ECO2102

Lec 6
SERVICES OFFERED BY SECURITIES FIRMS
VERSUS INVESTMENT BANKS
• Securities firms and investment banks help net suppliers of funds (e.g., households) transfer
funds to net users of funds (e.g., businesses) at a low cost and with a maximum degree of
efficiency
SERVICES OFFERED BY SECURITIES FIRMS
VERSUS INVESTMENT BANKS
• Investment banking involves transactions such as the raising of debt and equity securities for
corporations or governments
• Includes the origination, underwriting, and placement of securities in money and capital
markets for corporate or government issuers, as well as corporate finance activities (e.g.,
advising on mergers and acquisitions (M&As) and the restructuring of existing corporations)
• Investment banks specialize in origination, underwriting, and distributing issues of new
securities (commercial side of the business)
SERVICES OFFERED BY SECURITIES FIRMS
VERSUS INVESTMENT BANKS
• Securities services involve assistance in the trading of securities in the secondary markets
(brokerage services or market trading)
• Securities firms specialize in the purchase, sale, and brokerage of existing securities (retail
side of the business)
 SUBGROUPS OF INDUSTRY FIRMS

• Firms in the industry can be divided along several dimensions:

• Largest firms are diversified financial service (or national full-service) investment banks that
service both retail and corporate customers
• Assist retail customers by acting as broker-dealers
• Assist corporate customers by securities underwriting
 SUBGROUPS OF INDUSTRY FIRMS

• National full-service firms fall into three subgroups:

• Commercial banks (or financial services holding companies) are the largest of the full-
service investment banks (e.g., JPMorgan) and have extensive domestic and international
operations
• National full-service firms specialize more in corporate finance or primary market activities
and are highly active in trading securities, or secondary market activities (e.g., Goldman
Sachs)
• Large investment banks maintain more limited branch networks concentrated in major cities
operating with predominantly institutional client bases (e.g., Greenhill & Co.)
 SUBGROUPS OF INDUSTRY FIRMS

• Remainder of industry is comprised of firms that perform a mix of primary and secondary
market services for a particular segment of the financial markets:
• Regional securities firms
• Specialized discount brokers
• Specialized electronic trading securities firms
• Venture capital and private equity firms

• Other firms include research boutiques, companies with large clearing operations, and other
firms that do not fit into one of the categories above
 INVESTMENT BANKING

• Investment banking refers to activities related to underwriting and distributing new issues of debt
and equity securities
• New issues can be either first-time issues of a company’s debt or equity securities or the new
issues of a firm whose debt or equity is already trading (i.e., seasoned issues)

• Securities underwriting can be undertaken through either public or private offerings

• Public offering represents the sale of a security to the public at large
• In a private offering, an investment bank acts as a private placement agent for a fee, placing
the securities with one or a few large institutional investors (e.g., life insurance companies)
 MARKET MAKING

• Market making involves the creation of a secondary market in an asset by a securities firm or
investment bank

• Market making can involve either agency or principal transactions:

• Agency transactions are two-way transactions made on behalf of customers
• In principal transactions, the market maker seeks to profit on the price movements of
securities and takes either long or short inventory positions for its own account
 TRADING

• Trading is closely related to market-making; a trader takes an active net position in an underlying
instrument or asset

• There are at least six types of trading activities:

• Position trading
• purchases of large blocks of securities on the expectation of a favorable price move
• Pure arbitrage
• buying an asset in one market at one price and selling it immediately in another market
at a higher price
 TRADING

• Risk arbitrage
• buying securities in anticipation of some information release
• Program trading
• simultaneously buying and selling of a portfolio of at least 15 different stocks valued at
more than $1 million, using computer programs to initiate such trades
• Stock brokerage
• trading securities on behalf of customers
• Electronic brokerage
• direct assess, via the Internet, to the trading floor, therefore bypassing traditional
brokers
 INVESTING AND CASH MANAGEMENT

