and LIBOR, plus cost of hedging. Result: Dollar-denominated financing with a coupon lower than normal borrowing cost Goldman Sachs Trading profits from purchasing Nikkei Put Warrants at below theoretical market cost and delta hedging the risk position. Gained profits from fees for arranging investments, financing, swaps and managing risk for all parties involved within the Nikkei Put backed bonds

How were senior tranches of a CDO able to obtain investment grade credit ratings when some of the underlying assets were non-investment grade?

Many senior tranches of CDO were able to obtain investment-grade ratings as the pool is highly diversified of many assets.

Assume an investment bank has provided a fairness opinion on a proposed M&A transaction. Does this mean the board should go ahead and approve the transaction?

Not necessarily. All the fairness opinion is doing is showing that the merger and acquisition is "fair from a financial point of view". An investment bank who provides a fairness opinion is not advising either side of the transaction (in most cases). It is not business rationale, a legal opinion or recommendation to the board to approve the transaction. It is just an opinion.

.Why might OTC derivatives be considered more risky than exchange-traded derivatives?

OTC derivatives are not in the public domain and remain confidential unless reported by the parties to the trade. The market for OTC derivatives is also much larger than the one for listed derivatives. Newly proposed regulations may require OTC contracts to be cleared through regulated exchanges. Companies with OTC are usually smaller, unable to meet exchange listing requirements, so more risky. Exchange traded derivatives are more regulated and guaranteed by the exchange, and there's also the Clearing House that acts as an intermediary between buyer and seller.

Suppose you are the sell-side advisor for a multinational household and personal products manufacturer and marketer that sells primarily to the mass consumer markets. The analyst on your deal team prepares the following comparable companies analysis. Which, if any, of the companies in the list would you potentially remove from the analysis?

P&G may be too big; Prestige may be too small; McBride only sells in Europe (and may be too small).

What conflicts might exist as a result of having both an Asset Management business and a Private Wealth Management business?

PWM clients may be encouraged to invest in funds managed by the own bank's AM. The bank also can co-invest in the funds that are managed by AM

Describe what Prime Brokerage is, including four principal products in this area and the generic name of the financial institutions that are targeted for this business.

Prime brokerage is business in the trading division that focuses primarily on hedge fund investors who borrow cash and other securities to support their investment business. Prime Brokerage provides securities lending and margin loans trade clearing, custody, and settlement real estate and computer assistance and performance measurement and reporting. Hedge funds are the main Prime Brokerage clients.

What type of U.S. securities offerings do not need to be registered with the SEC?

Private Placements - these securities are not offered or sold in a public offering

What type of securities offerings do not need to be registered with the SEC?

Private Placements - these securities are not offered or sold in a public offering

Before an SEC registration statement is declared effective, companies (or their underwriters) that sell stock or are deemed to be promoting the sale of stock have a securities law problem. What is this problem called and what are its consequences?

Pursuant to Section 5 of the Securities Act of 1933, as amended ("Securities Act"), it is unlawful to "offer" or "sell" securities without a valid effective registration statement, unless an exemption is available. Any person who willfully violates the Act of 1933 or SEC rules and regulations is subject to five years in prison, a $10,000 fine, or both.

What are the major criticisms directed at Moody's, Standard & Poor's and Fitch?

Ratings agencies have been criticized for their role in rating mortgage backed securities higher than they should have leading up to the credit crisis. They are also criticized for not downgrading them quickly enough. Other criticisms stem from their relationships to issuers of bonds and other non-asset-backed securities. Since the issuers pay to have the securities rated it has been suggested that the agencies are influenced by the corporations into giving their securities a higher rating.

How do professionals in sales, trading and research work together?

Research analysts propose stock recommendation to sales. Sales person adds value to the report and contacts potential clients (portfolio manager for example). PM informs institutional trader, institutional trader informs bank's sales person with the order. Salesperson contacts the trader with the order and a contract is made up.

In a comparable transactions analysis, what additional considerations might an investment banker factor in when valuing an emerging market company?

Revenue opportunities and correspondingly large risks. Incremental risks associated with investment banking business in these countries include currency, political, liquidity, accounting, tax, and volatility risks (pg 165). Some investment banks have prioritized activities in these countries and have been very successful. Included among the most successful banks are Citigroup, Goldman Sachs, UBS, J.P. Morgan, Morgan Stanley, Deutsche Bank, and Credit Suisse.

