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Capital Markets and Investment Banking

Updated on August 7, 2014

What is the purpose of the capital markets?

The capital markets were created to give corporations various options of raising funds. The funds could be used for expansion, new product development, modifying existing products, or profitable investments companies pursue to create shareholder wealth. The capital markets consist of a primary market and a secondary market. Investment banks are an integral part of the primary capital markets. The portfolio construction of investment banks in crucial to their available opportunities. The primary market is the only market that the corporations receive funding. The secondary markets consist of investors who trade the shares of the corporations and drive the stock prices but the proceeds do not transfer to the companies.

Why are investment banks important to the capital markets?

The primary markets consist of the corporations seeking funding and the investment banks willing to fund the corporation’s investments. A company will need to secure funding and will approach many investment banks with the amount of funding they want to raise. The investment banks will decide the best way to raise the capital for the company. The funds can be raised through a sale of equity or fixed rate securities. The investment bank will form a syndicate of investment banks to help underwrite the transaction. This diversifies the risk of any poor investments by spreading the risks out over numerous investment banks instead of just one. The company will sell a specified amount of shares of the security chosen to the investment bank syndicate in exchange for the funds they need for their investment.

How do the investment banks generate profits from the capital markets?

 

The investment banks charges a fee, receives shares of stock, but is responsible for selling the shares to the public. The risk for the investment banks is the value of the shares of stock will drop lower than the price they bought them for. The company can hold the shares of the public offering for up to two years but a company’s stock price will determine the investment banks returns from their investment. A company that has the stock price increase after the public offering will provide good returns for the investment bank syndicate but a lower stock price will increase the risk the investment was a failure. This means the investment bank syndicate burdens the risk of a public offering. The syndicate often advertises the sale of the securities to build awareness to the public and raise the interest of the offering.

Who determines the price of Initial Public Offerings (IPO’s)?

 

Investment banks are also responsible for a company’s initial public offerings (IPO). A private or new company that wants to raise funding in the capital markets will use investment bank syndicates to enter the capital markets. The syndicate will take the IPO on road shows that build awareness of the offering to the larger investors. The road shows will help the syndicate determine the price of the offering. The large institutional investors will determine their interest in the IPO that translates to the syndicate the demand for the offering and helps them determine the price they should charge the company for each share to raise the funding.

How should an investment bank construct their portfolio to ensure funding is available for future opportunities?

            Portfolio construction of the investment banks should be liquid. The banks must have funds available to lend to companies in primary markets. Investment banks that have their funds tied up in long-term debt will miss out on many profitable offerings and will not be able to raise the funding for companies. The portfolio should also be well diversified to make sure that industry factors cannot deplete the value of their portfolio. The investment banks will want to hold a variety of investments from various industries to be well diversified to remain profitable throughout the many volatile conditions of the capital markets. An investment bank will make sure they are available to any company that provides an opportunity to generate returns.

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