1. Securities Operations25
Securities
Operations

2. Chapter Objectives
Review and evaluate the key functions of investment banking firms
Describe the services provided by investment banking firms when they assist in issuing new stock issues
Analyze the risks of securities firms
Evaluate the key functions of brokerage firms
Evaluate the key factors impacting the value of securities firms

3. Investment Banking Services
Investment banking firms (IBFs) assist in raising capital for corporations and state and municipal governments
IBF’s serve both financing entities and investors:
Serve as an intermediary buying securities (promise to pay) from issuing companies and selling them (securities) to investors
Generate fees for services rather than interest income
Sell investing services to institutional and other investors
Advise companies on mergers and acquisitions
Value companies for sale or purchase
In recent years, loaned funds for mergers and acquisitions

4. Investment Banking Services
Distribution
Origination
Investment
Banking
Services
Advising
Underwriting

5. How IBFs Facilitate New Stock Issues
Origination
Company wishes to issue additional stock or issue stock for the first time contacts IBF
Gets advice on the amount to issue
Helps determine stock price for first-time issues
IBF assists with SEC filings
Registration statement
Prospectus—summary of registration statement given to prospective investors

6. How IBFs Facilitate New Stock Issues
Underwriting stock
Issuer and investment bank negotiate the underwriting spread
The difference between the net price given the company and the selling price to investors
Incentive to under-price IPO’s
The lead investment bank usually forms an underwriting syndicate
Other IBFs underwrite a part of the security offering
Helps spread the underwriting risk among IBFs

7. How IBFs Facilitate New Stock Issues
Distribution of stock
Full underwriting vs. best efforts
IBFs in the syndicate have retail brokerage operations
Other IBF added as part of selling group
Corporation incurs flotation costs
Underwriting spread
Direct issuance costs—accounting, legal fees, etc.

8. How IBFs Facilitate New Stock Issues
Advising
The IBF acts as an advisor throughout the process
Corporations do not have the in-house expertise
Includes advice on:
Timing
Amount
Terms
Type of financing

9. How IBFs Facilitate New Bond Issues
Origination
IBF may suggest a maximum amount of bonds that should be issued based on firm characteristics
Decisions on coupon rate, maturity
Benchmark with market prices of bonds of similar risk
Credit rating
Bond issuers must register with the SEC
Registration Statement
Prospectus

10. How IBFs Facilitate New Bond Issues
Underwriting bonds
Public utilities often use competitive bids to select an IBF, versus…..
Corporations typically select an IBF based on reputation and prior working experience
The underwriting spread on bonds is lower than that for stocks
Can place large blocks with institutional investors
Less market risk

11. How IBFs Facilitate New Bond Issues
Distribution of bonds
Prospectus
Advertisements to public
Flotation costs are typically in the range of 0.5 percent to 3 percent of face value

12. How IBFs Facilitate New Bond Issues
Private placement of bonds
Avoids underwriting and SEC registration expenses
Potential purchaser may buy the entire issue
Insurance companies
mutual funds
commercial banks
pension funds
Demand may not be as strong, so price may be less, resulting in a higher cost for issuing firm
Investment banks may be involved to provide advice and find potential purchasers

13. How IBFs Facilitate Leveraged Buyouts
IBFs facilitate LBOs in three ways:
They assess the market value of the LBO firm
They arrange financing
Purchase outstanding stock held by public
Often invest in the deal themselves
Provide advice

14. How IBFs Facilitate Arbitrage
Arbitrage = purchasing of undervalued shares and reselling the shares at a higher price
IBFs work with arbitrage firms to search for undervalued firms
Asset stripping
A firm is acquired, and then its individual divisions are sold off
Sum of the parts is greater than the whole
Kohlberg, Kravis, and Roberts

15. How IBFs Facilitate Arbitrage
IBFs generate fee income from advising arbitrage firms as well as a commission on the bonds issued to support arbitrage activity
IBFs also provide bridge loans
When fund raising is not expected to be complete when the acquisition is initiated
IBFs provide advice on takeover defense maneuvers

