Capital Markets and Investment Banking Process
The investment environment is vast and can be overwhelming if not entered into correctly. Firm’s issuing new securities to enhance revenues understand the complexities and risks involved when entering the primary market, and will employ investment bankers to mitigate those risks. Described throughout this paper is the investment banking process and portfolio construction, factors for selecting the portfolio asset classes, the capital market instruments used in portfolio construction, and recommendations for the composition of an investment portfolio.
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Investment Banking Process and Portfolio Construction Investment bankers work with firms issuing new securities as both an advisor and intermediary in setting security prices, interest rates, and marketing the new securities for sale in the primary market (Bodie, Kane, & Marcus, 2008).
The primary market is where firms are able to sell their new securities and obtain funds that are needed to increase their capital base. Firms issuing new securities are strategically working to raise funds; however, there is a potential risk that all the newly issued securities will not sell and the strategy to raise funds could fail.To mitigate this potential risk firms hire an investment banker as an underwriter. As an underwriter the investment banker assumes the risks by purchasing the firms new securities at a fixed price lower than the offering price to the public, and then sells the securities at the current market price for a profit (Hirt & Block, 2008). “With underwriting, once the security is sold, the investment banker will usually make a market in the security, which means active buying and selling to ensure a continuously liquid market and wider distribution” (Hirt & Block, 2008, P. 27).After the investment banker has sold the new securities issued by a firm in the primary market, those securities then become an existing asset that is traded in the secondary market between investors (Hirt & Block, 2008).
In the secondary market investors buy and sell the different existing assets which allow the market to operate efficiently, competitively, continually, and liquidity. Investors investing in these existing assets create a portfolio to monitor their current investment assets, and make their investment decisions based on their portfolio size (Bodie, Kane, & Marcus, 2008).In the construction of a “top-down” portfolio the first step is asset allocation. “The process of building an investment portfolio usually begins by deciding how much money to allocate to broad classes of assets, such as safe money-market securities or bank accounts, longer-term bonds, stocks, or even asset classes such as real estate or precious metals” (Bodie, Kane, & Marcus, 2008, P. 24). Once the asset class allocation has been determined by the investor the next step in the process is to select which securities to purchase.Once a security in an asset class is decided on an investor may perform a valuation through a security analysis.
The security analysis will aid the investor’s decision by estimating the securities value and the positive or negative impact on the portfolio (Bodie, Kane, & Marcus, 2008). Factors among asset classes in an investment portfolio During the asset allocation process in an investment portfolio there are different factors that must be considered by the investor before an asset class is decided upon.The three factors important to investors when creating an investment portfolio and conducting the asset allocation process is: their investing goals, their investing time horizon, and their level of risk tolerance (Investor Guide, 2010). When considering the factor of investing goals during the asset allocation the investor is determining both long- and short-term goals in terms of income, or return, requirements. When considering this factor an investor is able to factor out any of the asset classes that will not work with their investing goals.The next factor investors should consider once the goals have been established is the expected investing time horizon. This is an important factor to consider when deciding asset classes because asset classes that perform better long-term, such as stocks, could create a portfolio loss if the investor had only required a short-term investment and sold the stocks too soon while they were down (Investor Guide, 2010).
If the investor had realized their short-term time horizon they could have purchased securities in the money market, such as a U.S. Treasury Bill, and avoided the portfolio loss. The last factor to consider in creating an investment portfolio, and during the asset allocation process, is the level of the investors risk tolerance. The risk tolerance factor is very important to consider because depending on the level of risk the investor is willing to take on will determine the asset class with the best suited securities, and the level of diversification needed to maintain that desired level of risk.Creating an investment portfolio can be overwhelming for investors when deciding on the asset classes that work best for their portfolio. However, during the asset allocation process investors should consider three factors in their investment needs to aid in the elimination of the asset classes that least fit those needs.
An investor that factors in their goals, investment time horizon, and level of risk tolerance will narrow down the asset classes that will likely meet their investment needs. Capital market instruments in portfolio constructionThere are several capital market instruments that are used in the construction of an investment portfolio but the two main capital market instruments are stocks or equity securities, and bonds or debt instruments. “While all capital market instruments are designed to provide a return on investment, the risk factors are different for each and the selection of the instrument depends on the choice of the investor” (Maps of World Finance, 2009, para. 6). Investors that use stocks in their portfolio construction are investing in equity securities that represent an ownership share in a publically traded company.Investors that purchase a company’s common stock are seeking to profit through capital gains, which is a profit gained if the stock price at the time of purchase is less than the stock price at the time of sale (Bodie, Kane, & Marcus, 2008). Using stocks as a capital market instrument in an investment portfolio is beneficial to investors that desire a long-term investment with moderate risk.
Investors still take on the risk that the stock price will fall below the purchase price at the time of sale, or that the company will go bankrupt and the stocks will be worthless.The other major capital market instrument used in portfolio construction is debt instruments, or bonds. The debt instruments in the capital market are, “Treasury notes and bonds, corporate bonds, municipal bonds, mortgage securities, and federal agency debt” (Bodie, Kane, & Marcus, 2008, P. 30). Investors that use bonds in their investment portfolio are investing in long-term debt instruments in an expectation to receive some form of income during the term of the security investment, and the total bond value when the security matures (Bodie, Kane, & Marcus, 2008).Recommendation for composition of an investment portfolio Creating an investment portfolio before investing in any securities is an important part in earning the returns expected by an investor. When creating an investment portfolio investors should always consider their ultimate goal for the portfolio, the time horizon in which to achieve that goal, and the level of risk tolerance they are willing to take.
Once these factors have been realized the investor then allocates the asset classes’ best suited for them.Once the asset classes are allocated, the investor then decides on the securities to invest in and conducts an analysis of the proposed securities value and the potential impact to the portfolio. These first recommended steps in the composition of an investment portfolio are an important aspect to building a profitable and long lasting portfolio. Through the planning and analysis of the portfolio requirements, investors will perform their due diligence, and create an investment portfolio that meets their investment needs and can be easily rebalanced as those needs and market conditions change.ReferencesBodie, Z. , Kane, A. , & Marcus, A.
J. (2008). Essentials of Investments (7th ed. ). New York, NY: McGraw-Hill/Irwin. Hirt, G. A.
, & Block, S. B. (2008). Fundamentals of investment management (9th ed. ). New York, NY: McGraw-Hill/Irwin.Investor Guide.
(2010). Understanding asset allocation while building a portfolio. Retrieved from http://www. investorguide. com/igu-article-541-asset-allocation-understanding-asset-allocation-while-building-a-portfolio. htmlMaps of World Finance. (2009).
Capital market instruments. Retrieved from http://finance. mapsofworld. com/capital-market/instruments. html