Download - Investment Banking

Investment Banking and Capital Markets – Universitat Hohenheim

Investment Banking and Capital Markets

Prof. Dr. Hans-Peter Burghof, Arne Breuer, Ulli Spankowski

Universitat HohenheimChair for Banking and Financial Services

Winter 2009/10

Chair for Banking and Finance Winter term 2009 Slide 1



Who’s that guy in front of me?

I Arne Breuer

I Started Studying in Ulm

I Continued in France

I Graduated in Hohenheim

I PhD-student Since mid-April 2008

Contact Details

I email: [email protected]

I phone: 0711 459-22903

I Office hours: Tue, 2-5pm




What is it all about?

Not yet a definite agenda, but it will cover

I Introduction - Modern Portfolio Theory

I Fixed Income

I Options, Futures, and Other Derivatives

I Credit Risk Markets

I Theory of Market Microstructure

I Model of Myers/Majluf (1984) - Information Asymmetry

I Islamic Banking

I Tutorials

I Hopefully a Guest Lecture on M&A

⇒ So the focus is on Capital Markets rather than on Investment Banking




The Investment Banking environment

1. Universal Banking vs. Specialized Banking

2. Commercial Banking vs. Investment Banking

3. Definition of Investment Banking

4. Systematisation of Investment Banking - Business Activities




1. Universal Banking vs Specialised Banking

The universal banking system

I Predominately present in Continental Europe

I In general, banks are allowed to offer all kinds of products to theircustomers

I Banks offer a broad range of financial services e.g. deposit taking, realestate and other forms of lending, foreign exchange (FX) trading,securities trading, underwriting, portfolio management etc.

I Banks offer both financial and consultancy services; the principle of one-bank-for-everything





Universal Banking, cont’d

Advantages for the Bank Advantages for the Client

I Detailed information about theclients economic and businessactivities

I Banking conditions are tailoredto the client

I Cross selling potential

I Competitive advantage due toinformation efficiency aboutclients

I Individual customer service

I Clients can be assured that thebank is very diplomaticconsidering the disclosure of theclient’s private information

I Implicit agreement betweenbank and client

I Banks tend to support clients indistressed economic situations





The specialised banking system

I Predominately present in the Anglo-Saxon countries and Japan

I Separation of commercial and investment bankingI Investment banking

I in in the USA via investment banks (emerged by government regulations)I in the UK via merchant banks (emerged on a historical basis)





The specialised banking system – USA

I 1933: Glass-Steagall-Act, Government regulation to separate commercialand investment banking

I to moderate speculationI to stabilize the financial system andI to prevent a banks’ conflict of interests

I The act was mainly triggered by the crash of the stock market and greatdepression of the late 1920s






I Regulators were afraid ofI the combination of a small group of banksI high volatility at the stock markets andI the overall macroeconomic development

However:

I The development of the financial industry in the US, globalisation andvertical integration lead to a slow but continuous maceration of the Glass-Steagall-Rules






I After a continuous reduction of regulative restrictions the specialisedbanking era ended 1999 with the Gramm-Leach-Bliley Act

I The act allowed US banks to offer the full range of financial products asfor instance credits, underwritings, structured finance products, deposittaking, credit business

I It enabled financial institutions to do insurance broking, advisory business,investment banking all in one

I After Gramm-Leach-Bliley large financial holding companies emerged asfor instance JPMorgan Chase etc.





The specialised banking system – UK

I Banks in UK developed to specialised institutions over the last twocenturies

I e.g. Barings and Schroders started to finance international merchant tradein the 18th century and provided credit supply to European countries

I Their main activities at that time included corporate finance, issuance ofsecurities (bonds, stock, etc.) and principal investment projects

I The merchant banks’ capital structure was mainly relatively short in equitycapital which meant that they needed innovative ways to finance theirprojects





The specialised banking system – Concluding Remarks

Investment banking arose because of

I a declining attractiveness of commercial banking (smaller margins, largercompetition, etc.)

I a growing specialisation into some particular field of universal banks

I increasing legal regulations, which forced a separation of commercial andinvestment banking




2. Commercial banking vs investment banking

Investors Banks Borrower

Commercial Banking Investment Banking

Investors: Depositors

Instrument: Credit

Function: SupervisorDecision Maker

Market Risk: Taken by Bank

Institutional Investors

Securities

AnalystConsultant

Passed to Market

Stability Change




2. The Downfall of Investment Banking – the year 2008

The big investment banks were

I Goldman Sachs

I Merrill Lynch

I Morgan Stanley

I Lehman Brothers and

I Bear Stearns




2. The Downfall of Investment Banking – the year 2008

The big investment banks were

I Goldman Sachs ⇒ gave up its investment bank privileges

I Merrill Lynch ⇒ bought by Bank of America

I Morgan Stanley ⇒ gave up its investment bank privileges

I Lehman Brothers ⇒ went bankrupt

I Bear Stearns ⇒ was bought by JPMorgan Chase




3. Definition of Investment Banking

I Very diffuse business – large variety of servicesI “Investment Banking is what Investment Banks do”

I “Goldman Sachs’ Investment Banking Division identifies, structures andexecutes diverse and innovative public and private market transactions forcorporations, financial institutions and governments. Transactions includemergers, acquisitions, divestitures, the issuance of equity or debt capital, ora combination of these.”

