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Investment Banking

Investment Banking

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What are Investment banks?

Investment banks are essentially financial intermediaries, who primarily help businesses and governments with raising capital, corporate mergers and acquisitions, and securities trade. In USA such banks are the most important participants in the direct market by bringing financial claims for sale. They help interested parties in raising capital, whether debt or equity in the primary market to finance capital expenditure. Once the securities are sold, investment bankers make secondary markets for the securities as brokers and dealers. In 1990, there were 2500 investment banking firms in USA doing underwriting business. About 100 firms are so large that they dominate the industry. In recent years some investment banking firms have diversified or merged with other financial institutions to become full service financial firms. What is the difference between Investment Banks & Commercial Banks? Investment banks have often been thought to be as Commercial banks, and rightly so. However, both the terms have different connotations in United States. Early investment banks in USA differed from commercial banks, which accepted deposits and made commercial loans. Commercial banks were chartered exclusively to issue notes and make short-term business loans. On the other hand, early investment banks were partnerships and were not subject to regulations that apply to corporations. Investment banks were referred to as private banks and engaged in any business they liked and could locate their offices anywhere. While investment banks could not issue notes, they could accept deposits as well as underwrite and trade in securities. As put forth earlier, the distinction between commercial banks and investment banks is unique and is confined to the United States, where it is by legislation that they are separated. In countries where there is no legislated separation, banks provide investment-banking services as part of their normal range of banking activities. Coming back to countries where investment banking and commercial banking are combined. Such countries have what is known as

universal banking system. Say for example, European Countries have universal banking system, which accepts deposits, make loans, underwrites securities, engage in brokerage activities and offer financial services.

Concept of Investment Banks The banking scenario in India is itself huge, covering the different facets of the economy. By and large, investment banks in India are itself an institution which generates funds in two different ways. The first manner in which it works is by drawing public funds via the capital market by way of selling stock in their company. The other way in which it operates is to seek for venture capital or private equity, as a substitute for a stake in their company. Role of an Investment Bank The major work of investment banks includes a lot of consulting. For instance, they offer advices on mergers and acquisitions to companies. The other arena where they give advice are tracking the market and determining when should a company come out with a public offering and what is the best possible way to manage the public assets of businesses. The role that an investment bank plays sometimes gets overlapped with that of a private brokerage house. The usual advice of buying and selling is also given by investment banks. There is no demarcating line between the investment banking and other forms of banking in India. This has been observed majorly of late. All banks nowadays want to provide their customers the best of services and create a niche for themselves and that is why apart from investment banks, all other banks too are aiming at making it big. At the macro level, investment banking is related with the primary function of assisting the capital market in its function of capital intermediation, i.e., the movement of financial resources from those who have them (the investors), to those who need to make use of them for producing GDP (the issuers). Over

the decades, investment banks have always suited the needs of the finance community and thus become one of the most vibrant and exciting segment of financialservices. Globally investment banks handle significant fund-based business of their own in the capital market along with their non-fund service portfolio which is offered to the clients. All these activities are broadly segmented across three platforms - equity market activity, debt market activity and merger and acquisitions (M&A) activity. In addition, given the structure of the market, there is also a segmentation based on whether a particular investment bank belongs to a banking parent or is a stand-alone pure investment bank Core investment banking activities Investment banking is the traditional aspect of the investment banks which also involves helping customers raise funds in the capital markets and giving advice on mergers and acquisitions. Investment banking may involve subscribing investors to a security issuance, coordinating with bidders, or negotiating with a merger target. Another term for the investment banking division is corporate finance, and its advisory group is often termed mergers and acquisitions (M&A). A pitch book of financial information is generated to market the bank to a potential M&A client; if the pitch is successful, the bank arranges the deal for the client. The investment banking division (IBD) is generally divided into industry coverage and product coverage groups. Industry coverage groups focus on a specific industry such as healthcare, industrials, or technology, and maintain relationships with corporations within the industry to bring in business for a bank. Product coverage groups focus on financial products, such as mergers and acquisitions, leveraged finance, project finance, asset finance and leasing, structured finance, restructuring, equity, and high-grade debt and generally work and collaborate with industry groups in the more intricate and specialized needs of a client. Sales and trading: On behalf of the bank and its clients, the primary function of a large investment bank is buying and selling products. In market making, traders will buy and sell financial products with the goal of making an incremental amount

strategists place companies and industries in a quantitative framework with full consideration of the macroeconomic scene. Sales is the term for the investment banks sales force. with highly technical and numerate employees working on creating complex structured products which typically offer much greater margins and returns than underlying cash securities. Banks seek to maximize profitability for a given amount of risk on their balance sheet. Structuring has been a relatively recent activity as derivatives have come into play. the sales force in suggesting ideas to customers. Research also serves outside clients with investment advice (such as institutional investors and high net worth individuals) in the hopes that these clients will execute suggested trade ideas through the Sales & Trading division of the bank. Strategists advise external as well as internal clients on the strategies that can be adopted in various markets. and investment bankers by covering their clients. risk undertaken by a trader after he buys or sells a product to a client and does not hedge his total exposure. This strategy often affects the way the firm will operate in the market. The necessity for numerical ability in sales and trading has created jobs for physics. Research is the division which reviews companies and writes reports about their prospects. thereby bringing in revenue for the firm. often with "buy" or "sell" ratings. Sales desks then communicate their clients' orders to the appropriate trading desks. While the research division may or may not generate revenue (based on policies at different banks). or structure new products that fit a specific need. as well as the way structurers create new products.D. Banks also undertake risk through proprietary trading. the suggestions salespersons give to clients. who can price and execute trades. the direction it would like to take in terms of its proprietary and flow positions.of money on each trade. done by a special set of traders who do not interface with clients and through "principal risk". its resources are used to assist traders in trading. There is a potential conflict of interest between the investment bank and its analysis in that published analysis can . whose primary job is to call on institutional and high-net-worth investors to suggest trading ideas (on caveat emptor basis) and take orders. math and engineering Ph. Ranging from derivatives to specific industries.s who act as quantitative analysts.

