Investment Banking

Investment Banking and Capital Markets Universitat Hohenheim
Investment Banking and Capital Markets

Prof. Dr. Hans-Peter Burghof, Arne Breuer, Ulli Spankowski
Universitat Hohenheim
Chair for Banking and Financial Services
Winter 2009/10
Chair for Banking and Finance Winter term 2009 Slide 1
Whos that guy in front of me?
Arne Breuer
Started Studying in Ulm
Continued in France
Graduated in Hohenheim
PhD-student Since mid-April 2008

Contact Details
email: arne.breuer@uni-hohenheim.de
phone: 0711 459-22903
Oce hours: Tue, 2-5pm

What is it all about?
Not yet a denite agenda, but it will cover
Introduction - Modern Portfolio Theory
Fixed Income
Options, Futures, and Other Derivatives
Credit Risk Markets
Theory of Market Microstructure
Model of Myers/Majluf (1984) - Information Asymmetry
Islamic Banking
Tutorials
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. Denition of Investment Banking
4. Systematisation of Investment Banking - Business Activities
1. Universal Banking vs Specialised Banking
The universal banking system
Predominately present in Continental Europe
In general, banks are allowed to oer all kinds of products to their

customers
Banks oer a broad range of nancial services e.g. deposit taking, real
estate and other forms of lending, foreign exchange (FX) trading,
securities trading, underwriting, portfolio management etc.
Banks oer both nancial and consultancy services; the principle of one-
bank-for-everything
Universal Banking, contd
Advantages for the Bank Advantages for the Client
Detailed information about the

clients economic and business
activities
Banking conditions are tailored

to the client
Cross selling potential
Competitive advantage due to

information eciency about
clients
Individual customer service
Clients can be assured that the

bank is very diplomatic
considering the disclosure of the
clients private information
Implicit agreement between

bank and client
Banks tend to support clients in

distressed economic situations
The specialised banking system
Predominately present in the Anglo-Saxon countries and Japan
Separation of commercial and investment banking
Investment banking
in in the USA via investment banks (emerged by government regulations)
in the UK via merchant banks (emerged on a historical basis)

The specialised banking system USA
1933: Glass-Steagall-Act, Government regulation to separate commercial

and investment banking
to moderate speculation
to stabilize the nancial system and
to prevent a banks conict of interests
The act was mainly triggered by the crash of the stock market and great
depression of the late 1920s
Regulators were afraid of
the combination of a small group of banks
high volatility at the stock markets and
the overall macroeconomic development

However:
The development of the nancial industry in the US, globalisation and

vertical integration lead to a slow but continuous maceration of the Glass-
Steagall-Rules
After a continuous reduction of regulative restrictions the specialised

banking era ended 1999 with the Gramm-Leach-Bliley Act
The act allowed US banks to oer the full range of nancial products as
for instance credits, underwritings, structured nance products, deposit
taking, credit business
It enabled nancial institutions to do insurance broking, advisory business,

investment banking all in one
After Gramm-Leach-Bliley large nancial holding companies emerged as

for instance JPMorgan Chase etc.
The specialised banking system UK
Banks in UK developed to specialised institutions over the last two

centuries
e.g. Barings and Schroders started to nance international merchant trade

in the 18th century and provided credit supply to European countries
Their main activities at that time included corporate nance, issuance of

securities (bonds, stock, etc.) and principal investment projects
The merchant banks capital structure was mainly relatively short in equity
capital which meant that they needed innovative ways to nance their
projects
The specialised banking system Concluding Remarks
Investment banking arose because of
a declining attractiveness of commercial banking (smaller margins, larger

competition, etc.)
a growing specialisation into some particular eld of universal banks
increasing legal regulations, which forced a separation of commercial and

investment banking
2. Commercial banking vs investment banking
Investors Banks Borrower
Commerca Bankng Investment Bankng
Investors: Depostors
Instrument: Credt
Functon: Supervsor
Decson Maker
Market Rsk: Taken by Bank
Insttutona Investors
Securtes
Anayst
Consutant
Passed to Market
Stabty Change
2. The Downfall of Investment Banking the year 2008
The big investment banks were
Goldman Sachs
Merrill Lynch
Morgan Stanley
Lehman Brothers and
Bear Stearns
2. The Downfall of Investment Banking the year 2008
The big investment banks were
Goldman Sachs gave up its investment bank privileges
Merrill Lynch bought by Bank of America
Morgan Stanley gave up its investment bank privileges
Lehman Brothers went bankrupt
Bear Stearns was bought by JPMorgan Chase