I Definition by areas of business?I (international) issuance of securitiesI special financial services (e.g. structuring and issuance of derivatives,

market making...)I trading activity in various markets (e.g. fixed income, commodity and

proprietary trading, hedging...)I activities in capital markets (e.g. M&A, corporate finance, IPOs ...)




4. Systematisation of Investment Banking - Business Activities

clients

instruments

business areas

industrial companiesfinancial service firmspublic institutionswealthy individualssmall customersown account

equitymezzaninedebtderivativescurrenciescommodities real estate

mergers and acquisitionscorporate financestructured financecapital marketssales and tradingasset managementprincipal investment




4. Systematisation of Investment Banking – Business Areas

Only activities that are remunerated directly by the client. Sometimes use oftrojan horses – small initial activities are performed at a low price (or free) toattract larger projects later on offsetting the initial costs

I M&AI Mergers and AcquisitionsI More activity on acquisitionsI Consultancy services for buy- or sell-sideI First: identification of potential buyers or sellersI Valuation, negotiations, contract-making, structured financeI Hostile takeovers or defending against





I Corporate FinanceI sometimes called Financial AdvisoryI restructuring of passivesI emission of equity or issuance of bonds or other more complex financingI IPO, recapitalisation, restructuring

I Structured FinanceI ABSI Project financingI Leasing

I Capital MarketsI Traditional playing field of investment banksI Emission and placement of securitiesI Consultancy, underwriting, distributionI Equity capital marketsI Debt capital markets





I Asset ManagementI Investment of clients’ fundsI Assessment of risk and returnI Creating portfoliosI cp. private banking

I Principal InvestmentI Investment in companies to generate profitI Taking influence on managementI Time horizon: some yearsI Exit via going public




4. Systematisation of Investment Banking – Instruments

I EquityI Either stocks or parts of equityI advantages: managerial-, information-, control-, and financial rightsI remuneration by dividends, shares of profit, stock price improvement

I MezzanineI hybrid form of equity and debt

I DebtI Provision of funds to private or public sectorI fixed or floating interestI the higher the risk, the higher the spreadI high importance

I DerivativesI based on another instrumentI increases flexibilityI most popular: options, futures




4. Systematisation of Investment Banking – Instruments

I CurrenciesI important for cross-border investments – hedging!

I CommoditiesI Trade in standardized goods and servicesI most important: oil, metals, food, energy

I Real EstateI Costly individual pricingI Important asset classI Trade got easier with REITsI Important sector for investment banks




4. Systematisation of Investment Banking – Clients

I Industrial CompaniesI Need all services of the investment bankI Financing needs differI Traditional focus on large multinationals with complex finance structuresI In the last years: trend to M&AI Esp. in Germany: medium-sized companies as potential clients

I Financial service firmsI Providing services with special knowledgeI Acting as counterparty, e.g. in swap transactions

I Public SectorI Important clientsI Large capital needsI Rolling of debtI Opens up for structured financeI Margins are low, but volumes are highI Privatisation of former state-owned firms




4. Systematisation of Investment Banking – Clients

I Institutional InvestorsI Insurances, mutual funds, etc.

I Wealthy IndividualsI HNWI, UHNWII Large volumesI Attractive market

I Small customersI Sales-intensiveI Can be important for IPOs or even M&AI Market for some types of structured securities – e.g. “Zertifikate”

I Own accountI Proprietary tradingI Spot- and futures marketsI Short-term transactions (6= Principal Investment!)




Literature

I Liaw, K. Thomas (2006): The Business of Investment Banking, ch. 1 and2

I Hockmann, Heinz-Josef/Thießen, Friedrich (2007): Investment Banking,ch. 1.1 and 1.5

I Achleitner, Ann-Kristin (2002): Handbuch Investment Banking, pp. 3-45

I Rich, G, Walter, C. (1993): The Future of Universal Banking, CATOJournal




Modern Portfolio Theory - a recap

Introduction

I based on Harry Markowitz’ article “Portfolio Selection”, Journal ofFinance, 1952

I central finding: diversify!

I “don’t put all eggs in one basket”

I reduction of idiosyncratic risk (unsystematic risk) via diversification




The ideas of Modern Portfolio Selection

I Splitting an investment efficiently on various assets

I Diversification of a portfolio depends on the volatility of each single assetbut ALSO on the correlation of each assets’ risk and return structure withother assets

I If single asset returns are not 100% positively correlated, risk reduction inthe portfolio is possible via diversification

I Risk reduction is possible via a simple split into equal units of theinvestment into many assets (naıve diversification)

I Assets have to be split within the portfolio according to the most efficientsetting of risk and return (efficient frontier, portfolio selection)




Modern Portfolio Theory - Model Assumptions

I One period model

I Risk aversion of investors (concave risk utility function)

I Investors maximize their utility

I Returns are normally distributed (Gaussian distribution)

I Homogenous expectations of investors

I No risk free assets (preliminary)

I No transaction costs, no arbitrage




How are returns modeled?

