1. Salaar - Finance Capital Markets Winter Semester 2009 Lahore School of Economics Salaar Farooq – Assistant Professor

2. Salaar - Finance Lecture Securities Firms & Investment banks

3. Salaar - Finance Securities Firms & Investment Banks Learning Objectives Underwriting? Broker-dealer-IPO’s Investment Banking? Secondary markets? Mechanics of Markets?

4. Salaar - Finance Primary Markets Learning Objectives What are Primary Markets & IPO’s? What is an Investment Banker? How securities are issued: Process? What is Arbitrage? What are private placements? What are some SEC regulations? World Capital Mkts considerations

5. Salaar - Finance Financial Markets? Primary Markets Primary Market Initial Public Offering (IPO)

6. Salaar - Finance Financial Markets? Primary Markets Primary Market Market for new issues of securities (investment bankers) Issuers receive funds (raise capital) Buyers receive financial claims Initial Public Offering (IPO) Process of initial sale of new securities After initial sale, securities trade in the secondary markets

7. Salaar - Finance Financial Markets? Investment Banker Firm specializing in the sale of new securities to the public Key Role of Investment Banks Assist in obtaining funds for Corporations, Govts, & Foreign Entities. And for Investors, act as brokers or dealers in buying & selling securities.

8. Salaar - Finance INVESTMENT BANKERS Specialize in design & sale of securities in the primary market Work with issuers to bring a new issue of securities to market— legal, accounting, pricing, and so forth Involved in other matters, such as advising firms on mergers and acquisitions, or reorganizations

9. Salaar - Finance INVESTMENT BANKING Investment bankers form a syndicate to sell new securities-- multiple investment bankers working together Investment bankers underwrite an issue, purchasing securities from issuer & assuming risk of reselling Investment bankers profit from the spread between price they pay & price they sell the issue

10. Salaar - Finance Financial Markets? Investment Banking Performed by 2 groups: Securities Firms Firm specializing in the distribution of new securities to the public & also in secondary mkts as brokers & dealers Commercial Banks Also underwrite securities.

11. Salaar - Finance Investment Banking How they make money? Commissions Fees Spread Income Also from: Money management Mergers & Acquisitions Trading of securities etc.

12. Salaar - Finance Financial Markets? Investment Banker Firm specializing in the sale of new securities to the public Underwriting – Buying of securities from issuer Process by which investment bankers purchase an issue of securities from a firm and resell it to the public PROSPECTUS: Provides info about the IPO to the customers

13. Salaar - Finance Financial Markets? Under-writing Process 3 Main Areas: 1.Advising the issuer on terms & timing of offering 2.Buying Securities from issuer 3.Distributing the securities to public

14. Salaar - Finance Financial Markets? Under-writing Process Buying securities: Firm Commitment: Investment Bank agrees to buy from issuer at fixed price Best efforts under-writing When the IB does not buy the securities but provides expertise Gross Spread – Discount (4-7%) Difference b/w price paid to issuer & price received from public

15. Salaar - Finance issuer Originating investment banker Underwriting Syndicate (group of invest bankers) Selling group (syndicate + selected retail brokers) INVESTORS BUYING IN PRIMARY MKT MARKETING MUSCLE CRITICAL

16. Salaar - Finance Privatization?

17. Salaar - Finance Privatization? Offering securities of Govt owned companies to public… Thereby liquidating Govt ownership Also performed by Investment Banks

18. Salaar - Finance Arbitrage? Another activity of Investment Banks

19. Salaar - Finance Arbitrage? Another activity of Investment Banks Trading discrepancies in same security at different locations… Example… JNJ at 51.83-.90 in NY JNJ at 51.95-99 in LDN Locking a profit with no risk

20. Salaar - Finance Financial Markets? Global Investment Banking & Private Placements Global Investment Banker Private Placements