Why might an investment bank place higher priority on sell-side M&A engagements over buy-side engagements?

Sell-side M&A engagements have a higher probability of completion. As fees are typically paid to M&A bankers only upon successful completion of a transaction, there is greater incentive alignment with sell-side engagements compared to the buy-side.

Provide definitions for strategic buyers and financial buyers in a prospective M&A transaction.

Strategic Buyers: generally competitors of a target company and will benefit from synergies when they acquire or merge with the target Financial Buyers: do not extract synergies from an acquisition

Why have strategic buyers traditionally been able to out bid financial buyers in auctions?

Strategic buyers are usually able to pay a higher price than that of financial buyers because of the synergies they can offer. However there are many cases of financial buyers winning auctions because of antitrust issues or because financial buyers are more aggressive regarding future cash flows, favorable debt financing terms, and aggressive exit strategies.

What is the significance of the Gramm-Leach-Bliley Act of 1999 in relation to the securities industry?

The Act overturned the mandatory separation of commercial banks and investment banks required by Glass-Steagall. It's also referred to as the Financial Services Modernization Act. The argument behind the act was that it would create a more stable business model, regardless of the economic environment.

What does the Dodd-Frank Act of 2010 mainly focus on?

The Dodd-Frank Act of 2010 mainly focused on regulating investment banks and their trading activities. The name of the most controversial part is the Volcker Rule. The Volcker Rule is a federal regulation that generally prohibits banks from conducting certain investment activities with their own accounts and limits their dealings with hedge funds and private equity funds, also called covered funds. The Volcker Rule aims to protect bank customers by preventing banks from making certain types of speculative investments that contributed to the 2008 financial crisis.The trading divisions had historically been the most profitable parts of the bank and so with new trading regulations, we see a massive drop in profits for investment banks.

How have the U.S. enforcement actions against sell-side research in 2003 heightened the issue of declining research revenues?

The NASD and the NYSE announced enforcement against 10 investment banks for a total of 1.4 billion to be paid in penalties and other fines. Banks also had to comply with new requirements that included the potential for the investment banking department to skew the research department, and making independent research available to consumers. These actions highlighted the fact that research was no longer becoming a profitable source of income to banks. The lack of clear revenue routes to research also play a role in the decreased role of research

A domestic airline based in the U.S. has placed a large $10 billion order for new airplanes with French aircraft manufacturer Airbus. Delivery is scheduled in four years. Payments are staggered based on a percentage of completion rate. The U.S. airline believes the Euro will appreciate against the Dollar during this time frame. How can the U.S. airline hedge currency risk related to this purchase with an investment bank?

The U.S. airline could use derivatives, specifically futures contracts, to hedge the exchange rate risk between the dollar and the Euro. The airline could purchase a foreign-exchange futures contract against the Euro/USD exchange rate. That way, if the value of the Euro increases, the losses due to exchange rates will be offset by gains from the increase in value of the futures contract.

Assume an acquiring company's P/E is 15x and the target company's P/E is 11x. Is the acquirer more or less likely to use stock as the acquisition currency? Why?

The acquirer is more likely to use stock as the acquisition currency. Whenever a high-P/E-ratio company acquires a lower-P/E-ratio company, as is the case here, the merger will be accretive (increase earnings per share). Higher P/E companies use stock if the target company prefers shares because they are more tax-effective for selling shareholders. Additionally, target shareholders prefer shares so that they are able to participate in future stock appreciation of the new combined company.

Why are most corporate Eurobond issuers large, multinational corporations?

The eurobond market is generally restricted to large, single issues ($50 million or more), and is limited to large companies, banks or governments. Maturities are usually around 10 years or less. However, there are programs available for MNCs to issue smaller amounts, and for shorter periods. Issuing eurobonds can help an MNC raise foreign-denominated debt in large amounts, for long periods of time, and usually at a fixed interest rate. This profile would be suitable for financing large, long-term, overseas developments - for example, establishing an overseas subsidiary.

Define proprietary trading.

The firm invests its own money in order to make a profit for itself.

After an initial hedge is in place, what do hedge fund investors in convertible bonds do with shares of the underlying stock when the stock price increases or decreases?

