Business Glossary

discount at which securities in a new issue offering (or a secondary distribution) are allocated to the members of a selling group by the underwriters. Since the selling group cannot sell to the public at a price higher than the public offering price, its compensation comes out of the difference between the price paid to the issuer by the underwriters and the public offering price, called the spread. The selling group's portion, called the concession, is normally one half or more of the gross spread, expressed as a discount off the public offering price.

Insurance: to assume risk in exchange for a premium.

Investments: to assume the risk of buying a new issue of securities from the issuing corporation or government entity and reselling them to the public, either directly or through dealers. The underwriter makes a profit on the difference between the price paid to the issuer and the public offering price, called the underwriting spread.

Underwriting is the business of investment bankers, who usually form an underwriting group (also called a purchase group or syndicate) to pool the risk and assure successful distribution of the issue. The syndicate operates under an agreement among underwriters, also termed a syndicate contract or purchase group contract.

The underwriting group appoints a managing underwriter, also known as lead underwriter, syndicate manager, or simply manager, that is usually the originating investment banker-the firm that began working with the issuer months before to plan details of the issue and prepare the registration materials to be filed with the Securities and Exchange Commission. The manager, acting as agent for the group, signs the underwriting agreement (or purchase contract) with the issuer. This agreement sets forth the terms and conditions of the arrangement and the responsibilities of both issuer and underwriter. During the offering period, it is the manager's responsibility to stabilize the market price of the issuer's shares by bidding in the open market, a process called pegging. The manager may also appoint a selling group, comprised of dealers and the underwriters themselves, to assist in distribution of the issue.

Strictly speaking, underwrite is properly used only in a firm commitment underwriting, also known as a bought deal, where the securities are purchased outright from the issuer.

Other investment banking arrangements to which the term is sometimes loosely applied are best effort, All Or None, and standby commitments; in each of these, the risk is shared between the issuer and the investment banker.

The term is also sometimes used in connection with a registered secondary offering, which involves essentially the same process as a new issue, except that the proceeds go to the selling investor, not to the issuer. For these arrangements, the term secondary offering or secondary distribution is preferable to underwriting, which is usually reserved for new, or primary, distributions.

There are two basic methods by which underwriters are chosen by issuers and underwriting spreads are determined: negotiated underwritings and competitive bid underwritings. Generally, the negotiated method is used in corporate equity (stock) issues and most corporate debt (bond) issues, whereas the competitive bidding method is used by municipalities and public utilities.

sealed bid, containing price and terms, submitted by a prospective underwriter to an issuer, who awards the contract to the bidder with the best price and terms. Many municipalities and virtually all railroads and public utilities use this bid system. Industrial corporations generally prefer negotiated underwriting on stock issues but do sometimes resort to competitive bidding in selecting underwriters for bond issues.

difference (spread) between the public offering price of a security and the price paid by an underwriter to the issuer. The spread breaks down into the manager's fee, the dealer's (or underwriter's) discount, and the selling concession (i.e., the discount offered to a selling group).

underwriting of new securities issue in which the spread between the purchase price paid to the issuer and the public offering price is determined through negotiation rather than multiple competitive bidding. The spread, which represents the compensation to the investment bankers participating in the underwriting (collectively called the syndicate), is negotiated between the issuing company and the managing underwriter, with the consent of the group. Most corporate stock and bond issues and municipal revenue bond issues are priced through negotiation, whereas municipal general obligation bonds and new issues of public utilities are generally priced through competitive bidding. Competitive bidding is mandatory for new issues of public utilities holding companies.

cost of issuing new stocks or bonds. It varies with the amount of underwriting risk and the job of physical distribution. It comprises two elements: (1) the compensation earned by the investment bankers (the underwriters) in the form of the spread between the price paid to the issuer (the corporation or government agency) and the offering price to the public, and (2) the expenses of the issuer (legal, accounting, printing, and other out-of-pocket expenses). Securities and Exchange Commission studies reveal that flotation costs are higher for stocks than for bonds, reflecting the generally wider distribution and greater volatility of common stock as opposed to bonds, which are usually sold in large blocks to relatively few investors. The SEC also found that flotation costs as a percentage of gross proceeds are greater for smaller issues than for larger ones. This occurs because the issuer's legal and other expenses tend to be relatively large and fixed; also, smaller issues tend to originate with less established issuers, requiring more information development and marketing expense. An issue involving a rights offering can involve negligible underwriting risk and selling effort and therefore minimal flotation cost, especially if the underpricing is substantial.

The underwriting spread is the key variable in flotation cost, historically ranging from 23.7% of the size of a small issue of common stock to as low as 1.25% of the par value of high-grade bonds. Spreads are determined by both negotiation and competitive bidding.

Payment to a mortgage broker by a lender for originating and processing a mortgage loan with a fractionally higher interest rate (called an above-par loan) than the lender would normally offer. Yield spread premiums should reduce the points and fees the lender would normally charge to the borrower for a par-rate loan. Also called premium pricing or volume-based compensation.