978-0078034800 Chapter 4

Unlock access to all the studying documents.

View Full Document

Chapter 04 – Financial Services: Securities Brokerage and Investment Banking

4-1

Education.

Solutions for End-of-Chapter Questions and Problems: Chapter Four

1. Explain how securities firms differ from investment banks. In what ways are they financial

intermediaries?

Securities firms specialize primarily in the purchase, sale, and brokerage of securities, while

investment banks primarily engage in originating, underwriting, and distributing issues of

2. In what ways have changes in the investment banking industry mirrored changes in the

commercial banking industry?

First, both industries have seen a concentration of business among the larger firms. This

3. What are the different types of firms in the securities industry and how does each type

differ from the others?

The firms in the security industry vary by size and specialization. They include:

Chapter 04 – Financial Services: Securities Brokerage and Investment Banking

4-2

Education.

b) National firms specializing in corporate finance and trading, such as Goldman Sachs,

above. This would include firms such as Knight Capital Group (a leading firm in off-

exchange trading of U.S. equities) and floor specialist LaBranche & Co.

4. What are the key activity areas for investment banks and securities firms? How does each

activity area assist in the generation of profits and what are the major risks for each area?

The seven major activity areas of security firms are:

a) Investment Banking: Investment banks specialize in underwriting and distributing both

Chapter 04 – Financial Services: Securities Brokerage and Investment Banking

4-3

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

investment in the firm. Venture capital firms do not make outright loans. Rather, they

purchase an equity interest in the firm that gives them the same rights and privileges

associated with an equity investment made by the firm’s other owners.

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

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 involves the purchase and

simultaneous sale of an asset in different markets because of different prices in the two

markets. Risk arbitrage involves establishing positions prior to some anticipated

e) Investing: Securities firms act as agents for individuals with funds to invest by

establishing and managing mutual funds and by managing pension funds. The securities

firms generate fees that affect directly the revenue stream of the companies.

f) Cash Management: Cash management accounts are checking accounts that earn interest

and may be covered by FDIC insurance. The accounts have been beneficial in

services, research and information services, and other brokerage services on a fee basis.

4-4

Education.

5. What is the difference between an IPO and a secondary issue?

6. What is the difference between a private placement and a public offering?

7. What are the risk implications to an investment bank from underwriting on a best-efforts

basis versus a firm commitment basis? If you operated a company issuing stock for the first

time, which type of underwriting would you prefer? Why? What factors may cause you to

choose the alternative?

8. An investment bank agrees to underwrite an issue of 15 million shares of stock for Looney

Landscaping Corp.

a. If the investment bank underwrites the stock on a firm commitment basis, it agrees to

pay $12.50 per share to Looney Landscaping Corp. for the 15 million shares of stock. It

Chapter 04 – Financial Services: Securities Brokerage and Investment Banking

4-5

If the investment bank sells the stock for $11.95 per share, Looney Landscaping Corp. still

13,600,000 shares = $3,740,000, and the stock price is $12.50 per share since that is what the

public pays.

9. An investment bank agrees to underwrite a $500 million, 10-year, 8 percent semiannual

bond issue for KDO Corporation on a firm commitment basis. The investment bank pays

KDO on Thursday and plans to begin a public sale on Friday. What type of interest rate

000,000,500$000,000,500$000,000,20$32.036,695,1$ 20%,025.420%,025.4 −+=− ==== nini PVPVA

4-6

Education.

000,000,500$000,000,500$000,000,20$67.557,702,1$ 20%,975.320%,975.3 −+= ==== nini PVPVA

10. An investment bank pays $23.50 per share for 4 million shares of JCN Company. It then

sells those shares to the public for $25 per share. How much money does JCN receive?

11. XYZ, Inc., has issued 10 million new shares of stock. An investment bank agrees to

underwrite these shares on a best-efforts basis. The investment bank is able to sell 8.4

12. What is venture capital?

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

4-7

Education.

13. What are the different types of venture capital firms? How do institutional venture capital

firms differ from angel venture capital firms?

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

14. What are the advantages and disadvantages to a new or small firm of getting capital funding

from a venture capital firm?

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

4-8

Education.

15. How do agency transactions differ from principal transactions for market makers?

Agency transactions are done on behalf of a customer. Thus, the investment bank is acting as a

16. One of the major activity areas of securities firms is trading.

a. What is the difference between pure arbitrage and risk arbitrage?