as seen in the "run on the bank" with Bear Stearns in 2008. as a commercial activity. and securities brokerage services to institutions. Investment management is the professional management of various securities (shares. Therefore in recent years the relationship between investment banking and research has become highly regulated requiring a Chinese wall between public and private functions. like international stock. custody services. It was . took shape in India through the management of Public Issues of capital and Loan Syndication. they invest on higher rates but less secured. etc. Fix interest. they place your money on a sure thing like government bonds. Prime brokerage with hedge funds has been an especially profitable business. The risk is higher but so might be the profit. Merchant banking is a private equity activity of investment banks. nothing radical. bonds. to meet specified investment goals for the benefit of the investors.affect the profits of the bank. real estate). corporations etc. "merchant bank" was the British English term for an investment bank. Finance companies take more chances with your money.[2] Current examples include Goldman Sachs Capital Partners and JPMorgan's One Equity Partners. (Originally.g. The investment management division of an investment bank is generally divided into separate groups. Other businesses that an investment bank may be involved in Global transaction banking is the division which provides cash management.) or private investors (both directly via investment contracts and more commonly via collective investment schemes e. as well as risky. pension funds. often known as Private Wealth Management and Private Client Services.) Commercial banking What are the differences between the products offered by investment banks as opposed to a basic finance company investment banks usually are more conservative. Investors may be institutions (insurance companies.g.) and other assets (e. lending. MerchantBanking. mutual funds).

acceptance of deposits is limited to commercial banks. Non-bank financial intermediaries accept deposits for . financial institutions. They can subscribe to securities in the primary market and trade in shares and debentures in the secondary market.originated in 1969 with the setting up of the Merchant Banking Division by ANZ Grindlays Bank. starting with the conferring of statutory powers on the Securities and Exchange Board of India (SEBI) and the repeal of Capital Issues Control Act and the abolition of the office of the Controller of Capital Issues. The main service offered at that time to the corporate enterprises by the merchant banks included the management of public issues and some aspects of financial consultancy. The early and mid-seventies witnessed a boom in the growth of merchant banking organisations in the country with various commercial banks. These have brought about significant improvement in the functional and regulatory efficiency of the market. Reform measures were initiated in the capital market from 1992. In India commercial banks are restricted from buying and selling securities beyond five percent of their net incremental deposits of the previous year. enabling the Merchant Bankers shoulder greater legal and moral responsibility towards the investing public. Further. broker's firms entering into the field of merchant banking. Scenario for Investment Banking in India.

investment and loan activities and housing finance. concerned with investigating. concerned with advising on the finances of corporations. including mergers. Corporate Finance. What is Universal Banking? It refers to the combination of commercial banking and investment banking including securities business. What are the Principal Functions of Investment Banks? Global investment banks typically have several business units.fixed term are restricted to financing leasing/hire purchase. and Sales and Trading. is often one of the biggest sources of profit. or Proprietary Trading.both individual investors and larger entities such as hedge funds and mutual funds regarding shares and corporate and government bonds). concerned with buying and selling shares both on behalf of the bank's clients and also for the bank itself. They cannot act as issue managers or merchant banks. and making recommendations to clients . the banks may arbitrage stock on a large scale if they see a suitable profit opportunity or they may structure their books so that they profit from a fall in bond price or yields. For Investment banks management of the bank's own capital. Research. In short the functions of Investment banks include: Raising Capital . For example. The following figure (figure 1). arrange mergers and offer portfolio services. Only merchant bankers registered with the Securities and Exchange Board of India (SEBI) can undertake issue management and underwriting. serves as an effective tool of rightly distinguishing between the above two banks. acquisitions and divestitures. Merchant banking in India is non-fund based except underwriting. For example. valuing. each looking after one of the functions of investment banks. It envisages multiple business activities and can take number of forms ranging from the true universal bank represented by the German Model with few restrictions to the UK model providing a broad range of financial activities through separate affiliates of the bank and the US model with a holding company structure through separately capitalized subsidiaries.

or other items with its own money as opposed to its customer’s money. “Brokerage Services” Function: Brokerage Services. bonds. bonds. These brokerages assist in the purchase and sale of stocks. often with "buy" or "sell" ratings.Brokerage Services Proprietary trading Research Activities Sales and Trading “Raising Capital” function: Corporate Finance is a traditional aspect of Investment banks. This in turn also provides liquidity to the market. typically involves trading and order executions on behalf of the investors. Though Investment Banks are usually defined as businesses. “Research Activities” Function: Research. which assist other business in raising money in the capital markets (by selling stocks or bonds). options. is usually referred to as a division which reviews companies and writes reports about their prospects. and mutual funds. Generally the highest profit margins come from advising on mergers and acquisitions. they are not shy of making profit for itself by engaging in trading activities. with a view to make a profit for itself. Investment Bankers have had a palpable effect on the history of American business. as they often proactively meet with executives to encourage deals or expansion. commodities. which involves helping customers raise funds in the Capital Market and advising on mergers and acquisitions. Although in . “Proprietary Trading” Function: Under Investment banking proprietary trading is what is generally used to describe a situation when a bank trades in stocks.

What does the Business Portfolio of Investment Banks constitute? CORE BUSINESS PORTFOLIO 1 NON-FUND BASED . it is usually responsible for a much larger amount of revenue than the other divisions. or other things the firm might have on its books. In the process of market making. bonds. underwritten by the firm. investment banks will buy and sell stocks and bonds with the goal of making an incremental amount of money on each trade. Sales is the term for the investment banks sales force. research has historically been performed by Investment Banks (JM Morgan Stanley. Goldman Sachs etc). The primary reason for this is because the Investment Bank must take responsibility for the quality of the company that they are underwriting Vis a Vis the prices involved to the investor.theory this activity would make the most sense at a stock brokerage where the advice could be given to the brokerage's customers. Another activity of the sales force is to call institutional investors to sell stocks. whose primary job is to call on institutional investors to buy the stocks and bonds. “Sales and Trading” Function: Often referred to as the most profitable area of an investment bank. commodities.