3. Denition of Investment Banking
Very diuse business large variety of services
Investment Banking is what Investment Banks do
Goldman Sachs Investment Banking Division identies, structures and

executes diverse and innovative public and private market transactions for
corporations, nancial institutions and governments. Transactions include
mergers, acquisitions, divestitures, the issuance of equity or debt capital, or
a combination of these.
Denition by areas of business?
(international) issuance of securities
special nancial services (e.g. structuring and issuance of derivatives,

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

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

4. Systematisation of Investment Banking - Business Activities
clients
instruments
business areas
industrial companies
financial service firms
public institutions
wealthy individuals
small customers
own account
equity
mezzanine
debt
derivatives
currencies
commodities
real estate
mergers and acquisitions
corporate finance
structured finance
capital markets
sales and trading
asset management
principal investment
4. Systematisation of Investment Banking Business Areas
Only activities that are remunerated directly by the client. Sometimes use of
trojan horses small initial activities are performed at a low price (or free) to
attract larger projects later on osetting the initial costs
M&A
Mergers and Acquisitions
More activity on acquisitions
Consultancy services for buy- or sell-side
First: identication of potential buyers or sellers
Valuation, negotiations, contract-making, structured nance
Hostile takeovers or defending against

Corporate Finance
sometimes called Financial Advisory
restructuring of passives
emission of equity or issuance of bonds or other more complex nancing
IPO, recapitalisation, restructuring
Structured Finance
ABS
Project nancing
Leasing
Capital Markets
Traditional playing eld of investment banks
Emission and placement of securities
Consultancy, underwriting, distribution
Equity capital markets
Debt capital markets

Asset Management
Investment of clients funds
Assessment of risk and return
Creating portfolios
cp. private banking
Principal Investment
Investment in companies to generate prot
Taking inuence on management
Time horizon: some years
Exit via going public

4. Systematisation of Investment Banking Instruments
Equity
Either stocks or parts of equity
advantages: managerial-, information-, control-, and nancial rights
remuneration by dividends, shares of prot, stock price improvement
Mezzanine
hybrid form of equity and debt
Debt
Provision of funds to private or public sector
xed or oating interest
the higher the risk, the higher the spread
high importance
Derivatives
based on another instrument
increases exibility
most popular: options, futures

4. Systematisation of Investment Banking Instruments
Currencies
important for cross-border investments hedging!
Commodities
Trade in standardized goods and services
most important: oil, metals, food, energy
Real Estate
Costly individual pricing
Important asset class
Trade got easier with REITs
Important sector for investment banks

4. Systematisation of Investment Banking Clients
Industrial Companies
Need all services of the investment bank
Financing needs dier
Traditional focus on large multinationals with complex nance structures
In the last years: trend to M&A
Esp. in Germany: medium-sized companies as potential clients
Financial service rms
Providing services with special knowledge
Acting as counterparty, e.g. in swap transactions
Public Sector
Important clients
Large capital needs
Rolling of debt
Opens up for structured nance
Margins are low, but volumes are high
Privatisation of former state-owned rms

4. Systematisation of Investment Banking Clients
Institutional Investors
Insurances, mutual funds, etc.
Wealthy Individuals
HNWI, UHNWI
Large volumes
Attractive market
Small customers
Sales-intensive
Can be important for IPOs or even M&A
Market for some types of structured securities e.g. Zertikate
Own account
Proprietary trading
Spot- and futures markets
Short-term transactions (= Principal Investment!)

