Nomura Workshop

INTRODUCTION TO INVESTMENT BANKING

Introduction to Investment Banking

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TABLE OF CONTENTS

Introduction ............................................................................................................................................. 3

Course Objectives ....................................................................................................................................... 3

List of Chapters ........................................................................................................................................... 3

Chapter 1: Investment Banking Basics ..................................................................................................... 5

Chapter Objectives ..................................................................................................................................... 5

Introduction to Investment Banking Basics ................................................................................................ 5

Case Study .................................................................................................................................................. 6

Introduction to Securities ........................................................................................................................... 8

What is an Investment Bank? ..................................................................................................................... 9

Summary of Investment Banking Structure ............................................................................................. 13

Chapter Summary ..................................................................................................................................... 13

Chapter 2: Investment Banking Products and Services ........................................................................... 15

Chapter Objectives ................................................................................................................................... 15

Introduction .............................................................................................................................................. 15

Investment Banking Overview .................................................................................................................. 16

Equity Investments ................................................................................................................................... 16

Fixed Income ............................................................................................................................................ 17

Derivatives ................................................................................................................................................ 20

Prime Brokerage ....................................................................................................................................... 22

Foreign Exchange ...................................................................................................................................... 25

Investment Management ......................................................................................................................... 27

Summary................................................................................................................................................... 27

Chapter 3: Lifecycle of a Trade ............................................................................................................... 29

Chapter Objectives ................................................................................................................................... 29

Introduction .............................................................................................................................................. 29

Trading Risks ............................................................................................................................................. 31

Trade Lifecycle Overview .......................................................................................................................... 32

Trade Execution ........................................................................................................................................ 33

Confirmation ............................................................................................................................................. 35

Settlement ................................................................................................................................................ 36

Reconciliation ........................................................................................................................................... 37

Accounting ................................................................................................................................................ 38

Chapter Summary ..................................................................................................................................... 40

Course Summary ...................................................................................................................................... 40

Introduction to Investment Banking

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Introduction

This e-book contains all the content covered in the Introduction to Investment

Banking course. You may choose to use this e-book as a reference document.

Course Objectives

The objectives of the course are:

Define investment banking

Describe investment banking products and services

List the stages in the lifecycle of a trade

List of Chapters

This course comprises three chapters:

Chapter 1: Investment Banking Basics

Chapter 2: Investment Banking Products and Services

Chapter 3: Investment Banking Processes

INVESTMENT BANKING BASICS

CHAPTER 1


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Chapter Objectives

Welcome to Chapter 1: Investment Banking

Basics. At the end of the chapter, you will

be able to:


Describe the role of an investment

bank

Distinguish between investment and

retail banks

Describe the typical structure of an investment bank

Introduction to Investment Banking Basics

"Lack of money is the root of all evil." – George Bernard Shaw

We need money to buy a house, plan a vacation, or just

pay bills. For some things, your savings might be enough.

For others such as buying a house, you may have to take

a loan from a bank or sell some personal possessions.

Have you ever wondered how large organizations and

companies raise capital? A lot of them take the help of

investment banks. Let‘s look at a scenario to understand

how investment banks help companies raise funds.


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Case Study

Shane, an employee at a top investment bank, was sipping coffee at his desk when

the phone rang. On the call was his client, John, the CEO of ABC Steel.

Shane, Investment Banker John, CEO of ABC Steel

Shane: Hey John, how are you?

John: I‘m fine, thank you. How are you?

Shane: I‘m doing good. I hear things are going great for ABC Steel.

John: Oh yeah, things are great – the economy is booming and there‘s a lot of

demand for our products.

Shane: Wow! That‘s nice to hear. I also hear you bagged a big contract.

John: Yeah, and we need to build a new production facility soon. But we have a

problem…

Shane: Tell me about it.

John: Well, we need $200 million dollars to fund this new project…

Shane: And you want to know how you can raise this money, right?

John: Right. We spoke to the bank, but man those interest rates are ridiculous!

Shane: I know. But there are other options you know.

John: That‘s why I called. I was wondering if you could help us.

Shane: Sure, John. Let me do some homework and get back to you. I‘ll call you

tomorrow morning?

John: Sounds perfect. Thanks Shane!


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Shane’s Options

Shane thought about John‘s funding requirements. He made a

list of all funding options for John‘s company and filtered the

list down to three.