• Investing involves managing pools of assets such as mutual funds

• Securities firms can manage such funds either as agents for other investors or as principals
for themselves and their stockholders
• Objective in funds management is to select asset portfolios to beat some return-risk
performance benchmark, such as the S&P 500 Index

• Securities firms and investment banks offer bank deposit-like cash management accounts
(CMAs), money market mutual funds that offer checkwriting privileges
• Can be covered directly or indirectly by federal deposit insurance from the FDIC
 MERGERS AND ACQUISITIONS

• Investment banks frequently provide advice on, and assistance in, mergers and acquisitions
• Assist in finding merger partners
• Underwrite any new securities to be issued by the merged firms
• Assess the value of target firms
• Recommend terms of the merger agreement
• Assist target firms in preventing a merger
 RECENT TRENDS

• Industry trends depend heavily on the state of the stock market and the economy
• Commission income fell after the 1987 stock market crash
• Record stock market trading volumes between 1992 through 2000 resulted in a recovery in
commission income
• Improvements in the U.S. economy in the mid-2000s led to even greater increases in commission
income, but income fell with the stock market in 2006-2008
• Commission income again rose in the early and mid-2010s, as the economy and the stock market
recovered
SECURITIES INDUSTRY PRETAX PROFITS,
IN BILLIONS OF DOLLARS, 2001 - 2018
 REGULATION

• Securities and Exchange Commission (SEC) is the primary regulator of the securities industry
• Established in 1934 largely in response to abuses by securities firms that many at the time
felt were partly responsible for the economic problems in the U.S.
• Primary role of SEC includes administration of securities laws, review and evaluation of
registrations of new securities offerings, review and evaluation of annual and semiannual
reports summarizing the financial status of all publicly held corporations, and the prohibition
of any form of security market manipulation
 REGULATION

• While the SEC sets the overall regulatory standards for the industry, the Financial Industry
Regulatory Authority (FINRA) is involved in the day-to-day regulation of trading practices
• FINRA is an independent, not-for-profit organization authorized by Congress
• FINRA writes and enforces rules governing the activities of securities firms, examines firms
for compliance with those rules, works to foster market transparency, and supports investor
education
• FINRA monitors trade abuses, trading rule violations, and securities firms’ capital (solvency
positions)
• FINRA also performs market regulation under contract for the major U.S. stock exchanges
 REGULATION

• Spring of 2010
• Subcommittee hearing focused on the contributing role of investment banks (e.g., Goldman
Sachs) in the financial crisis
• Subcommittee brought up evidence and internal Goldman documents that showed Goldman
knew the housing market was on the brink of collapse but continued to sell mortgage-backed
securities to investors
• Goldman allegedly bet against the securities it built and sold with the knowledge that the
housing market’s collapse would bring the firm a sizable payday
 GLOBAL ISSUES

• Securities firms and investment banks are by far the most global of any group of financial
institutions
• Both U.S. and European IBs compete for business worldwide
• As domestic securities trading and underwriting grew in the 1990s and 2000s, so did foreign
securities trading and underwriting
• Result of the financial crisis in the late 2000s was that large investment banks around the world
became more concerned than ever with capital, liquidity, and leverage
 DERIVATIVE SECURITIES: OVERVIEW

• A derivative security is an agreement between two parties to exchange a standard quantity of an

asset at a predetermined price at a specified date in the future
• Payoff is linked to another, previously issued security
• As the value of the underlying security to be exchanged changes, the value of the derivative
security changes
• Involves the transference of risk
• Traders can experience large losses if the price of the underlying asset moves against them
significantly
• At the heart of the recent financial crisis were losses associated with off-balance-sheet
derivative securities created and held by FIs
 OPTIONS

