4 Variations on the Usual Underwriting Process Auction Process (competitive bidding underwriting) various syndicates bid on the issue Preemptive rights offering: existing shareholders have rights to buy issue below market value Directly Public Offering (DPO): Company itself sells its securities directly to public, usually over the web. Small firms. Example: Internet Ventures, a web service provider, raised $3.8 million in 1998 by advertising the securities to its customers on the web. Source: www.econ.yale.edu/~shiller/course/252/Lect15IBanks.ppt
Maclachlan, Money & Banking Spring 2005 5 Initial Public Offerings Price tends to jump up immediately after an IPO is issued. Apparently leave money upon the table Source: www.econ.yale.edu/~shiller/course/252/Lect15IBanks.ppt
Maclachlan, Money & Banking Spring 2005 6 Poor Long-Run Performance of IPOs Jay Ritter, Journal of Finance, 1991 Although average IPO earns a +16% return on the first day, this return tends to be offset over the next three years. Source: www.econ.yale.edu/~shiller/course/252/Lect15IBanks.ppt
Maclachlan, Money & Banking Spring 2005 7 Why This Performance of IPOs? Impressario Hypothesis: analogy to sellers of tickets to concerts
Maclachlan, Money & Banking Spring 2005 8 Survey of IPO Investors “Do you think that investors expect reputable underwriters to take some account of true investment value in deciding the offering price in an IPO, rather than just the price the market will bear on the day of the offering?” 84% agree Source: www.econ.yale.edu/~shiller/course/252/Lect15IBanks.ppt
Maclachlan, Money & Banking Spring 2005 9 Survey of IPO Investors Have you done any calculations of what the true fundamental value of a share in the company was, and compared the price of a share with this value? –80% no. Source: www.econ.yale.edu/~shiller/course/252/Lect15IBanks.ppt
Maclachlan, Money & Banking Spring 2005 11 Dutch Auction Dutch auction An auction method that uses a bidding process to find an optimal market price for the stock, the lowest price at which an issuing company can sell all the available shares. An alternative to the traditional negotiated pricing process used by underwriters to set IPO prices, this auction format was most recently employed by Google and is used for US Treasury auctions. Also called as descending price auction, it was named after the famous auctions of Dutch tulip bulbs in the 17th century, and is based on a pricing system devised by Nobel prize winning economist William Vickrey.auctionbiddingIPO Treasury auctions Source
Maclachlan, Money & Banking Spring 2005 12 Here's how the filing describes the process for buying shares in the auction: Open an account with one of the two underwriters, CSFB or Morgan Stanley. You must obtain a prospectus detailing the investment's risks, as well as an underwriter's account eligibility and suitability requirements. This will be available electronically, according to the company. After receiving the prospectus and sometime before the auction, bidders must obtain a "unique bidder ID." Bidder IDs will not be available after the bidding begins. Once you qualify, you're able to bid when the auction starts. The bid you make must include the number of shares you want and the price you're willing to pay for them. You may bid below the price range if you believe that there'll be lower demand than has been speculated. And you can also bid higher if you think there'll be more.
Maclachlan, Money & Banking Spring 2005 13 Definition A derivative is a financial instrument whose value depends on (or derives from) the value of another instrument (the underlying). Example: the value of a stock option depends on the value of the underlying stock.
Maclachlan, Money & Banking Spring 2005 14 Three Basic Types of Derivatives 1.Futures/Forwards 2.Options 3.Swaps Derivatives can be created through combining the basic types, e.g., swaptions, futures options.
Maclachlan, Money & Banking Spring 2005 15 Forward Contracts Began as a way for farmers to hedge risk. Suppose price of wheat could be $10 a bushel or $20 a bushel, depending on the weather. How could farmer hedge? Currency and interest rate forward contracts.
Maclachlan, Money & Banking Spring 2005 16 Futures Contracts Standardized. Exchange traded and insured. Marked to market, margin requirements. Highly liquid.
Maclachlan, Money & Banking Spring 2005 17 Comparison Forward Contracts Customized Arranged by bankers. Subject to counterparty risk Illiquid Futures Standarized Exchange traded Insured, margin requirements Liquid Marked to market
Maclachlan, Money & Banking Spring 2005 18 Hillary Clinton’s 1979 Investment in Cattle Futures "It's a mockery of the profession to say you took a thousand dollars and made a hundred thousand," says Joe Gressel, a 19-year veteran of the Merc's trading pits. "Around here," he adds, in a sentiment echoed by some of his colleagues, "we're flabbergasted that she's bamboozled the people of New York state."
Maclachlan, Money & Banking Spring 2005 19 Options Right but not the obligation to buy (sell) an underlying instrument at a prespecified price. Call vs. put. Strike (or exercise) price. Price of underlying vs. price of option. Hockey stick diagrams.
Maclachlan, Money & Banking Spring 2005 20 Swaps Allows a floating rate borrower to get a fixed rate obligation. Longshore Construction can only get a loan from the bank at a floating rate. Sallie Mae can issue long-term bonds to investors at a fixed rate. How can they both benefit through trade?