Valuation of underwriting agreements for UK rights issues: evidence from the traded option market

A recent study by Professor Marsh of the London Business School has estimated that sub-underwriters of rights issues (firms that commit to buy up any remaining shares at the end of a rights issue) make an excess profit of 86% of the fee they charge. Because of this study, the OFT (who originally commissioned it) have argued that underwriting is too expensive and have encouraged firms to reconsider their issuance techniques. Marsh's study, however, is based on a number of assumptions that are unlikely to hold in practice. In particular, Marsh used the Black and Scholes option pricing formula to value the economic cost of underwriting (underwriting is like a put option since it gives the firm the right but not the obligation to sell shares to the underwriter). But it is well known that the Black and Scholes formula is based on a high unrealistic view of financial markets with no transactions costs and no information asymmetries. To make a more realistic estimate of the economic cost of underwriting, this paper looks at the cost of buying put options in the traded option market. This does not mean that buying a put option in the traded option market is a viable alternative to underwriting it simply allows for a more realistic measure of transactions costs. By looking at the price of put options on firms who have just announced a rights issue the paper funds, unsurprisingly, that the true cost of put options was much higher than the Black and Scholes formula predicted. However, it still found that underwriters made an abnormal profit, even if it was only 40% of the fee rather than 86%.