selloff and exits. hive-offs. who primarily help businesses and governments with raising capital.Merchant Banking Services for management of Public offers of equity and debt instruments Open offers under the Takeover Code Buy back offers De-listing offers Advisory and Transaction service in Project Financing Syndicated Loans Structured Finance Venture Capital Private Equity Preferential Issues Private Placements of equity and debt Business advisory and structuring Financial restructuring Corporate Reorganisations such as mergers and de-mergers. strategic sale of equity. Acquisitions and takeovers Government disinvestments and privatization Asset Recovery agency services (presently in take off stage) 2. which accepted deposits and made commercial loans. FUND BASED Underwriting Market Making Bought Out deals Investments in primary market Investment banks are essentially financial intermediaries. . Early investment banks in USA differed from commercial banks. corporate mergers and acquisitions. and securities trade. asset sales.

the investment banking activity was mainly confined to merchant banking services. In 1972. ICICI was the first financial institution to set up its merchant banking division in 1973. The SBI set up its merchant banking division in 1972 and the other banks followed suit. The merchant banks were meant to manage investments and provide advisory services. Countries where investment banking and commercial banking are combined have universal banking system. The erstwhile Grindlays Bank began its merchant banking operations in 1967 after obtaining the required license from RBI. Soon after Citibank followed through. the Banking Commission report asserted the need for merchant banking activities in India and recommended a separate structure for merchant banks totally different from commercial banks’ structure. Both the banks focussed on syndication of loans and raising of equity apart from other advisory services. Universal Banking refers to the combination of commercial banking and investment banking including securities business Sales and Trading is often referred to as the most profitable area of an investment bank. where it is by legislation that they are separated. The foreign banks were the forerunners of merchant banking in India. How did the formation of SEBI boost the Development of Investment banking in India? . it is usually responsible for a much larger amount of revenue than the other divisions How did Investment banking evolve in India? For more than three decades.Distinction between commercial banks and investment banks is unique and is confined to the United States.

Post-1992. The lack of depth in the secondary market. Also not all the merchant bankers were able to transform themselves into fullfledged investment banks. What are the Characteristics of Indian Investment Banking Industry? . Currently bigger industry players who are in investment banking are dominating the industry. there was lot of fluctuations in the issue market affecting the merchant banking industry.The advent of SEBI in 1988 was a major boost to the merchant banking activities in India and the activities were further propelled by the subsequent introduction of free pricing of primary market equity issues in 1992. which would have otherwise paved way for other smaller players. SEBI started regulating the merchant banking activities in 1992 and a majority of the merchant bankers were registered with it. Many merchant bankers succumbed to the downturn in the primary market because of the over-dependence on issue management activity in the initial years. especially in the corporate debt market could not supplement the primary market for any major development. Many of the merchant bankers were into issue management or associated activity such as underwriting or advisory. The bigger industry players were the only ones to survive because of a general lack of institutional financing in a big way to fund capital market activity. What were the major constraints in Indian Investment banking industry? The major constraints were: The Indian investment banks depended on issue management to a greater extent and so some of them had to perish due to the primary market downturn in the 90’s. The number of merchant bankers registered with SEBI began to dwindle after the mid nineties due to the inactivity in the primary market.

merchant banking and asset management services flourished. A capital market was still an unorganised industry and was mostly restricted to stock broking activity. NBFCs and financial institutions entered the merchant banking. Over the subsequent years. In the early nineties. To prevent excessive exposure to business risk 2. underwriting and advisory services driven by the boom in the primary market. Also. the capital markets and investment banking activities came under lot of regulatory developments that required separate registration. The commercial banks are prohibited from getting exposed to stock market investments and lending against stocks beyond certain specified limits under the provisions of RBI and Banking Regulation Act. The Equity research activity has to be carried out independent of the merchant banking activity to avoid conflict of interest. the merchant banking industry had faced a huge downturn due to recession in the capital markets. Merchant banking activities can be carried out only after obtaining a merchant-banking license from SEBI. To prescribe and monitor capital adequacy and risk mitigation mechanisms. . the Indian financial services industry was characterised by debt services in the form of term lending by financial institutions and working capital financing by banks and non-banking financial companies. Merchant bankers other than banks and financial institutions are not authorised to carry out any business other than merchant banking. when the capital markets opened up. This proved to be an impediment for the growth of the investment banking industry. What is the Structure of Indian Investment Banking Industry? The Indian investment banking industry has a heterogeneous structure for the following reasons: The regulations do not permit all investment banking functions to be performed by a single entity for two reasons: 1.Till the 1980s. Many banks. licensing and capital controls.

All Non-banking Finance Companies that function as investment banks are regulated by RBI under RBI Act. The long-term financial institutions like ICICI and IDBI have converted themselves into full service commercial banks (called as Universal banks). Citibank and others offer almost all of the investment banking activities permitted in the country. 1956 are governed by the provisions of that Act. 1934. Those investment banks that are incorporated under a separate statute are regulated by their respective statute. The middle level constitutes of some niche players and a few subsidiaries of the public sector banks. IL&FS. IDBI. The Indian investment banks have not gone global so far though some banks do have a presence in the overseas. Universal banks that function as investment banks are regulated by RBI under the RBI Act. 1992. 1999 with respect to foreign investment. Certain banks like Canara bank and Punjab National bank have had successful merchant banking activities while some other . SEBI governs the functional aspects of Investment banking under the Securities and Exchange Board of India Act. Kotak Mahindra. Who are the major Players in the Indian Industry? Several big investment banks have set many group entities in which the core and noncore business segments are distributed. IDBI. 1934. Ex: SBI.Stock broking business has to be separated into a different company Regulatory framework for Investment banking: An overview of the regulatory framework is furnished below: All investment banks incorporated under the Companies Act. SBI. Those investment banks that carry foreign direct investment either through joint ventures or as fully owned subsidiaries are governed by Foreign Exchange Management Act. ICICI.

