Chapter 1 - Other Aspects

Private equity Vs. Venture capital

Money invested in firms which have not 'gone public' and therefore are not listed on any
stock exchange. Private equity is highly illiquid because sellers of private stocks (called
private securities) must first locate willing buyers. Investors in private equity are generally
compensated when:
(1) the firm goes public
(2) it is sold or merges with another firm, or
(3) it is recapitalized.
Private Equity vs. Venture Capital
Although they're both types of investors, there is a world of difference between private
equity and venture capital. As a rule of thumb, private equity businesses invest in existing
businesses which are not profitable, then make them turn a profit.
Venture capitalists take bets on new companies, and buy in for a set amount of money
hoping to see their investments grow.
Private Equity
Private equity investors are all about streamlining a current business in order to make it
profitable. They typically buy out the business in its entirety, in order to have the freedom
they need to restructure it. Private equity firms will then do everything in their power to
turn the business around, often bringing in new management and changing methods to
become more profitable.
Venture Capital
Venture capitalists make their money by finding good deals in young businesses. They offer
to invest a set amount of money for a stake in the company. Venture capitalists may be very
hands-off, or they may want a say in how the company is run. Typically, they look for
promising young businesses that need an injection of cash in order to grow. Venture
capitalists may own a portion of a business, but compared to private equity firms they rarely
buy a company outright.
What is Private Equity? How Does Private Equity Work?
Private equity is money for investments made directly in private companies or in public
companies that become private.
Although some private equity comes from private individuals, most private equity funding
comes from private equity firms. These firms are often partnerships that obtain
their investment funds from wealthy individuals, investment banks, endowments,
pension funds, insurance companies, various financial institutions and even corporations
wishing to foster new products, businesses or technologies.
A private equity firm must raise the money it needs to make investments in businesses. This
fund-raising is typically done by circulating a prospectus to potential investors who then
agree to commit money to the fund. Once the private equity firm has enough commitments,
the firm may begin collecting or “calling” those commitments when it wants to make
an investment. If and when the private equity firm invests all of its money, or if it simply
wants to expand its investing activities, it may start another fund. Most funds have a fixed
life, meaning they must make their investments within a certain period (usually about 10
years). Private equity firms may have several funds going at the same time.
What is Private Equity? How Does Private Equity Work?
Private equity firms are different than venture capital firms in that they generally invest only
in private companies (or in public companies that want to go private). Whereas venture
capital firms tend to concentrate their investments in new and young businesses, private
equity firms often aren't afraid to invest in older companies. Private equity firms might also
use debt in their financing structures, often when they are participating in leveraged
buyouts.

The managers of many private equity firms receive an annual management fee (usually 2%
of the invested capital) and a portion of the fund’s net profits (typically 20%). These fees
compensate the managers for their expertise and responsibility to help
their investments become successful.

Typically, private equity firms decide which companies to invest in by reviewing hundreds of
business plans, meeting entrepreneurs and company managers, and performing
extensive due diligence on investment candidates. They are very selective because they are
seeking opportunities in which their investments will grow and provide a successful exit
within a certain time frame.

One of the most common and controversial characteristics of private equity funding is that
private equity firms usually take active management roles and board seats in the companies
they invest in. This often means that management gives some control over their businesses
to the firms. However, private equity firms can also provide crucial managerial or technical
expertise, particularly in areas where the management is less confident. This is especially
the case when the private equity firm specializes in an industry or niche.

One of the most important parts of a private equity investment is the “exit” or the private
equity firm’s plans for selling its investment in a company. Usually the exit, also known as
the “harvest,” takes place anywhere from three to 10 years, often via an initial public
offering or through the merger or sale of the company.
Investment Management
Investment management has two general definitions, one relating to advisory services and
the other relating to corporate finance.

In the first instance, a financial advisor or financial services company provides investment
management by coordinating and overseeing a client's financial portfolio --
e.g., investments, budgets, accounts, insurance and taxes. 
In corporate finance, investment management is the process of ensuring that a company's
tangible and intangible assets are maintained, accounted for, and put to their highest and
best use.
How Does Investment Management Work?
An investment management company serving as an advisor to a client has one overriding
goal -- to substantially grow its client's portfolio. Investment managers are often hired by
institutional investors like pension funds, corporations, and financial intermediaries, as well
as high net worth individuals.

Investment managers conduct interviews, research, and statistical analyses of companies,

markets, and trends to determine what investments to make or avoid on behalf of their
clients. Investment managers do not generally need a specific "investment manager"
license, though the firms that hire investment managers often require registration with one
or more exchanges and/or the National Association of Securities Dealers (NASD).