NPV = −I0 +TX

t=1

CFt

(1 + it)t+

CFT

(1 + iT )T(1)

with

I0 initial investmtentt time

CFt Cash flow in tT end of investmentit risk-free rate in t




How are returns modeled? (continued)

t = 0 t = 1

-I0

CF 11

CF 12

CF 13

CF 14

risky cash flows in t = 1

⇒ Calculate the expected value E(CF1)




Two different ways to calculate returns

I Discrete returns

rd,t =Kt − Kt−1

Kt−1+

Dt

Kt−1=

Kt + Dt

Kt−1− 1 (2)

“capital return plus dividend return equals general return”with

rd,t discrete return in period tt timeKt Capital at the end of the period

Kt−1 Capital at the beginning of the periodDt risk-free rate in t




Two different ways to calculate returns

I Continuous returns

rs,t = ln

„Kt + Dt

Kt−1

«= ln(Kt + Dt)− ln Kt−1 (3)

with

rs,t continuous return in period t




MPT - Risk and Return

I In MPT all assets are classified according to two criteria:I Expected return E [rj ], also known as µ ANDI Expected variance of the return E [var(rj )], also known as σ2, respective the

standard deviation σ

I Markowitz defines the standard deviation (SD) of an expected return asRISK

I This definition of risk is also know as volatility

I The return of an asset which bears a 20% SD is obviously more risky thanthe return of another asset with 10% of SD




Modern Portfolio Theory – Expected Return, Standard Deviation, andVariance

I pk = Probability of condition k to happen

I rk = Return of the asset in condition k

Expected return of an asset:

E(ri ) = µ =KX

k=1

pk rk (4)

Variance of the asset’s return:

Var(r) = σ2 =KX

k=1

pk(rk − µ)2 (5)

SD (volatility) of the asset’s return:

σ =√σ2 (6)




Modern Portfolio Theory – Covariance and Correlation

Covariance and correlation describe direction and strength of the relationbetween the returns of two assets i and j

Covariance between the returns of assets i and j :

cov(ri , rj) = σij =KX

k=1

pk(ri,k − µi,k)(rj,k − µj,k) (7)

Correlation between the returns of assets i and j :

ρij =σij

σiσj(8)

Advantage of using the the correlation rather than the covariance:Standardisation between

−1 ≤ ρij ≤ 1




Modern Portfolio Theory - Expected Value of the Portfolio Return

There are two ways to calculate a portfolio return

I via the condition based portfolio return

E(rP) = µP =KX

k=1

pk rP,k with rP,k =NX

i=1

xi ri,k (9)

I via the expected return of the assets

E(rP) = µP =NX

i=1

xiµi withNX

i=1

xi = 1 (10)




Modern Portfolio Theory – Variance of the Portfolio Return

There are also two ways to calculate the portfolio variance

I via the condition based portfolio returns

var(rP) = σ2P =

KXk=1

pk(rP,k − µP)2 (11)

I via the variance/covariance matrix of the asset returns

var(rP) = σ2P =

NXi=1

NXj=1

xixjσij (12)




Modern Portfolio Theory – naıve diversification

1

2

4

3

5diversified portfolio

return

risk

I Diversification possible if ρ < 1




Modern Portfolio Theory with Uncorrelated Returns

I Suppose xi = 1N

and σij = 0

I The variance is calculated according to the following formula:

σ2P =

NXi=1

NXj=1

xixjσij =NX

i=1

x2i σ

2i +

NXi=1

NXj=1j 6=i

xixjσij =

=NX

i=1

x2i σ

2i =

NXi=1

1

N2σ2

i =1

N

NXi=1

σ2i

N=

1

Nσ2

i

I If more and more assets are added to the portfolio variance becomes

limN→∞

σ2P = lim

N→∞

σ2i

N= 0




Modern Portfolio Theory with Correlated Returns

I Usually asset returns are positively correlated, i.e. σij > 0

I Calculating the variance under the premise of positive correlation yields

σ2P =

NXi=1

1

N2σ2

i +NX

i=1

NXj=1j 6=i

1

N

1

Nσij =

=1

N

NXi=1

σ2i

N+

N − 1

N

NXi=1

NXj=1j 6=i

σij

N(N − 1)=

=1

Nσ2

i +N − 1

Nσij =

1

N(σ2

i − σij) + σij

I If more and more assets are added to the portfolio, the variance becomes

limN→∞

σ2P = lim

N→∞

„1

N(σ2

i − σij) + σij

«= σij