The technological and market developments influencing the capital market will also provide an additional impetus to the growth of the investment banks. and Price Water Coopers etc. KPMG. There are also merchant banks structures as NBFCs such as Alpic Finance. Ernst & Young. What are the Core Services of Indian Investment banks? They are:Merchant Banking. This proves to be a significant point for a bright future for the Indian investment banks. Rabo India Finance ltd and so on. A lot of pure merchant banks and advisory firms have an opportunity to convert themselves in to full service investment banks. Some of the pure advisory firms that operate in the Indian market are Lazard Capital. . With this. Underwriting and Book Running Mergers and Acquisition Advisory Corporate Advisory What are the Support services and Businesses of Indian Investment banks? They are:Secondary Market Activities Asset Management Services Wealth Management Services (Private Banking) Institutional Investing How does the Future of Investment banking in India look like? The scope for investment banking in India is very big. as much of it has not been exploited so far. their markets are bound to broaden and their service deliveries poised to be more efficient.subsidiaries have either closed their operations or sold off their business due to a couple of securities scam in the industry.

These shares represent the issued capital of the company. and economic risks as . depository bank. representing foreign shares held by the bank. The Issuing Company issues the requisite shares underlying the DRs in its domestic jurisdiction to a domestic custodian against receipt of cash from the investors for the DRs. The functions of a global depository are: To administer the DRs for the individual investors Handling transfer of DRs arising out of secondary market trades Dividend distribution Recovery of withholding tax Conversion of the DRs into shares etc. The underlying shares are not allowed to be traded in the domestic market because the DRs representing The depository mechanism creates two distinct pools of securities One being the issued shares The other being the DRs representing those shares. one share or a bundle of shares of a foreign corporation. usually by a branch or correspondent in the country of issue. One ADR may represent a portion of a foreign share. DRs are issued with the support of an agency that acts as a global depository. ADRs are subject to the same currency.What is a global depository? A Company in one jurisdiction can issue depository receipts in other jurisdictions where such issues are permitted. They are Certificates issued by a U. political. ADRs are American Depository Receipts.S. The DRs are listed and then traded on the exchanges where they are listed.

compliance with Foreign Exchange Management Act and RBI approvals is not required for sale of depository receipts by foreign investors. A capital gain through investment in shares in India by foreign investors is subject to taxes whereas there is no tax for capital gains made on DRs. What do you mean by Fungibility of Depository Receipts? Fungibility refers to the convertibility of depository receipts in to the shares underlying them. To invest in depository receipts. This provides for a two-way exit route to the foreign investors. Shares are listed only on the domestic stock exchanges and not on international stock exchanges. The ADRs . they have to register with SEBI. Fungibility makes the prospects for the investor better since the price differential between the depository and the underlying shares can be exploited to make arbitrage gains. Lastly. Indian companies are not supposed to make an issue of its shares abroad to the foreign public and list these shares directly on global exchanges. Settlement of transactions in DRs happens through international settlement systems. Why should there be a complicated issue of DRs instead of issuing shares directly to investors? Answers to the above question: Under current regulations. which are more convenient for the foreign investors whereas settlement in shares have to be cleared in domestic clearinghouses in India.What is the relationship between depository receipts and the shares underlying them? The following figure depicts the relationship between the two. foreign investors need not register with SEBI whereas to invest in shares. They can exit either through the sale of DRs in the overseas market or through the sale of shares in the domestic market.

The IDRs would be listed and traded in India like any other domestic shares issued by Indian companies. . The reverse Fungibility process is being governed by RBI guidelines. The IDR mechanism is exactly the inverse of ADR/GDR mechanism. Meaning of “Fungible”? You can't tell them apart. The Indian government had initially prescribed two year lock-in-period for GDRs to become fungible. Somebody who is owed $1 does not care which particular dollar he gets.became fungible in US market in 1990. When such bonds are issued in the euro market they are known as euro convertibles. This restriction is now removed. This means that an overseas investor may convert DRs in to shares but they can be traded only in the domestic market. Anything that people want to use as MONEY must be fungible. A domestic depository in India issues these IDRs against shares of the issuing company. beads or shells. which are held by an overseas custodian bank. a domestic investor may convert shares into tradable DRs but they can be traded in markets wherein the DRs are listed. What does Two-way Fungibility of Depository Receipts mean? Two-way Fungibility of DRs implies that DRs and the shares underlying them are convertible both ways but within their respective jurisdictions. What are Foreign Currency Convertible Bonds? A company can issue bonds that are convertible in to depository receipts at a later date. These are known as Foreign Currency Convertible Bonds or FCCBs in India. foreign companies incorporated outside India may take an issue of IDRs in the Indian Capital market to raise funds. Similarly. Something is fungible when any one single specimen is indistinguishable from any other. Indian Depository Receipts (IDRs): Under the IDR mechanism. whether it is GOLD bars. The issue of IDRs is subject to the guidelines issued by the Indian Government.

What is a Derivative? A Derivative can be defined as a financial instrument whose value is derived from the values of the underlying traded assets. For example. With the developments happening in the derivatives market. The main types of derivatives are: Forwards Futures Option markets Forward Contracts: They are simplest form of derivatives They are basically agreements to buy or sell an asset at a certain future time for a certain price. . What are the types of derivatives? Derivatives are either Financial Derivatives or Commodity Derivatives. Financial Derivatives . weather derivatives and insurance derivatives. electricity derivatives.Financial Derivative Contracts are interest futures. futures and options on stock indices. foreign exchange and equity derivative products have been created. currency futures. extensions of the existing products like interest rate. a stock option is a derivative whose value is dependent on the price of a stock. oilseeds. etc.These contracts are futures and options on standard contracts of various commodities transacted in wholesale. Derivatives can be made of any variable (not necessarily financial assets) like price of sugar to the amount of snow falling at a certain location. there is now active trading in credit derivatives. Also. For example: Tea. options on stocks. Commodities Derivatives . metals and other products like energy. bandwidth etc.