The hedge fund will maintain it's hedge ratio by buying or selling the convertible issuer's shares in the open market. If the price goes up, the issuer will borrow additional shares to sell short. If the price decreases, the fund will buy shares and return them to the share loaners. See the below example for details. "As an example, assume a company's share price is $10 at the time of its convertible issuance.A hedge fund purchases a portion of the convertible, which gives the right to convert into 100 common shares of the issuer. If the hedge ratio is 65%, the hedge fund may sell short 65 shares of the issuer's stock on the same date as the convertible purchase. During the life span of the convertible, the hedge fund investor may sell more shares short or buy shares, based on the changing hedge ratio. To illustrate, if one month after purchasing the convertible (and establishing a 65-share short position) the issuer's share price decreases to $9, the hedge ratio may drop from 65 to 60%. To align the hedge ratio with the shares sold short as a percent of shares the investor has the right to convert the security into, the hedge fund investor will need to buy five shares in the open market from other shareholders and deliver those shares to the parties who had lent the shares originally. "Covering" five shares of their short position leaves the hedge fund with a new short position of 60 shares. If the issuer's share price two months after issuance increases to $11, the hedge ratio may increase to 70%. In this case, the hedge fund investor may want to be short 70 shares. The investor achieves this position by borrowing 10 more shares and selling them short, which increases the short position from 60 to 70 shares. This process of buying low and selling high continues until the convertible either converts or matures.The end result is that the hedge fund investor is generating trading profits throughout the life of the convertible by buying stock to reduce the short position when the issuer's share price drops, and borrowing and selling shares short when the issuer's share price increases. This dynamic trading process is called "delta hedging," which is a well-known and consistently practiced strategy by hedge funds." (pg. 177)

What is a key consideration in determining the cost and other parameters of a corporate debt offering and why is it important?

The issuer's credit will determine if they are an investment grade or a non-investment grade issuer.

In the U.S., if an M&A transaction is relatively large within its industry, what is the name of the regulatory filing that is probably necessary before the transaction can be consummated? Which agency is it filed with? How long is the waiting period after a filing is made? What is the name of the European regulator that may be relevant in an M&A transaction?

The name of the filing is the Hart-Scott-Rodino filing with the FTC and the Department of Justice. There is a 30 day waiting period after the filing is made where the FTC or DOJ may request more information. The companies may also need to file with the European Commission or with other antitrust regulators in relevant countries.

What drove the need to separate research and investment banking?

The potential conflicts of interest drove the need to separate research and investment banking. There was the potential for the sell-side analysts to skew their research activities based on the Investment Banking Division's underwriting or M&A effort, rather than on the firm's investing clients' priorities for objective research

How are the different functions of the sell-side versus the buy-side manifested through their fee structures?

The sell-side collects fees through an indirect approach as part of the commission for selling a security to an investing client which is then reallocated to the research department. As for the buy side, who are concerned with additional fees impacting their investment record, were initially against a direct fee for research as it would lower their investment return (because the purchase price would be higher with a separate fee for research). However, the model changed in 2006 with Fidelity coming to terms with many investment banks that allowed a separate fee while simultaneously reducing commissions

What is the role of states in the U.S. in regulating investment banks?

There was limited federal regulation of the investment banks before the Great Depression but banks had to adhere to state securities laws called Blue Sky laws. After the passage of the National Securities Markets Improvement Act in 1996, states were effectively removed from securities regulation of investment banks, except for antifraud matters. Now states only regulate anti fraud matters.

What conflicts might exist between a proprietary trading business and the rest of the investment bank?

They can use internal information to make trades, though this is prohibited. Internalization of trade orders also can occur. Bank can also exploit inherent conflicts of interest in their trades

What are the "Risk Factors" in a prospectus? Why are they important to the issuer and to the investor?

They're important for the investor to understand the risks they might be facing in investing in the security and the company. The issuers use the section to specify risks and provide transparency to potential investors. This covers the bases of the issuers. -risks related to a borrower's default -risks inherent in investing -risks related to compliance and regulatory requirements

A BBB-/Baa3 rated company is looking at acquiring a smaller (but sizeable) competitor. Discuss considerations the company should take into account when deciding whether to fund the acquisition with new debt, equity, or convertible securities.

