Underwriting

Definition

Underwriting is the process of evaluating and assuming the risk associated with financing securities, particularly in the context of issuing bonds or stocks. This process is crucial in international bond markets as it involves investment banks or financial institutions agreeing to purchase the entire bond issue from the issuer, subsequently selling these bonds to investors. The underwriting process ensures that the issuer raises the desired capital while providing a degree of assurance to investors regarding the security's viability.

5 Must Know Facts For Your Next Test

1. Underwriting can be done on a firm commitment basis, where the underwriter buys all issued bonds and assumes full responsibility for selling them, or on a best efforts basis, where the underwriter only agrees to sell as many bonds as possible without guaranteeing a specific amount.
2. The underwriting spread is the difference between what the underwriters pay the issuer for the bonds and what they receive from selling them to investors, representing their profit.
3. The presence of a reputable underwriter can enhance investor confidence and improve demand for an issue in international bond markets.
4. Underwriting also involves assessing the credit risk associated with the bond issuer, which impacts pricing and interest rates of bonds.
5. Regulatory frameworks in different countries often dictate specific underwriting practices to ensure transparency and protect investors.

Review Questions

• How does underwriting affect the capital-raising process for issuers in international bond markets?
  • Underwriting plays a pivotal role in helping issuers raise capital by ensuring that they have buyers for their securities before they are issued. By having investment banks or financial institutions commit to purchasing the entire bond issue, issuers can be confident they will receive the required funds. This process reduces uncertainty for issuers and allows them to focus on their business operations instead of worrying about whether they will be able to sell their bonds.
• Discuss the risks associated with underwriting for both issuers and underwriters in international bond markets.
  • For issuers, the primary risk involves not being able to attract sufficient investor interest in their bonds, which could lead to unfavorable pricing or terms if demand is low. For underwriters, the risk lies in purchasing a large volume of bonds upfront; if they cannot sell them at a profit, they may incur significant losses. Additionally, both parties face reputational risks if the bond performs poorly post-issuance, potentially affecting future financing opportunities.
• Evaluate how changes in market conditions could impact underwriting practices in international bond markets.
  • Changes in market conditions, such as fluctuations in interest rates, economic downturns, or shifts in investor sentiment, can significantly impact underwriting practices. For instance, rising interest rates may lead underwriters to reassess risk levels and potentially tighten their underwriting standards. In volatile markets, underwriters might choose to adopt a best efforts approach rather than a firm commitment, as they seek to minimize exposure. These shifts can affect capital access for issuers and alter investor confidence in new bond offerings.

Related terms

Syndicate: A group of investment banks or financial institutions that work together to underwrite and distribute a new bond or stock issue, sharing both the risk and the profits.

Prospectus: A formal document that provides details about an investment offering for sale to the public, including information about the issuer, the terms of the offering, and the risks involved.

Credit Rating: An assessment of the creditworthiness of a borrower, usually expressed as a letter grade, which influences the interest rates that borrowers must pay on bonds.