5.9. Research and innovation

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From the course by Moscow Institute of Physics and Technology

Capital Markets and Financial Institutions – How to Survive Them

1 оценка

Moscow Institute of Physics and Technology

Capital Markets and Financial Institutions – How to Survive Them

1 оценка

Course 1 of 5 in the Specialization Understanding Modern Finance

Capital markets and financial institutions are all around us. This is an enormous industry in which powerful players oftentimes challenge investors and the public at large and expose them to significant risks. This Course provides for the deep understanding of the core ideas, concepts, and mechanisms of the modern capital market in a learner-friendly way. We will analyze the market’s most fundamental problems, realize the intrinsic interests of the market participants, reveal the true meaning of certain financial terms, and uncover credible signals of the likely behavior of economic agents – all that with little math and a lot of fun. The learners will be much better positioned with respect to the financial environment. They will see through the financial news, reveal the risks of the financiers’ wishful thinking promises, and protect themselves against dangerous adventures. The learners will get the opportunity to use the obtained knowledge, skills, and understanding for the successful professional career in the financial and other business areas, as well as in their day-to-day life.

From the lesson

Public Investments and Investment Banking

Week 5 of the Course is devoted to public investments and investment banking. We consider the major activities of investment banks – underwriting, trading, consulting, and financial innovation. We study the details of underwriting and the core reasons for underpricing as an important phenomenon that determines the observed behavior of market participants in the process of financing. We also discuss the mechanism of market bubbles and crises as well as the role of investment banks and other financial institutions in the crisis development. That sets the background for the idea of regulation of investment banks.

5.1. Public investments – an introduction3:57

5.2. Public capital markets. The demand for investment banking services11:38

5.3. What do investment bankers do?13:42

5.4. Winner’s curse – a model of private information in underwriting. Underpricing14:17

5.5. Underwriting – private information, underpricing, and the empirical evidence7:44

5.6. Underwriting (1) – the mechanism11:19

5.7. Underwriting (2) – the services of an investment bank in the era of global equity markets10:56

5.8. Trading and market support11:48

5.9. Research and innovation8:07

5.10. Bubbles and crises – an overview10:45

5.11. Regulation of investment banking10:40

Meet the Instructors

Konstantin Kontor
Director and Professor of Finance and Strategy
American Institute of Business and Economics (AIBEc)

Now, I'd like to say a few words about research and innovation.

I thought that they deserve a special episode.

Well, this is a very important part of the investment banking activity,

but I would start with research in its routine form.

That investment banks they have really advanced personnel,

including mathematicians and physicists, and

the people who are really advanced in the rocket science.

So, these people basically do two things, the first thing, although,

seems to be routine and not very much advanced, it still plays an important role

in support of both underwriting and trading.

And this is research in a generic meaning of this word.

Namely, they employ specialist who study and

monitor the issuers, the markets, the industries, and the clients.

So these people basically, they study let's say, the airline industry.

And they say, well, these airlines are better positions and

these are worse positioned, and these are the trends,

these are gaining market share, these are losing market share.

So as a result they produce some notes,

reports, sometimes they answer phone calls for their clients.

So basically, they provide the up to date information about these companies.

Now, this in itself may be kind of within and

maybe you can always say well, everyone can get that on Internet.

But you can get the real information in some financial statements for

public companies.

But you're unlikely to be able to digest that quickly, and to provide some

ideas of future development, some recommendations, and some assessments.

And by the same token, when providing support for underwriting in this

process of due diligence there are special people who do that.

But they sometimes use pieces of information that is produced by

these generic research people who just they say,

well, what are the standards for the industry?

And they take that from that from them.

Now like I said, this is no rocket science but this is also kind of important.

The next thing, that is important here is innovation.

And by innovation, we mean the invention of new financial instruments,

schemes, and financial technologies, financial engineering, whatever.

So, why is that the key activity of an investment bank?

Well first of all, in order to do so we have to have a really very advanced and

experienced people who know how to use not only algebra, but very high math.

And who are extremely advanced in modern technology of

stochastic calculations and some others.

And as a result, the company who does that

should be able to afford to hire these people and

sometimes powerful team, so you have to have you know quite a few.

And then the more important thing is that they these banks,

they have a huge incentive to do so.

Because if for example, we take someone's idea, or

the idea of a client's, or the idea of an issue, and then we

pack that up as a new product that can be marketed to the investment community.

Then we may have, maybe a short living, but still a monopoly advantage.

The average a life of this quotes

monopoly over the last couple of decades has been no more than two weeks.

So basically, other competing investment banks they

create similar products because you cannot have a patent for that.

Because basically a new financial product is just

a scheme of repackaging cash flows and risk analysis.

Well, that sounds very generic.

But that still opens up a huge area of creative activity.

Now, on top of that there is also the idea of technology that I mentioned

the previous episodes.

And sometimes with the existence of new technology, we have a better way to market

that, and even sometimes you have other options to invent something.

Now, this kind of activity seems great.

It seems to be really a front edge of the financial business.

And clearly this is the area in which you seem to be really

jumping ahead so this is pretty cool.

However, the key story here is that if you have these proprietary

systems of valuation, often times you may first of all make a mistake.

Because sometimes these systems are quite difficult, and quite complex obviously.

But on the other way,

sometimes there's some bank is not interested in telling the whole truth.

This is not what you're lying but this is your competitive advantage.

And so you can claim that we assess the risk this way and

our valuation brings us these numbers.

And they can declare or go to the market some

other numbers that will allow them to reap some monopoly profit.

Now, this in itself is not so bad,

or it's not illegal because that's an invented thing.

But what is important is sometimes that results in the fact that

other people in this process, they have inferior information about that.

They are sort of uninformed investors.

And that creates a conflict of interest because here what happens

is that if I market very risky new financial instruments,

then I can easily get an advantage over the public.

And then these people will roughly speaking, overpay or

they will be in disadvantageous position.

Because they do not have this ability to really value that properly,

even if there's a procedure.

Now, what I just said seems to be kind of strange and

highly unlikely, but that's what's going on.

And that results oftentimes in some fundamental crises,

because we will talk about crises in the next episode and quite some details.

But here, I am specifying the idea that the new crises,

the crises of the new era of this century, they are closely linked to

the fact that oftentimes the instruments that feed these crises are so advanced.

That sometimes it's not enough for the people just to know that they exists,

but it does require some kind of specific procedures of information disclosure and

even of explaining to the people why the risk are so and so.

We can see some conflict here, because the inventor would not

like to disclose everything to be able to take advantage of that.

And on the other hand,

if there is the process in which a lot more people get involved, and

they all know this standard perfectly, that may result in significant damage.

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