Fin

How are after-hours trades typically handled?

After-hours orders are typically filled only if they can be matched with identical opposing orders at the desired price, called crossing orders. Many large brokerage firms, both traditional and online, offer after-hours trading sessions for clients. ECNs are used to handle much of the after-hours trading sessions for clients who are typically brokerage houses or other large, institutional investors

What incentives would the partners in an investment bank have to turn it into a public corporation?

Although investment banks may take on more risk than commercial banks or most other financial firms, they also may deliver higher returns. Investors who find this trade-off between risk and return to be tractive will buy the investment banks' stock.

How can an investment bank be subject to a run?

An investment bank can be subject to a run when investors do not renew their repurchase agreements, do not purchase the investment bank's commercial paper, or other counterparties want to cash investments out.

During the 2000s, why did investment banks become more reliant on repo financing and also, more highly leveraged?

Because by the 1990s most of these banks had converted from partnerships to publicly traded companies. As proprietary trading became a more important source of profits, investment banks increasingly borrowed to finance investments in securities and direct loans to firms.

In what ways are investment institutions similar to commercial banks?

Both financial intermediaries that raise funds and invest them in loans and securities

What IPOs are sold in dealer markets ?

Both listed and unlisted securities and IPOs

How are banks able to attract small savers if small savers can usually receive a higher interest rate from money market mutual funds than from bank savings accounts?

Deposits in bank savings accounts are covered by federal deposit insurance whereas money market mutual fund shares are not. Also, money market mutual funds restrict savers to writing checks only above a specified amount, such as $500 (Money market savings aren't as liquid as bank deposits.)

What is the 'run potential' in money market mutual funds?

refers to the possibility that real or perceived bad news about the quality of money market mutual fund assets could cause investors to redeem their shares and trigger runs on other money market mutual funds, shutting down the commercial paper market.

Repos

short-term loans with the securities serving as collateral.

Underwriting syndicate

spread the financial risk across multiple firms.

A run on a financial firm

the attempt by investors to get their money out before the firm fails.

Leverage

the financing of investments by borrowing rather than using capital.

Bid price

the highest price at which the dealer is willing to purchase a security. This is not because the dealer wants to pay a higher price, but because he wants the order flow.

ask price

the lowest price at which the dealer is willing to sell the security. Again, the dealer's willingness to sell at a high price is a trade-off with his desire to get the sale.

What does 'breaking the buck' mean?

the net asset value of the money market fund had fallen below $1 to $0.97.

What risk do underwritters bear?

the risk of reselling the issue to the public at a profit.

What is 'systemic risk'?

the risk to the entire financial system rather than to individual firms or investors.

Where do dealers buy and sell from?

their own inventories. Their main source of profit results from making trades, thus, they seek to maintain a relatively stable inventory size.

Some critics of the current IPO system claim that underwriters may knowingly underprice an issue. Why might they do this?

to increase their own profits and make shares easier to sell.

What do investment banks involve?

1. underwriting new security issues 2. providing advice on mergers and acquisitions

In what way is a repurchase agreement like a bank deposit?

A repurchase agreement is a short-term loan that pays a small amount of interest. In this sense, repos are equivalent to you "lending" funds to your bank by depositing them in your checking account in return for a small interest payment.

What is a 'run' and what is 'contagion'?

A run is a rush to withdraw money before everyone else does. One money market mutual fund breaking the buck signaled that other money market mutual funds might also do so. Investors became worried about the value of the assets in their money market mutual funds and whether they would be able to redeem their shares at the usual value of $1 per share.

Broker market

Broker markets are security exchanges with centralized, physical locations where securities listed on a particular exchange are traded

How do investment banks 'unlock capital markets'?

By knowing the ins and outs of financial markets and knowing the current willingness of investors to buy different types of securities as well as the price investors are likely to require. Investment banks use this knowledge to help firms raise funds through stock and bond issues.

Why have runs on commercial banks become rare while multiple shadow banking firms experienced runs during the financial crisis?

Commercial banks do not typically have bank runs because their deposits are insured by the Federal Deposit Insurance Corporation (FDIC) which reduces the risk to depositors. The shadow banking industry, however, is not covered by the FDIC because their short-term borrowing is not in the form of deposits.

OTC Bulletin Board

Companies that do not meet Nasdaq listing standards or don't want to be listed, are traded in the OTC Bulletin Board market or Pink Sheets. These firms may be too small to be liquid or to be continuously priced.

Dealer market

Consist of a complex system of buyers and sellers (market-makers) linked by sophisticated telecommunications networks. These markets are made up of traders known as dealers who offer to buy or sell stocks at specific prices.

In what ways are contractual savings institutions similar to commercial banks?

Contractual savings institutions are similar to commercial banks because like all financial intermediaries, they raise funds and invest them in loans and securities.

Investment bankers

Financial intermediaries who specialize in selling new security issues as either initial public offerings (IPOs) or seasoned equity offerings. also provide the securities' issuer with advice about pricing and other important aspects of the issue.