Taking a Loan

ABC Steel has a good credit rating. So getting a loan

from any bank would be easy. But the rates of

interest are quite high. Also, the new plant will

generate revenue only after a few years. This would

make immediate repayment difficult, adding to the

debt burden.

Saving Money

ABC could save a percentage of the profits and build a

plant after few years. However, John couldn‘t wait that

long because this would make it difficult for ABC Steel to

meet the demand for steel in the near future.

Selling Stocks

John could raise capital by offering company stocks to

the public. Since the steel market is booming, a lot of

investors would buy ABC‘s shares. But the challenge is

to manage the risks and complications involved in the

IPO process, government regulations and market

uncertainties.

If you were in Shane‘s shoes, what option would you consider and why?


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Shane’s Advice

Shane carefully evaluated the options and advised John

to sell company stocks through an initial public offering

(IPO). John was apprehensive about the technicalities

and risks involved with launching an IPO. This is where

Shane‘s investment banking expertise was crucial. He

helped John decide the offer price and guided him on

government regulations and the requisite documentation.

Shane also used his contacts with different large

investors to generate interest in ABC Steel.

Thanks to Shane, the IPO was a success, ABC raised the capital it needed, and

investors were happy about buying stocks of a company with good fundamentals.

Introduction to Securities

You just saw how ABC raised money by selling their

stocks. But what exactly is a stock? A stock or share or

equity literally means a share or stake in the company.

If you owned 100% stock of a company, it would

mean that you are the only owner of the company!

Another option for raising money is a bond, which is essentially a loan to a company.

The key difference between stocks and bonds is that buying a bond does not mean

that you own a share in the company. Bond-holders are paid the principal along with

the interest, but are not entitled to the profits made by the company. On the other

hand, a company doesn‘t have to ―repay‖ its shareholders. Instead, it simply shares

its future profits with them.

Both stocks and bonds are examples of securities. This means that you can trade

stocks and bonds for money.


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What is an Investment Bank?

Believe it or not, even investment bankers find it

difficult to describe what exactly investment banks do!

This has to do with the sheer complexity and enormity

of the financial transactions involved.

In simple words, an investment bank is an

intermediary between organizations such as ABC Steel

that need money and individuals and institutions that

need to invest. Broadly speaking, an investment bank

is an institution that:

Helps organizations or governments raise money by issuing and selling

securities such as stocks and bonds

Provides a range of advisory services on complex transactions such as

mergers and acquisitions

Offers a range of structured products and services to institutional and

individual investors to help them manage their assets and wealth

Role of an Investment Bank

Investment banks could play different roles in a

financial transaction. Some of the most common

roles played by them are:

Underwriter

Principal Trader

Broker or Agent

Prime Broker

Advisor

Underwriter

As an underwriter, an investment bank purchases all

new securities of a company and resells them to the

public. For example, ABC issues 20,000,000 shares for

$10 each. An investment bank directly purchases all

these shares from ABC and sells it to the public at a


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higher price, say $15 each. The investment bank also bears the cost of the sale.

Principal Trader

As a principal trader, an investment bank buys shares

from other investment banks and investors and keeps

them in its inventory. It may sell these shares at a

higher price in the future. The term ‗principal trading‘

simply means that the trader of securities is also its

owner or principal.

For example, after ABC Steel‘s shares are sold to the public, an investment bank

may purchase some of these shares from the market. It may sell these shares later

when the price rises.

Broker or Agent

As an agent or broker, an investment bank buys and

sells securities on behalf of a company. The key here is

that the investment bank does not own these securities.

It only trades in them for a commission.

The important thing to remember here is that the brokerage or agency represents

buyers or sellers who are the principals or owners of the securities.

Prime Broker

A prime broker offers a range of services to professional

investors, including:

Administrative and operational support for

trading

Lending of securities

Management and safeguarding of securities

Financing


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Without a prime broker, it would be difficult for professional investors to trade with

several different brokers and manage their cash and securities from one centralized

account.

Advisor

Investment banks provide a range of advisory services

on complex transactions such as mergers and

acquisitions. They also advise companies on the

different options to raise capital. They provide high

net-worth individuals with customized wealth

management services.

Why an Investment Bank

So why do companies require an investment bank?

Can‘t they raise funds on their own? Yes, companies

can sell shares or bonds directly to investors. But

most don‘t because they simply don‘t have the

expertise. Without professional help, companies

would end up violating rules and regulations that

they didn‘t even know existed.

