1 Chapter 24 Securities Operations Financial Markets and Institutions, 7e, Jeff Madura Copyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved.

2 Chapter Outline Investment banking services Brokerage services Sources of income Regulation of securities firms Risks of securities firms Valuation of a securities firm Interaction with other financial institutions Participation in financial markets Globalization of securities firms

3 Investment Banking Services One of the main functions of investment banking firms (IBFs) is raising capital for corporations  IBFs originate, structure, and place securities in the capital markets  They serve as an intermediary rather than a lender or investor  Their compensation is typically in the form of fees

4 Investment Banking Services (cont’d) How IBFs facilitate new stock offerings  An IBF acts as an intermediary between a corporation and investors  Origination IBFs recommend the appropriate amount of stock to issue IBFs evaluate the corporation’s financial condition to determine the appropriate stock price

5 Investment Banking Services (cont’d) How IBFs facilitate new stock offerings (cont’d)  Origination (cont’d) The issuing corporation registers with the SEC  The registration statement is intended to ensure that accurate information is disclosed by the issuing corporation  Included in the registration information is the prospectus, disclosing relevant financial data on the firm and provision applicable to the security The IBF and the issuing firm may engage in a road show to meet with institutional investors

6 Investment Banking Services (cont’d) How IBFs facilitate new stock offerings (cont’d)  Underwriting The IBF may form an underwriting syndicate and ask other IBFs to underwrite a portion of the stock In a best-efforts agreement, the IBF does not guarantee a price to the issuing corporation During IPOs:  IBFs want to set the price high so that the issuing corporation receives higher proceeds  IBFs do not want to set the price too high in order to place the entire issue  IBFs tend to underprice IPOs

7 Investment Banking Services (cont’d) How IBFs facilitate new stock offerings (cont’d)  Distribution of stock The prospectus is distributed to all potential purchasers of the stock The issue is advertised to the public Some IBFs have brokerage subsidiaries that can sell stock on a retail level The corporation incurs two types of flotation costs:  Fees paid to the underwriters  Issue costs, including printing, legal, registration, and accounting expenses

8 Investment Banking Services (cont’d) How IBFs facilitate new stock offerings (cont’d)  Advising The IBF acts as an adviser during the origination stage and may provide advice after the stock is issued  Private placement of stocks IBFs may be able to place an entire offering with a small set of institutional investors Rule 144A allows firms to engage in private placement without the registration statement An underwriting syndicate may not be necessary The issuing firm’s costs are lower

9 Investment Banking Services (cont’d) How IBFs facilitate new bond offerings  Origination The IBF may suggest a maximum amount of bonds based on existing debt levels The coupon rate, maturity, and other provisions are decided The asking price on the bonds will be determined by evaluating market prices of existing bonds Issuers of bonds must register with the SEC and a registration statement must be filed

10 Investment Banking Services (cont’d) How IBFs facilitate new bond offerings (cont’d)  Underwriting bonds Some issuers may solicit competitive bids on the price of bonds from various IBFs IBFs provide several services to the issuer Underwriting spreads on newly issued bonds are normally lower than on newly issued stock The IBF may organize an underwriting syndicate to participate in placing the bonds  Distribution of bonds A prospectus is distributed to all potential purchasers The issue is advertised to the public The asking price is normally set to ensure a sale of the entire issue Flotation costs range from 0.5 to 3 percent of the value of the bonds

11 Investment Banking Services (cont’d) How IBFs facilitate new bond offerings (cont’d)  Advising IBFs may serve as advisers even after the placement is completed  Private placement of bonds In a private placement, the issuing corporation sells the issue to a purchaser of the entire issue  Avoids underwriting fees Private placements are more common for bonds than for stocks

12 Investment Banking Services (cont’d) How IBFs facilitate leveraged buyouts  IBFs assess the market value of the firm  IBFs arrange financing, which involves raising funds and purchasing any common stock outstanding that is held by the public  IBFs may be retained in an advisory capacity  IBFs may purchase a portion of the firm’s assets to provide financial support Exposes the IBF to a high degree of risk  Merrill Lynch has designed a mutual fund that finances LBOs Purchase junk bonds of firms that went private Provides bridge loans that offer temporary financing to firms until junk bonds can be issued

13 Investment Banking Services (cont’d) How IBFs facilitate arbitrage  Arbitrage activity involves the purchasing of undervalued shares and the resale of those shares for a higher profit  Arbitrage firms search for undervalued firms and IBFs raise funds for these firms  Asset stripping involves acquiring the firm and selling its individual divisions off The sum of the parts is greater than the whole

14 Investment Banking Services (cont’d) How IBFs facilitate arbitrage (cont’d)  IBFs generate fee income from advising arbitrage firms and receive a commission on the bonds issued to support the arbitrage activity  IBFs receive fees from divestitures of divisions  IBFs may provide bridge loans if additional financing is needed  IBFs may provide advise on defense takeover tactics and finance takeovers  Some arbitrage firms take positions in hostile takeover targets to benefit from the expected takeover by another group Some attempts at arbitrage fail because target firms are successful at defending against a takeover

15 Investment Banking Services (cont’d) How IBFs facilitate arbitrage (cont’d)  History of arbitrage activity Sometimes arbitrage firms have accumulated shares of targets with the expectation that targets will buy back the shares at a premium  Greenmail Some IBFs helped to finance greenmail Arbitrage activity has been criticized because:  It often results in excessive financial leverage and risk for corporations  The restructuring of divisions after acquisitions results in layoffs