This company is barely investment grade rating, and so must seriously take into consideration the debt structure of the company that it is looking at acquiring. The company, when considering funding the acquisition with debt, will need to determine how much debt it can take on, since an increase in debt may cause the debt offering rating to go below BBB-/Baa3 and thus become non-investment grade. If the company is considering an equity funding, then it must consider the dilutive effects of the equity offering, and thus the loss in shareholder value for each shareholder. If the company would like to fund the acquisition with convertible securities, it must determine whether it would be better to issue optionally converting convertibles or mandatorily converting convertibles. This consideration is important since, from a credit agency point of view, the optional convertible will exhibit bond-type characteristics (and may reduce the credit rating), whereas the mandatory convertible will exhibit equity-type characteristics.

How has the Chinese government's relaxation of its foreign exchange controls helped facilitate growth in the Chinese economy?

This growth has been facilitated in part by the government's relaxation of its foreign exchange controls in 1996. Under relaxed regulations, current account renminbi (RMB) became convertible (subject to certain restrictions) into other currencies. A currency that can be readily bought or sold without government restrictions, in order to purchase another currency. Convertibility is important in international trade, it allows companies to do business across borders with confidence and transparent pricing. Also, a convertible currency is more liquid, which reduces volatility. The most convertible currency is the U.S. dollar. It is the most traded currency in the world, central banks hold the U.S. dollar as their main reserve, and a number of asset classes are denominated in U.S. dollars meaning payment and settlements are made in U.S. dollars. Currencies such as the South Korean won, and Chinese Yuan are deemed convertible, but on the lesser side, as the government places capital controls that limits the amount that can exit or enter the country. This was followed in 2002 with the creation of the Qualified Financial Institutional Investor (QFII) program, which allowed qualifying foreign investors to participate in the Chinese equity market via domestic A-shares and in the Chinese debt market.

Explain traders' market-making function.

Traders focus on two different areas: Supporting primary market transactions. This is purchasing securities directly from corporate or government issuers, reselling as a profit, and standing ready to repurchase securities at any time. Participating in secondary market by buying and selling previously owned securities to make a profit.

True or false (and explain your answer): Convertible arbitrage hedge funds invest in convertible bonds because the fund managers have a bullish view on the company's stock.

True. The convertible is the hedging device. The short selling is the revenue generating function. The convertible caps the loss if the stock climbs. There is gain if the stock declines significantly. If it trades sideways, the convertible coupon should help offset the costs of holding the short position.

What are some major differences between the regulatory frameworks of the four countries covered in this chapter?

U.S. U.K. Self-regulation prevailed until 1986, until the Securities and Investment Board (SIB) was created to be a comprehensive government regulator. Financial firms have to register with the SIB unless they are SRO's. The SRO's were given enforcement powers (fines, censures, bans). SIB became the FSA in 1997 and combined the powers of all 9 regulatory bodies into a single regulator for the industry, removing the influence of SROs. Like the SEC, FSA rules are binding without any Parliamentary Action. The U.K. is also subject to the EU banking and securities legislation as a member of the EU. China originally had two commissions in 1992, the State Council Securities Commission and the China Securities Regulatory Commission. The SCSC deal with centralized market regulation whereas the CSRC is the enforcer of the regulations. These two entities merged in 1998 and became a direct entity of the state council, the head council of the Central People's Government of China. Japan Pre-WWII Japanese banks were controlled by a Zaibatsu, a large conglomerate of businesses owned by a single holding company. Japan initiated the "Big bang" and began to deregulate the financial industry. They separated the Ministry of Finance and the Securities Exchange and Surveillance Commission and created the Financial Supervisory Agency which is the current securities regulatory body.

Compare the regulatory bodies of the four countries covered in this chapter.

U.S. & Japan are very similar, because the U.S. directed the rebuilding of Japan following WWII so the two regulatory bodies were very similar. (This question is basically the previous one, reworded, so just use question 11 answer).

What steps have U.S. regulators taken to reduce the systemic risk associated with OTC derivatives?

U.S. regulators announced in May of 2009 that they would be increasing federal regulation of the previously under regulated OTC market. This was due to the fact that many regulators and politicians believed that financial institutions' involvement in OTC derivatives contributed to the financial crisis in 2008. These new regulations increased transparency and promoted market discipline by requiring many standard OTC derivative contracts to be cleared through regulated central counterparties. These contracts are guaranteed by the exchange, which mitigates the risk of systematic failure from the collapse of one large counterparty. Also new reporting requirements were put into place for firms with significant positions in complex derivative transactions. This legislation was designed to bring a higher level of disclosure across all major players in the derivative market.

