Underwriters and Market Makers – This is the 6th tutorial in 9 series tutorials on Investment Banking.
- Part 1 – Investment Banking vs Commercial Banking
- Part 2 – Equity Research in an Investment Bank
- Part 3 – What is Asset Management Company
- Part 4 – Sales and Trading
- Part 5 – Private Placements, IPOs and FPOs
- Part 6 – Underwriters and Market Makers
- Part 7 – Mergers and Acquisitions
- Part 8 – Restructuring and Reorganization
- Part 9 – Investment Banking Roles and Responsibilities
In this tutorial, we discuss the following –
- Market Making
Investment Banking – Underwriting and Market Making Video
Let us now look at over all frame work we have learn what is research we have looked at sale sales and trading we have also looked at rising capital now we will move to underwriting and market making these are basically to industry jargons which are very important for us understand so when we talk about IPO’s what happens is let say if the company is wanting to raise 100 Million Dollars and if they are unable to do so then what happened there is risk associated with it were we probably assumed that the IPO may go unsuccessful mitigate the risk investment banks actually underwrite an IPO which means that if there is under subscription them investment bank will actually buy those shares.
Now let us discuss another important function of an investment bank when we talk about IPOs that is called as Underwriting. So we are hearing a lot about investment banks to underwriting for various IPOs what exactly it means? So let’s take an example here in order see what Underwriting means let’s see that you know there is a small company that is a private company and they want to kind of raise new securities so we have discussed this earlier. So they may raise using an IPO or the Initial Public Offerings but the problem is that you know there may be risk associated with under-subscription?
What this under-subscription would mean is let’s say this company wanted to raise 100 Million Dollars from the market. The risk of under-subscription means that whatever they wanted to raise they may not able to raised so not 100 million may be they are able to raise 50 Million that’s under-subscription you know there are investment bankers who basically underwrite the securities and the helps the firms raise the committed amount so what this mean is that if an investment banker is underwriting the securities he virtually guaranteeing that the amount that is committed to be raised will be raised and how does the investment bank actually ensures this? So essentially when IPO actually comes so the stocks are given to the investor and let say if there is under-subscription of any kind let’s say to an extent of 10 Million Dollars. So these 10 Million Dollars worth of stocks will be absorbed by investment bank so we are essentially saying that the investment bank will actually buy this share and sale that appropriate time in order to make a profit. So underwriting means that essentially you guaranteeing that any amount of under-subscription will be absorbed by the investment bank and obviously as you can see that the investment bank is assuming financial risk, the financial risk could be that let’s say IOP was not success full so the investment bank may have to buy the stock to an extent it was undersubscribed and let’s say the stocks stang after some time so that’s a huge risk for investment bank. So that’s why when we talk about underwriting investment banks actually charge hefty fees during the underwriting scenarios and in this process they have to actually talk in detail with risk department as well compliance department about amount of risk or quantum of risk that the investment banks can take with respect to underwriting. So with this we have understood underwriting as one of the most important function investment banks are also you know enabling market making activities in the stock exchange so what is market making and why investment banks actually play very important role here let’s look at that through this video.
No. 2 is very interesting this is related to the Market Maker. Now what do you really understand by being a market Maker? So there can be companies like you know the investment banks firms which also are Market Maker. Market Maker is someone who actually ensures liquidity in the market. Just to give you a basic example let’s say there is stock called ABC this IB is a market Maker for this stock ABC. When a Market Maker meaning that you know when there are trades that happened in the market the role of a Market Maker is essentially to provide liquidity to the stocks and this could be done by either buying the shares or selling the shares in order to literally explain this to you in a very basic way let’s take an example ABC for which IBs are Market maker and let’s say there is buy there is an investor who wants to buy 1000 shares of ABC but his price is $50. Let’s say then there is a seller in the market who wants to sale this share of ABC but he wants to sell it at 100 and he also wants to do that for 1000 shares. So now if you look at the distance between 50 and 100 is too huge. So you know the transaction may never get completed at all so I mean what happens is that there may be few buyers and few sellers in this company all together. So what the role of market maker is all about is pitch in between and offer some lucrative price to the buyer or the seller store those shares probably trade them later for profit. Now how do will they do that? So let’s assume that in one of the cases let’s say this IB who is a Market Maker actually offers to buy this share at $75. So here there was a seller at 100 but here there was buyer at 50 but IB who is a market maker has kind of given quota. So there may be some sellers who may want to actually sale the stock so in that case you know they mat match and this investment banking who is Market Maker will actually own this share so what this Market Maker as actually done is in able to transaction of the security by providing liquidity in the Market. So he is come in between and they you know kind of try to create the market and on the other side if let’s say he own the stock you know he can also look at selling the stock. So let’s say he I mean the investment bank who owns this 1000 shares now want to sale this at $80. So instead of 100 you now try to selling at $80 so you may find some buyers as well so what you are doing incrementally is that since here the bid and the asks spread was to high as Market Maker you had coming between and now you have lowered bid as spread and ensure that there are some liquidity in the market so I mean this example was bit exaggerated but the bid as spread actually run into only couple of sense in that way this market makers have really proved very efficient and have been helping in the smooth running of the Financial Markets. So now that we have understood pretty much these 2 jargons underwriting and market making.