What is Underwriting?
In case of the underwriting function, the underwriters take the financial risk of their client in return of the financial fees and in case of the function of market makers, financial institution and large banks ensures that there is enough amount of liquidity in the market by ensuring that enough trading volume is there.
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
- Part 3 – AMC
- Part 4 – Sales and Trading
- Part 5 – Private Placements
- Part 6 – Underwriters and Market Makers
- Part 7 – Mergers and Acquisitions
- Part 8 – Restructuring and Reorganization
- Part 9 – Investment Banking Responsibilities
If you want to learn M&A professionally, then you may want to look at 25+ video hours of Mergers and Acquisitions Course
In this tutorial, we discuss the following –
- Market Making
Investment Banking – Underwriters and Market Makers Video
Let us now look at overall framework we have learned what is the research we have looked at sale sales and trading we have also looked at raising capital now we will move to underwriters and market makers 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 bankFunction Of An Investment BankInvestment banks perform various functions for their clients, including initial public offerings (IPOs), mergers and acquisitions, risk management, equity research, structuring of derivatives, merchant banking, and investment management. when we talk about IPOs that are called 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 to 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 Initial Public Offerings Initial Public OfferingsInitial Public Offering (IPO) is when the shares of the private companies are listed for the first time in the stock exchange for public trading and investment. This allows a private company to raise the capital for different purposes. 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 raise so not 100 million maybe 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 means 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 riskFinancial RiskFinancial risk refers to the risk of losing funds and assets with the possibility of not being able to pay off the debt taken from creditors, banks and financial institutions. A firm may face this due to incompetent business decisions and practices, eventually leading to bankruptcy., 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 the 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 the 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 functions investment banks are also you know enabling market-making activities in the stock exchangeStock ExchangeStock exchange refers to a market that facilitates the buying and selling of listed securities such as public company stocks, exchange-traded funds, debt instruments, options, etc., as per the standard regulations and guidelines—for instance, NYSE and NASDAQ. so what is market-making and why investment banks actually play a very important role here let’s look at that through this underwriters and market makers 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 but 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 sell 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 altogether. So what the role of a 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 a 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 a 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 sell 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 the ability to transaction of the security by providing liquidity in the Market. So here is come in between and they know kind of try to create the market and on the other side if let’s say he owns 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 sell this at $80. So instead of 100 you now try to sell 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 too high as Market Maker you had coming between and now you have lowered bid as a spread and ensure that there is some liquidity in the market so I mean this example was bit exaggerated but the bid as spread actually run into the only a 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 jargon underwriters and market makers.