Investment banks have a large pool of experts who are well versed with market

regulations and conditions. Moreover, they are more cost effective due to their scale

of operation and optimal use of technology. Considering all this, it would be too

expensive and time consuming to not use an investment bank.

Investment ‘Banks’

Have you wondered why investment banks are called

‗banks‘? After all, they do not provide home loans or car

loans to customers. Nor do they provide savings accounts.

The reason investment banks are also considered ‗banks‘

is that they help to finance an organization‘s capital needs

by taking money from investors. This is similar to how a regular bank lends money

deposited with it by customers to businesses and individuals.


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Investment Banking Structure

Let‘s now take a look at what a typical investment bank is structured like. Usually, all

investment banks consist of three units—front office, middle office and back office.

Front Office

The front office refers to the sales, marketing, trading and other divisions that

involve customer interaction and revenue generation. The front office of an

investment bank typically handles the following functions:

Investment management

Investment banking

Research

Strategy

Trading and sales

Structuring of complex financial instruments such as derivatives

Middle Office

The middle office of an investment bank manages risk. For an investment bank, risk

can be of two types:

Market risk – the risk of decrease in value of investments due to market

fluctuations

Credit risk – the risk of loss due to non-payment of a loan

The middle office calculates profits and losses. It also analyzes the risk of trading

portfolios and ensures compliance with regulations. It works closely with both the

front and back office.

Back Office

The back office consists of the operational and administrative functions of the

investment bank. Typically, the back office handles the following functions:

Clearing

Settlement

Regulatory compliance

Record-keeping

Reporting of transactions


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The back office may also consist of a technology division that creates software tools

that automate processes and integrate different systems.

Summary of Investment Banking Structure

Here‘s a quick summary of what you learned in the

previous pages:

The front office interacts with customers, trades

in securities, and researches the market.

The middle office calculates the risk, profit, and

loss associated with trading.

The back office is the administrative and

operational backbone.

Chapter Summary

You have completed Chapter 1: Investment

Banking Basics.

You should be able to:


Describe the role of an investment bank

Differentiate investment banking from

retail banking

Describe the typical investment banking structure

INVESTMENT BANKING PRODUCTS

& SERVICES

CHAPTER 2


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Chapter 2: Investment Banking Products and

Services

Chapter Objectives

Welcome to Chapter 2: Investment Banking Products and

Services.

At the end of the chapter, you will be able to:

List the important types of investment banking

services and products

Define important investment banking terms

Describe investment banking products, services and related terms

Introduction

"Finance is the art of passing currency from hand to hand until it finally disappears."

– Robert W. Sarnoff

Mention ‗investment banking‘ and most

people think of pinstriped suits, power

lunches, and complicated jargon such as

‗collateralized debt obligation‘ or ‗credit

default swaps.‘ If you are the kind who

gets jittery when someone uses a big

word, do not worry. Even experts can

get confused! Things are so complicated

because investment banks have to constantly innovate and create new products and

services. This way, they can demand higher margins and attract new investors.

This chapter will introduce you to common investment banking services and products.

But don‘t expect to become an investment banker by just reading this! To get a more


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detailed understanding of the subject, speak to experts in the field and refer to

books and websites on investment banking.

Investment Banking Overview

In the past, investment banking meant helping

companies raise capital or take strategic decisions on

mergers or acquisitions. Today‘s investment banks

have expanded and consolidated with several other

industries such as brokers and commercial banks.

They offer an overwhelming range of investing and

financing services that can be roughly classified into

the following categories:

Equity investments

Fixed income

Derivatives

Prime brokerage services

Foreign exchange

Investment management

Equity Investments

A wise man once said about the share market that every

time somebody buys, another sells, and both think that

they are smart! The market for shares, or the equity

market, is an excellent way for companies to raise

money and for investors to make money by buying and

selling shares. The difference between the cost price and

selling price is known as capital gain.

Investment banks trade in the market either on behalf of their clients or for their

own portfolios using a variety of strategies. They conduct extensive equity research

and analysis and provide reports to their clients. Equity investments have the

potential to give higher returns but at a higher risk.


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Fixed Income

Let‘s say you want to use your savings to generate

regular income to pay your bills. You don‘t want to

invest in the equity market because you know it is

too risky. What would you do? One option you could

consider is fixed income.