They are traded on exchanges unlike forward contracts They carry certain standardised features as per exchange specifications They carry a guarantee given by the exchange to both the parties that the contract will be honoured The underlying assets are a very wide range of commodities and financial assets Options: The right to buy or sell an asset is referred to as an Option Options are traded both on exchanges and in the over-the-counter market There are two basic types of options namely “call option” and “put option” Call option gives the holder the right to buy the underlying assets by a certain date for a certain price Put option gives the holder the right to sell the underlying asset by a certain date for a certain price The price in the contract is known as the “exercise price” or the “strike price” The date in the contract is known as the “expiration date” or “maturity” The holder of an option does not have to exercise his right whereas in forwards and futures.They are traded in the over-the-counter market usually between two financial institutions or between a financial institution and its clients Forward Contracts on foreign exchange are very popular They can be used to hedge foreign currency risk Both the parties to a contract have a binding commitment in the contract One of the parties to the contract assumes a long position and agrees to buy the underlying asset on a certain specified future date for a certain specified price The other party assumes a short position and agrees to sell the asset on the same date for the same price Futures Contracts: They are basically agreements between two parties to buy or sell an asset at a certain time in the future for a certain price. the holder is obligated to buy or sell the underlying asset .

The Chicago Board of Trade. The underlying assets include foreign currencies and futures contracts as well as stocks and stock indices.There is a cost to acquiring an option whereas it costs nothing to enter into forwards and futures. are traded. which have been defined by the exchange. 1848 and the Chicago Mercantile Exchange. The debt market consists of a bond market that is very vibrant and much sought after by foreign issuers A Depository receipt (DR) is a security that represents ownership in a foreign security The depository receipt mechanism is an indirect way of inviting the foreign investors by issuing the shares in a foreign jurisdiction with a surrogate listing mechanism Fungibility refers to the convertibility of depository receipts in to the shares underlying them Under the Indian Depository Receipts (IDR) mechanism. foreign companies incorporated outside India may take an issue of IDRs in the Indian Capital market to raise funds A Derivative – It can be defined as a financial instrument whose value is derived from the values of the underlying traded assets . The Euro Market is a market in which financial instruments – both short and long terms that are denominated in a variety of currencies other than the domestic currency of the host currency are transacted. 1919 are considered to be pioneer derivatives exchanges. Derivatives exchanges have been in existence for a long time. What is a Derivatives Exchange? A derivatives exchange is a market where standardized contracts.

However. it will be able to issue further shares via a rights issue. The company is never required to repay the capital. it will almost invariably look to issue additional new shares in order at the same time. most IPOs are of companies going through a transitory growth period. where the money passes between investors). Also. but can also be done by large privately-owned companies looking to become publicly traded. are traded An initial public offering (IPO) – It referred to simply as an "offering" or "flotation. ." is when a company (called the issuer) issues common stock or shares to the public for the first time. which helps it determine what type of security to issue (common or preferred). The existing shareholders will see their shareholdings diluted as a proportion of the company's shares. it is tough to predict what the stock or shares will do on its initial day of trading and in the near future since there is often little historical data with which to analyze the company. once a company is listed. An IPO. they hope that the capital investment will make their shareholdings more valuable in absolute terms. best offering price and time to bring it to market. thereby again providing itself with capital for expansion without incurring any debt. For the individual investor. The money paid by investors for the newly-issued shares goes directly to the company (in contrast to a later trade of shares on the exchange. which have been defined by the exchange.A derivatives exchange is a market where standardized contracts. allows a company to tap a wide pool of stock market investors to provide it with large volumes of capital for future growth. but instead the new shareholders have a right to future profits distributed by the company and the right to a capital distribution in case of a dissolution. younger companies seeking capital to expand. They are often issued by smaller. In an IPO the issuer may obtain the assistance of an underwriting firm. therefore. In addition. and they are therefore subject to additional uncertainty regarding their future value Reasons for listing When a company lists its shares on a public exchange. An IPO can be a risky investment.

Common methods include:       Best efforts contract Firm commitment contract All-or-none contract Bought deal Dutch auction Self distribution of stock A large IPO is usually underwritten by a "syndicate" of investment banks led by one or more major investment banks (lead underwriter). The sale ( allocation and pricing) of shares in an IPO may take several forms. convertible debt. The underwriter then approaches investors with offers to sell these shares. Upon selling the shares. the underwriters keep a commission based on a percentage of the value of the shares sold (called the gross spread). etc. the underwriters selling the largest proportions of the IPO. i. Procedure IPOs generally involve one or more investment banks as "underwriters.e. called the "issuer. take the highest commissions—up to 8% in some cases. the lead underwriters. ." The company offering its shares.This regular ability to raise large amounts of capital from the general market. is a key incentive for many companies seeking to list. Benefits of being a public company• Bolster and diversify equity base • Enable cheaper access to capital • Exposure and prestige • Attract and retain the best management and employees • Facilitate acquisitions • Create multiple financing opportunities: equity. cheaper bank loans." enters a contract with a lead underwriter to sell its shares to the public. Usually. rather than having to seek and negotiate with individual investors.

in addition to separate syndicates or selling groups for US/Canada and for Asia. the lead underwriter in the main selling group is also the lead bank in the other selling groups. Some of the models explained it as a consequences of deliberate underpricing by issuers or their agents. Pricing The underpricing of initial public offerings (IPO) has been well documented in different markets (Ibbotson. the offering will include the issuance of new shares. Ritter. the purchase price simply includes the built-in sales credit. 1991. an issuer based in the E. smaller issues are observed to be underpriced more than large issues (Ritter. Public offerings are primarily sold to institutional investors. Levis.U. Levis. may be represented by the main selling syndicate in its domestic market. such as the Magic Circle firms of London and the white shoe firms of New York City. McGuinness. 1975. The issuer usually allows the underwriters an option to increase the size of the offering by up to 15% under certain circumstance known as the greenshoe or overallotment option. The client pays no commission to purchase the shares of a public offering. However. Europe. In general. Because of the wide array of legal requirements. IPOs typically involve one or more law firms with major practices in securities law. intended to raise new capital. as well the secondary sale of existing shares. the underpricing of IPOs has constituted a serious anomaly in the literature of financial economics. IPOs both globally and in the United States . certain regulatory restrictions and restrictions imposed by the lead underwriter are often placed on the sale of existing shares. A broker selling shares of a public offering to his clients is paid through a sales credit instead of a commission.Multinational IPOs may have as many as three syndicates to deal with differing legal requirements in both the issuer's domestic market and other regions. 1992). but some shares are also allocated to the underwriters' retail investors. Many financial economists have developed different models to explain the underpricing of IPOs. While Issuers always try to maximize their issue proceeds. For example. Usually. 1990. Usually. 1990) Historically. Ritter 1984. 1984.

