Thus, investment banking firms perform a critical role in US primary and secondary markets. However, the traditional role associated with investment banking is the underwriting of securities. Entities that issue securities include agencies of the US government, state and local governments, corporations, supranational entities, foreign governments, and foreign corporations. The following are the functions of investment bankers during the public offer of a new security: Advising: Advising corporations about the type of security issue, its features, timing, pricing, and size (Baker, Powell, 2005, p. 328).
The investment banker provides valuable advice to the company concerning the best way to raise the funds. The investment banker is familiar with the various issues of long-term funds, debt and equity markets, and the Securities and Exchange Commission SEC regulations (Shim, Siege, 2007, p. 372). ? Underwriting: Assume the risk of sale of an issue by buying security issuer and then reselling it to investors (Baker, Powell, 2005, p. 328). This means that the investment banker buys a new security issue, pays the issuer, and markets the securities.
When an investment banking firm agrees to buy the securities from the issuer and accepts the risk of selling the securities to investors at a lower price, it is referred to as underwriter. The underwriter’s compensation is the difference between the price at which the securities are sold to the public, and the price paid to the company for the securities (Shim, Siege, 2007, p. 372). The investment banker guarantees that the issuer of the new securities will receive a certain amount minimum amount of cash for its new securities should the market conditions change.
Not all the new securities are however underwritten. In this case, the investment banker may arrange for direct private placement or agree to sell the shares in a public offering on a best effort basis while assuming no responsibility if all the securities cannot be sold (Carey, Essayyad, 1994, p. 83) ? Marketing: Form an underwriting syndicate to spread the risk and to get greater financial and marketing resources. Stabilize the market price of a new security through buying and selling in the open market to ensure acceptance by the market (Baker, Powell, 2005, p. 328).
This means that the investment bankers capitalize on their reputation and sell the issue directly or indirectly to the public. The market for new issues is the focal point for the economic function of the capital markets. In addition, investment in new securities issues involves and element of risk that historically has been rewarded by a higher rate of return. Investment bankers are specialists who assist the issue and sale of new securities. Investment banks underwrite and distribute new issues of debt and equity, bonds and stocks.
They advise the firm on the timing and pricing of a new issue, help in the preparation of the prospectus, and investigate the legal aspects of a new issue (Abdelhamid, 2003, p. 181). The investment banker usually bears the complete risk of distributing and selling a new issue. The investment banker gets the spread between the offering price and the price it pays the issuing firm. However, they need not undertake the buying the securities from the issuer. An investment banker can always merely act as an advisor and/or distributor of the new security.
Further, it would be a mistake to think that once the securities are all sold the investment banking firm’s ties with the deal are ended. In the case of bonds, those who bought the securities will look to the investment banking firm to make a market in the issue (Fabozzi, Peterson, Drake, 2003, p. 62) References Abdelhamid DM, (2003), “International regulatory rivalry in open economies: the impact of deregulation on the US and UK financial markets”, Published: Ashgate Publishing, Ltd. , Vermont
Baker HK, Powell GE, (2005), “Understanding financial management: a practical guide”, Published: Wiley-Blackwell, Malden, Massachusetts Carey OL, Essayyad M, (1994), “Essentials of Financial Management”, Published: Research & Education Association, New Jersey Fabozzi FJ, Peterson PP, Drake PP, (2003), “Financial management and analysis”, 2nd Edition, Published: John Wiley and Sons, Danvers, Massachusetts Shim JK, Siege JG, (2007), “Schaum's Outline of Financial Management”, 3rd Edition, Published: McGraw-Hill Professional, New York