In corporate finance, investment management requires finding ways to maximize company

value by managing long-term tangible and intangible assets to be more reliable, efficient, or
cheaper -- including evaluating asset financing options, accounting methods, productions
operation management, and maintenance schedules.
Consulting Services
A range of consulting services provided by Certified Public Accountants (CPA) and other
financial advisors to businesses and high net worth individuals who require specialized
advice on capital formation, cash flow and wealth management. Advisory clients pay fees
based on services provided or as a percent of assets under management
Problems & Prospects of investment banking in BD:
As lack of proper information it’s hard to find our assessment over investment bank
influence. Our findings on this are Investment banking face problem as their activity are
limited especially more in capital market making. Only this type of activity didn’t help in
playing effective role in economic growth in greater prospect. Investment bank creates
investment for industry and economic development which are not adequate in amount. As
our economy emerging their investment amount is very low in term of that. Investment
bank contributes very small in women empowerment. Investment banking activities on
employment generation are significant but they can do better role in overall employment.
Investment banking invests for larger and bigger industry, rather small industry as well as
individual. Though investment bank has impact on infrastructure development but that’s
not adequate in term of national economy. Lack of good governance and policy regarding
this sector has less scope to play crucial role over economic development. Lack of financial
reform in continuous basis is held another finding of our research. As global investment
banking lies on technology, Bangladeshi investment banking needs to keep pace with
changing technology. But the adoption is not significant in number.
Investment banking is one of the most important organ of a countries financial structure
and play crucial role in the development of a country. In this capitalist world a countries
development depends upon the amount of investment it’s create to develop its economy.
Bangladesh economic development also depends greatly on it. As Bangladesh is a
developing country and its want to be a middle income country within year 2021its need a
great support from investment banking. we cannot deny Investment Banking roles in the
economic development of Bangladesh through providing its impact on employment
creation, capital market making, raising short term and long term capital fund for industry as
well as boost commercial sector, GDP growth through creating investment and so on.
Though Bangladesh haven’t any specialize investment bank bit it doing well and contributing
our countries economic growth. It will contribute more if government take necessary
initiative and establish specialized investment bank to operate such activities with more
importance. Investment banking activities also need emphasis and monitor closely by a
regulatory body and Bangladesh need to use this sector to generate more & more
sustainable investment.
Conclusion
We provide our recommendation in regarding our findings as follows: Financial structure of
investment banking needs necessary reform so that it can contribute more in economic
development. Activities of investment banking need to expand as we want to boost our
economic growth in quick time and to achieve vision 2020. Investment policy of investment
bank need to make for easy.
Investment bank need to invest in small project as well as individual so that it will encourage
new entrepreneur. Investment need to provide funding and invest in women
empowerment. Investment bank need to work with latest technology to boost their
activities and provide more assistance in economic development. Investment need to make
more investment in infrastructure development. Government need to sanction more
investment bank, so that more employment opportunity creates as well as they can help in
economic growth. On the other hand, as more investment bank raises more assistance for
industrialization and more employment opportunity will create and help in economic
growth. Investment banking activity very crucial to monitor, government need to provide
proper governess in this sector for this political stability is must.
 Chapter 2 - Primary market making
The investment bank serves three distinct but related functions in this process:
Origination involves the development and registration of the securities offering.
Underwriting involves the purchase of the securities from the issuer by the underwriting
syndicate for subsequent sale to the public.
Distribution involves the final sale of the securities to the public.
Public offerings Vs. Private Placements
There are two fundamental ways for an investment bank to intermediate between issuers
and investors. These are a public offering and a private placement. In a public offering,
securities that are issued are offered for sale to the public investor. In a private placement,
the securities are placed, via negotiations, in the hands of a small group of sophisticated,
usually institutional investors.
Public offerings of securities issued by corporations must be registered with SEC, and the
offering procedure must satisfy a number of well-defined criteria. But registration is not
required for privately placed issues.
Private placements are a much simpler affair and can work to the advantage of both the
issuer and the investor.
Seasoned public offerings:
A public offering (PO), also called a seasoned public offering, as a new offering of securities
by a firm that has already issued securities to the public. There are, however, three distinct
types of seasoned public offerings. These include primary seasoned offerings, secondary
offerings and combined offerings.
Primary seasoned offering: A Primary seasoned offering is an offering of a new issue of
securities by a firm that has already done an initial public offering. The purpose of primary
seasoned offering is to raise new capital for the firm.
A secondary public offering: A secondary public offering, also called a secondary placement,
is used by a firm’s founders, and other republic owners and some post public holders of the
securities to cash-out of the firm; i.e., the securities distributed in a secondary public
offering are purchased by the underwriters directly from the pre-public owners and not
from the firm.
Seasoned public offerings:
Combined offering: A combined offering is partly primary and partly secondary; it is used to
both raise new capital for the firm and to cash out some of the republic owners.

