Services Offered by Securities Firms versus Investment Banks

Services Offered by Securities Firms versus Investment Banks • Investment Banks – originating, underwriting, and placing securities in money and capital markets • Securities Firms – brokerage services or market making • The largest companies in the industry perform multiple services (e. g. , underwriting and brokerage) and are generally called investment banks Mc. Graw-Hill /Irwin Copyright © 2001 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Size, Structure, and Composition of the Industry • Size of the industry is measured by the equity capital of the firms participating in the industry • Three major types of firms – national full-line investment banks that service retail and corporate customers (e. g. , Merrill Lynch) – national full-line firms that specialize more in corporate finance (e. g. , Goldman Sachs) – the remainder of the industry and includes four classes • • • Mc. Graw-Hill /Irwin specialized investment bank subsidiaries of commercial banks specialized discount brokers regional securities firms specialized electronic trading securities firms venture capital firms Copyright © 2001 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Securities Firm and Investment Bank Activity Areas • Securities firms and investment banks engage in as many as seven key activity areas – – – – Investing Investment Banking Market Making Trading Cash Management Mergers and Acquisitions Other Service Functions Mc. Graw-Hill /Irwin Copyright © 2001 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Investing • Involves managing pools of assets such as mutual funds • Compete with commercial banks, life insurance companies, and pension funds • Manage funds either as agents for other investors or as principals • Objective is to select asset portfolios to beat some return-risk performance benchmark such as the S&P 500 Mc. Graw-Hill /Irwin Copyright © 2001 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Investment Banking • Refers to activities related to underwriting and distributing new issues of debt and equity securities • Industry is dominated by a small number of underwriting firms (1999 the top ten firms did 81% of the underwriting) • Securities underwriting can be undertaken through either public or private offerings – Private placement - securities issue placed with one of a few large institutional investors – Public placement - may be underwritten on a best efforts or firm commitment basis and offered to the public Mc. Graw-Hill /Irwin Copyright © 2001 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Investment Banking Risk Example Profit for BP Underwriter 10/26/87 Price = 2. 65 0 10/15/87 Offer price = 3. 300 Maximum Profit on 10/15/87 = 17. 7 Million 10/15/87 Bid price = 3. 265 311 Million Loss Mc. Graw-Hill /Irwin 10/15/87 U. S. syndicate commits to purchase 505, 800, 000 shares of British Petroleum Offer period usually shorter Periods of extreme volatility (stock market crash) are relatively rare Copyright © 2001 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Market Making • Involves the creation of a secondary market in an asset by a securities firm or investment bank • Either agency or principal transactions – Agency transactions - two-way transactions on behalf of customers – Principal transactions - the market maker seeks to profit on the price movements of securities and takes long or short inventory positions for its own account Mc. Graw-Hill /Irwin Copyright © 2001 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Trading • Closely related to market-making activities • Six types of trading – Position trading - purchases of large blocks on expectation of favorable price move – Pure Arbitrage - buying an asset in one market and selling it immediately in another market at a higher price – Risk Arbitrage - buying securities in anticipation of some information release • “Fund of funds” example – Announced merger Mc. Graw-Hill /Irwin Copyright © 2001 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Trading (continued) – Program Trading - simultaneous buying and selling using a computer program to initiate such trades • Portfolio of at least 15 different stocks • Portfolio size greater than $1 million • Objective – arbitrage discrepancies between the futures and cash market price – Stock Brokerage - trading of securities on behalf of individuals – Electronic Brokerage - offered by major brokers, direct access via internet to trading floor Mc. Graw-Hill /Irwin Copyright © 2001 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Cash Management • Securities firms and investment banks offer bank deposit-like cash management accounts (CMAs) to individual investors – money market mutual fund sold by investment banks that offer check-writing privileges Mc. Graw-Hill /Irwin Copyright © 2001 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Mergers and Acquisitions • Frequently provide advice on, and assistance in, mergers and acquisitions – assist in finding merger partners – underwrite any new securities – assess the value of target firms – recommend terms of the merger agreement – assist target firms in preventing a merger Mc. Graw-Hill /Irwin Copyright © 2001 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Other Service Functions • Custody and escrow services • Clearance and settlement services • Research and advisory services Mc. Graw-Hill /Irwin Copyright © 2001 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Regulation • The primary regulator of the securities industry is the Securities and Exchange Commission (SEC) established in 1934 • SEC sets rules governing securities firms’ underwriting and trading activities • Shelf registration - allows firms that plan to offer multiple issues of stock over a two-year period to submit one registration statement summarizing the firm’s financing plans for the period • The Securities Investor Protection Corporation (SIPC) protects investors against losses of up to $500, 000 on securities firm failures Mc. Graw-Hill /Irwin Copyright © 2001 by The Mc. Graw-Hill Companies, Inc. All rights reserved.