Fixed income refers to an investment where

investors ―loan‖ their money to obtain a fixed periodic return. For example, say you

lent $1,000 to your friend at an interest rate of 10% with a period of five years.

Every year, this would generate a fixed income of $100. At the end of five years,

your friend agrees to return the $1,000. In short, not only do you get your money

back, but you also get the interest on your loan as a regular income. This interest

paid to you is called a coupon.

More About Fixed Income

The most common type of a fixed income instrument

is a bond. This is an excellent option for companies

that want to raise money though at a slightly high

cost. Moreover, investors are assured regular returns

for a certain period. Other types of fixed income

instruments include government-issued treasury bills,

municipal bonds, and certificates of deposit.

Investment banks provide a range of structured fixed income instruments. A

collateralized debt obligation is one such instrument. It is a way of raising money

through bonds and then investing that money typically in other fixed income

instruments such as mortgages. Buyers of such bonds are paid a regular coupon.

Just like stocks, fixed income securities are traded in the market. You may wonder

why anyone would trade in fixed income securities when other instruments provide

higher returns. To understand this, let‘s look at a simple scenario.


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Scenario: Risk and Return

Amanda has two friends, Rachel, and Sophie. Both need

$10,000 for their personal needs.

Rachel

Rachel has a poultry business that has been adversely

affected by the bird flu panic. Since the price of eggs is at its

lowest, she plans to borrow $10,000 to buy large quantities

of eggs from a wholesaler and stock them for the next few

months. As the prices rise by 200% in the next three

months, she plans to sell her stock at a higher rate. Rachel

is willing to pay Amanda $14,000 at the end of the year.

Sophie

Sophie has a low-paying job at a government bank. She needs

$10,000 to buy a new car. This would reduce her commuting

cost by $400 a month. Sophie promises Amanda that she‘ll

pay her $12,000 at the end of two years.

If you were Amanda, whom would you lend to?


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Analysis

There is no right or wrong answer for Amanda.

The final choice depends on her ability to take

risks and her need for returns. While Rachel is

ready to pay a higher rate of interest, the

volatile egg business makes the loan very risky.

On the other hand, Sophie‘s bank job makes it

easy for her to repay the money along with the

interest. Still, the risk of default still exists.

Moreover, Amanda‘s money would be ―tied up‖ for two years, earning a low interest.

As a rule, higher the risks, higher the returns, and vice versa. Typically, most

investors reduce their risks by ‗diversification‘ or investing in diverse instruments. To

offset the risk of volatile equity investments, investors often allocate a certain

percentage of their portfolio to fixed income. There are other ways to reduce risks,

as we shall see in the next few topics.

Reducing Risk

How does one reduce risk? Like Amanda, companies and

banks spend sleepless nights pondering over this question.

Bad weather, credit default, demand slump, and other

unexpected events can wreck any business. This need to

reduce risks led to the creation of derivatives.

A derivative is a kind of insurance against something going

wrong. For example, in the previous example, Rachel would have suffered heavy

losses if the expected price rise of eggs did not happen. Amanda would have lost

money if Rachel did not repay her loan. Purchasing the right derivative in their case

would have protected them in the case of an adverse event.


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Derivatives

So what are derivatives really? A derivative is a

financial instrument whose value depends on the

value of one or more financial instruments or the

‗underlying.‘ These instruments could be interest

rates, foreign exchange rates, or even the price

of commodities such as coffee or wheat.

The advantage of derivatives is that they can be

bought or sold without having to deal with the underlying asset. For example, you

can trade in derivative contracts for the price of cotton without actually dealing in

cotton. Moreover, just like stocks, derivatives can also be traded on an exchange or

sold over the counter. New derivatives are constantly being invented. For example,

now you can even buy earthquake derivatives!

Let‘s take a look at the different types of derivatives contracts.

Futures and Forwards

A future or forward is a contract to buy a

specified quantity of a financial instrument at a

certain price and time. For example, if you were

afraid that the price of coffee would rise in

three months, you could buy a future contract.

This gives you the right to buy or sell, say

10,000 kilos of coffee at the price you want

after three months.

The difference between a future and forward is that in a future, a clearing house that

operates an exchange writes the contract while forward contracts are written by both

the parties themselves. In short, futures are traded on the stock exchange while a

forward is sold over the counter.


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Options

As the name suggests, an option provides you the ‗option‘ or

right to buy or sell at a specific time in the future. Buying a

call option gives you the right to buy a specified quantity of a

security at a certain price. Buying a put option gives you the

right to sell.