Initial public offering(IPO) Vs. Public offering(PO):

When a firm with no public financial history or experience in the public capital markets
wants to offer securities to the public for the first time, the offering is called an IPO.
When a firm with existing publicly traded securities brings out additional securities, the
issuance constitutes a public offering(PO).
IPOs represents a far greater challenge to an investment bank than do public offerings, and
this will generally be reflected in the cost to the issuer.

The public offering process: 60-61

As a first step, the investment bank negotiates a mandate to “do the deal” and prepares the
issuance to the satisfaction of the SEC. This part of the process is called origination. The
process involves an investigation of the issuer, preparation and filing of required
documents, and the organization of an underwriting syndicate.

The public offering process:

The next phase is underwriting proper. In the underwriting phase, the investment banker
negotiates, on behalf of an underwriting syndicate, with the issuer for(i) an offering price
range for the securities and (ii) the size of the issuance. They must also negotiate the
underwriting spread i.e. the difference between
the offering price to the public and the proceeds to the issuer.
The final phase is the distribution. Here, an underwriting syndicate and an affiliated selling
group distribute the securities to the investing public. Together, the underwriting syndicate
and the selling group constitute the distribution syndicate.

Origination Due Diligence investigation

Due diligence is a process of verification, investigation, or audit of a potential deal or
investment opportunity to confirm all relevant facts and financial information, and to verify
anything else that was brought up during an M&A deal or investment process.  Due
diligence is completed before a deal closes to provide the buyer with an assurance of what
they’re getting.
The role of the investment banker in this process is paradoxical. On the one hand, the
investment banker represents the firm and is being paid by the firm and needs to present
the firm in the most favorable light possible to preserve its relationship with the firm. On
the other hand, the bank is ever conscious of its legal responsibilities, and the potential
liabilities for both the bank and the firm from misstatements of fact, misrepresentation and
absence of material information.

The Underwriting
The underwriting agreement between the issuer and the underwriting syndicate an take
either of three common forms:
A firm commitment
A best efforts
A standby underwriting.

A firm commitment underwriting

Almost all underwriting deals are firm commitment by which the underwriters guarantee
that they will sell a specified minimum quantity of the issuance at the offering price. If the
underwriters fail to sell the guaranteed amount, they must take it themselves.
A best efforts Underwriting
In a best efforts underwriting, the underwriters do not make a guarantee. They simply agree
to do their best to the securities, with the understanding that any unsold securities will be
returned to the issuer.

A standby underwriting
In essence, the investment bank guarantees that it will buy any and all stock that is not
taken by the right holders. If the standby underwriting is actually used, the underwriter will
take the securities at an agreed upon price, just as it would have done in a firm commitment
underwriting.
Preemptive Right
A provision in the corporate charter or by laws that gives common stockholders the right to
purchase on a pro rata basis new issues of common stock.
Preemptive right offering
Suppose that the market price of the stock of XYZ corporation is $20 per share and there are
30,000 shares outstanding. Thus the capitalization of the firm is $600,000. Suppose that the
management of XYZ corporation is considering a right offering in connection with the
issuance of 10,000 new shares. Each current shareholder would receive one right for every 3
shares owned. The terms of the rights offering are as follows: for 3 rights & $17
(subscription price) anew share can be acquired.
Before right offering:
No of shares 30,000 After Right offer:
Price $20 No of shares 40000
Market capitalization $6,00,000 Market Capitalization 770,000
Right share 10000 Market price $19.25
Price $17 Dilution $0.75
Market capitalization 170,000 Net gain or loss 0

Problem-1
The market price of the Bernstein Corporation is $50 per share & there are one million
shares outstanding. Suppose that the management of this corporation is considering a rights
offering in connection with the issuance of 500000 new shares. Each current shareholder
would receive one right for every two shares owned. The terms of the rights offering are as
follows: For two rights & $30 (the subscription price), a new share can be acquired.
What would the share price be after the rights offering?
What is the value of one right?
Demonstrate net gain or loss as a result of rights offering.

Tombstone Vs. Prospectus

The tombstone does not constitute either an offer to sell securities or a solicitation of an
offer to buy securities. The tombstone is merely a public notice that an offering is being
made. The actual offering can be made only by the prospectus.
Distribution
New issues of securities are distributed through what is known as distribution syndicate. The
distribution syndicate includes both the underwriting syndicate, which bears risk, and selling
group (if any), which does not bear risk. The primary purpose of forming a distribution
syndicate is to distribute the securities as quickly as possible. Thus the faster the distribution
can be completed, the better off are the underwriters.
Structure of a syndicate
The underwriting syndicate consists of several distinct groups: the managers, the bulge
bracket, the major bracket, the mezzanine bracket, and the sub major bracket.