com IPO which helped fuel the IPO mania of the late 90's internet era. therefore. One great example of all these factors at play was seen with theglobe. underpricing an IPO results in "money left on the table"— lost capital that could have been raised for the company had the stock been offered at a higher price. Even if they sell all of the issued shares. Underwritten by Bear Stearns on November 13. it may lose its marketability and hence even more of its value. The effect of "initial underpricing" an IPO is to generate additional interest in the stock when it first becomes publicly traded. take many factors into consideration when pricing an IPO. However. The process of determining an optimal price usually involves the underwriters ("syndicate") arranging share purchase commitments from leading institutional investors Issue Price A company that is planning an IPO appoints lead managers to help it decide on an appropriate price at which the shares should be issued. and attempt to reach an offering price that is low enough to stimulate interest in the stock. which would then either require the physical delivery of the stock certificates to the clearing . Through flipping. The danger of overpricing is also an important consideration. There are two ways in which the price of an IPO can be determined: either the company.have been underpriced. fixes a price or the price is arrived at through the process of book building. Although the company did raise about $30 million from the offering it is estimated that with the level of demand for the offering and the volume of trading that took place the company might have left upwards of $200 million on the table. and famously jumped 1000% at the opening of trading all the way up to $97. before deflating and closing at $63 after large sell offs from institutions flipping the stock . Investment banks. If a stock is offered to the public at a higher price than the market will pay. but high enough to raise an adequate amount of capital for the company. with the help of its lead managers. the underwriters may have trouble meeting their commitments to sell shares. 1998 the stock had been priced at $9 per share. this can lead to significant gains for investors who have been allocated shares of the IPO at the offering price. Note: Not all IPOs are eligible for delivery settlement through the DTC system. if the stock falls in value on the first day of trading.

company insiders. analysts. underwriting is an agreement by the underwriter to subscribe to the security being issued in case the persons to whom they are offered donor subscribed to them. issuers. generally the lead underwriters will initiate research coverage on the firm. underwriting is always in connection with proposed issue securities by a body corporate. according to the SEBI (underwriters) rules 1993 means ‘ a person who engages in the business of underwriting of an issue of securities of a body corporate’ let us analysis this definition. It is not a general undertaking between company and an underwriter. . The specific underwriter commitment has to be documented through underwriting agreement. the NASD and NYSE have approved a rule mandating a 10-day quiet period after a Secondary Offering and a 15-day quiet period both before and after expiration of a "lockup agreement" for a securities offering. insiders and any underwriters involved in the IPO are restricted from issuing any earnings forecasts or research reports for the company. The first and the one linked above is the period of time following the filing of the company's S-1 but before SEC staff declare the registration statement effective. and other parties are legally restricted in their ability to discuss or promote the upcoming IPO. Secondly. During this time. Regulatory changes enacted by the SEC as part of the Global Settlement enlarged the "quiet period" from 25 days to 40 days on July 9. 2002. Additionally. Firstly. When the quiet period is over. During this time. The other "quiet period" refers to a period of 40 calendar days following an IPO's first day of public trading. Quiet period There are two time windows commonly referred to as "quiet periods" during an IPO's history.agent bank's custodian. Underwriting Different service obligations depending upon the way it has evolved as an area of capital market SEBI DIP guidelines as ‘an agreement with or without conditioned to subscribe to the securities of a body corporate when the existing share holders of the body corporate or the public do not subscribe to the security offered to them’ an underwriter. or a delivery versus payment (DVP) arrangement with the selling group brokerage firm.

underwriting is primarily a fee based service provide by underwriter since there is no fundamental obligation to subscribe to the underwritten securities. However.underwriters are also included along with those procured by the underwriter directly. The underwriter enters into sub-underwriting directly with the sub-underwriter through a subunderwriting agreement. If the issue is fully subscribed to by the investors. Since sub-underwriting agreements do not concern the issuer or lead manager. . In other words.it is due to this reasons that underwriting is the risky activity for investment banks that requires careful assessment of issue before they can be taken up for underwriting. the underwriter has no further obligation to the issue. for the purpose of ascertaining the fulfillment of obligation by an underwriter. The underwriter’s job is to market the underwritten securities to investors and procure subscriptions for such securities Thirdly. However. Sub underwriting is a process under which the underwriter appoints other persons to underwrite his/her own underwriting obligation. In addition. underwriting becomes a fund based service since the underwriter has to purchase the security that have remained unsubscribed by the invesrots. these do not become a part of essential documentation for a public issue. the underwriter shall remain primarily responsible for the underwritten shares and any failure part of the sub-underwriters to fulfill their obligations shall not absolve or discharge the underwriter’s obligations to the issuer company. underwriting require sufficient financial resources to be allocated to such activity. the obligating falls upon the underwriter to pickup unsubscribed portion of the issue in such a situation. the issuer company is not a part to sun-underwriting arrangement. The underwriter normally shares the underwriting fee with the sub-underwriter for their efforts. the subscriptions procured by the sub. Sub underwriting Sub underwriting used by an underwriter to spread the risk assumed in underwriting an issue of shares. Notwithstanding a sub underwriting arrangement. if investors do not subscriber to the issue fully. It is required to take cognizance of any sub-underwriting arrangements of its underwriters and can require the underwriters to fulfill their obligation even if their sub-underwriters have not done so. underwriting is service that consists of taking a contingent obligation to subscribe to an agreed number of securities in an issue if such securities are not subscribed to by the intended investors.Therefore.