21. Salaar - Finance Financial Markets? Global Investment Banking & Private Placements Global Investment Banker Firm specializing in the sale of new international securities to the public Private Placements Securities are issued directly to financial institutions bypassing the open market. - typically insurance, pension funds and investment companies No SEC filing required Investment banking fees is saved

22. Salaar - Finance OTHER PRIMARY MARKET ISSUES Investment banking is a global operation now, …as firms raise capital around the world in order to reduce costs

23. Salaar - Finance Financial Markets? Regulation of Issuance of Securities Underwriting is regulated by the SEC Some rules: Registration statement of intent to issue Part I: Prospectus Part II: Supplemental Info Responsibility of Due Diligence is with underwriter Shelf Registration rule : can sell in the market (not allowed before)

24. Salaar - Finance Continued… Regulation of Issuance of Securities Underwriting is regulated by the SEC Some rules: Continued Reporting Rule 144A: Privately placed securities CAN be sold immediately (not allowed before)

25. Salaar - Finance Raising Capital outside domestic market 4 main reasons:

26. Salaar - Finance Raising Capital outside domestic market 4 main reasons: 1.Local market may not be large enough 2.Reduced cost of funding 3.To diversify source of funding 4.To manage foreign exchange risks

27. Salaar - Finance Financial Markets? Secondary Markets Markets where existing securities are traded For investments to be attractive… they must have… “LIQUIDITY” & SECONDARY markets provide that

28. Salaar - Finance Financial Markets? Secondary Markets Function of Secondary Markets?

29. Salaar - Finance Financial Markets? Secondary Markets Function of Secondary Markets Provides info on Value of Security Indicates Consensus price Shows how well the Firm is using funds Gives an idea of how NEW issues would be received Provides Liquidity to the markets Allows for investments to change ownership easily

30. Salaar - Finance Financial Markets? US Securities Markets for Equities Where are these exchanges? Equity NYSE AMEX NASDAQ ECN’S KSE BONDS NYSE & AMEX Bond markets

31. Salaar - Finance Financial Markets? US Securities Markets for Equities Equity NYSE (New York Stock Exchange) AMEX (American Stock Exchange) NASDAQ (National Association of Securities Dealers) ECN’S (Electronic Communications Network) KSE (Karachi!) BONDS NYSE & AMEX Bond markets

32. Salaar - Finance Financial Markets? US Securities Markets for Equities Equity NYSE – 1366 seats (1.5mil$)-2800 co’s valued 13 trillion-Dvol 1.5Bil AMEX – 807 seats – 760 companies – 2% of ttl value – 200mil vol NASDAQ- 3843 co’s – 1bil vol – computerized mkt network ECN’S (Electronic Communications Network)-linked to all OTC – Not listed but registered, 3000 co’s – dealer network linked KSE: 200 seats, 163 active, 658 co’s, 35B MCap, 350m! vol, 100 co’s =90% Mcap BONDS NYSE & AMEX Bond markets

33. Salaar - Finance Perfect Markets? Conditions Required?

34. Salaar - Finance Perfect Markets? Conditions Required 1.Large no. of buyers & sellers & no one is significant. (LIQUIDITY) 2.Everyone is a price taker 3.Price is determined by pure Supply-Demand 4.No frictions exist (COSTS) Frictions Costs & barriers to affecting Buyers/sellers payoffs Eg. Commisions Bid-ask spreads Taxes etc

35. Salaar - Finance Financial Markets? Securities Markets for Equities Bid price Offer Price Block trades Program trading

36. Salaar - Finance Financial Markets? Securities Markets for Equities Bid price Px some one will buy for Offer Price Px someone will sell for Block trades Trades of 10,000 or more Program trading Computer generated buy & sell signals for $1 mil or more

37. Salaar - Finance Financial Markets? Securities Markets for Equities OTC (Over the counter mkts) ECN’s After Hours Trading