16. How IBFs Facilitate Arbitrage
History of arbitrage activity
Greenmail is when a target company buys back stock from arbitrage firm at a premium over market price
Arbitrage activity has been criticized
Results in excessive financial leverage and risk for corporations
Restructuring sometimes results in layoffs
Arbitrage helps remove managerial inefficiencies
Target shareholders can benefit from higher share prices

17. Brokerage Services Full-service versus discount brokerage services
Full-service firms provide investment advice as well as executing transactions
Discount brokerage firms only execute security transactions upon request
Online brokerage firms

18. Allocation of Revenue Sources
Importance of brokerage commissions has declined in recent years
Largest source of revenue has been trading and investment profits
Underwriting and margin interest also make up a significant portion of revenue
Revenue from fees earned on advising and executing acquisitions has increased over time

19. Regulation of Securities Firms
Regulated by the National Association of Securities Dealers (NASD) and securities exchanges
The SEC regulates the issuance of securities and specifies disclosure rules for issuers
Also regulates exchanges and brokerage firms
SEC establishes general guidelines, while the NASD provides day-to-day self-regulatory duties

20. Regulation of Securities Firms
The Federal Reserve determines the credit limits (margin requirements) on securities purchased
The Securities Investor Protection Corporation (SIPC) offers insurance on brokerage accounts
Insured up to $500,000
Brokers pay premiums to SIPC to maintain the fund
Boosts investor confidence, increasing economic efficiency

21. Regulation of Securities Firms
Financial Services Modernization Act of 1999
Permitted banking, securities activities, and insurance to be offered by a single firm
Varied financial services organized as subsidiaries under special holding company
Financial holding companies regulated by the Federal Reserve

22. Risks of Securities Firms
Interest Rate
Risk
Market Risk
Exchange Rate
Risk
Credit Risk

23. Risks of Securities Firms
Market risk
Securities firms’ activities are linked to stock market conditions
When stock prices are rising:
Greater volume of stock offerings
Increased secondary market transactions
More mutual fund activity
Securities firms take equity positions which are bolstered when prices rise

24. Risks of Securities Firms
Interest rate risk
Performance of securities firms can be sensitive to interest rate movements because:
Market values of bonds held as investments increase as interest rates fall
Lower rates can encourage investors to withdraw money from banks and invest in stocks
Exchange rate risk
Operations in foreign countries
Investments in securities denominated in foreign currency

25. Valuation of Securities Firms
Value of a securities firm depends on its expected cash flows and required rate of return
V = f [E(CF),k] +
Where:
V = Change in value of the securities firm
E(CF) = Change in expected cash flows
k = Change in required rate or return

26. Valuation of Securities Firms
Factors that affect cash flows
E(CF)= f (ECON, Rf , INDUS, MANAB) + ? +
Where:
E(CF) = Expected cash flow
ECON = Economic growth
Rf = Risk free interest rate
INDUS = Prevailing industry conditions
MANAB = The ability of the security firm’s management

27. Valuation of Securities Firms
Investors required rate of return
k = f(Rf , RP) + +
Where:
Rf = Risk free interest rate
RP = Risk premium

28. Interaction With Other Financial Institutions
Offer investment advice and execute security transactions for financial institutions that maintain security portfolios
Compete against financial institutions that have brokerage subsidiaries
Glass-Steagall Act of 1933 separated the functions of commercial banks and investment banking firms
Financial Services Modernization Act of 1999
Effectively repealed Glass-Steagall
Commercial banks, securities firms, and insurance companies will increasingly offer similar services

29. Globalization of Securities Firms
Securities firms have increased their presence in foreign countries
Merrill Lynch has more than 500 offices spread across the world
Allows them to place securities in various markets for corporations or governments
International M&A
Ability to handle transactions with foreign securities

30. Globalization of Securities Firms
Growth in international securities transactions
Created more business for large securities firms
International stock offerings
Increased liquidity for issuing firm, avoiding downward price pressure
Growth in Latin America
Increased business due to NAFTA
Growth in Japan
Some barriers to foreign securities firms still exist