which is known as underwriting commission. which is recommendatory and should be followed to the extent possible by all underwriters. the underwriters can be paid an additional 1% on the securities picked up by them. Underwriting agreement The underwriting agreement is the document that establishes the contract between the underwriter and the issuer company. is paid as a percentage of the value of underwriting (the total number of securities underwritten multiplied by the offer price per security).5% with respect of equity shares. Underwriting commission is payable is irrespective of whether the underwriter ultimately has any requirement to purchase the underwritten securities or not.000 the applicable ceiling is 1% if the issue is fully subscribed by the investors. It forms a part of material contracts for the issue and requires to be approved by the concerned stock exchange part from being filed with the ROC as part of prospectus registration. Broke is merely a marketing commission while underwriting commission is compensation for taking underwriting risk besides procuring subscriptions. the lower rate shall apply. The SEBI evolved a model underwriting agreement. This is further subject to authorization under the article of association of the company and if the article prescribes a lower rate. an issuer company is free to negotiable lower rates of commission with underwriters. incase. This fee. The model agreement list out the following main clauses:   Amount being underwritten Provisions for sub underwriting . Within the above said ceiling.5% with respect to debentures. In case of other securities wherein the total issue size is more than Rs 500. the government of India (ministry of finance) fixed a cap of 2. which stipulates a ceiling of 5% with respect to shares and 2. Within the above ceilings fixed by the government. the issue is under subscribed.Underwriting commission The underwriters compensation for the service rendered is the fee that is paid by the issuer company. Underwriter commission should not be confused with ‘brokerage’ this is paid to a stock broker for dealing in share or for procuring subscriptions. This payment of underwriting commission is governed by section 76 of the company’s act.

    Computation of development Procedure for effecting or discharge of underwriting obligation Right to receive commission within statutory stipulation Statutory declarations Regulatory framework Underwriting activity in India is regulated under the SEBI (underwriters) Rules 1993 and SEBI (underwriters) Regulations 1993.  All underwriters shall have necessary infrastructure. . All the above entities except registered merchant bankers require registering as underwriters with SEBI.  Sub-underwriting is permissible provided there are contracts to evidence the same. mutual funds. past experience.  In the case of financial institutions. the issuer company has to apply separately prior to finalization of the issue for underwriting support. stock brokers and NBFCs. merchant bankers registered with SEBI. minimum of two employees and shall comply with the minimum capital adequacy requirement as stipulated from time to time and further comply with additional capital adequacy requirement of the concerned stock exchanges.   Underwriting commission cannot exceed the statutory ceilings. commercial banks. The underwriting agreement has to be approved by the stock exchange wherein the shares are proposed to be listed.  Underwriters have to enter into legally binding agreement with the issuer companies. The regulatory framework for underwriting activity under the above side Rules and Regulations is summarized below:  Underwriting business can be taken up by the financial institutions. banks and mutual funds. All underwriting contracts have to be classified as material contracts and disclose as such in the offer document and filed with the Registrar of companies prior to the issue of the offer document.

any investment advice about any security publicly unless a discloser of its interest has been made as prescribed. directors etc.Besides the above. The following method of computation is recommended by SEBI for the purpose of arriving at devolvement of underwriters. b) All procurements made by a particular underwriter or his/her sub-underwriters out of (a) above shall be allocated to that underwriter. The code prescribes inter alia. . Development THE AMOUNT OF FINACIAL SUPPORT TO BE PROVIDED BY AN UNDERWRITER IN AN UNDER Subscribed issue of securities is known as devolvement development happen when an underwriting firm procures lesser subscriptions from investors than what has been underwritten by it . However. however the extent of devolvement on an underwriter also depends upon the extent of subscriptions procured by other underwriters to the issue and the overall performance of the issue. If a particular underwriter has been able to market the issue and procure enough subscriptions to cover his or her underwriting completely such underwriter will not face any devolvement event if the issue has been under subscribed overall. the following main provisions:  Underwriter should avoid conflict of interest and make necessary disclosures of their interests if any.cannot indulge in insider trading in the securities they underwrite.  An underwriting firm or any of its employees shall nor rendered directly or indirectly.  Underwriters or their employees.  An underwriter should abide by the award of the ombudsman incase of disputes with the issuer company in arriving at contractual obligations a liabilities.to ascertain each underwriter’s devolvement if any. a) All eligible applications received from investors towards subscriptions for the securities in the issue shall go to reduce underwriters obligations to that extent. underwriter should also comply with a code of conduct in conducting their business. the following steps should be followed in sequence.

the total of all the individual amounts of underwriter devolvement shall be amount of undersubscription in the issue. In book built offers. The book runner (s) enter into underwriting agreement with issuer company. The standard disclosure of an underwriting agreement and the obligations of the underwriters in an offer document for a book-built offer would be as follows. However. UNDERWRITING IN BOOK-BUILT OFFERS AS PER PREVALENT REGULATIONS. the whole underwriting obligation is shared between the book runners and the syndicated members and is co-ordinate by the book.c) All applications forming part of (a) above but invested directly by investors without being routed through underwriters/ sub-underwriters shall be allocated pro-rata to all underwriters in the ratio of their underwriting obligations.if any underwriter has been allocated more than his/her have a deficiency. this requirement does not apply to issues wherein 50% of the NPO has to be mandatorily allotted to QIBs. The syndicate members enter into an un derwriting agreement with the book runner(s) indicating the number of securities that they wish to subscribe at the predetermined price.e. only the balance portion of the NPO. In the case of asyndn undersubscription in the issue. Incase there is more than one book runner. In such issues. the book runner assumes the responsibility for the overall underwriting.runners in-charge of syndicating the underwriting . Under the 100% book-builiding route. it devolves on the book runners. If the issue is fully underwritten. Therefore. d) After following steps (b) and (c). in the event of the syndicate member (s) failing to fulfill their underwriting obligation. underwriting becomes mandatoryfor the entire NPO. Underwriting has to be done by the book runners and the syndicate members. In order to spread the risk. if a company opts for the 75% book-building route. e) Devolvement is the positive balance that remains in the account of a particular underwriter after the above steps are completed.i. 25% or 50% as the case may be shall be subject to mandatory underwriting. UNDERWRITING IS compulsory in book-built offers to the Extent of the NPOand the issuer company does not have any discretion therein. the inter-se allocation among the book runners determines the extent of their obligation. the book runner(s) shall be responsible for bringing in the amount required to make good the devolvement. . However. underwriting would be necessary to the extent of 75% of the NPO.