Pure arbitrage involves the buying and selling of similar assets trading at different prices. Pure

arbitrage has a lock or assurance of the profits that are available in the market. This profit

17. If an investor observes that the price of a stock trading in one exchange is different from

the price in another exchange, what form of arbitrage is applicable, and how can the

4-9

Education.

18. An investor notices that an ounce of gold is priced at $1,518 in London and $1,525 in New

York.

a. What action could the investor take to try to profit from the price discrepancy?

An investor would try to buy gold in London at $1,518 and sell it in New York for $1,525

19. What three factors are given credit for the steady decline in brokerage commissions as a

percent of total revenues over the period beginning in 1977 and ending in 1991?

4-10

Education.

20. What factors are given credit for the resurgence of profitability in the securities industry

beginning in 1991? Are firms that trade in fixed-income securities more or less likely to

2008 through 2009 pushed stock market values down. As a result, commission income in the

securities industry declined as well. As the economy and the stock market recovered in the early

2010s, commission income again rose to almost 20 percent of total revenues.

2001-2003, they declined in 2004-2006 because interest rates increased quite suddenly. Many

firms with exposed interest rate instruments reported large losses.

21. Using Table 4-6, which type of security accounts for most underwriting in the United

States? Which is likely to be more costly to underwrite: corporate debt or equity? Why?

22. How did the financial crisis affect the performance of securities firms and investment banks?

Signs of the impending financial crisis arose in 2007. The industry began 2007 on a strong note,

2007. The worst of the financial crisis hit in 2008 as the industry reported a record loss for the

4-11

Education.

for 2009 were $212.4 billion, 33.7 percent below 2008 levels. Of this, interest expenses fell to

just $21.9 billion, 82.2 percent below 2008 levels. While still in a fragile state, the industry

seemed to be recovering along with the economy.

23. How do the operating activities, and thus the balance sheet structures, of securities firms

differ from the operating activities of depository institutions? How are the balance sheet

structures of securities firms similar to depository institutions?

Securities firms and investment banks primarily help net suppliers of funds (e.g., households)

In contrast, depository institutions have fixed-term time and savings deposit liabilities.

24. Based on the data in Table 4-7, what were the largest single asset and the largest single

4-12

Education.

The largest asset category was a reverse repurchase agreement, and the largest liability was a

repurchase agreement. When a financial institution needs to borrow funds, one source is to sell

an asset. In the case of financial assets, the institution often finds it more beneficial to sell the

asset under an agreement to repurchase the asset at a later time. In his case, the current money

market rate of interest is built into the agreed upon repurchase price, and the asset literally does

not leave the balance sheet of the borrowing institution. The borrowing institution receives cash

and a liability representing the agreement to repurchase. The lending institution, which has

excess funds, replaces cash as an asset with the reverse repurchase agreement.

25. How did the National Securities Markets Improvement Act of 1996 (NSMIA) change the

26. Identify the major regulatory organizations that are involved in the daily operations of the

investment securities industry, and explain their role in providing smoothly operating

markets.

The primary regulator of the securities industry is the Securities and Exchange Commission

4-13

Education.

2003 the issue culminated in an agreement between regulators and 10 of the nation’s largest

securities firms to pay a record $1.4 billion in penalties to settle charges involving investor

abuse. The long-awaited settlement centered on civil charges that securities firms routinely

issued overly optimistic stock research to investors in order to gain favor with corporate clients

Also overseeing this industry at the federal level is the U.S. Congress. Along with changes

instituted by the SEC, the U.S. Congress passed the Sarbanes-Oxley Act in July 2002. This act

created an independent auditing oversight board under the SEC, increased penalties for corporate

wrongdoers, forced faster and more extensive financial disclosure, and created avenues of

Chapter 04 – Financial Services: Securities Brokerage and Investment Banking

4-14

More recently, the U.S. Senate Permanent Subcommittee on Investigations was created with the

regulated. The bill’s Financial Services Oversight Council of financial regulators was given

oversight of the industry in its charge to identify emerging systemic risks. Also under the act,

effective July 21, 2011, the dollar threshold for determining whether an investment advisor must

management of under $100 million must register with state regulators and those with over $100

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 Reserve to oversee payment, clearing, and settlement systems. Finally,

the bill gave authority to the government to resolve nonbank financial institutions whose failure

from member firms. The fund protects investor accounts against the possibility of a member

broker–dealer not being able to meet its financial obligations to customers. The fund does not,

however, protect against losses on a customer’s account due to poor investment choices that

reduce the value of a portfolio.

27. What are the three requirements of the U.S.A. Patriot Act that financial service firms must

implement after October 1, 2003?