A U.S.-based BBB-rated company is looking to make a large acquisition. Management believes synergies from the acquisition will create new market opportunities. Unfortunately, these new opportunities will take a few years to realize and until then, benefits will not be fully reflected in the company's stock price. If the company has rating agency concerns and wants tax deductions from interest payments, what type of security is this company likely to issue in support of its acquisition and why?

Unit Structure Mandatory Convertible (182-183) Provides tax deductions on the interest payments associated with the subordinated debt Provides the company with with equity credit of 50%-70% from rating agencies Results in less EPS dilution on the date of issuance in comparison to common stock

What does VaR stand for? What is its definition and why is it important to investment banks? What are some of the criticisms of VaR?

VaR stands for Value at Risk, and it represents the potential loss in value of trading positions due to adverse market movements over a defined time horizon (typically one-day horizon) based on a specified statistical confidence interval (typically 95%).

What risks do investors take on when buying on margin?

When investors borrow money, or buy on margin, they're going for these types of gains. But the strategy is extremely risky. Buying on margin involves getting a loan from your brokerage and using the money from the loan to invest in more securities than you can buy with your available cash.

Assume a company's ADTV is 240,000 shares. How many days would it take to complete a 10.8 million share repurchase program? The company has 120 million shares outstanding and its estimated EPS for the current fiscal year is $3.40. Assuming the company meets its earnings estimate, what would year-end EPS be under an ASR program for the full 10.8 million shares, assuming it is executed 20 business days before the company's fiscal year end? Under an open market repurchase program?

a.) 240,000 * .25 = 60,000 daily share purchase limit 10.8m / 60,000 = 180 days to complete repurchase program b.) 120m * $.3.40 = $408m $408m / (120m - 10.8m) = $3.74 EPS c.) 20 * 60,000 = 1,200,000 repurchased shares at the end of the year $408m / (120m - 1.2m) = $3.43 EPS

Suppose you are a current shareholder in a company that is contemplating capital raising alternatives. Assuming the transaction would have no negative credit repercussions and you want minimal EPS dilution, rank the following types of convertibles from least potential for dilution to most potential for dilution: coupon-paying convertible, mandatory convertible, zero coupon convertible.

zero coupon convertible - Least Risk to EPS Dilution "A ZCC is, therefore, a positive cash flow bond financing with a lower chance of earnings per share (EPS) dilution since conversion is somewhat less likely." Conversion is less likely because non-hedge fund ZCC purchasers are unlikely to convert the offering unless the value of the common stock is greater than the cash redemption price (assuming no issuer liquidity or credit problems). (pg179) Because tax benefit to issuer, turns into a tax disadvantage to the investor, usually only non-taxable investors are willing to buy a ZCC. coupon-paying convertible Greater risk of EPS dilution than ZCC. Less risk than mandatory convertible because of the option to receive cash or stock. mandatory convertible - Greatest Risk to EPS Dilution No option to receive cash. Only stock will be distributed at maturity.

W hat are league tables and why are league tables important in investment banking?

"League tables" is the way that investment banking industry keeps track of underwriting participations by all banks and this becomes a basis for comparing banks' underwriting capabilities - there is one for every different type of security and geographic region.

WheelCo is raising $200 million via a mandatory convertible bond issuance. Assuming the company's share price on the date of issuance is $20 and the convertible bond carries a 25% conversion premium, what is the number of shares WheelCo has to deliver to investors if its share price at maturity is (a) $19; (b) $22, (c) $26, and (d) $30?

$200m /$20 = 10m shares $200m/$22 = 9.1m shares $200m/$25 = 8m shares $200m/$25 = 8m shares See page 180

What were the two main arguments for rejoining investment banks and retail deposit-taking banks that led to the passing of the Gramm-Leach-Bliley Act?

(1) to provide for a more stable and countercyclical business model for these banks and (2) to allow US banks to better compete with international counterparts (e.g., UBS, Credit Suisse, and Deutsche Bank) that were less encumbered by the Glass- Steagall Act.

Describe what a "Chinese Wall" is, which U.S. regulator would be concerned with issues involving the wall and what is meant by being brought "over-the-wall".

- The Chinese Wall is a physical and legal barrier between public information and private (non-public information). This "wall" typically separates Investment Bankers (Private Side Info) from Traders (Public Side Info) to negate the possibility of insider trading. - The SEC would be most interested in issues involving the chinese wall and possible infractions with it. - Being brought "over the wall" is when someone is given access to private (non-public) information, this results in them no longer being able to legally make trades based on that information.