What 'government guarantees' did commercial banks receive 75 years ago?

Government guarantees refer primarily to federal deposit insurance through the FDIC.

What would be the consequences for a shadow bank if "depositors" failed to renew their repos?

If "depositors" (lenders) refuse to renew their repos, it is the equivalent of depositors making a withdrawal from a commercial bank. The shadow bank would need to pay off the loans of the lenders who did not renew their lending through repos. Given that the shadow banks typically invested the borrowed funds in longer-term assets, they would have to sell some of these long-term assets to pay off the loans. If the longer-term assets lost value, as mortgage-backed securities did during the financial crisis, then the shadow banks could be in serious financial trouble.

Brokers

facilitate trades by bringing buyers and sellers together, but don't generally buy or sell the traded securities.

Money market

In the money markets, short-term securities such as CDs (maturities ≤ 1 year), Treasury bills, and commercial paper, etc. are traded.

What impact do institutional investors have on IPO pricing?

Institutional investors tend to receive most of the shares of IPOs that are in demand ('good IPOs'.) Their concern about overpaying for shares may contribute to underpricing.

How do these activities make investment conduits of credit?

Investment banks are conduits of credit for all of the above mentioned reasons. In this role, they help match savers and borrowers and decrease the risk of borrowing and lending.

How do investment banks help firms to manage risk? \

Investment banks help firms use derivative contracts and design new securities to help corporations manage risk.

Why might too much leverage be a problem for an investment bank? Why might relying too much on short-term borrowing be a problem?

Leverage magnifies profit, but it also magnifies loss. Relying too much on short-term borrowing creates a large mismatch between the maturity of assets (loans) and the maturity of liabilities, and when lenders become concerned about the quality of an investment bank's assets, they stop rolling-over their short-term loans to the bank. Without access to short-term borrowing, an investment bank may be forced to raise funds by selling assets, possibly at low prices. Falling asset values can force the bank into insolvency.

Capital market

Long-term securities such as stocks and bonds are traded in the capital markets.

describe the main features, functions and problems that would be faced by a single global market exchange on which transactions could be made in all securities of all of the world's major companies.

Many developing economies place foreign ownership restrictions on their listed stock and do not insist on the level of disclosure required on other major exchanges. Another stumbling block relates to currency conversion.

The largest netowrk linking dealers in the US

Nasdaq

Primary market

New securities, first-time issues, are sold in the primary market.

Is an investment bank that buys securities with its own capital acting as a financial intermediary?

No. It is buying securities with the expectation of profit from the yield or from changes in the prices of the securities. Investing in this way does not involve acting as an intermediary by funneling funds from savers to borrowers.

Secondary market

Once a security has been issued, it can be bought and sold in the secondary market.

What factors might contribute to the huge first-day returns on IPOs?

One reason for initial high returns is the significant amount of hype that surrounds new issues and underpricing by underwriters. Another reason for initial high returns is that underwriters may intentionally underprice issues to increase their own profits and make shares easier to sell.

Why do some large, well-known companies such as Cisco Systems, Intel, and Microsoft prefer to trade on Nasdaq rather than on the NYSE?

Segments of Nasdaq-listed firms have equivalent liquidity (Global Select Market) to those of the NYSE, but it is less expensive to list on Nasdaq. Nasdaq also has additional segments that allow less liquid firms to be listed.

In what ways does the shadow banking system differ from the commercial banking system?

Shadow banking firms are less regulated than commercial banks and so can invest in more risky assets and become more highly leveraged than commercial banks. Unlike commercial banks, there is no federal deposit insurance for the investors who provide funds to the shadow banking system.

How is this 'run potential' related to systemic risk in the financial system?

Shutting down the commercial paper market would cause problems for many financial and nonfinancial firms that raise funds by issuing commercial paper. The run potential in money market mutual funds generates a risk throughout the financial system. A run can easily become a contagion.

What do commercial banks involve?

Taking deposits and making loans

What are deposits backed by?

The FDIC

Why was the Lehman paper in the fund's portfolio worthless?

The Lehman paper was worthless because Lehman Brothers had gone bankrupt.

What are the advantages and disadvantages to employees

The advantage of the 'up or out' policy to investment banks and other firms is that workers have an incentive to work very hard during their first years with the firm to demonstrate that they are worthy of being promoted. A disadvantage is that risk averse people may not apply for jobs at investment banks or other firms using the up or out policy do to fear of being fired after just a few years.

How did these government guarantees halt commercial bank runs?

The creation of the FDIC eliminated the incentive for depositors to run on the bank because their money was insured if the bank failed.

What information from this excerpt indicates that Long-Term Capital Management was highly leveraged?

The excerpt indicates that the Long-Term Capital Management hedge fund used $5 billion in capital to get an additional $125 billion in funds. The $125 billion in funds were then used to control $1.25 trillion in securities. So, Long-Term Capital Management was highly leveraged because it used relatively little capital and a great amount of borrowing to control investments that were many times larger.

