Definition
The “Underwriting Spread” refers to the difference between the amount paid to an issuer of securities in a Primary Distribution and the Public Offering Price. This spread essentially compensates the underwriters, typically investment banks, for their role in facilitating the issuance and distribution of new securities.
Key Aspects Influencing the Underwriting Spread
- Size of the Issue: Larger issues might have different spreads compared to smaller ones due to economies of scale.
- Financial Strength of the Issuer: More financially stable issuers might receive better terms.
- Type of Security: Stocks, bonds, and other financial instruments each carry different underwriting risks and therefore different spreads.
- Status of the Security: The seniority, whether the security is secured or unsecured, and its junior status can affect the spread.
- Type of Commitment by Investment Bankers: Firm commitment involves higher risk for bankers than best-effort agreements, typically resulting in varied spreads.
Examples
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Firm Commitment: An investment bank agrees to buy the entire issue from the issuer and sells it to the public. If the public offering price is $50 per share and the bank pays the issuer $47 per share, the underwriting spread is $3 per share.
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Best Efforts Commitment: The underwriter agrees to sell as much of the issue as possible but does not guarantee the total amount. If the public offering price is $50 per share and the bank has negotiated a commission of $2 per share, the spread includes that commission.
Frequently Asked Questions (FAQs)
What is the purpose of the underwriting spread?
- Answer: The underwriting spread compensates underwriters for the risk they take on and the services they provide, including marketing and selling efforts, due diligence, and price stabilization.
How is the underwriting spread calculated?
- Answer: It is the difference between the price paid to the issuer by the underwriters and the offering price paid by the public.
Does a larger issue always result in a smaller underwriting spread?
- Answer: Not necessarily. While larger issues may benefit from economies of scale, the spread still largely depends on other factors like the issuer’s financial health and market conditions.
Why do different types of securities have different spreads?
- Answer: Different securities carry varying levels of risk. For instance, underwriting bonds may involve different risk assessments and cost structures compared to underwriting stocks due to interest rate sensitivity and market demand.
Can the underwriting spread be negotiated?
- Answer: Yes, the spread can be negotiated between the issuer and the underwriters. However, it typically reflects the risk, effort, and market conditions at the time of issuance.
Related Terms
Primary Distribution
The sale of new issues of stocks or bonds, usually by an investment bank or underwriting syndicate, directly to investors.
Public Offering Price (POP)
The price at which new issues of stock are offered to the public by an underwriter.
Firm Commitment
A type of underwriting agreement where the underwriter purchases all the securities from the issuer and resells them to investors.
Best Efforts
An underwriting agreement where the underwriter commits to selling as much of the issue as possible but does not guarantee the sale of the entire issue.
Online References to Online Resources
Suggested Books for Further Studies
- Investment Banking: Valuation, Leveraged Buyouts, and Mergers and Acquisitions by Joshua Rosenbaum and Joshua Pearl
- Underwriting Services and the New Issues Market by Timothy J. Brailsford and Robert Faff
- The Business of Investment Banking: A Comprehensive Overview by K. Thomas Liaw
Fundamentals of Underwriting Spread: Finance Basics Quiz
### What does the underwriting spread represent?
- [ ] The difference between the offer price and the market price.
- [x] The difference between the amount paid to the issuer and the public offering price.
- [ ] The total fees paid to all advisors in an issuance.
- [ ] The risk premium for underwriting a bond.
> **Explanation:** The underwriting spread is the difference between the amount paid to the issuer of securities and the public offering price. It represents the compensation to the underwriters for their services.
### Which type of commitment typically results in a higher underwriting spread?
- [ ] Best Efforts
- [x] Firm Commitment
- [ ] Allotment Commitment
- [ ] Equity Commitment
> **Explanation:** Firm commitments typically involve higher underwriting spreads as the underwriter takes on the risk of buying the entire issue and then reselling it to the public.
### How does the financial strength of the issuer affect the underwriting spread?
- [ ] Strong issuers receive higher spreads.
- [ ] Weak issuers receive lower spreads.
- [ ] There is no impact.
- [x] Strong issuers receive lower spreads.
> **Explanation:** Strong financial issuers generally receive lower underwriting spreads as they pose less risk to the underwriters.
### What aspect of a security can affect its underwriting spread?
- [ ] The currency in which it is issued.
- [x] The type of security (stocks, bonds).
- [ ] Whether it's trading on NYSE or NASDAQ.
- [ ] The total market volume.
> **Explanation:** The type of security (stocks, bonds, etc.) impacts its underwriting spread due to different risk levels and underwriting structures.
### Can the underwriting spread be negotiated?
- [x] Yes
- [ ] No
> **Explanation:** The underwriting spread can indeed be negotiated between the issuer and the investment bankers.
### Which is NOT an influencing factor for the underwriting spread?
- [ ] Issue size
- [ ] Financial strength of the issuer
- [ ] Security type
- [x] Recent credit scores of public investors
> **Explanation:** The recent credit scores of public investors do not influence the underwriting spread, which factors in issue size, issuer's financial strength, and security type.
### What does a larger underwriting spread indicate?
- [ ] Higher compensation for underwriters.
- [ ] Lower risk for underwriters.
- [ ] Lesser marketing effort required.
- [x] Higher compensation and higher risk for underwriters.
> **Explanation:** A larger underwriting spread generally indicates both higher compensation and higher risk for underwriters.
### Who typically absorbs the underwriting spread cost?
- [ ] The end investors
- [x] The issuing company
- [ ] The regulators
- [ ] The underwriters’ competitors
> **Explanation:** The cost of the underwriting spread is absorbed by the issuing company as it represents the discount on the amount they receive from underwriters.
### When does the underwriting spread become income for the underwriters?
- [x] Upon successful distribution to the public
- [ ] When the securities are first issued
- [ ] When the terms are agreed upon
- [ ] At fiscal year-end
> **Explanation:** The underwriting spread becomes income for the underwriters upon the successful distribution of securities to the public.
### Firm commitment underwriting implies what about the underwriting spread?
- [ ] It remains constant regardless of risk
- [ ] Underwriters are less interested in marketing
- [x] It compensates underwriters for the risk of purchasing and selling the entire issue
- [ ] It is non-negotiable
> **Explanation:** Firm commitment underwriting implies that the underwriting spread compensates underwriters for assuming the risk of purchasing the entire issue and then selling it to the public.
Thank you for exploring the concept of underwriting spread and participating in our comprehensive quiz. Keep enhancing your financial acumen!