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

2
Hockmann, Heinz-Josef/Thieen, Friedrich (2007): Investment Banking,

ch. 1.1 and 1.5
Achleitner, Ann-Kristin (2002): Handbuch Investment Banking, pp. 3-45
Rich, G, Walter, C. (1993): The Future of Universal Banking, CATO

Journal
Modern Portfolio Theory - a recap
Introduction
based on Harry Markowitz article Portfolio Selection, Journal of

Finance, 1952
central nding: diversify!
dont put all eggs in one basket
reduction of idiosyncratic risk (unsystematic risk) via diversication

The ideas of Modern Portfolio Selection
Splitting an investment eciently on various assets
Diversication of a portfolio depends on the volatility of each single asset

but ALSO on the correlation of each assets risk and return structure with
other assets
If single asset returns are not 100% positively correlated, risk reduction in
the portfolio is possible via diversication
Risk reduction is possible via a simple split into equal units of the
investment into many assets (nave diversication)
Assets have to be split within the portfolio according to the most ecient
setting of risk and return (ecient frontier, portfolio selection)
Modern Portfolio Theory - Model Assumptions
One period model
Risk aversion of investors (concave risk utility function)
Investors maximize their utility
Returns are normally distributed (Gaussian distribution)
Homogenous expectations of investors
No risk free assets (preliminary)
No transaction costs, no arbitrage

How are returns modeled?
NPV = I
0
+
T
X
t=1
CF
t
(1 + i
t
)
t
+
CF
T
(1 + i
T
)
T
(1)
with
I
0
initial investmtent
t time
CF
t
Cash ow in t
T end of investment
i
t
risk-free rate in t
How are returns modeled? (continued)
t = 0 t = 1
-I
0
CF
1
1
CF
1
2
CF
1
3
CF
1
4
risky cash flows in t = 1
Calculate the expected value E(CF
1
)
Two dierent ways to calculate returns
Discrete returns
r
d,t
=
K
t
K
t1
K
t1
+
D
t
K
t1
=
K
t
+ D
t
K
t1
1 (2)
capital return plus dividend return equals general return
with
r
d,t
discrete return in period t
t time
K
t
Capital at the end of the period
K
t1
Capital at the beginning of the period
D
t
risk-free rate in t
Two dierent ways to calculate returns
Continuous returns
r
s,t
= ln
K
t
+ D
t
K
t1
= ln(K
t
+ D
t
) ln K
t1
(3)
with
r
s,t
continuous return in period t
MPT - Risk and Return
In MPT all assets are classied according to two criteria:
Expected return E[r

j
], also known as AND
Expected variance of the return E[var(r

j
)], also known as
2
, respective the
standard deviation
Markowitz denes the standard deviation (SD) of an expected return as

RISK
This denition of risk is also know as volatility
The return of an asset which bears a 20% SD is obviously more risky than
the return of another asset with 10% of SD
Modern Portfolio Theory Expected Return, Standard Deviation, and
Variance
p
k
= Probability of condition k to happen
r
k
= Return of the asset in condition k
Expected return of an asset:
E(r
i
) = =
K
X
k=1
p
k
r
k
(4)
Variance of the assets return:
Var (r ) =
2
=
K
X
k=1
p
k
(r
k
)
2
(5)
SD (volatility) of the assets return:
=
2
(6)
Modern Portfolio Theory Covariance and Correlation
Covariance and correlation describe direction and strength of the relation
between the returns of two assets i and j
Covariance between the returns of assets i and j :
cov(r
i
, r
j
) =
ij
=
K
X
k=1
p
k
(r
i ,k

i ,k
)(r
j ,k

j ,k
) (7)
Correlation between the returns of assets i and j :
ij
=

ij
j
(8)
Advantage of using the the correlation rather than the covariance:
Standardisation between
1
ij
1
Modern Portfolio Theory - Expected Value of the Portfolio Return
There are two ways to calculate a portfolio return
via the condition based portfolio return

E(r
P
) =
P
=
K
X
k=1
p
k
r
P,k
with r
P,k
=
N
X
i =1
x
i
r
i ,k
(9)
via the expected return of the assets

E(r
P
) =
P
=
N
X
i =1
x
i
i
with
N
X
i =1
x
i
= 1 (10)
Modern Portfolio Theory Variance of the Portfolio Return
There are also two ways to calculate the portfolio variance
via the condition based portfolio returns

var (r
P
) =
2
P
=
K
X
k=1
p
k
(r
P,k

P
)
2
(11)
via the variance/covariance matrix of the asset returns

var (r
P
) =
2
P
=
N
X
i =1
N
X
j =1
x
i
x
j
ij
(12)
Modern Portfolio Theory nave diversication
1
2
4
3
5
diversified portfolio
return
risk
Diversication possible if < 1

