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PRINCIPLES OF FINANCE

Finance Assignment -02

Name : Labiba Iqbal


Roll no: 1304052
Section : B Batch: 04

Who are underwriters? What are their roles in economics???


Underwriter
A firm, usually an investment bank, that buys an issue of securities from a company and
resells it to investors. In general, a party that guarantees the proceeds to the firm from a
security sale, thereby in effect taking ownership of the securities.
Underwriter
A company, usually an investment bank, that an issuer hires to place a new issue with
investors. The issuer normally hires several underwriters for a single issue, where each is
responsible for placing a certain amount of the new issue. The underwriters contact potential
investors to gauge interest and sell the issue. Underwriters guarantee the price for a certain
number of shares of the new issue. Because of their expertise on placing securities with
investors, using underwriters often increases the chance that the placement will be successful.
An underwriting firm is also called a house of issue. See also: Bracketing, Oversubscribed,
Undersubscribed, Underwriting agreement.
Farlex Financial Dictionary. 2012 Farlex, Inc.
Example:
When a company wants to issue stock, bonds, or other publicly traded securities, it hires an
underwriter to manage what is often a long and complex process.
To begin the offering process, the underwriter and the issuer first determine the kind of
offering the issuer needs. Sometimes the issuer wants to sell shares via an initial public
offering (IPO) cash proceeds return to the issuing company as capital to fund its projects.
Other offerings, such as secondary offerings, funnel the proceeds to a shareholder who is
selling some or all of his or her shares. Split offerings occur when a portion of the offering go
to the company while the rest of the proceeds goes to an existing shareholder. Shelf offerings
allow the issuer to sell shares over a two-year period.
After determining the offering structure, the underwriter usually assembles what is called a
syndicate to get help manage the minutiae (and risk) of large offerings. A syndicate is a group
of investment banks and brokerage firms that commit to sell a certain percentage of the
offering. (This is called a guaranteed offering because the underwriters agree to pay the issuer
for 100% of the shares, even if all the shares can't be sold). With riskier issues, underwriters
often act on a "best efforts" basis, in which case they sell as many shares as they can and
return the unsold shares back to the issuing firm.
After the syndicate is assembled, the issuer files a prospectus. The Securities Act of 1933
requires the prospectus to fully disclose all material information about the issuer, including a
description of the issuer's business, the name and addresses of key company officers, the
salaries and business histories of each officer, the ownership positions of each officer, the
company's capitalization, an explanation of how it will use the proceeds from the offering,
and descriptions of any legal proceedings the company is involved in.
With prospectus in hand, the underwriter then proceeds to market the securities. This usually
involves a road show, which is a series of presentations made by the underwriter and the
issuer's key executives to institutions (pension plans, mutual fund managers, etc.) across the

country. The presentation gives potential buyers the chance to ask questions from the
management team. If the buyers like the offering, they make a non-binding commitment to
purchase, called a subscription. Because there may not be a firm offering price at the time,
purchasers usually subscribe for a certain number of shares. This process lets the underwriter
gauge the demand for the offering (called indications of interest) and determine whether the
contemplated price is fair.
Determining the final offering price is one of the underwriter's most important
responsibilities. First, the price determines the size of the capital proceeds. Second, an
accurate price estimate makes it easier for the underwriter to sell the securities. Thus, the
issuer and the underwriter work closely together to determine the price. Once an agreement is
reached on price and the SEC has made the registration statement effective, the underwriter
calls the subscribers to confirm their orders. If the demand is particularly high, the
underwriter and issuer might raise the price and reconfirm this with all the subscribers.
Once the underwriter is sure it will sell all of the shares in the offering, it closes the offering.
Then it purchases all the shares from the company (if the offering is a guaranteed offering),
and the issuer receives the proceeds minus the underwriting fees. The underwriters then sell
the shares to the subscribers at the offering price. If any subscribers have withdrawn their
bids, then the underwriters simply sell the shares to someone else or own the shares
themselves. It is important to note that the underwriters credit the shares into all subscriber
accounts (and withdraw the cash) simultaneously so that no subscriber gets a head start.
Although the underwriter influences the initial price of the securities, once the subscribers
begin selling, the free-market forces of supply and demand dictate the price. Underwriters
usually maintain a secondary market in the securities they issue, which means they agree to
purchase or sell securities out of their own inventories in order to keep the price of the
securities from swinging wildly.
Why it Matters:
Underwriters bring a company's securities to market. In so doing, investors become more
aware about the company. Issuers compensate underwriters by paying a spread, which is the
difference between what the issuer receives per share and what the underwriter sells the
shares for. For example, if Company XYZ shares had a public offering price of $10 per share,
XYZ Company might only receive $9 per share if the underwriter takes a $1 per share fee.
The $1 spread compensates the underwriter and syndicate for three things: negotiating and
managing the offering, assuming the risk of buying the securities if nobody else will, and
managing the sale of the shares. Making a market in the securities also generates commission
revenue for underwriters.
As mentioned earlier, underwriters take on considerable risk. Not only must they advise a
client about matters large and small throughout the process, they relieve the issuer of the risk
of trying to sell all the shares at the offer price. Underwriters often mitigate this risk by
forming a syndicate whose members each share a portion of the shares in return for a portion
of the fee.
Underwriters work hard to determine the "right" price for an offering, but sometimes they
leave money on the table. For example, if Company XYZ prices its 10 million share IPO at
$15 per share but the shares trade at $30 two days after the IPO, this suggests that the

underwriter probably underestimated the demand for the issue. As a result, Company XYZ
received $150 million (less underwriting fees) when it could have possibly fetched $300
million. Thus, the issuing company must also follow a robust due diligence process on their
end in order to optimize their capital raising efforts.