How is an option different from a future? Well, a future

contract makes it obligatory for you to perform the transaction

while option does not. For example, say you bought a derivative to sell a company

share at $100 after six months. After six months, however, the market price of the

share has shot up to $150.

If you had bought a:

future contract, you would have to sell it at $100.

put option, you could exercise the right to sell it at $150 and not $100.

Swaps

A swap means an exchange of something. You could have swaps

for several things including interest rates, cash flows, and

currencies.

A common type of swap is a credit default swap. For example,

Sam borrows $100 from Anita. Anita is not sure if Sam will repay

her. Therefore, she buys a swap from Mike for protection against default. As per the

swap agreement, Anita agrees to pay Mike $10. In case Sam does not pay Anita,

Mike will pay Anita the full amount. How does Mike benefit? For sharing Anita‘s risk,

he gets a small payment. Moreover, Mike would have agreed to share Anita‘s risk

only after researching Sam‘s creditworthiness and his ability to repay.


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Prime Brokerage

A hedge fund, as the name suggests, is a fund

that aims to protect against potential losses using

a combination of trading strategies including

derivative contracts. Such funds are open only to

a few professional or wealthy investors.

Investment banks provide specialized services

known as prime brokerage to professional investors such as hedge funds. These

services include administrative and operational support, financing, and advisory

services. Prime brokerage allows hedge funds to work with multiple brokers and

manage their cash and securities from a single account. Investment banks benefit by

charging fees for their various services.

Hedge Fund Strategies

Someone once said that you could easily recognize

a hedge fund manager at a bar. He‘s the person

holding a drink with the least transparency and

liquidity!

Jokes apart, hedge funds have received a lot of

bad press in the last few years primarily because of

their secretiveness about their trading strategies.

Also, such funds are not subject to the same regulations as other institutions. Let‘s

take a quick look at some of their strategies and how investment banks help them.


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Short selling and Long Selling

Most people buy shares expecting price to rise in the future. Selling shares that you

own is known as long selling. If the price were to fall and not rise, you would make

a loss if you were to sell.

Short selling is just the opposite of long selling. If you believed that the share price

of a company would fall tomorrow, you could borrow shares from a broker and sell it

in the market today at a higher price. When the price falls, you would buy the shares

again at a lower price and return them to the broker.

Hedge funds often borrow securities from their partner investment banks for short

selling.

Derivatives

Investment bankers offer a range of derivative

products to hedge funds along with futures clearing

and execution services. Hedge funds use

derivatives for hedging against possible market


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risks. For example, hedge funds may buy or sell credit default swaps (CDS), which

protect against possible defaults on a loan.

Arbitrage

Arbitrage refers to taking advantage of

differences in prices of the same

quantity between two or more markets.

Suppose the price of a share of a

company is $10 in one stock exchange

and $11 in another. Here arbitrage

would mean purchasing the cheaper

share and selling it in the other exchange for a profit.

Leverage

Leveraging refers to using somebody

else‘s funds to amplify your earnings.

Investment banks provide equity and

debt financing services to hedge funds

for leveraging. While leveraging has

the power to magnify your gains, it

also substantially increases your risk.

A simple example of leverage would be

buying a house. Say the cost of buying

a house is $100,000. You pay $20,000 in cash and borrow the rest from a bank. In

this case, a bank loan is the leverage, as it makes your $20,000 more productive.

How does it amplify your earnings? The following two cases are possible:

Suppose the price of the house rises to $110,000. By investing only $20,000,

you earned $10,000—a 50% growth!

If the value of the house decreases to $90,000, your initial investment of

$20,000 has made a loss of $10,000.

Of course, there is a cost for the leverage. In the above example, it would be the

interest rate paid to the bank.


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Foreign Exchange

If you were travelling out of the

country, you would need the local

currency—to shop or to pay your bills.

After all, most businesses prefer being

paid in their own currency. You would

need to buy foreign currencies or the

U.S. dollar in what is known as the

foreign exchange market (currency

or forex or FX). To know what the FX

market looks like, imagine a huge

network of people across the world connected by telephones and computers.

Participants

The foreign exchange market consists of the following

participants:

Banks and other financial institutions earn profits by

buying and selling currencies in huge volumes.

Brokers act as the ‗middlemen‘ between banks. They

usually charge a commission on each transaction.