What is the difference between asset management and wealth management?

-Wealth management is quite broader in perspective and includes asset management services, investment management, real estate planning, tax planning, etc. -Asset management, on the other hand, is related to the management of assets and investments such as stocks, bonds, real estate and other assets. -Wealth management refers to advisors who provide investment advice to selected individual, family, and institutional investing clients. Wealth management professionals create investment advisory relationships with investors and are not directly involved in the management of asset classes (role of the Asset Managers)

What is two key considerations for bankers in the debt capital markets division when working with an issuer on an offering?

1)Determining the likely impact that a new debt offering will have on the issuer's credit ratings. 2) Investor reaction to a potential offering.

List the three types of bank participants in an underwriting syndicate and their core responsibilities, in order of compensation received, from high to low.

1. Lead bookrunners - they have the responsibility for determining the marketing method and the pricing for the transaction and, therefore, receive the highest underwriting allocation and a proportionately higher percentage of the gross spread 2. Co-managers - they take on smaller underwriting allocations and provide minor input to the bookrunners on marketing a pricing issues, and have less risk and less work to, and so receive lower compensation 3. Selling Group - these banks don't take any financial risk and receive even lower compensation

****Provide seven reasons that an investment bank might give to support their advice that a private company should "go public".

1.) If a private company goes public that it now has access to public market funding (in its IPO as well as in follow-on offerings), which allows the company to have a broad, diverse ownership structure that may help stabilize the company's share prices during market down cycles. 2.) Public companies would have enhanced profile and marketing benefits since public companies generally receive more media attention, and thus will be able to increase interest in their products and increased market share. 3.) New equity creates an acquisition currency and compensation vehicle, in which public stock can be used instead of cash for future transactions as well as increasing employee incentives and compensation (stock and stock options). 4.) Creates liquidity for shareholders, i.e. IPOs will allow founders to reduce exposure to their company by selling shares. Founders and other key employees usually cannot sell more than 25% of their shares to provide IPO purchasers with confidence that founders and managers will remain economically motivated to increase shareholder value.

List six characteristics of companies that are good targets for an equity issuance.

1.) Strong stock performance or supportive equity research. 2.) Large insider holdings or illiquid trading. 3.) Over-leveraged capital structure. 4.) Strategic events imminent: financing an acquisition or large capital expenditure. 5.) Sum of Parts analysis (Carve-out, spin off, tracking stock) indicates hidden value. 6.) Investor focus, i.e. a Road Show focuses investors on misunderstood value and brings in additional equity research.

An investor lends 10,000 shares of ABC for two months when the stock is at $50 and requires 102% cash collateral. The market interest on cash collateral is 4.0%. The rebate rate on ABC shares is 2.5%. Calculate the combined profit for the stock lender and investment bank.

10,000 shares $50 = $500,000 102% = $510,000 total collateral. $510,000 4% = $20,400 / 12 = $1,700 2 months = $3,400 Market Interest $510,000 2.5% = $12,750 / 12 = $1,062.50 2 months = $2,125 Rebate to borrower $3,400 - $2,125 = $1,275 profit for stock lender and investment bank. Cash collateral is the % * total market value Stock lender gets interest, but loses rebate Interest is % * total market value Rebate is % * total market value Stock lender profit is interest - rebate REMEMBER IF IT'S MONTHS YOU HAVE TO MULTIPLY BY months/12

Suppose a company issues a $180 million convertible bond when its stock is trading at $30. Assuming it is convertible into 5 million shares, what is the conversion premium of the convertible?

180 million/5 million shares = $36/share. Conversion premium: (36-30)/(30)*100% = 20%.

Explain what a "green shoe" is.

A Green Shoe is an over allotment option that gives an investment bank the right to sell short a number of securities equal to 15% of an offering the bank is underwriting for a corporate client. The SEC permits this activity to enable investment banks to stabilize the price of an equity offering following its initial placement, in order to mitigate downside share price movement in the secondary market. This benefits the shareholders, the company, and the investment bank underwriters.

When is a break-up fee paid? What is the normal fee as a percent of equity value?

A breakup fee is a fee paid if the target company walks away after the agreement is signed and the transaction is not completed. The fee is usually 2-4% of the target company's equity value.

What are the benefits of issuing Eurobonds? Investing in Eurobonds?