The role of underwriter in Economics

An initial public offering, commonly known as an IPO, is the process of selling


corporate shares in an open stock exchange for the first time. The underwriter is a
financial specialist who specializes in IPOs and plays a critical role. The IPO is
usually one of the rare make-or-break moments in the life of a firm, and its success or
failure can have serious long-term ramifications.

Public vs Private
Every for-profit corporation has stockholders, since every firm is owned by someone. There
is, however, a critical difference between a public and private corporation. A public firm is
one whose stocks you can buy in an open exchange, such as the New York Stock Exchange.
There is an openly displayed price at which the stock has just changed hands, and the stock's
issuer must make financial data freely available. Shares of private firms, however, are held by
far fewer individuals, and such companies aren't obligated to publish financial data. If you
wish to buy shares of such firms, you must get in touch with one of the shareholders, who
may or may not be willing to sell.
Going Public
Companies almost always start their lives as private firms and "go public" after they grow.
The process of going public, also known as the IPO, involves selling shares to a far larger
audience than before and publishing financial as well as other strategic information for the
world to see. A public firm must conform to many more regulations than a private company
and must actively market its shares to a large number new investors, who may never have
heard of the firm before. To help with this process, firms hire an underwriter.
IPO Underwriter
The underwriter is usually an investment bank that employs IPO specialists. These bankers
ensure that the firm satisfies all regulatory requirements, such as filing with the appropriate
bodies and depositing all fees, and makes all mandatory financial data available to the public.
Next, and perhaps most importantly, the underwriter contacts large prospective buyers of
stock, such as mutual funds and insurance companies who have large sums of money to
invest. The underwriter takes the pulse of prospective buyers and then recommends an IPO
price to the firm. This is the price at which the shares will be sold. An excessive price may
leave the firm with unsold stock, while a price that is too low will mean forgone revenue
from the stock sale.
Underwriter Guarantee
The underwriter usually provides a guarantee to the firm to sell a specific
quantity of stock during the IPO process. Should the underwriter fail to

convince prospective investors to buy this many shares, it must buy the
surplus itself. money to a failed IPO, the underwriter must therefore work
especially hard to sell all available shares. Should the underwriter end up
with a great quantity of stock, which it was forced to buy from the issuing
firm, it will sell these shares in the open market. Such sales must proceed
with caution, because suddenly dumping a lot of shares can drag the price
down, hurting both the issuer as well as the underwriter.

An underwriter is critical to the mortgage process, as he is the one who will approve
or deny the loan. He prepares a careful, detailed analysis of the loan package to
determine if a potential borrower presents an appropriate level of risk. He has total
knowledge of the lender's policies and procedures, allowing him to make sound
judgments on every application he reviews.

Review Mortgage Applications


The underwriter's first responsibility is to make sure that the application package is complete.
Not only does he ensure that every section of the application is completely filled out, he
verifies that all supporting documents are included. If any information is missing, especially
about the borrower's income or the collateral property, the underwriter won't be able to make
the most accurate recommendation on the loan. If an underwriter receives an incomplete
package, it is his duty to return that package to the processor to obtain the necessary items
from the borrower.
Know the Processing Systems
Underwriters work with a number of automated processing systems. When a loan application
is submitted, the processor enters information into a loan tracking system. The underwriter
must make sure that all information is entered and accurate, especially if that system is used
in decision making. He also uses various online vendors to carry out credit checks, flood
determinations, and property searches and determine tax statuses among other important
factors. He must be able to accurately use all of these processing systems in underwriting the
loan.

Loan Analysis
An underwriter must fully understand his institution's policy for approving loans, the two
most notable elements of which are acceptable loan-to-value (LTV) and debt-to-income
(DTI) ratios. Using the information in the application and supporting documents, the
underwriter calculates these ratios. If the application meets these guidelines, the underwriter
approves the loan. The underwriter must also specify closing conditions so that the file is
complete and all applicable regulations are met. For example, if his flood search reveals that
the property is in a flood hazard zone, he must require flood insurance as a condition of
closing.

Compensating Factors
While the numbers on the application are typically an accurate representation of a borrower's
ability to pay, an underwriter must know when to look at factors beyond the numbers. For
example, if the bank allows a 40 percent DTI ratio and a borrower comes in at 42 percent,
policy says that loan will be denied. However, the underwriter may see that the applicant has
long-time, stable employment, highly liquid assets and a very low LTV. The underwriter can
then approve the loan as an exception, citing the compensating factors.