will also be required to procured/subscribe to the extent of the defaulted amount as specified in the underwriting agreement. the Following Procedure is Envisaged in the case of an under -Subscribed issue. Pursuant to the terms of the underwriting agreement. the book running lead managers (BRLMs) shall be responsible for bringing in the amount devolved in the event that the members of the syndicate do not fulfill their underwriting obligations. the BRLMs and the syndicate members shall be responsible for ensuring payment with respect to equity shares allocated to investors procured by them.The company and the underwriters have entered into an underwriting agreement for the equity shares propose to be preferred through the offer.Allocation among underwriters may not necessarily be in proportion to their underwriting commitments. as specified therein. the obligations of the underwriters are subject to certain conditions to closing.mentioned underwriters are sufficient to enable them to discharge their respective underwriting obligations in full. and the number of securities to be taken up by the underwriter or subscriptions to procured therefore. in addition to other obligations defined in the underwriting agreement. All the abovementioned underwriters are registered with SEBI under section 12 (1) of the SEBI act or registered as brokers with the stock exchange (s). the above underwriting agreement is dated. Allotment to QIBs is discretionary as per the terms of this prospectus and may not be proportionate in any way and the patterns of allotment to the QIBs could be different for the various underwriters DEVOLVEMENT NOTICE As per SEBI’S Model Underwriting Agreement. • The issuer company shall within 30 days after the date of closure of the subscription list communicate in writing to the underwriter ( the devolvement notice ) the total number of securities remaining unsubscribed. the respective underwriting. IN the event of any default in payment.In the opinion of our board of directors and the BRLM (based on a certificate given by the underwriters. Pursuant to the terms of the underwriting agreement. .) The resources of all the above. Notwithstanding the above table.

Assesement of an issue for underwriting . several issuer companies prefer to get underwriters to bail out an issue prior to closure of subscription lists so that the issue can be officially closed as a successful issue . live with the stigma of a devolved public issue. companies go through option(b). From the above mechabism.the company shall be free to make alternative arrangements without prejudice to legal remedies against the underwriter for failure to meet devolvement requirements. • The underwriter on being satisfied about the extent of devolvement. it is evident that if a company has to enforce devolvement on underwriters. Many a time. Thereafter. companies prefer option (a).Only if the issue is heavily under. It may be understood from the above that when an issue has not fared well . make or procure payment to the company. brokers and other large investors and (b) to go through the devolvement route by declaring the issue under-subscribed and issuing devolvement notices to underwriters.subscribed and they are compelled. more often than not. it has to initially close the issue and declare it to be an under-subscribed issue. issuer companies hesitate to go through the devolvement route since that would cause humiliation in public.• The company shall make available to the underwriter the manner of computation of devolvement and also furnish a certificate in support of such computation from the company’s auditors. including the right to claim damages. In addition. shall within required 30 days after the receipt of the devolvement notice. the company has two options-(a) to get the issue bailed out prior to close of the subscription lists with help of underwriters. In borderline cases. which could even affect its market prospects and the opportunity to make future public offers. it has to send devolvement notices to respective underwriters. the applications to subscribe to the securities and submit them along with the • In the event of failure of the underwriter to do so. the company has to Due to this reason.

fundamentals at the time of issue. These factors determine the equilibrium price of the company’s share in the market that a large investor looks for. past track record. sub-brokers and marketing agents over a period of time they have to carefully assess the marketability of every issue that they underwrite. underwriters have assess the above factors thoroughly and arrive at the optimum level of subscription . the support will not continue. unless investors make money through such recommendations. level of brand visibility etc. Keeping the above mind-set of institutional. As a corollary in order to mitigate these risks.As explain above the critical risk factor underwriting business is (a) development probability. financial performance. The capacity to procure depends upon the distribution network and investor base of the underwriter and the marketability of an issue.Institutional investors are driven more by the fundamentals of the issue and are therefore keen to wait for appreciation in the market price over a longer time frame of one to two years. A lot depends on factors such as the industry. pricing of the issue. look for short-term profit booking within the first three to six months after listing. HNI and retail investors in minda. However. Assessment of an issue for underwriting should always be made from an investor’s perspective since the issue is successful only when it finds favour with investors. (b) development quantum and (c) capital loss from developed securities. underwriters have to look at the potential of the issue to meet these expectations and their oown distribution strengths to reach these investors. Therefore what matter more to retail investors is the affordability of the share. post-issue floating stock and possibility of piece appreciation. Underwriters have to convince these investors and recommend to the issue strongly. retail investors are driven more by profit motive and arbitrage opportunities than by fundamentals. Therefore. Needless to say. While underwriters build an expansive network of brokers. As explained in chapter 4 . Many underwriters and brokers develop a strong and loyal investor base that can support significant number of issues. the critical success factors are capital adequacy and the capacity to procure subscriptions. soundness of the business plan. institutional investors look at primary issues from the perspective of medium term growth while the retail investor by and largen more by the. Capital adequacy comes through financial strength but it would not suffice unless the capacity to procure is augmented with it.

Summary The erstwhile Grindlays Bank began its merchant banking operations in 1967 after obtaining the required license from RBI The advent of SEBI in 1988 was a major boost to the merchant banking activities in India and the activities were further propelled by the subsequent introduction of free pricing of primary market equity issues in 1992 Till the 1980s.they can expect from their own investors base for a particular issu3e before entering into an underwriting commitment. the Indian financial services industry was characterised by debt services in the form of term lending by financial institutions and working capital financing by banks and non-banking financial companies The Indian investment banking industry has a heterogeneous structure The commercial banks are prohibited from getting exposed to stock market investments and lending against stocks beyond certain specified limits under the provisions of RBI and Banking Regulation Act The Indian investment banks have not gone global so far though some banks do have a presence in the overseas .

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