For the last week or so you have been in discussions with the officers of by a m
ID: 2789019 • Letter: F
Question
For the last week or so you have been in discussions with the officers of by a mid-sized client of UCLA Securities that is planning a bond issue. The CEO is concerned that, given the relatively small size of the issue, the bonds are likely to be thinly traded in the aftermarket and that this may deter potential investors. However, she has heard that in some cases investment bankers underwriting an issue have also guaranteed to make a market in the security afterwards. She wonders if including a feature like this in the bond issue under discussion would make sense. Specifically, the in return for payment of an appropriate fee, the investment bank will undertake to continuously quote bid and ask prices, not more than $1.00 apart, at which they are willing to transact.
a) What benefit would the client derive from this arrangement?
b) What disadvantages or costs will result?
c) You recall that you have heard the CEO express the desire to build a stable base of investors with a long-term outlook. Should this objective influence the choice of whether or not to include the market support feature? If so, explain whether it would make the client more or less likely to include the feature.
Explanation / Answer
(a) The prime advantage that the client gains by appointing the advising investor bank as a market maker is ensuring liquidity of the upcoming bond issue. Market makers are authorized agents who sell and buy securities on a consistent basis at publicly quoted prices. The spread (difference) between the buy price ( bid rate) and sell price (ask rate) also known as the Bid-Ask Spread is how the Market Makers earn a profit. When an accredited securities trader such as Market Maker regularly trades in a security (the upcoming bond issue in this case) it ensures that these securities can be bought or sold at short notice without them undergoing any significant price change. This happens because market makers keep up the demand by buying and/or keep up the supply by selling these securities regularly. This ensures that other investors initially shying away from purchasing these securities owing to the perceived inability of selling them at a later date withhout taking significant cut in their selling price, are now assured of a ready buyer (the market maker). This in turn attracts more investors to the issue. The ability to sell a security without drastic cut in its price or to buy the same security without proping up its price is known as the security's Liquidity.