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Investment Bank

We all know the stereotype of the investment banker, but what actually happens behind the doors of these fabled institutions? Investment banks help companies raise money through issuing securities. In 2012, Facebook (FB) employed Morgan Stanley (MS) to handle its initial public offering (IPO). In this capacity, Morgan Stanley researched the company to determine a fair price for the shares and handled other logistical matters that would transform Facebook from a private company to a public company trading on the NASDAQ.

Investment banks are also often employed to assist with mergers and acquisitions. Competition between investment banks to be a lead underwriter on an IPO or merger is fierce so you can imagine why the 100 hour work weeks are often necessary. And let’s be honest, after logging major hours, wouldn’t you also feel entitled to a nice annual bonus?

Initial Public Offering (IPO)

 You are probably familiar with what an IPO is—when a company sells its shares on a stock exchange for the first time—but what you may not know is why a company would do this. One way to think about it is this: it costs money to make money. As a private company has success, it will eventually need more funding to expand by buying new equipment, developing new products, and hiring more employees. After a certain point, it becomes difficult to secure private investors, so a company will decide to trade some ownership of the company to shareholders in exchange for cash.

By “going public,” a company can tap into a wider funding base, enjoy some added prestige and exposure by being public, and have access to capital for expansions. These benefits are not without costs. Going public is an expensive endeavor. Owners give up control of the company they built and are accountable to shareholders in how they run the business and share information. With the problems of the Facebook (FB) IPO fresh in our mind, you can understand why despite rumors, Twitter may be hesitant to go public. pay attention to Twitter’s road to going public to get a greater sense of the mechanics of an IPO.

Venture Capital

Before a company can go public, it has to be formed. While several companies are able to start and succeed with a few dollars and charisma, most need a little outside help. Unfortunately, because new companies by definition lack operating history, banks are not often willing to lend to them and if they do, the terms may not be favorable. Enter venture capital, or funds provided by individuals or firms to help companies get up and running. For their investment, venture capitalists not only get a share of the returns, they are also able to direct the company’s path. This can be an asset when the firm’s founders are big on ideas but short on strategy.

Commodity (market)

In economic terms, commodities are goods that lack differentiation across a market. For example, aside from the finest tuned palate, coffee is generally indistinguishable whether it is grown in Kenya or Brazil. Other examples of soft commodities include: cocoa, sugar, soy, and wheat, whereas hard commodities are: iron, silver, gold, and oil. Commodity trades are derivative trades. In the simplest sense, think of the farmer who wants to lock in the sale price of his wheat and the mill that wants to lock in the purchase price of wheat. The two parties agree on a price and delivery date. The commodities market becomes more difficult when you add investors and speculators to the mix. These parties may buy and sell these goods to take advantage of price swings despite having no interest in actually possessing them. At face value, one may think that speculation unfairly influences prices—and there are times when that has been true—but it can also be said that by bringing more people to the market, true prices are maintained.

Hedge Fund

 Like mutual funds and ETFs, hedge funds are collective investment vehicles in which groups of people pool their resources together to invest in a variety of financial instruments. However, unlike mutual funds and ETFs, hedge funds are limited to accredited investors, or investors who have sufficient assets to weather the risks of a more aggressive investing strategy. Hedge funds are set up as partnerships which implies that investors have a much greater obligation to the fund. Invested money cannot easily be withdrawn from a fund as there are often lock up periods and/or significant penalties for early withdrawal. Because of this structure and the stipulation that investors be accredited, hedge funds are not heavily regulated by the financial industry. This allows hedge funds to adopt investing strategies, such as the use of leverage (think the use of derivatives) to try to achieve higher than average returns.

What other financial terms do you struggle with? 

Ask Donna Orender to tell you what she knows about finance!