Stabilizing Bid
The stabilizing bid is set at the offering price and serves to guarantee, at least for a time,
that investors can exit their positions in the securities for the same price that they paid for
them.

Overallotment option/Green shoe option

An overallotment option is an option that is available to underwriters to sell additional
shares during an IPO.
Let’s say XYZ co goes public and sells 10 million shares in its IPO at $10 per share, $100
million. As part of the IPO, it grants its underwriter a 30 day’s over-allotment option equal to
15% of the IPO shares. While doing so, underwriter actually sells 11.5 million shares to
buyers at $10 per share.
Once the stock starts trading, the initial trade is $12 per share and the price keeps going
steadily up from there, closing its first day of trading $15 per share and closing at $20 per
share a couple days later. But underwriter sold 11.5 million shares. This is where
underwriter exercises the overallotment option to obtain those extra shares.
But what if the stock doesn’t perform well. Let’s assume XYZ co starts trading at $11 per
share, but the price starts to drift down to the $10 IPO price. When the trades get to $10 per
share, underwriter will begin to support the stock by buying shares at $10 per share.
Because the IPO was oversold by 1.5 million shares, underwriter can buy back up to 1.5
million share at $10 per share.

Division of revenues
• Fair market price $52.75
• Offering price $50
• Proceeds to the issuer $47.50
• Gross spread = (50-47.50) = $2.50
• Underpricing = (52.75-50) = $2.75
• Flotation cost to the issuer is (2.75+2.50+.75) = 6.00

The gross spread is divided into three parts: the management fee, underwriting fee and
selling concession. The general rule of thumb is 20%, 20% and 60% respectively.
Let’s suppose that a rep is going to sell 200 shares of the same stock to some individual
investors. The gross spread is $2.50 and selling concession is 60% or $1.50. Since the sale
will be made to individuals, the rep will get 35%, or, $.525 for each share sold.

The reps typically receive 35% of the selling concession for sales to individuals, 20% for sales
to small institutions, 15% for sales to midsized institutions, 10% for sales to large
institutions.

Let’s suppose that fair market price for a firm’s stock is $52.95. The negotiation with the
underwriters results in an agreement that the offering price will be $50 and the proceeds to
the issuer will be $47.35. The issuer will be required to pay fees to cover the cost of SEC
filings, legal fees, printing fees and so on. These amount is equal to $0.90 per share. Selling
concession is 60% of gross spread. And the reps typically receive 38% of selling concession
for sales to individuals. You are required to compute:
(i) What is the flotation cost to the issuer?
(ii) How much money reps will get for each share sale to individual?

Chapter 3 - Secondary Market Making

A. Secondary Market Making

Dealer/Broker Activity
Give financial claims greater liquidity
 Investors
 Issuers
 Investment Bankers
Stock return, Liquidity and Order imbalance
Order imbalance theory:
Order imbalance is a situation resulting from an excess of buy or sell orders for a specific
security on a trading exchange, making it impossible to match the orders of buyers & sellers.
Extreme cases of order imbalance may cause suspension of trading until the imbalance is
resolved.
Buyer-initiated trades:
Indicates number of trades that were executed at a seller’s price, an increasing number
would indicate buyers are more aggressive than sellers.
Seller-initiated trades:
Indicates number of trades that were executed at a buyer’s price, an increasing number
would indicate sellers are more aggressive than buyers.
Information asymmetry in return-volume relation
Speculative trade:
Speculators trade based on their educated guesses on where they believe the market is
headed. For example, if a speculator thinks that a stock is overpriced, they may sell short
the stock and wait for the price to decline, at which point it can be bought back for a profit.
Hedge trade:
Hedging against investment risk means strategically using financial instruments or market
strategies to offset the risk of any adverse price movements.
Dealing vs. Brokering
 Bid-ask spread
 commission
B. Dealers
1. Instruments
 Traders in dealer markets – swaps, mortgage-backed products, etc.
 Traders in exchanges – futures
Traders in dealer markets and exchange markets
2. Functions
 Provide a quote: The quote includes both a bid price & the ask price.
 Size a quote: The size is the minimum number of shares, in the case of stock or the
maximum amount of principal, in the case of bonds.
3. Reasons to participate
 Take profit – bid-ask spread: Investment banks participate in the secondary market
as securities dealers for a number of reasons. First and generally foremost, securities
dealing are a profit center for the bank. That is, dealers earn, or at least try to earn,
profits for the firm from their bid-ask spread.
Price vs. Inventory: In stable markets, the dealer’s life is relatively easy. He buys, he sells,
and he buys or sells again. If his pricing is right, then his inventory will tend to be relatively
stable. If his pricing is too high, more people will sell to him than buy from him and his
inventory will grow. This would suggest a need to lower his pricing. If, on the other hand,
the dealer’s pricing is too low, more people will buy from him than sell to him and his
inventory will shrink-perhaps become negative (a short position).
Market Microstructure:
Market microstructure is a branch of finance concerned with the details of how exchange
occurs in markets. It deals with issues of market structure and design, price formation,
volatility, price discovery, transaction & timing cost, information and disclosure, and
investor behavior. It is the functional set up of a market functioning under a given set of
rules and deals.
Develop and maintain good pricing skills:
Besides the profit motive, there are other reasons that investment banks act as dealers in
the secondary markets. One reason is to develop and maintain good pricing skills. This is a
critical ingredient for effectively pricing issues of new securities in primary market making.
Secondary market making supports primary market making:
The secondary markets support the primary markets by offering liquidity to the initial
investors in a security. This liquidity helps issuers attract more demand for their security
offerings in the primary markets, leading to higher initial sale prices and a lower cost of
capital. Without liquidity, a financial claim is much less attractive to investor. Thus, an
investor in an illiquid asset can be expected to demand a higher yield as compensation for
the asset’s illiquidity, and the higher yield would have to be borne by the issuer.
4. Managing dealers’ risks

