Financial markets and investment bankingCourse outline and descriptionClass TopicWeek 1 Introduction

What will the class cover? Who should take the class? Work and assignments

Week 2 Investment banking – who does what? Investment banking (M&A) Capital raising Fixed income and equity trading Sales Research

Week 3 Structure of the financial markets Corporate and government bond markets Equity markets Types of financial intermediaries

Week 4 Why and how do companies raise money? Capital structure issues Marketing, mandates, syndication and sales IPOs

Week 5 Outside speakers We will invite investment bankers to join us to discuss their work

Week 6 The structure of the investor base What is the role of a financial market? What kinds of investors are there? What roles do each play?

Week 7 Fund management Hedge funds, mutual funds, pension funds, etc. Who does what?

Week 8 Trading The role of traders Risk management

Week 9 Outside speakers We will invite traders to join us to discuss their work

Week 10 How traders evaluate marketsWeek 11 Derivatives and structured products

Disaggregating risks Using swaps, futures, options Hedging new issues CBOs, CMOs, CLOs etc.

Week 12 Outside speakers: the life of an investment banker We will invite newly hired bankers to join us discuss their work

Week 13 Review of materialWeek 14 Exam

Professor Michael Pettis (MIA, MBA – Columbia University) is a former investment banker with fourteen years of experience in the international fixed income markets. He has also been a professor of finance at Columbia University for the past nine years. He has headed bond trading, capital markets and liability management desks at various major Wall Street firms, and has taught courses in international economics, finance and financial history. In addition he has written extensively on trading, risk management, international capital flows, and sovereign debt policy.

1

Class 1In this class we will outline the goals of the course, discuss why it is important to understand the markets, and go into a brief history of investment banking as a separate part of the financial intermediation process.

What will the class cover? The different functions of what are called investment banking The markets in which investment banks operate General descriptions of specialized but widely used products

What are investment banks? Universal banking Banking regulation in the US following the 1929 crash What is a commercial bank? What is an investment bank? The gradual erosion of legal distinctions Why does investment banking continue to be treated separately?

Why study investment banking?1. Financial system is at heart of economic development

Markets allocate capital Market structure determines cost of capital Market structure determines the economic impact of external and internal

shocks The only way to understand the markets is to be in the markets

2. The failure of the financial markets may be China’s biggest impediment to growth Excessive concentration in the banking system Bankrupt banks Wholly speculative stock markets Degradation of national balance sheet

3. Great opportunities for ambitious students Responsibilities come very quickly Immersion into markets gives direct knowledge of how they function Shortcut to senior positions in government and large corporations Contacts and compensation

Class 2What are the basic functions we associate with investment banking and how are they related?

1. Retail vs institutional financial intermediation

2. Functions of investment banking

Primary function: Capital markets Equity

2

Bonds – CP, corporate bonds, junk bonds, tax-exempt, Loans

Supporting capital market liquidity: Trading Market making vs. principal trading Bonds: Government, corporate, emerging markets, foreign currency, junk, tax

exempts Equity: Common, preferred, international, emerging markets Currencies: majors, exotics Commodities Derivatives Structuring

Supporting trading: Sales

Supporting sales: Research Equity Macro Credit

Equity relationship: Advisory M&A Liability management Capital raising

Associated function: Fund management Mutual funds Private equity, venture capital Other (NPLs, restructurings, arbitrage) Third party vs. propietary

Class 3-4In these two classes we create a “map” of the financial markets setting out the types of financial instruments and their inter-relations.

Structure of financial markets Bond markets

Government Developed markets vs. undeveloped markets Trading issues Chinese market

Exchange traded FI OTC

3

Corporate CP, notes, bonds Junk vs. investment grade Traded vs. OTC Samurai, eurodollar, etc.

Financial institutions Active source of funding FRNs

Other Project finance Municipals and provinces Securitization

Trade finance CBOs Mortgages Receivables

Equity markets Major global exchanges Local exchanges Exchange traded vs OTC vs. automated trading Should Chinese companies list overseas?

Financial intermediaries Banks Investment banks Insurance companies Pension funds Hedge funds and other active managers Leasing companies Official institutions

National development banks International institutions

Classes 5-6Why do companies raise capital and what is involved in the capital raising process?

Liability management issues Why does capital structure matter?

Absorbs external shocks Less susceptibility to shocks reduces financial distress costs Capital structure can permit speculative strategies

Determines the distribution of operating earnings Determines investment strategy Changes risk appetite

In undeveloped markets investors cannot hedge or speculate directly and issuers may face restrictions on their ability to raise capital, so capital structure strategies

4

are affected by investor needs as well as by limitations in issuing equity, debt and hedges

Why do companies hedge? In developed markets, investors can limit volatility directly, so hedging does not

increase value by reducing the volatility of earnings or asset value In undeveloped markets, investors have few hedging tools Hedging increase marginal benefit of debt and reduces marginal cost of debt

(financial distress) thereby permitting more leverage

Doing the deal: the mechanics of capital markets transactions

1. Company makes funding decision BANKERS, CAPITAL MARKETS Purpose of funding Overall liability management issues

investment or acquisition may reduce overall earnings volatility overall exposure to currency, interest-rate or commodity risk may change

Market conditions low interest rates? maturity demand? currency demand? using derivatives to reconcile market conditions and client needs

