Chapter 11
Discussion Questions 1 – 12
The corporations appoint investment bankers in order to sell and to distribute securities. The investment bankers have a sales network along with constant connection with the financial marketplace. In the case of corporations, they issue securities on an irregular basis while the investment bankers tend to do it regularly. The investment banker will provide their expertise on such securities by designing the right security, gaining a wide distribution, and obtaining a fair price for the securities.
Identify the primary market functions of investment bankers.
The investment bankers tend to establish new firms or find growing firms which can gain from the securities offerings. The investment bankers promote his or her firm in order to raise capital through enhanced reputation. Such bankers underwrite or take the risk for a new offering by purchasing the securities from an issuer and reselling it again to the investor. In the case of high-risk issuers, the bankers tend to provide high efforts for selling the securities with reducing risk due to no capital but on a commission basis. The bankers also suggest firms offer shelf-registered securities or private placement securities to reduce cost attached with a public offering.
Discuss how investment bankers assume risk in the process of marketing securities of corporations. How do investment bankers try to minimize these risks?
For a firm, an outright purchase or firms underwriting commitment will create the highest risk. There is no market risk in case of best effort agreement. However, there are opportunity costs for unsuccessful sales efforts. The overall risk can be reduced in three different ways listed as follows.
The large securities or issues are distributed through groups or collectives, which helps to spread the risk with more than one banking house
Market stabilization
The immediate sale of securities after the approval made by SEC.
Briefly, describe the process of competitive bidding and discuss its relative advantages and disadvantages.
After the initial notification regarding a firm who wants to issue a given type of security, investment banking firms tend to enter the bid to get the rights to underwrite the offering. In such case, the bank with the highest price gets the business. The benefit of competitive bidding is that the issuing firm will benefit from the competition by receiving the highest price from the sale. The bankers also believe that the advice provided by a banker for the negotiated offering will help the issuer in taking a decision. The due diligence that the bankers perform in negotiated offering will enable the information sharing in the market regarding the sale of securities. For competitive bidding, there is no process of providing advice or performing due diligence.
Explain market stabilization.
After the offering, the syndicate members will be willing to repurchase the shares which were initially offered to them at the offer price. It will help to support the price for the new offering of stock in the market. It will reduce the market anxiousness regarding the new security. It refers to making the price stable in the market after a new issue is made.
Identify the costs associated with going public.
There are basically three costs incurred while going public. Firstly, there are direct costs such as the accounting fees, legal fees, SEC registration fees, etc. Secondly, the cost for the spread which refers to the difference between the offer price and the actual price the issuer receives from the sale. Thirdly, the underwriting cost which suggests a difference of offer price and the market price of the security after its issuance in the market.
Briefly, describe how investment banking is regulated.
The Federal regulations of investment banking are directed by the provisions of the Securities Act of 1993. The basic intent of the act is to ensure a transparent and accurate disclosure regarding the characters of newly issued securities as well as to minimize or avoid fraudulent activities in relation to the sale of such securities. In order to issue securities, the issuing firm files a registration statement along with prospectus of potential investors of the firm to the Securities and Exchange Commission. The Securities and Exchange Commission (SEC) was established under the Securities Exchange Act of 1934 and bestowed authority for the security markets. The agents in securities market such as brokers and dealers must register with the SEC to work in the organized market. There are several states which have blue sky laws along with the Federal regulation of investment banking to safeguard the investors from fraud offerings. The Glass-Steagall Act of 1933 restricted the ability of commercial banks to perform underwriting for newly issued securities. However, there has been a constant discussion with the commercial banking circles to overthrow the barrier.
Describe the inroads into investment banking being made by commercial banks.
During the late 1980s, the commercial banks were allowed to underwrite the federal government obligations and general obligation bonds for the state and local governments. However, since 1987, commercial banks started to underwrite new issues of commercial paper and securities which were backed up by mortgages. During 1989, the banks were given authority to underwrite the corporate bonds. However, the underwritings were performed by the subsidiaries of the banks which must not exceed the 10% of their total business. Such subsidiaries were responsible to their parent banks. The Gramm-Leach-Bliley Act withdrew several restrictions on commercial banks, investment banks and other financial services which initially separated these bodies.
In 2003, several investment banking firms were fined $1.4 billion for ethics abuses related to the underwriting process. Will this be a deterrent for ethical lapses?
The fines were accounted for about $1.4 billion but the actual total underwriting volume recorded in 2003 was about $5.3 trillion ($5,326 billion) and total fees in 2003 was about $14.5 billion. These data were found in publications such as The Wall Street Journal. The fines were only 10% of the total gross fees undertaken for the underwriting, which was a large portion of their revenue. The sanctions can affect the deal flow in case of further abuses to their right. Shareholder lawsuits against such firms which make sales of share for such underwriting business will add to the multiple fines of SEC. Such fines must be a deterrent, but it will depend on the time.
What are some of the characteristics of an organized securities exchange?
An organized securities exchange is a place where the trading takes place under the rules of security exchange. The NYSE and AMEX are a national level security exchange which enlists firms across the country. There are regional exchanges which incorporates firms of specific regions and smaller firms even which are listed in NYSE. Such special types of securities are dual listed. The organized securities these days are adopting new electronic communication in order to publicize transactions and to aid in trading securities.
Describe the types of members of the New York Stock Exchange.
There are several types of members on the New York Stock Exchange. They are Designated Market Makers, Trading Floor Brokers, Supplemental Liquidity Providers and Retail Liquidity Providers. The Designated Market Makers are the only market participants who assume a fair accountability in order to maintain a fair and ordered market. Trading Floor Brokers are the brokers on the trading floor who match flexibility, judgment, automation, etc. with the technology and order management tools. The Supplemental Liquidity Providers are members who trade in high volume which enhances the liquidity of NYSE. It also rewards the members who add to the competition to existing quote providers. Retail Liquidity providers would provide benefits for Retail Orders in the form of non-displayed interest. For meeting an obligation, Retail Liquidity Providers would receive economic advantages. The Designated Market Members and Supplemental Liquidity Providers can participate as Retail Liquidity Provider.
Why is there a difference between bid and ask prices at some point in time for a specific security?
Bid price represents the maximum amount or price a buyer or buyers are willing to pay for security. The ask price refers to the minimum price that seller plans to receive for the issued security. The transaction occurs at the point when buyer and seller agree on the same price for the security. The difference between the bid and asked prices shows the liquidity of the asset i.e. smaller the asked prices, the better will be the liquidity. The difference between the asked and bid price will go to the broker or specialist who deals with the transaction.