1.Identify the risks

Systematic risk: This tendency of stock prices to respond collectively to changing economic
fundamentals is referred to as systematic risk.
Unsystematic risk: The price of stock may change as a direct consequence of an event that
is specific to the firm or industry.
Interest rate risk: which is the sensitivity of the prices of fixed income securities to changes
in interest rate levels?
Credit risk: the risk that the issuer’s credit worthiness may deteriorate.
Call risk: the risk that issuer may choose to retire the issue prior to maturity.
Prepayment risk: Similar to call risk but applicable to mortgage type debt securities.
Purchasing power risk: Loss of purchasing power as a consequence of inflation.
Tax rate risk: The risk that the tax treatment of an issue might change due to change in the
tax law or an unfavorable ruling by tax courts.

2. Quantify the risks

Natural hedge: Unlike other types hedges, a natural hedge does not require the use of
sophisticated financial products such as forwards or derivative.
Value at Risk (VaR): It is a statistical technique used to measure & quantify the level of
financial risk within a firm or investment portfolio over a specific time frame.
Managing the risks
Short or long position: When an investor long on an investment, it means that he or she
bought a stock believing its price will rise in the future. On the other hand, when an investor
goes short, he or she is anticipating a decrease in share price.
Building blocks
5. Inventory financing
Repo market: A repurchase agreement (repo) is a form of short-term borrowing for dealers
in government securities. In the case of a repo, a dealer sells government securities to
investors, usually on an overnight basis, and buys them back the following day at a slightly
higher price. In a repurchase agreement, a dealer sells securities to a counterparty with the
agreement to buy them back at a higher price at a later date. ... The dealer is raising short-
term funds at a favorable interest rate with little risk of loss. The transaction is completed
with a reverse repo.
Essentially, repos and reverse repos are two sides of the same coin — or rather, transaction
— reflecting the role of each party. A repo is an agreement between parties where the
buyer agrees to temporarily purchase a basket or group of securities for a specified period.
The buyer agrees to sell those same assets back to the original owner at a slightly higher
price using a RRP.
A reverse repurchases agreement (RRP) is an act of buying securities with the intention of
returning, or reselling, those same assets back in the future at a profit. This process is the
opposite side of the coin to the repurchase agreement. To the party selling the security with
the agreement to buy it back, it is a repurchase agreement. To the party buying the security
and agreeing to sell it back, it is a reverse repurchase agreement. The reverse repo is the
final step in the repurchase agreement, closing the contract.
In a repurchase agreement, a dealer sells securities to a counterparty with the agreement to
buy them back at a higher price at a later date. The dealer is raising short-term funds at a
favorable interest rate with little risk of loss. The transaction is completed with a reverse
repo. That is, the counterparty has sold them back to the dealer as agreed.
The counterparty earns interest on the transaction in the form of the higher price of selling
the securities back to the dealer. The counterparty also gets the temporary use of the
securities.