38. Salaar - Finance Financial Markets? Securities Markets for Equities OTC (Over the counter mkts) Stocks not listed on an exchange but traded on closed computer networks ECN’s Computerized trading network for large traders & brokers – computer matched orders After Hours Trading Normal hrs: 9.30 – 1600 AHT hrs: 1600-2000

39. Salaar - Finance Financial Markets? Securities Markets for Equities Dow Jones Industrial Average Standard & Poor’s (S&P 500) Nasdaq

40. Salaar - Finance Financial Markets? Securities Markets for Equities Dow Jones Industrial Average 30 Blue chip stocks – stock price weighted average Standard & Poor’s (S&P 500) 500 stock composite Nasdaq 100 Large cap companies

41. Salaar - Finance KSE 30

42. Salaar - Finance Brokerags vs Dealers? Brokers = middle-men Dealers = shopkeepers (MARKET MAKERS)

43. Salaar - Finance Brokerage Firms Full Service Brokers Discount Brokers Online Discount Brokers

44. Salaar - Finance Brokerage Firms Full Service Brokers Offer Full Range of services including info and advice. Discount Brokers offers execution services Online Discount Brokers offers platforms on the net

45. Salaar - Finance Types of Brokerage Accounts Cash Account Margin Account Asset Management Account Wrap Account Commissions Drip (Dividend Reinvestment Plan)

46. Salaar - Finance Types of Brokerage Accounts Cash Account Only cash transactions Margin Account Allows cash and debt transactions Asset Management Account Offers investment of cash balances and Cheque writing Wrap Account all fees are wrapped into one Commissions Drip (Dividend Reinvestment Plan) free reinvestment by companies DOLLAR COST AVERAGING - illustrate

47. Salaar - Finance How Orders Work Organize Exchanges (NYSE, NASDAQ) Super Dot (NYSE) NASDAQ System of dealers Decimalization of stock prices

48. Salaar - Finance How Orders Work Organize Exchanges (NYSE, NASDAQ) Super Dot (NYSE) Electronic system for NYSE NASDAQ System of dealers Through computer market making firms Decimalization of stock prices Jan 2001 stocks were decimalized, average spread five cents (NOW 1c)

49. Salaar - Finance Types of Orders Market Order Limit Order Stock Order

50. Salaar - Finance Types of Orders Market Order Best price on the floor – ENSURES EXECUTION NOT PX Limit Order (new position) specified or better price – ENSURES PX – NOT EXECUTION Stop Order (existing position) Automatic execution at specified price BUY STOP – PROTECTS PROFITS SELL STOPS – PROTECT LOSSES

51. Salaar - Finance Investor Protection Government Regulation SEC Self Regulation NASD

52. Salaar - Finance Investor Protection Government Regulation SEC 1934 Self Regulation stock exchanges monitor and regulate NASD Also monitor

53. Salaar - Finance Margin Initial Margin Maintenance Margin Margin Call

54. Salaar - Finance Margin (Leveraged Positions) Margin part of transaction value which is customers equity Initial Margin the part the customer must pay to initiate a transaction – 50% Maintenance Margin %age of securities value which must be on hand as equity – 25% Margin Call demand from broker for cash if actual M < maintenance M

55. Salaar - Finance Margin Margin part of transaction value which is customers equity Initial Margin amount investor puts up / value of transaction Maintenance Margin %age of securities value which must be on hand as equity Margin Call MARKED TO MARKET EVERYDAY Actual margin = (current value of stock – amount borrowed) / current value

56. Salaar - Finance Short Sales Being Long Being Short Short Sale Short Interest Ratio

57. Salaar - Finance Short Sales Being Long normal position of buying stock Being Short having sold stock not owned Short Sale selling stock not owned but borrowed Short Interest Ratio shares short to average daily volume

58. Salaar - Finance Market Efficiency Markets absorb & reflect all new information into security prices

59. Salaar - Finance Securities Firms & Investment Banks Learning Objectives Underwriting? Broker-dealer-IPO’s Investment Banking? Secondary markets? Mechanics of Markets?