16 Investment Banking Services (cont’d) How IBFs facilitate corporate restructuring  IBFs provide advice on corporate restructuring IBFs assess potential synergies that might result from the combination of two businesses  The sum of the whole is greater than the sum of the parts IBFs may suggest a carve-out in which the firm sells a unit of the firm to new shareholders through an IPO by the unit  The sum of the parts is greater than the sum of the whole  The unit may also be spun off, where new shares of the unit are created and distributed to existing shareholders

17 Investment Banking Services (cont’d) How IBFs facilitate corporate restructuring (cont’d)  IBFs provide advice on mergers and acquisitions IBFs are critical in the valuation of the business IBFs have loaned out their funds to companies involved in mergers and acquisitions or even provided equity financing The IBF can help finance an acquisition by:  Providing loans to the acquirer  Underwriting bonds or stock for the acquirer  Investing their own equity in the acquirer’s purchase of the target

18 Brokerage Services Market orders are requests by customers to purchase or sell securities at the market price existing when the order reaches the exchange floor Limit orders are requests by customers to purchase or sell securities at a specified price or better  Specialists monitor limit orders and execute transactions in accordance with the limits specified  If investors order a sale of securities when the price reaches a specified minimum, it is a stop-loss order

19 Brokerage Services (cont’d) Short selling involves the sale of securities investors do not own  Used to speculate on expectations of a decline in securities prices  Short sellers are required to reimburse the owners of the stock for any missed dividends Full-service versus discount brokerage services  Full-service brokerage firms provide information and advice as well as executing transactions  Discount brokerage firms only execute transactions upon requests and do not provide advice The required minimum opening balance is typically between $1000 and $3,000 Most discount brokers offer some degree of research on a website

20 Brokerage Services (cont’d) Online orders  The implementation of an online order system has reduced costs of brokerage firms  Online trading has become very competitive Prices charged are low, typically $25 or less for 100 shares of stock

21 Sources of Income (cont’d) Income allocation among securities firms  The proportion of income derived from each source varies among securities firms in any particular year e.g., when IPOs are hot, income from underwriting fees will be high  Some securities firms emphasize investment banking and therefore generate a high proportion of income from underwriting and advising fees e.g., Goldman Sachs  Some firms emphasize brokerage and generate a higher proportion of income from trading commissions e.g., Charles Schwab  Many securities firms attempt to diversify their services so that they can capitalize on economies of scope

22 Regulation of Securities Firms Securities firms are subject to a variety of regulations The SEC attempts to ensure that investors have access to financial information The SEC has power to ensure that publicly- traded companies provide sufficient financial information to existing or prospective investors The SEC tends to establish general guidelines that can affect trading on security exchanges

23 Regulation of Securities Firms (cont’d) Rules regarding analyst compensation and ratings  When firms need underwriting or advisory services, they are more likely to hire a securities firm whose analyst would rate the stock highly  The compensation of some analysts in the 2001– 2002 period was sometimes aligned with the new business they brought in  Analysts were tempted to inflate the ratings of stocks and investors were misled

24 Risks of Securities Firms Market risk  When stock prices are rising there is a greater volume of stock offerings and secondary market transactions  Securities firms benefit from a bullish stock market Some take equity positions in the stocks they underwrite Some take a partial equity interest in target firms Acquisitions tend to be more common in bullish markets Interest rate risk  The market values of bonds held as investment by securities firms increase as interest rates decline  Lower interest rates can encourage investors to withdraw deposits from banks and invest in the stock market

25 Risks of Securities Firms (cont’d) Credit risk  Securities firms offer bridge loans and other types of credit to corporations  Default risk increases during periods when economic conditions deteriorate Exchange rate risk  Many securities firms have operations in foreign countries  Earnings remitted by foreign subsidiaries are reduced when the foreign currencies weaken against the parent firm’s home currency  Market values of foreign investments decline as the currencies weaken against the parent firm’s home currency

26 Valuation of a Securities Firm The value of a securities firm is the present value of its future cash flows  The value should change in response to changes in expected cash flows and the required rate of return: Factors that affect cash flows:

27 Valuation of a Securities Firm (cont’d) Economic growth  Economic growth increases the level of income of firms and households and can increase the demand for the firm’s services The volume of brokerage activity increases Business expansion increases Debt securities are less likely to default Equity securities should perform well Change in the risk-free interest rate  The valuation of a securities firm is inversely related to interest rate movements Assets are adversely affected by rising interest rates

28 Valuation of a Securities Firm (cont’d) Change in industry conditions  Affected by regulations, technology, and competition  Reduced regulations may increase expected cash flows  Increased competition from reduced regulations may reduce expected cash flows Change in management abilities  Managers can attempt to make decisions that will capitalize on external forces the firm cannot control  Securities firms need skillful management to create new financial services that may complement the brokerage services they already offer

29 Valuation of a Securities Firm (cont’d) Factors that affect the required rate of return by investors:  The risk-free rate is positively related to inflation, economic growth, and the budget deficit level, but inversely related to money supply growth  The risk premium is inversely related to economic growth and the company’s management skills  Regulatory constraints may discourage firms from taking excessive risk  Loosening of regulatory barriers to entry may increase the risk of securities firms

30 Participation in Financial Markets (cont’d) Competition between securities firms and commercial banks  Commercial banks can offer discount brokerage services at lower fees than full-service fees Commercial banks compete with discount brokers Commercial banks must either establish a brokerage subsidiary or acquire a brokerage firm  Recently, some securities firms have provided loans to businesses

31 Globalization of Securities Firms (cont’d) Growth in international joint ventures  Securities firms have expanded internationally by engaging in joint ventures Allows foreign market penetration with a limited stake  Securities firms facilitate privatizations of firms in foreign markets such as Latin America and Europe Growth in international securities transactions  The growth in international securities transactions has created more business for the larger securities firms Growth in Latin America Growth in Japan