C. Brokers
1. Functions
Fill orders market order vs. limit order
Market orders buy or sell at the current price, whatever that price may be. In an active
market, market orders will always get filled, but not necessarily at the exact price that the
trader intended. For example, a trader might place a market order when the best price is
1.2954, but other orders might get filled first, and the trader's order might get filled at
1.2955 instead. Market orders are used when you definitely want your order to be
processed and are willing to risk getting a slightly different price. If you are buying, your
market order will get filled at the ask price, as that is the price someone else is currently
willing to sell for.
If you are selling, your market order will get filled at the bid price, as that is the price
someone else is currently willing to buy at.
Limit orders are orders to buy or sell an asset at a specific price or better. Limit orders may
or may not get filled depending on how the market is moving, but if they do get filled it will
always be at the chosen price, or better.
For example, if a trader placed a limit order with a price of $50.50, the order would only get
filled at $50.50 or better. In this case, a better price would be below $50.50, if it got filled at
all. Limit orders are used when you want to make sure that you get a suitable price and are
willing to risk not being filled at all. The order only gets filled if someone is willing to sell to
you if you are buying at $50.50, or below.
If you wanted to sell at $50.50 or better—which would be above $50.50, in this case—you
could use a sell limit order. The order will only be executed if someone else is willing to buy
from you at $50.50 or above.
 Floor trading order book
 Other services
 Monitor margin accounts
Initial margin vs. maintenance margin:
The amount which is required to deposit to the broker to purchase security on margin is
called initial margin. For example, if investor plans to buy security worth of Tk.2000 on
margin, the brokerage firm tells investor to deposit a minimum amount, say Tk. 1500 is the
initial margin. Maintenance margin is the minimum level by which investor’s equity position
may fall as a result of unfavorable price movement.
 Margin call: In case of unfavorable price movement, investor’s value of equity may fall from
maintenance margin. At that times, investors’ have to deposit an additional amount. That
additional amount is called the call margin.
 Offer investment management service Process dividends and interest coupon.
 Assist in structuring portfolios
I. Real estate
II. Stock and bonds
III. Mutual funds
IV. Life insurance policy
V. Retirement account
 Provide research and recommendation
2. Possible abuses
Bucket shops: Securities firms that take customer orders but do not immediately execute
them.
Boiler rooms: Firms that use high-pressure sales tactics to sell securities.
Churning: Excessive trading of a customer’s account to earn commission, especially in
discretionary trading account.
Front running: Trading ahead of a customer. For example, if a broker/dealer receives an
order to buy a large number of shares of stock or a significant amount of par on a bond
issue, in anticipation of this they may buy the stock or the bonds for its own account prior to
filling the order for the customer. Then, as the price rises, they sell out its own position at
the higher prices.
Poor fills: There have been instances in which floor broker, working in concert with floor
traders trading for their own accounts, have deliberately transacted on behalf of customers
at disadvantageous prices.

Chapter 4 - Structured Finance

What Is Structured Finance?

Structured finance is a heavily involved financial instrument presented to large financial
institutions or companies with complicated financing needs who are unsatisfied with
conventional financial products. Since the mid-1980s, structured finance has become
popular in the finance industry. Collateralized debt obligations (CDOs), synthetic financial
instruments, collateralized bond obligations (CBOs), and syndicated loans are examples of
structured finance instruments.

Why is structured finance important?

