Questions
1. Regulation of Securities Activities. Explain the role of the SEC, the NASD, and the stock exchanges
in regulating the securities industry.
ANSWER: The SEC regulates the issuance of securities and specifies disclosure rules for the issuers.
2. SIPC. What is the purpose of the SIPC?
3. Investment Banking Services. How do securities firms facilitate leveraged buyouts? Why are
securities firms that are more capable of raising funds in the capital markets preferred by corporations
that need advice on proposed acquisitions?
4. Origination Process. Describe the origination process for corporations that are about to issue new
stock.
ANSWER: A corporation about to issue new stock contacts an IBF, which recommends the amount of
5. Underwriting Function. Describe the underwriting function of a securities firm.
ANSWER: An IBF may be willing to underwrite the stock of an issuing corporation, which
6. Best-Efforts Agreement. What is a best-efforts agreement?
ANSWER: In a best-efforts agreement, the IBF does not guarantee a price to the issuing corporation,
7. Failure of Lehman Brothers. Why did Lehman Brothers experience financial
problems during the credit crisis?
ANSWER: Lehman Brothers had much exposure to mortgage-backed securities. It had a relatively
8. Direct Placement. Describe a direct placement of bonds. What is an advantage of a private
placement? What is a disadvantage?
ANSWER: A direct placement involves the sale of securities directly to a specific investor (or
9. International Expansion. Explain why securities firms from the United States have expanded into
foreign markets.
ANSWER: U.S. securities have expanded overseas because: (1) their international presence allows
10. Proprietary Trading. Explain the process of proprietary trading by securities firms.
ANSWER: Securities firms can engage in proprietary trading, in which they use their own funds to
make investments for their own account. They may invest in equity securities, bonds and other debt
11. Asset Stripping. What is asset stripping?
12. Securities Firm’s Use of Financial Leverage. Explain why securities firms have used a high level of
financial leverage in the past. Explain how the leverage affects their expected return and their risk.
ANSWER: Securities firms use a high level of financial leverage because it can enhance their return
13. Systemic Risk. Why was the Federal Reserve concerned about systemic risk due to the financial
problems of Bear Stearns?
ANSWER: The failure of Bear Stearns could have spread adverse effects throughout financial
markets. Since Bear Stearns was a major provider of clearing operations for many types of
14. Access to Inside Information. Why do securities firms typically have some inside information that
could affect future stock prices of other firms?
ANSWER: Securities firms are often aware of which firms are targets to other acquiring firms. They
15. Sensitivity to Stock Market Conditions. Most securities firms experience poor profit performance
after periods in which the stock market performs poorly. Given what you know about securities firms,
offer some possible reasons for these reduced profits.
ANSWER: Profits are reduced because of (1) less stock transactions by investors, resulting in less
commissions; (2) less issuances of new stock by firms (since their stock prices are so low, they do not
16. Conversion to BHC Structure. Explain how the credit crisis encouraged some securities firms to
convert to a bank holding company (BHC) structure. Why might the expected return on equity be
lower for securities firms that convert to a bank holding company structure?
ANSWER: While securities firms were allowed to borrow short-term funds from the Federal Reserve
during the credit crisis, their conversion to a bank holding company would give them permanent
17. Financial Services Modernization Act. How did the Financial Services Modernization Act affect
securities firms?
ANSWER: The Financial Services Modernization Act resulted in the creation of more financial
conglomerates that include securities firms. One of the key benefits to securities firms in a financial
conglomerate is cross-listing. When individuals use brokerage services of a securities firm, that firm
18. Regulation FD. What impact has the SEC’s Regulation Fair Disclosure (FD) had on securities
firms?
ANSWER: As a result of Regulation FD, firms more frequently provide their information in the form
of news releases or conference calls rather than leaking it to a few analysts. Those analysts who relied
Interpreting Financial News
Interpret the following statements made by Wall Street analysts and portfolio managers.
a. “The stock prices of most securities firms took a hit because of the recent increase in interest
rates.”
Some securities firms hold bonds, which decline in value when interest rates rise. Some securities
firms may lose some underwriting business when interest rates rise, as corporations reduce their
b. “Now that commercial banks are allowed more freedom to offer securities services, there may be
a shakeout in the underwriting arena.”
If commercial banks are allowed more freedom to underwrite securities, this will create more
c. “Chaos in the securities markets can be good for some securities firms.”
Chaos may cause a substantial amount of trading in securities in the securities markets, if
Managing in Financial Markets
As a consultant for a securities firm, you are assessing the operations of a securities firm.
a. The securities firm relies heavily on full-service brokerage commissions. Do you think that heavy
reliance on these brokerage commissions is risky? Explain.
Brokerage commissions are dependent on the volume of transactions executed, which can change
b. If this firm attempts to enter the underwriting business, would it be an easy transition?
Full-service brokerage firms have some experience in valuing stocks, and therefore have some
c. In recent years, the stock market volume increased substantially, and this securities firm
performed very well. In the future, however, many institutional and individual investors may
invest in indexes rather than in individual stocks. How would this affect the securities firm?
Flow of Funds Exercise
How Investment Banking Facilitates the Flow of Funds
Recall that Carson Company has periodically borrowed funds, but contemplates a stock or bond offering
so that it can expand by acquiring some other businesses. It contacted Kelly Investment Company, an
investment bank.
a. Explain how Kelly Investment Company can serve Carson and how it will serve other clients as
well when it serves Carson. Also explain how Carson Company can serve Kelly Investment
Company.
Kelly can underwrite stocks or bonds issued by Carson Company so that Carson can obtain
funds to support its expansion. Kelly would place securities with investors who wanted to
b. In a securities offering Kelly Investment Company would like to do a good job for its clients,
which include both the issuer and institutional investors. Explain the dilemma.
Kelly wants to ensure that the securities are offered at a high enough price to satisfy the issuer
and a low enough price to satisfy the investors. If the investors earn a very high return on the
c. The issuing firm in an IPO hopes that there will be a strong demand for its shares at the offer
price, which will ensure that it receives a reasonable amount of proceeds from its offering. In
some previous IPOs, the share price by the end of the first day was more than 80 percent above
the offer price at the beginning of the day. This reflects a very strong demand relative to the price
at the end of the day. In fact, it probably suggests that the IPO was fully subscribed at the offer
price, and that some institutional investors who purchased the stock at the offer price flipped their
shares near the end of the first day to individual investors who were willing to pay the market
price. Do you think that the issuing firm would be pleased that its stock price increased by more
than 80 percent on the first day? Explain. Who really benefits from the increase in price on the
first day?
If the price increases by 80 percent in one day, this may suggest that the underwriter used an
d. Continuing the previous question, assume that the stock price drifts back down to near the
original offer price over the next three weeks (even though the general stock market conditions
were stable over this period) and then moves in tandem with the market over the next several
years. Based on this information, do you think the offer price was appropriate? If so, how can you
explain the unusually high one-day return on the stock? Who benefited from this stock price
behavior, and who was adversely affected?
Given this information, it appears that the equilibrium stock price is near the offer price, which
suggests that the offer price was a reasonable estimate of the equilibrium price. The high initial
return is not due to major underpricing by the underwriter, but is due to the excessive demand for