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Answers to Chapter 16
Questions:
1. As with all intermediaries, these firms bring together those who may need extra money with those who wish to
2. Beginning in 1980 and until the stock market crash of October 19, 1987, the number of firms in the industry
expanded dramatically from 5,248 in 1980 to 9,515 in 1987. The aftermath of the crash included a major shakeout,
3. The firms in the security industry vary by size and specialization. They include:
a) National, full-line firms operating as commercial bank holding companies are the largest of the full
service investment banks. They have extensive domestic and international operations and offer advice,
h) Other firms in this industry include research boutiques, floor specialists, companies with large clearing
4. A major similarity between securities firms and all other types of FIs is a high degree of financial leverage. They
all solicit funds that are used to finance an asset portfolio consisting of financial securities. The difference is that
securities firms' liabilities tend to be extremely short term (see the balance sheet in Table 16-7). Typically payables
5. The key activity areas of security firms are:
a) Investment Banking: Investment banks specialize in underwriting and distributing both debt and equity
issues in the corporate market. New issues can be placed either privately or publicly and can represent
either a first issued (IPO) or a secondary issue. Secondary issues of seasoned firms typically will
b) Venture Capital: A difficulty for new and small firms in obtaining debt financing from commercial banks
is that CBs are generally not willing or able to make loans to new companies with no assets and business
history. In this case, new and small firms often turn to investment banks (and other firms) that make
c) Market Making: Security firms assist in the market-making function by acting as brokers to assist
customers in the purchase or sale of an asset. In this capacity the firms are providing agency transactions
d) Trading: Trading activities can be conducted on behalf of a customer or the firm. The activities usually
involve position trading, pure arbitrage, risk arbitrage, and program trading. Position trading involves the
purchase of large blocks of stock to facilitate the smooth functioning of the market. Pure arbitrage
e) Investing: Securities firms act as agents for individuals with funds to invest by establishing and managing
f) Cash Management: Cash management accounts are checking accounts that earn interest and may be
g) Mergers and Acquisitions: Most investment banks provide advice to corporate clients who are involved
6. Investing involves managing pools of assets such as closed- and open-end mutual funds and in competition with
life insurance companies and pension funds. Securities firms can manage such funds either as agents for other
Investment banking refers to activities related to underwriting and distributing new issues of debt and equity
8. With a best efforts underwriting, the investment banker acts as an agent of the company and receives a fee based
on the number of securities sold. With firm commitment underwriting, the investment banker purchases the
9. Venture capital is a professionally managed pool of money used to finance new and often high-risk firms. Venture
capital is generally provided by investment institutions or private individuals willing to back an untried company
and its managers in return for an equity investment in the firm. Venture capital firms do not make outright loans.
10. Institutional venture capital firms are business entities whose sole purpose is to find and fund the most promising
new firms. Private-sector institutional venture capital firms include venture capital limited partnerships (that are
established by professional venture capital firms, acting as general partners in the firm: organizing and managing the
11. A difficulty for new and small firms in obtaining debt financing from banks is that banks are generally not
willing or able to make loans to new companies with no assets and business history. In this case, new and small
firms often turn to venture capital firms to get capital financing as well as advice. As equity holders, venture capital
firms are not generally passive investors. Rather, they provide valuable expertise to the firm’s managers and
12. Pure arbitrage involves the immediate buying and selling of similar assets trading at different prices. Risk
arbitrage also is based on the similar principle of buying low and selling a similar asset (or an asset with same
13. Agency transactions are done on behalf of a customer. In this case the investment banker is acting as a
stockbroker. In this case, the company earns a fee or commission. In a principal transaction, the investment bank is
14. One reason for the decline is the stock market crash of 1987, but even before that, commissions were falling
because of the abolition of fixed commissions by the SEC in 1975 and the resulting competition among firms. More
15. Profits for securities firms increased between 1991-2000 because of:
i. the resurgence of stock markets and trading volume,
16. The continued slowdown of the U.S. economy in 2001, an accompanying drop in stock market values, and
terrorist attacks on the World Trade Center (which housed offices of many securities firms and investment banks) in
September 2001 brought an end to record profits in the securities industry. Industry pretax profits for 2001 fell 24
17. Signs of the impending financial crisis arose in 2007. The industry began 2007 on a strong note, but hit by the
subprime mortgage market meltdown that began in the summer of 2007, ended the year with pretax profits of just
18. Reverse repurchase agreements—securities purchased under agreements to resell (i.e., the broker gives a
19. An investor would try to buy gold in London at $1,318 and sell it in New York for $1,325 yielding a riskless
22. According to Table 16-6, debt issues were greater than equity issues by a ratio of roughly ten to one in the
23. The National Securities Markets Improvement Act (NSMIA) of 1996 reiterated the significance of the SEC in
this capacity. Prior to NSMIA, most securities firms were subject to regulation from the SEC and each state in which
24. The primary regulator of the securities industry is the Securities and Exchange Commission (SEC), 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 United States. The primary role of the SEC includes administration of securities laws,
While the SEC sets the overall regulatory standards for the industry, the Financial Industry Regulatory
Also overseeing this industry at the federal level is the U.S. Congress. For example, The U.S. Senate
Permanent Subcommittee on Investigations was created with the broad mandate to determine whether any changes
are required in U.S. law to better protect the public. In the spring of 2010, a subcommittee hearing focused on the
The financial crisis reshaped much of the securities firms and investment banking industry. In response,
regulators were charged with reshaping regulations to prevent events similar to those that led to the market collapse
and the near collapse of this industry. The 2010 Wall Street Reform and Consumer Protection Act set forth many
changes in the way securities firms and investment banks are regulated. The bill’s Financial Services Oversight
Investment banks also saw stricter oversight as the bill called for the regulation of securitization markets,
stronger regulation of credit rating agencies, a requirement that issuers and originators retain a financial interest in
securitized loans, comprehensive regulation of all over-the-counter derivatives, and new authority for the Federal
25. As domestic securities trading and underwriting have grown in the 1990s and 2000s so has foreign securities
trading and underwriting. Figures 16-4 and 16-5 show the foreign transactions in U.S. securities and U.S.
transactions in foreign securities from 1991-2013. For example, foreign investors’ transactions involving U.S. stocks
increased from $211.2 billion in 1991 to $12,037.9 billion in 2008 before falling to $6,654.0 in 2009, during the
Problems:
1. a. If the investment bank sells the stock for $13.25 per share, Looney Landscaping Corp. receives $12.50 x
15,000,000 shares = $187,500,000. The profit to the investment bank is ($13.25 - $12.50) x 15,000,000 shares =
$11,250,000. The stock price of Looney Landscaping
b. If the investment bank sells the stock for $12.50 per share, Looney Landscaping Corp. receives ($12.50 - $0.275)
x 13,600,000 shares = $166,260,000, the investment bank’s profit is $0.275 x 13,600,000 shares = $3,740,000, and
the stock price is $12.50 per share since that is what the public pays.
2. An increase in interest rates will cause the value of the bonds to fall. If rates increase 5 basis points over night, the
bonds will lose $1,695,036.30 in value. The investment bank will absorb the decrease in market value, since the
issuing firm has already received its payment for the bonds. If market rates decrease by 5 basis points, the
investment bank will benefit by the $1,702,557.67 increase in market value of the bonds. These two changes in price
can be found with the following two equations respectively:
4. GM receives $33.50 x 4,000,000 shares = $134,000,000. The profit/loss to the investment bank is ($32.00 -
