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Can You Answer These 5: Investment Banking Questions V5

Investment bankers are the masters of the universe

Investment Banking Inteview Questions
Sales and Trading Interview Questions
Brain Teasers

Past Editions

Can You Answer These 5 Investment Banking Questions 1
Can You Answer These 5 Investment Banking Questions 2
Can You Answer These 5 Investment Banking Questions 3
Can You Answer These 5 Investment Banking Questions 4

Best of luck to all of our friends and readers who are writing the CFA this Saturday! You better pass, or eternal shame.

Also starting next week we will have friends who work at major hedge funds write some market insights starting next week as we are sure you are all bored of the oil posts (we know no one reads them).

This Week’s Questions

  1. Should a Canadian oil & gas exploration and production company hedge US$ debt? (Investment Banking)
  2. How does a company hedge interest rate risk for future bond issues? (Debt Capital Markets/Sales & Trading)
  3. Would a company rather have revenue or cost synergies? (Mergers & Acquisitions)
  4. What is an incurrence covenant and what types of debt are they associated with? (Corporate Banking/Leveraged Finance)
  5. What is debtor-in-possession (DIP) financing? (Restructuring)

Last Week’s Questions

Napoleon needs to get to his horse, but there is a train between him and his horse. How does he get to his horse? (Brain Teaser)

He just walks to his horse. Trains were not invented until he was in exile.

This has been a popular question in Asia and Europe. We are aware that it is a stupid question, but the point of the question is to see whether the candidate is rattled and can remain composed and laugh it off. Good articulation of a wrong thinking process is also helpful.

What is an interest rate collar? (Sales & Trading)

An interest rate collar is the simultaneous sale of an interest rate floor and purchase of an interest rate ceiling or cap. Collars are used by fixed income investors to lock in a range of interest rates, which allows for them to be protected from rising rates while giving up the potential benefits of lower interest rates (remember for bonds, lower interest rates means a higher present value of cash flows and vice versa).

The interest rate cap and interest rate floor must both have the same notional principal (the dollar amount to which the contracted terms are relevant to), and the ceiling/cap must be above the floor strike.

The interviewer can subsequently ask about reverse collars or zero cost collars.

What is a mortgage backed security? (Debt Capital Markets/Sales & Trading)

A mortgage backed security (MBS) is an asset backed security (ABS) secured by mortgages.

To understand why this is a relevant product, an investor looks at the value of a standalone mortgage versus a pooled mortgage trust. If an investor has one individual mortgage, the standalone default or prepayment risk is high. If there are thousands of mortgages, the defaults will blend into an effective interest rate on the MBS.

Mortgages themselves are an illiquid security. Packaging mortgages through securitization provides a liquid product with a higher yield (although less than the yield of an individual mortgage). Usually, MBS are overcollateralized (secured by a greater notional amount of mortgage loans than the principal on the security) to enhance the security. Investment banks will take a cut/fee in structuring the MBS.

What is a greenshoe or overallotment? (Investment Banking/Equity Capital Markets)

The greenshoe or overallotment is the option afforded to underwriters of an equity offering (the investment bank) to sell more than the number of shares initially set aside for the issue. Usually, the overallotment can be up to 15% of the original issue size. This usually happens when demand for the company’s equity is robust (institutional or retail demand covers the issue size by a large multiple) and the investment banks are confident a good price per share can be obtained.

The overallotment is not only for IPOs, but can be for secondary issues as well.

How do you get to your price target? (Equity Research)

At the end of all reputable equity research reports, the equity research analyst will disclose their valuation methodology.

The price target will depend on valuation convention for the industry that the company is part of – but usually this will be Price/Earnings or EV/EBITDA. Equity research analysts will use multiples (P/E or EV/EBITDA) because they are market based, but usually will have a DCF as a secondary opinion from an intrinsic standpoint. Some analysts will switch it up and use a DCF as the primary methodology, but end up with implied P/E or EV/EBITDA multiples to back it up (as such, price targets usually line up with other analysts – assumptions are also based on company guidance).

For oil and gas or metals & mining, this may be something more esoteric such as EV/DACF or P/NAV.

The price target is usually a target to be reached within 12-18 months, so it is not really what the price should be today. The multiples are based on next twelve months (NTM) earnings or EBITDA, so they may not actually tell much of a story today. Tricky, tricky.

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ex investment banking associate

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