What do investment banks do?

Investment banks operate in a multi-billion dollar industry and hold a very interesting characteristic – not many people know the details of what they actually do. Even more interesting is the fact that a surprisingly large number of people who work in the industry find this hard to articulate as well.

There are three fundamental activities in investment banking, as follows:

1. Speculation
2. Hedging
3. Arbitrage

Speculation is the most familiar activity, which involves trading for financial gain, either with the banks money ('proprietary trading'), or with a customer's money. This involves increasing 'financial risk' (or the exposure to financial loss) by buying and selling on the financial markets.

Hedging is the process of reducing your financial risk by 'trading' that risk with a third party (or 'counterparty') via the use of derivatives (see below). This involves committing to a financial product that will move in the opposite direction to your current financial exposure. So, for example, if you are a Japanese company selling goods in America, you may wish to trade in Yen/Dollar derivatives that will increase in value if the value of your dollar sales is reduced by an adverse exchange rate movement.

Arbitrage is the process of exploiting inefficiencies in a market. So, for example, if you converted sterling to dollars to krona then back to sterling in an inefficient market, you may end up with more or less than you started with if exchange rates are not aligned. This is, of course, not a common opportunity in well developed and efficient Western markets, but there are those who make money at this in less developed markets by executing, for example, such "triangulation" transactions in an instant, and making themselves equally instant, risk-free money. Please note, however, you need to be very clever to be able to do this.

Investment banking activities are based around the following two categories of 'product':

1. Securities
2. Derivatives

Securities are familiar to most people and are financial products that hold a finite value, such as Shares and Bonds. These products are popular in the wider world because their value will hopefully increase, and cannot decrease below zero, so the most you can lose is your original purchase payment.

Derivatives are more risky, however, and involve a potential commitment to pay a future amount that depends on the level of the market at a future date. Derivatives come in three flavours: Futures, Swaps and Options. Unlike Securities, they do not require an up-front purchase payment. So, for example, if you agree to pay a certain price for a bond in the future (via a 'bond future'), the market could swing massively in the other direction, thus exposing you to a significant financial loss.

Confused? sure, but remember that you are not alone, and that includes a number of people who work in the industry.

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