Customers are organizations or individuals who require

foreign currency for their own businesses or personal

needs.

Central banks such as the Reserve Bank of India (RBI) manage the value of

their currencies to avoid disastrous effects of currency fluctuations on their

country‘s economy.

Reasons for Trading

Why do people trade in the foreign exchange

market—the largest and most volatile market in the

world? Let‘s understand with the help of simplified

examples.

Profit: The fluctuations in exchange rates


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make it profitable for traders who buy currencies in large volumes. For

example, say you bought a pound for $1.25 and sold it for $1.30. If $0.05

seems too less, imagine a transaction of thousands or millions of dollars. The

sheer volumes make forex a highly lucrative but also volatile business.

Protection: A small fluctuation in the exchange rate can make the difference

between profit and loss for a business. If you were an exporter who earned in

dollars and spent in rupees, the fluctuation in the exchange rates would affect

you. If the dollar became more expensive, you would make more money. But

if the dollar became cheaper, it would reduce your earnings.

Usage: Businesses and countries need foreign currency to buy goods and

services from other countries. For example, India imports huge quantities of

oil with the help of dollars. A stronger dollar will make oil more expensive,

which can have a negative effect on the economy.

Types of Transactions

Fluctuations in foreign exchange can be costly for

businesses, such as exporters and importers. That

explains the popularity of foreign exchange derivatives.

There are four types of foreign exchange transactions:

Spot – A spot transaction refers to a two-day

delivery transaction.

Forward or future – In a forward transaction, both parties agree to

exchange a fixed quantity of currency at a specified time in the future.

Forwards are traded in the over-the-counter market. A future is a type of

forward transaction that is traded on the exchange.

Swap – In a swap, both parties exchange currencies and agree to reverse the

transaction in the future.

Option – An option provides its owner with the right but no obligation to

exchange currencies at a predetermined rate in the future.


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Investment Management

Investment management is a term for an array

of services offered by investment banks to

large investors such as institutions or very

wealthy individuals to manage their wealth,

securities, or assets such as real estate. The

services include:

Providing investment and financial

advisory services

Ensuring compliance with regulations

Managing assets for large funds

An example of investment management would be a mutual fund that pools in money

from several small and large investors and invests it in shares, bonds, and other

securities.

Summary

You have completed Chapter 2: Investment Banking Products

and Services


List the important types of investment banking services

and products

Define important investment banking terms

Describe investment banking products and services and related terms

Lifecycle of a Trade

CHAPTER 3

Chapter 3: Lifecycle of a Trade

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Chapter Objectives

Welcome to Chapter 3: Lifecycle of a Trade.

At the end of the course, you will be able to:


Describe each stage in the lifecycle of a trade

Introduction

"The market can remain irrational longer than you can remain solvent." - John

Maynard Keynes

What would happen if there was no stock

exchange? You would probably have to

place an ad in the newspaper to buy or sell

a share or a commodity like coffee!

Even after stock exchanges were invented,

trading simply meant shouting out loud in a

crowded chaotic room along with several

other traders. Thankfully, technology has made trading as easy as clicking a mouse

or making a phone call. But what happens behind the scenes is still quite a

complicated process. It involves thousands of people and an astonishing use of

technology.

If you are a beginner in investment banking, this chapter will provide a basic

understanding of the trade lifecycle.


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Trade Definition

What is a trade really? It is the exchange

of a commodity for money or other

commodities. A simple example is buying

fruits. To buy apples, you would go to the

market and pay the vendor. In the

securities market, you would trade in the

stock exchange through a broker. Large

clients typically use the services of investment banks which act as brokers and

execute large orders on their behalf.

Formally speaking, a trade is a legal contract between a buyer and a seller. As per

this contract:

The seller must provide the commodity that has been sold to the buyer.

The buyer must pay the purchase price on the date agreed upon by both

parties.

Types of Trade

An investment bank trades in two ways:

Client trading

Principal trading

Client trading

Client trades are trades done for a client such as a

hedge fund. Investment banks earn a commission on each transaction. While

representing their clients, investment banks may need to trade and negotiate with

other entities known as counterparties.

Principal trading

Principal or proprietary trading refers to buying and selling of securities for the

investment bank‘s own portfolio. At times, traders have the leeway to buy or sell the

securities they want using the bank‘s capital. Using a variety of strategies and

cutting-edge technology, traders constantly make bets on the market.