• An option is a contract that gives the holder the right, but not the obligation, to buy or sell the
underlying asset at a specified price within a specified period of time
• Call option gives the purchaser (or buyer) the right to buy an underlying security (e.g., a
stock) at a prespecified price called the exercise or strike price (X)
• In return, buyer of call option must pay the writer (or seller) an up-front fee known as a
call premium (C)
• Put option gives the option buyer the right to sell an underlying security (e.g., a stock) at a
prespecified price to the writer of the put option
• In return, the buyer of the put option must pay the writer (or seller) the put premium (P)
BUYING A CALL OPTION
WRITING A CALL OPTION
BUYING A PUT OPTION
WRITING A PUT OPTION
 OPTION VALUES

• Model most commonly used to price options is the Black-Scholes pricing model
• Black-Scholes model examines five factors that affect the price of an option:
1. The spot price of the underlying asset
2. The exercise price on the option
3. The option’s exercise date
4. Price volatility of the underlying asset
5. The risk-free rate of interest
• Time value of an option is the difference between an option’s price (or premium) and its intrinsic
value
CHARACTERISTICS OF ACTIVELY TRADED
OPTIONS
 COLLAR STRATEGY

• Consists of 3 positions
1. long position in the underlying security
2. Long put option (buying put option)
• hedge the downside risk on the underlying security

3. Short call option (Writing call option)

• on the underlying security to finance the long put position
COLLAR STRATEGY
JPM COLLAR
 JPM COLLAR

• Consists of 4 positions
1. long position in the underlying security
2. Long put option
3. Short call option
4. Short put option
 EXAMPLE

• Current price of the underlining security = 4288

• Long put option X = 4050
• Short call option X = 4500
• Short put option X = 3410

• light blue = profit/ loss

dark blue = payoff
DERIVATIVE SECURITIES USED TO MANAGE
RISK
• Managers are increasingly turning to off-balance-sheet (OBS) instruments such as forwards,
futures, options, and swaps to hedge the risks their FIs face
• Derivatives play a role in managing an FI’s interest rate, foreign exchange, and credit risk
exposures

• Traders of derivatives can be speculators or hedgers

• Speculators buy derivative contracts to profit from a price increase or sell to profit from a
price decrease
• Hedgers take a position in a derivative contract as protection against an increase or decrease
in the price of a security
 OPTION STRATEGIES:
(1) BUYING A CALL OPTION ON A BOND
• Buying (or taking a long position in) a call option
• a strategy to take when interest rates are expected to fall
• As interest rates fall, bond prices rise,
call option buyers has a large profit potential
• As interest rates rise, bond prices fall,
the potential for a negative payoff (loss)
for the buyer of the call option increases
 OPTION STRATEGIES:
(2) WRITING A CALL OPTION ON A BOND
• Writing (or taking a short position in)
• a call option is a strategy to take when interest rates are expected to rise
• but is an unacceptable strategy when hedging interest rate risk
• When interest rates rise and bond prices fall
the potential for the writer of the call
to receive a positive payoff or profit increases
• When interest rates fall and bond prices rise
the probability that the writer will take a loss
increases
 OPTION STRATEGIES:
(3) BUYING A PUT OPTION ON A BOND
• Buying (or taking a long position in) a put option
• a strategy to take when interest rates are expected to rise
• When interest rates rise and bond prices fall
the probability that the buyer of the put will
make a profit from exercising the option increases
• When interest rates fall and bond prices rise
the probability that the buyer of a put
will lose increases
 OPTION STRATEGIES:
(4) WRITING A PUT OPTION ON A BOND
• Writing (or taking a short position in) a put option
• a strategy to take when interest rates are expected to fall
• When interest rates rise and bond prices fall,
the writer of the put is exposed to potentially large losses
• As interest rates fall and bond prices rise
the writer has an enhanced probability of
making a profit
BUYING A PUT OPTION TO HEDGE THE
INTEREST RATE RISK ON A BOND
NET PAYOFF OF BUYING A BOND PUT AND
INVESTING IN A BOND