A eurobond is a bond denominated in a currency not native to the issuer's home country. Eurobonds are commonly issued by governments, corporations, and international organizations. Let's assume Company XYZ is headquartered in the United States. Company XYZ decides to go to Australia to issue bonds denominated in Canadian dollars. This is an example of a eurobond. In many cases, an issuer sells its eurobonds in a number of international markets. Company XYZ might sell its Canadian dollar-denominated bonds in Japan and Canada too.

Why might a board want to include a "go-shop" provision in the merger/purchase agreement?

A go shop agreement is allows the target company to solicit interest from potential buyers for a short period of time (usually less than 2 months). If a better offer emerges, the target company is able to exercise a "fiduciary out" and terminate the merger agreement.

Why might a younger high-tech company select equity over debt when raising capital?

A high-tech company, that has a less certain future cash flow, will prefer an equity offering since there are no regular payments required in raising equity capital; it may not be able to generate the necessary cash to make regular coupon payments on debt capital. A young company that does not have the same credit reputation as older will have to pay more for debt financing - interest rates are higher and so raising debt capital will be more expensive.

How does a negotiated (best efforts) transaction differ from a "bought deal"?

A negotiated/best efforts transaction differs to a "bought deal" in that the issuer will bear the price risk; whereas in the underwriting in a bought deal, the investment bank bears the price risk.

What is a "Red Herring"?

A preliminary registration statement that must be filed with the SEC describing a new issue stock. It's called a red herring because it contains a passage in red that states the company is not trying to sell shares before registration is approved by the SEC

Under what circumstances would an investment bank hold a public auction in an attempt to help sell a company?

A public auction would be held if they believe the company's business is unlikely to be damaged by public process (even though this exposes the company to more risk), and they are having difficulty finding or identifying potential buyers. They are more likely to find potential hidden buyers, and obtain the highest offer.

What is a shelf registration statement and what securities can be included in it?

A shelf registration allows a company to file one registration statement that covers multiple issues of different types of securities (under Rule 415). Once accepted by the SEC, the company can have multiple offerings of several types of securities over a three-year period, as long as the company updates the registration with quarterly financial statements and other required updates. Securities of any public capital markets financings, such as equity offerings, debt, and convertible securities can be included after a shelf registration statement is made.

Why would a wealth manager choose to allocate some of a client's asset to another bank?

A wealth manager would choose to allocate some of a client's asset to another bank in the event of (i) their own bank not having the a specific investment product, (ii) performance of an internal fund is less than a competing firm at another firm

What is ASR an abbreviation for? Describe this transaction and the principal benefit for a client? What additional benefit did IBM achieve in their ASR?

Accelerated Stock Repurchase (192-194) Benefit: Share repurchases provide cash payout for stockholders while improving EPS by decreasing the number of shares outstanding. Due to regulations, repurchases can take up to a year to complete, thus delaying the stock price benefit from an improved EPS. ASR is designed to capture the EPS benefit of a repurchase program up front, rather than over a year or more. Transaction: Company A purchases large block of its shares from Investment Bank B To provide large block of shares, Investment Bank B borrows shares from current shareholders, thus entering a short position on Company A. Investment Bank B covers short position through daily open market purchases of Company A stock (According to regulation limit of no daily share purchases greater than 25% of prior 4 week average daily trading volume.). Once Investment Bank B buys enough shares to cover short postion, price modifications are enacted. If repurchase price was greater than what Company A originally paid Investment Bank B, then Company A reimburses Investment Bank B. If repurchase price was less than what Company A originally paid Investment Bank B, then Investment Bank B reimburses Company A.

What is a potential risk of trying to complete a stock-based acquisition during periods of high market volatility?

Because of the time period between the announcement and the actual merger and acquisition, share price might see some significant movement. There is typically a period of 3-9 months that share price might experience some changes that would not be favorable.

Why might a universal bank be better able to compete against a pure-play investment bank for M&A and other investment banking engagements?

Because of their broad-based banking business they could hire pure-play investment bank professionals and give them more resources and flexibility to increase lending capabilities and increase market share. Easy access to low interest capital.

Why would a prospective issuer prefer to hire as underwriter an investment bank that has traders already active in its security?

Being active in the stock can lead to more accurate pricing and higher trading-based revenue" - Active traders "become well versed in the trading characteristics of that stock, and have a deeper understanding of who currently holds the stock, the approximate price at which the stock was acquired, and which investors are willing to sell. Traders active in that stock are more familiar with that stock.