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The profit from principal trading stems from buying securities at a low price and

selling at a higher price later. This difference is known as the bid-ask spread.

Trading Risks

In 1995, Barings Bank of London collapsed due to

unauthorized trading by a rogue trader who lost $1.4

billion in derivative contracts. There are several other

cases of rogue trading. The kind of money and stocks

that investment banks handle makes it critical to

prevent any possible errors, human or otherwise.

At every stage of the trade lifecycle, necessary checks

are kept in place. For example, traders are prevented from influencing the

confirmation and settlement processes. Advanced strategies using computer

modeling and well-defined rules are used to eliminate the emotional aspect of

trading.


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Trade Lifecycle Overview

An investment bank consists of a

front office, middle office, and

back office. The front office initiates

the trade by negotiating with all

parties. The middle office calculates

the risks and suggests amendments

to the trade. The back office provides

the operational and technological

support to the entire trade.

The trade lifecycle consists of the

following stages:

Trade Execution

Trade Capture

Confirmation

Settlement

Reconciliation

Accounting


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Trade Execution

When both the buyer and

seller agree to a transaction,

the trade is executed. You

might be surprised to know

that most trades are executed

by a simple verbal agreement

between the client and the

front office of the investment

bank. After a trade is executed,

investment banks typically

hedge the trade to reduce the

risk associated with the trade.

This involves the buying or

selling of derivative contracts to offset any potential loss.

The business day on which the trade is executed on a securities exchange or market

is known as the trade date or simply as T.


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Trade Capture

A trade is captured in the

trading desk using a deal

capture system. The deal

capture system is simply

technology used by the trading

desk to validate and enter deal

information. More details are

added in a process known as

trade enrichment. These

details are important for the

completion and settlement of

the trade.

The middle office checks the basic details of a trade and reports any errors or issues

to the front office. If the front office accepts the request for amendment, it makes

changes in the source system. This ensures that all systems used by the front office

and the back office are updated. An acknowledgement may be sent to the

counterparty with the required trade details for confirmation.


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Confirmation

Confirmation involves sending

an electronic notification to all

the parties with important trade

details and obtaining a written

agreement. The trade details are

then entered into the clearing

systems of both the parties.

Most of the times, there is no

problem. However, sometimes

the details provided by both the

firms don‘t match. In such cases,

the system may report a

discrepancy to both parties so that they can rectify it.


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Settlement

In the securities market, if you

buy a share today, you do not

get actual possession on the

same day. Blame it on the

complex regulations and

procedures that govern this

market. Settlement essentially

refers to ensuring that the seller

has received payment and the

buyer the security or the

commodity. The time required

for buyer to pay and for the

seller to deliver the purchased

goods is known as settlement cycle.

This cycle differs from instrument to instrument. For example, it is usually three days

after the trade is executed or T + 3 for equity instruments.


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Reconciliation

The main objective of

reconciliation is to spot any

discrepancies in the trade—

either manually or with the help

of automated tools. For example,

cash reconciliation involves

checking if the flow of cash

occurs as predicted by the

trader.

Reconciliation also involves

reporting any open trades or

transaction differences between

systems.


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Accounting

After a trade has been

successfully executed, the details

of the transaction are recorded.

Why is this important? Trade

accounting helps the investment

bank determine the profit or loss

on each transaction. Also, due to

government regulations, firms

have to report several aspects of

the trade. Traders require a daily

profit and loss report so that

they can trade from the most

accurate position.

The sheer complexity and volume of transactions make trade accounting a

challenging job. Moreover, investment banks have to adhere to strict accounting

standards.


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Summary of Trade Cycle

Here‘s a quick summary of the trade lifecycle:

After negotiating with the client, the front

office executes the trade.

Trade capture involves entering the

transaction details in a computer system.

Confirmation involves sending

electronically generated transaction details

to both parties of a deal. These details are

checked for any discrepancies.

Settlement involves the actual exchange of cash for the purchased securities.

Reconciliation involves checking the process to see if the transaction was

completed correctly.

Accounting involves recording all the transaction details as per accounting

standards and calculating the profit and loss on the deal.


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Chapter Summary

You have completed Chapter 3: Lifecycle of a Trade


list the important stages in the lifecycle of a trade

describe each stages in the lifecycle of a trade

Course Summary

You have completed Introduction to Investment Banking.



Describe investment banking products and services


Documents

Nomura Workshop