Investment banks may advise issuer, or propose transactions during this period

2. Awarding of mandate BANKERS, CAPITAL MARKETS Banks compete on the basis of

relationship with and understanding of client understanding of industry understanding of optimal investor base distribution skills innovative proposal price talk (sometimes)

3. Syndication SYNDICATION DESK Lead and co-lead managers Allocation of issue among managers

4. Marketing issue SYNDICATION DESK, SALESMEN, RESEARCH Roadshow Price talk and investor circles Book-building

5. Launch SYNDICATION DESK, SALESMEN, TRADERS Price is set Orders come in from investors Paper is allocated

“good” versus “bad” investors

5

6. Stabilization/after-market support SYNDICATION DESK, TRADERS Syndicate desk is usually short Initial trading for price discovery Hot deals versus dogs

7. Secondary market trading TRADERS

Class 7

We discuss broadly in the various ways in which individuals, corporations and governments save

Individuals: Bank deposits, direct investment in markets, mutual funds, pension schemes, insuranceCorporations and governments: Bank deposits, cash management accounts, insurance

Class 8

Outside speaker

Classes 9-10

The structure of the investor base is the key determinant of the maturity of a market. Along with traders, whose function is to provide liquidity for investors, there are broadly speaking three very separate types of investment strategies that account for almost every investment activity. A well-functioning market requires all thee.

Types of players Traders/market makers Speculators Arbitragers Fundamental investors

Role of trader Make markets for clients (market maker) Provide market information to bankers Profit from knowledge of supply and demand (speculator) Profit from knowledge of pricing inconsistencies (speculator)

What kind of knowledge does a trader need?

6

How fundamental supply and demand will change Market contagion mechanisms (how information or activity from one market is

transmitted into another) Structure of the investor base and how it affects short term supply and demand Pricing inconsistencies

How do traders profit? Bid/offer spread Proprietary positions

Risks What are the risks for market makers?

Holding period risk Trading errors Risks not associated with assets traded

What are the risks for proprietary desks? Positions Trading errors Hidden trades The incentive problem (option analysis)

Risk management Holding period risk Secondary risks

Interest rates Currency Contagion

Three types of investment strategy:

7

What are the investment goals of the three different strategies? Profits Risks Holding period

How does each strategy contribute to the market? Liquidity Market integration Capital allocation

What are the tools needed for each strategy? Discount rates Information Technical factors

Classes 11-12How do traders operate and manage risk?

What kind of information do traders look at?Types of information Primary impact Secondary impactChanges in expected cashflow associated with asset

Has only a small impact in the short-term

Can affect value investor behavior

Changes in appropriate discount rate Little impact in discounting near-term variables

May change financing cost, and can affect value investor behavior

Spec.

ValueArb

8

Financing cost Can have large impact on margin positions, derivative pricing, and short positions

NA

Changes in behavior of value investors

Can have large near-term impact on supply or demand

NA

Fund flows Can have large near-term impact on supply or demand

NA

Changes in supply of asset, such as government sales of stock, etc.

Can have large near-term impact Can affect value investor behavior

Changes in demand for asset, such as by new entrants into market, etc.

Can have large near-term impact Can affect value investor behavior

Insider behavior and market manipulation

Can have large near-term impact on supply and demand factors

Can reduce role of value investor

Legal and regulatory changes Can have large near-term impact on supply and demand factors

Can affect value investor behavior

Analysts’ reports No impact Can affect value investor behavior

How does the structure of the market matter? Positive vs. negative feedbackStructural factor Behavior ImpactSubstantial number of value investors

Tend to act against market moves by buying when prices decline against target price and selling when they rise against target price

Stabilizing

Existence of arbitrageurs

Buy undervalued assets and sell overvalued assets, thereby forcing pricing consistency and crossing markets (which increases liquidity)

Stabilizing

Margin owners of assets

When prices rise, buying power increases, when assets decline, selling pressure increases

Highly destabilizing

Large open short positions

Short covering on big price moves Stabilizing on the way down, reinforcing on the way up

Large option positions Delta hedging Highly destabilizingProgram trading Delta hedging Highly destabilizingTrend trading Buy rising market and short declining market Highly destabilizingHoldings across asset classes

When coupled with other destabilizing structures can lead to contagion

Highly destabilizing

Class 13There have been a number of derivative instruments and securitization technologies that have transformed the markets in recent years. In spite of all that has been written about their complexities, they are basically variations on a few instruments.

1. What are derivatives? Forwards and futures Options Interest rate swaps Currency swaps

9

Exotics: total-return swaps, swaptions, complex options,

2. What are structured products? CBOs and CMOs Special transactions: Treasury stripping, Brady bond stripping, IO/PO bonds Structured notes: super-floaters, inverse floaters, multi-currency bonds

3. Purpose of derivatives and structured products

Disaggregating risks Each risk can be separately sold to an investor best suited to take on the risk

Mortgage securities (interest-rate risk on payment streams, prepayment risk, default risk)

Emerging market CBOs (short-term versus long-term risk

Combining risks Allows investors to “get around” restrictions

Notes indexed to equity markets Allows investors access to less accessible markets

Local currency indexed bonds Allows investors to make complex bets

Inverse floaters Provides a better mix of risks

Convertible bonds

Leverage Leverage can be imbedded into product

Total return swaps, super-floaters, futures, options

Hedging Investors or corporations can identify and eliminate risks they do not want

Treasury locks, commodity futures, commodity-indexed notes, floating-credit-spread notes (like Argentina deal)

10