Capital Markets and the Investment Banking Process

Investment banks provide a wealth of critical services to our economy. One important role of the investment bank is to assist public and private corporations in raising funds in the capital markets. A second service is in providing strategic advisory services for mergers, acquisitions and other types of financial transactions. They also act as intermediaries in trading for clients. Investment banks differ from commercial banks, which take deposits and make commercial and retail loans. The focus of this paper will be to describe the investment banking process including the function of portfolio construction.

To better understand the investment banks role it is important to distinguish between what is known as the primary and secondary markets. Secondary markets are defined as “markets for existing assets that are currently traded between investors” (Hirt and Block, 2006). The secondary markets are important because they create prices and provide liquidity. Without secondary markets investors would have no avenue to sell their assets eliminating liquidity. “Primary markets are distinguished by the flow of funds between the market participants” (Hirt and Block, 2006). Instead of trading between investors as in the secondary markets, participants in the primary market buy their assets directly from the source of the asset.

Investment banks comprise the most active participants in the primary market. Investment Banks act as the intermediary between the public and the issuer of the security. Corporations that need to raise money will issue securities. Investment banks will become the underwriter. The bank will purchase all the shares at a fixed price that is discounted from the public price, eliminating the risk that the corporation would assume if unable to sell all their securities. At this point the investment bank has assumed the risk and is responsible for all shares of the security. The investment bank must now form a strategy concerning the distribution of the security. If the issue is large, the bank will share the risk and distribution duties by forming a group known as a syndicate. A syndicate is a group of investment banks. The investment bank makes money by selling the securities to the public at a par value per share above the price per share paid to the corporation. The investment bank does assume the risk that the price per share on the market could fall below the price paid by the bank before all the shares are sold in the market.

There are three broad types of financial assets, fixed income, equity, and derivatives. Fixed income assets will provide either a fixed stream of income or an amount of income that is determined by a specialized formula. Fixed income securities come in a wide variety of maturities and payment provisions. On one extreme are money market securities. Money market securities are short-term, highly marketable, low risk, fixed-income securities. Examples include U.S. Treasury Bills, and Certificates of Deposit. The other end of the fixed income scale is capital markets which include long-term securities such as Treasury Bonds and bonds issued by Federal, State, and local municipalities, and corporations.

Equity assets, better known as common stock, are the second type of financial assets. Shares of common stock represent an ownership in the company issuing the stock. Owners of common stock are not promised payment. Owners may receive dividends from the issuing company. The success of stock owners is directly tied to the success of the corporation; therefore, equity assets are riskier than fixed income assets.

The third class of financial assets is known as derivative securities. Derivative assets include options and futures. The success of these contracts is determined by the prices of other assets such as stocks or bonds. Options and futures comprise the riskiest of the financial assets but also offer the greatest