Investment bank clients can be categorized into two broad groups of issuers and investors. These two groups often have competing objectives (issue equity at highest possible price vs. acquire stock in companies at lowest possible price). Who within the investment bank is responsible for balancing these competing interests?

Capital Market Group

Disclosure of information to investors is another recurring theme in U.S. regulation of the securities industry. Provide examples of disclosure required by U.S. regulations.

Companies must give regulators and prospective investors through a filing with the SEC called the Registration Statement. Companies are also required to provide investors with a prospectus, which contains certain elements of the information included in the registration statement. The prospectus cannot be distributed until after the issue has been registered with the SEC.

If company A and B are identical in every respect except B has higher stock price volatility, which company would likely achieve better convertible pricing? Assuming convertibles issued by A and B have the same terms except for conversion price, would the company you selected above have a higher or lower conversion price?

Company A would receive a higher convertible pricing due to its lower volatility and resulting lower risk. For a hedge fund to purchase a convertible offering, there needs to be substantial liquidity and depth in the issuers stock for the hedge fund to buy and sell shares to maintain it's hedge ratio. Markets with low volatility or market depth provide extra risk for when the hedge fund must adjust it's shareholdings to meet it's hedge ratio. (pg. 178)

List the four principal alternative methods for establishing value in an M&A transaction.

Comparable Companies Analysis Comparable Transactions Analysis Discounted Cash Flow Analysis Leveraged Buyout Analysis

Of the major valuation methods which one(s) are based on relative values? ...on intrinsic values? ...on ability to pay?

Comparable Companies and Comparable Transactions are based on relative values. They draw on a peer group of public companies that have similar characteristics to the company being valued. Discounted Cash Flow is based on intrinsic value of the company. A DCF analysis takes into account the company's future cash flows and the riskiness of those cash flows. Leveraged Buyout is based on the company's ability to pay or the value to the financial buyer. Debt repayment and return on equity investment are considered.

Which valuation method tends to show the lowest valuation range? Why?

Comparable company range valuations tend to show valuation ranges lower than a comparable transaction range valuation. DCF analysis generally sits along with the valuation range of a comparable company range. LBO provides a floor price in the valuation range because it represents the price a financial buyer would be willing to pay given the required IRR. Financial buyers pay less on average than strategic buyers because the cost and work synergies are accounted for. Leveraged buyout pricing ranges would be the lowest unless in the case of a liquidity problem which still had high acquisition cost.

Which of the following companies would make a better LBO target, and why? (a) a diversified manufacturer of consumer snack products or (b) a manufacturer of factory automation equipment for car makers, agricultural equipment and other heavy machinery.

Consumer snack products. Obviously it depends on several factors pertaining to the nature of the LBO, but simply speaking in purchasing debt of the assets of a company. A company with raw goods that are very low in cost and much less capitalized expenditures to purchase is a much better target than a company with a vast array of capitalized equipment, factory space, and other assets that require debt burdens. A prime candidate has low capital expenditures and debt, with a lot of assets that can be sold. Increasing debt so much on an already leveraged firm could lead to cash flow problems when meeting debt obligations.

Why are revenue synergies typically given less weight than cost synergies when evaluating the combination benefits of a transaction?

Cost synergies are considered to be more important namely because they reduce costs, they arise through efficiencies created by eliminating redundant activities, improved operating practices, and economies of scale. Revenue synergies come from the ability to create greater revenue through a combined company rather than the sum of both independent companies.

Compare the different roles provided to the investor community by credit rating analysts and sell-side research analysts.

Credit analyst: assign ratings to company's debt, ratings are used by investors, banks and governments as an input into their decisions. Leads to increased efficiency in the market, lower costs for borrowers, investors and lenders and expands the total supply of capital. The issuer, not the investor, must pay for the rating. Sell-side research analysts: provide research to investing clients of the firm. Sell side research consists of building models to forecast a company's future earnings based on factors like company guidance econ conditions historical trends etc. also use multiples based on revenue, ebitda, earnings, book value and cash flow to assess a future share price. They are basically doing research to help a client determine if they should invest in a security.

How many shares will be issued by a convertible issuer if conversion occurs for a $200 million convertible with a conversion premium of 20%, which is issued when the issuer's stock price is $25? (show your calculation).

Current price = 25*(1+.2) = $30 -> $200 million/$30 = 6.66 million shares.