Structured financial products are not always the typical lending and ‘market products’ that
are advanced on the high street.
Usually structured finance is necessary when there is one or a number of discretionary
transactions, and it is where alternative lending is used with risk mitigation instruments
implemented.
A new type of financing has led to the creation of instruments which are used to fund.
Techniques are also used to manage risks that are inherent in transactions, which have
developed to suit the financial markets and expand business reach. The net cash flows are
transformed and the liquidity of financial portfolios is reshaped.
Structured finance products include:
 Derivatives
 Securitized and collateralized debt instruments
 Syndicated loans
 Collateralized debt obligations (CDOs),
 Collateralized mortgage obligations (CMOs)
 Collateralized bond obligations (CBOs)
 Credit Default Swaps (CDSs) and
 Hybrid securities
Benefits of Structured Finance
Structured financial products are typically not offered by traditional lenders. Generally,
because structured finance is required for major capital injection into a business or
organization, investors are required to provide such financing. Structured financial products
are almost always non-transferable, meaning that they cannot be shifted between various
types of debt in the same way that a standard loan can.
Increasingly, structured financing and securitization are used by corporations, governments,
and financial intermediaries to manage risk, develop financial markets, expand business
reach, and design new funding instruments for advancing, evolving, and complex emerging
markets. For these entities, using structured financing transforms cash flows and reshapes
the liquidity of financial portfolios, in part by transferring risk from sellers to buyers of the
structured products. Structured finance mechanisms have also been used to help financial
institutions remove specific assets from their balance sheets.
Meaning of Securitization:
Securitization is the process of transformation of non-tradable assets into tradable
securities. It is a structured finance process that distributes risk by aggregating debt
instruments in a pool and issues new securities backed by the pool. When a bank or
financial institution is in need of additional capital to finance a new facility, to raise the fund,
instead of selling the assets, the financial institution decides to sell the portion of the loan a
trustee named as a special purpose vehicle (SPV) and collect the fund up front and remove
the loan asset from the balance sheet of the institution. SPV holds the asset as collateral in
balance sheet and issue bonds to the investors. It uses the proceeds from those bond sales
to pay the originator for the assets.
RBI in its circular on Securitization of Standard Assets, describes Securitization.
“as a process by which assets are sold to a bankruptcy remote special purpose vehicle (SPV)
in return for an immediate cash payment”.
Securitizations can be defined as:
“Acquisition of financial assets by any securitization company or reconstruction company
from any originator, whether by raising funds by such securitization company or
reconstruction company from qualified institutional buyers by issue of security receipts
representing undivided interest in such financial assets or otherwise.”
In such cases the cash flow from the underlying pool of assets is used to service the
securities issued by the SPV.
Let us try to understand it from a layman’s view. In the normal course assets like loans and
securities held by banks/financial institutions are expected to yield a quantifiable stream of
future income (e.g. EMIs etc.). However, since this income is yet to be realized, it cannot be
brought onto their books immediately. Through the process of Securitization Banks try to
encase these future flow of as- yet-unrealized income.
We can also sum up that securitization means the conversion of existing or future cash in-
flows into tradable security which then is sold in the market. The cash inflow from financial
assets such as mortgage loans, automobile loans, trade receivables credit card receivables,
fare collections become the security against which borrowings are raised.
Securitization thus follows a two-stage process. In the first stage there is sale of single asset
or pooling and sale of pool of assets to a ‘bankruptcy remote’ special purpose vehicle (SPV)
in return for an immediate cash payment and in the second stage repackaging and selling
the security interests representing claims on incoming cash flows from the asset or pool of
assets to third party investors by issuance of tradable debt securities.
Process of Securitization:
We have seen above that Securitization is a process by which the future cash inflows of an
entity (originator) are converted and sold as debt instruments. These debt instruments are
popularly known as “Pay Through or Pass Through Certificates”, with a fixed rate of return
to the holders of beneficial interest.
Under this process, the originator of a typical securitization actually transfers a portfolio of
financial assets to a “Special Purpose Vehicle” (SPV). (An SPV is an entity specially created
for doing the securitization deal. It invites investment from investors, uses the invested
funds to acquire to receivables of the originator An SPV may be a trust, corporation, or any
other legal entity.)
As a consideration for the transfer of such a portfolio, the originator gets cash up-front on
the basis of a mutually agreed valuation of the receivables.
The transfer value of the receivables is arrived in such a way so as to give the lenders a
reasonable rate of return. In ‘pass-through’ and ‘pay-through’ securitizations, receivables
are transferred to the SPV at the inception of the securitization, and no further transfers are
made. All cash collections are paid to the holders of beneficial interests in the SPV (basically
the lenders).
Thus, we can say that a securitization deal usually passes through the following stages:
1. First of all the originator determines which assets they wants to securitize.
2. At second stage originator has to find out a SPV or new SPV is formed.
3. The SPV collects the funds from investors and in return issues securities to them.
4. The SPV acquires the receivables under an agreement at their discounted value.
5. The Servicer for the transaction is appointed, who is usually the originator.
6. The debtors are/are not notified depending on the legal requirements.
7. The Servicer collects the receivables, usually in an escrow mechanism, and pays off the
collection to the SPV.
8. The SPV either passes the collection to the investors, or reinvests the same to pay off to
investors at stated intervals.
9. In case of default, the servicer takes action against the debtors as the SPV’s agent.
10. When only a small amount of outstanding receivables are left to be collected, the
originator may clean up the transaction by buying back the outstanding receivables.
11. At the end of the transaction, the originator’s profit, if retained and subject to any losses
to the extent agreed by the originator, in the transaction is paid off.
Advantages of the Securitization:
1. Securitization helps in raise funds for the standard assets, though the rating of the
originator may not be high;
2. Securitized assets (receivables) go off the balance sheet of the originator which at times
can be of great help to the originator. For example, a bank may need to reduce its exposure
to credit so as to meet the capital adequacy norms.
3. Securitization also helps in generating liquidity which may; be critical at times for the
bank/company.
4. Small investors are able to profit from such deals as under this scheme even they can
invest small amounts through SPV and acquire beneficial interest in the securitized assets.
Disadvantages of the Securitization:
1. Securitization is an off-balance sheet item. The originator may thus be able to hide the
true picture of its financial health by securitization of its good assets and keeping only sub-
standard assets in its portfolio.
2. Another disadvantage of securitization is its opaqueness. For example, a company may
have taken huge liabilities but that may not be reflected in the balance sheet or
conventional financial statements of the company. This is especially true where the
securitization is with recourse i.e. if the receivables which have been- securitized to the SPV,
but later become NPA.
In such a case, the SPV will have the right to recover the dues from the originator. Thus, in
such cases, it may be realized later on that the originator actually had a large amount of
contingent liabilities but these were not reflected in the balance sheet.
What Is a Credit Derivative?
A credit derivative is a financial asset that allows parties to handle their exposure to risk.
Credit derivative consisting of a privately held, negotiable bilateral contract between two
parties in a creditor/debtor relationship. It allows the creditor to transfer the risk of the
debtor's default to a third party.
Various types of credit derivatives exist, including
Credit default swaps (CDS)
Collateralized debt obligations (CDO)
Total return swaps
Credit default swap options
Credit spread forward
In all cases, their price is driven by the creditworthiness of the parties involved, such as
private investors or governments.
How a Credit Derivative Works
Banks and other lenders can use credit derivatives to remove the risk of default entirely
from a loan portfolio—in exchange for paying an upfront fee, referred to as a premium.
As an example, assume company A borrows $100,000 from a bank over a 10-years.
Company A has a history of bad credit and must purchase a credit derivative as a condition
of the loan. The credit derivative gives the bank the right to "put" or transfer the risk of
default to a third party.
In other words, in exchange for an annual fee over the life of the loan, the third party pays
the bank any remaining principal or interest on the loan in case of default. If company A
does not default, the third party gets to keep the fee. Meanwhile, company A receives the
loan, the bank is covered in case of default by company A, and the third party earns the
annual fee. Everyone is happy.
Collateralized Mortgage Obligation (CMO)
A collateralized mortgage obligation (CMO) refers to a type of mortgage-backed security
that contains a pool of mortgages bundled together and sold as an investment. Organized
by maturity and level of risk, CMOs receive cash flows as borrowers repay the mortgages
that act as collateral on these securities. In turn, CMOs distribute principal and interest
payments to their investors based on predetermined rules and agreements.
Collateralized bond obligation (CBO)
Debt financing mechanism that converts junk grade bonds into an investment grade asset
based security (ABS). In this arrangement, a bank's portfolio of low-rated bonds (as the
underlying collateral for an issue of CBO) is transferred to a specially created corporation or
trust (called special purpose vehicle or CPV) which has no other assets and manages the
issue. Typically, a CBO is issued at two or more levels (called tiers or tranches) with different
degrees of risk and rates of interest.
Collateralized debt obligations (CDOs)
CDOs, or collateralized debt obligations, are financial tools that banks use to repackage
individual loans into a product sold to investors on the secondary market. These packages
consist of auto loans, credit card debt, mortgages or corporate debt. They are called
collateralized because the promised repayments of the loans are the collateral that gives
the CDOs their value.
What is a Credit Default Swap (CDS)?
A credit default swap (CDS) protects lenders in the event of default on the part of the
borrower by transferring the associated risk in return for periodic income payments.