In what ways are insurance companies financial intermediaries?

They obtain funds by charging premiums to policyholders and then use these funds to make investments

If there are no advantages to employees, how are investment banks able to find people willing to work for them?

To attract new hires, many 'up and out' firms offer an above-average starting salary.

In what sense is an investment bank that engages in underwriting acting as a financial intermediary?

Underwriting is financial intermediation because the bank brings together savers and the firms who issue new securities.

What is underwriting?

Underwriting is where investment banks guarantee (typically) a price to the issuing firm for new stocks or bonds and then sell the new issue at a higher price in financial markets or directly to investors (private placement.)

In what ways are contractual savings institutions different to commercial banks?

Unlike commercial banks, however, contractual savings institutions do not raise funds through deposits but rather, receive payments from individuals as a result of a contract. They also have access to a wider range of assets than commercial banks.

In what ways are investment institutions different to commercial banks?

Unlike commercial banks, investment institutions do not raise funds through deposits and they have access to a wider variety of investment assets than commercial banks.

Shadow banking system

a collection of nonbank financial institutions that channel money from savers to borrowers.

Bull Market

a favorable market normally associated with rising prices, investor optimism, economic recovery, and government stimulus.

Public offerings

a firm offers its shares for sale to the general public after registering the shares with the SEC

Repo financing

a way of borrowing funds through the use of repurchase agreements

What is 'Lehman paper'?

commercial paper that Lehman Brothers had issued to raise funds.

Bear market

are associated with falling prices, investor pessimism, economic downturn, and government restraint.

Why was "breaking the buck" significant to the financial system?

because it was highly unusual for a money market mutual fund to allow the price of its shares to drop below $1. Investors in money market mutual funds were willing to accept the relatively low interest rates these funds offered relative to some other investments only if they were sure that they would not suffer a capital loss from a decline in the value of the shares. 'Breaking the buck' badly hurt investor faith in money markets and reminded them that their higher return had come at the acceptance of higher risk.

Why was the financial crisis difficult to foresee?

because of the complexity of some of the financial securities that been introduced over the previous decade and because of how quickly the financial markets have changed. Some people saw the potential for a financial crisis because of the increased use of unregulated credit derivatives and because of the growth in the unregulated shadow banking system where financial leverage was high and no FDIC insurance existed.

what happened with the Reserve Primary Fund, a money market mutual fund, on September 16, 2008?

At 4:15p.m., the fund issued a press release. The Lehman paper in its portfolio was worthless and the fund's shares were worth not $1, but only 97 cents: breaking the buck. The news triggered a run that spread through the $3.4 trillion money market mutual fund industry.

Why might competitive pressure lead a hedge fund manager to take on more leverage? Would the same reasoning apply to managers of an investment bank?

Hedge funds compete for investor funding by offering higher rates of return than alternative investments. If a hedge fund manager sees that other hedge funds are earning higher rates of return because of the leverage they employ, the manager may feel the need to increase the leverage at his or her fund to compete. The same reasoning applies to investment banks and their proprietary trading.

Underwriting

Involves the purchase of a security issue from the issuing firm at an agreed-on price

Why might issuing companies accept lower IPO prices?

Issuing firms may be willing to accept lower prices if it draws attention to their firm which may make it easier raise funds through add additional share offerings at a later date.

What is leverage?

Leverage involves using borrowed funds to invest rather than using capital or equity to invest.

What risks did Long-Term Capital Management's high leverage pose to the firm? What risks did it pose to the financial system?

Leverage is a double-edged sword. It can increase profits, but it also magnifies losses. These losses were so massive that they created systemic risk to the rest of the system. If Long-Term Capital Management had defaulted on its loans, many other financial firms would have taken large losses as well.

If money market mutual funds have problems, can't savers just deposit their money in banks?

People can deposit money in banks rather than buying money market mutual shares, but they will receive a lower return on their funds. If a rise in deposits resulted in significantly decreasing the amount of investment into money market mutual funds, the ability of firms to borrow through the commercial paper market would be greatly reduced.

What became of the large, standalone investment banks during the financial crisis of 2007-2009?

The large stand-alone investment banks either went bankrupt, were taken over, or converted to bank holding companies to obtain access to Federal Reserve lending to survive the financial meltdown.

Why is the money market mutual fund industry so important?

because these institutions hold so much short-term debt. In particular, money market mutual funds buy large amounts of commercial paper, which many firms rely on to meet payroll and other operating costs. Problems with money market mutual funds would sharply reduce firms' access to this source of funding.

Market makers

hold an inventory of the stock they make markets in.

Crossing orders

if they can be matched with identical opposing orders at the desired price

Repurchase agreement

is the selling of securities under the condition that the seller is to buy back the securities at a slightly higher price within a short period of time (typically, the next day or within a few days.)

private placement

rather than issue shares publicly, shares are sold directly to investors who can purchase large volumes of shares such as insurance companies and pension funds. Private placements don't require SEC registration.