Modern Portfolio Theory with Uncorrelated Returns
Suppose x
i
=
1
N
and
ij
= 0
The variance is calculated according to the following formula:
2
P
=
N
X
i =1
N
X
j =1
x
i
x
j
ij
=
N
X
i =1
x
2
i

2
i
+
N
X
i =1
N
X
j =1
j =i
x
i
x
j
ij
=
=
N
X
i =1
x
2
i

2
i
=
N
X
i =1
1
N
2
2
i
=
1
N
N
X
i =1
2
i
N
=
1
N
2
i
If more and more assets are added to the portfolio variance becomes
lim
N
2
P
= lim
N
2
i
N
= 0
Modern Portfolio Theory with Correlated Returns
Usually asset returns are positively correlated, i.e.

ij
> 0
Calculating the variance under the premise of positive correlation yields
2
P
=
N
X
i =1
1
N
2
2
i
+
N
X
i =1
N
X
j =1
j =i
1
N
1
N
ij
=
=
1
N
N
X
i =1
2
i
N
+
N 1
N
N
X
i =1
N
X
j =1
j =i
ij
N(N 1)
=
=
1
N
2
i
+
N 1
N

ij
=
1
N
(
2
i

ij
) +
ij
If more and more assets are added to the portfolio, the variance becomes
lim
N
2
P
= lim
N
1
N
(
2
i

ij
) +
ij
=
ij

Investment Banking

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Investment Banking

Uploaded by

Copyright:

Available Formats

Investment Banking and Capital Markets Universitat Hohenheim

Investment Banking and Capital Markets

Started Studying in Ulm

PhD-student Since mid-April 2008

phone: 0711 459-22903

Oce hours: Tue, 2-5pm

Introduction - Modern Portfolio Theory

Options, Futures, and Other Derivatives

Credit Risk Markets

Theory of Market Microstructure

Model of Myers/Majluf (1984) - Information Asymmetry

Hopefully a Guest Lecture on M&A

Predominately present in Continental Europe

In general, banks are allowed to oer all kinds of products to their

Detailed information about the

Banking conditions are tailored

Cross selling potential

Competitive advantage due to

Individual customer service

Clients can be assured that the

Implicit agreement between

Banks tend to support clients in

Predominately present in the Anglo-Saxon countries and Japan

Separation of commercial and investment banking

in in the USA via investment banks (emerged by government regulations)

in the UK via merchant banks (emerged on a historical basis)

1933: Glass-Steagall-Act, Government regulation to separate commercial

to stabilize the nancial system and

to prevent a banks conict of interests

Regulators were afraid of

the combination of a small group of banks

high volatility at the stock markets and

the overall macroeconomic development

The development of the nancial industry in the US, globalisation and

After a continuous reduction of regulative restrictions the specialised

It enabled nancial institutions to do insurance broking, advisory business,

After Gramm-Leach-Bliley large nancial holding companies emerged as

Banks in UK developed to specialised institutions over the last two

e.g. Barings and Schroders started to nance international merchant trade

Their main activities at that time included corporate nance, issuance of

a declining attractiveness of commercial banking (smaller margins, larger

a growing specialisation into some particular eld of universal banks

increasing legal regulations, which forced a separation of commercial and

Lehman Brothers and

Goldman Sachs gave up its investment bank privileges

Merrill Lynch bought by Bank of America

Morgan Stanley gave up its investment bank privileges

Lehman Brothers went bankrupt

Bear Stearns was bought by JPMorgan Chase

Very diuse business large variety of services

Investment Banking is what Investment Banks do

Goldman Sachs Investment Banking Division identies, structures and

Denition by areas of business?

(international) issuance of securities

special nancial services (e.g. structuring and issuance of derivatives,

trading activity in various markets (e.g. xed income, commodity and

activities in capital markets (e.g. M&A, corporate nance, IPOs ...)

Mergers and Acquisitions

More activity on acquisitions

Consultancy services for buy- or sell-side

First: identication of potential buyers or sellers

Valuation, negotiations, contract-making, structured nance

Hostile takeovers or defending against

sometimes called Financial Advisory