How does a Credit Default Swap (CDS) work?

In a credit default swap (CDS), two counterparties exchange the risk of default associated
with a loan (e.g. a bond or other fixed-income security) for periodic income payments
throughout the life of the loan. In the event that the borrowing party (the issuer) does
default, the insuring counterparty agrees to pay the lender (bondholder) the par value in
addition to lost interest. The bondholder (lender) seeks protection against the risk that the
issuing company (borrower) might default. The insuring counterparty hedges that the
issuing company will not default, and will ultimately profit from the income payments
without having to compensate the bondholder for the par value and remaining interest.
To illustrate, suppose Bob holds a 10-year bond issued by company XYZ with a par value of
$1,000 and a coupon interest amount of $100 each year. Fearful that XYZ will default on its
bond obligations, Bob enters into a CDS with Steve and agrees to pay him income payments
of $20 (similar to an insurance premium) each year commensurate with the annual interest
payments on the bond. In return, Steve agrees to pay Bob the $1,000 par value of the bond
in addition to any remaining interest on the bond ($100 multiplied by the number of years
remaining). If XYZ fulfills its obligation on the bond through maturity after 10 years, Steve
will make a profit on the annual $20 payments.
Asset based security & mortgage based security
ABS & MBS: Securities backed by mortgage receivables are called mortgage backed
securities, while those backed by other types of receivables are called asset backed
securities. The market for ABS developed after the MBS market had matured. Instead of
mortgages, ABS represent an interest in a wide range of pooled assets, such as credit card
receivables, aircraft leases, home equity leases, auto loans and leases, equipment leases etc.