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

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  • Francis Breedon
  • Ian Twinn

Abstract

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%.

Suggested Citation

  • Francis Breedon & Ian Twinn, 1995. "Valuation of underwriting agreements for UK rights issues: evidence from the traded option market," Bank of England working papers 39, Bank of England.
  • Handle: RePEc:boe:boeewp:39
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    File URL: http://www.bankofengland.co.uk/archive/Documents/historicpubs/workingpapers/1995/wp39.pdf
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    References listed on IDEAS

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    1. Breedon, F J & Fisher, P G, 1996. "M0: Causes and Consequences," The Manchester School of Economic & Social Studies, University of Manchester, vol. 64(4), pages 371-387, December.
    2. Quah, Danny & Vahey, Shaun P, 1995. "Measuring Core Inflation?," Economic Journal, Royal Economic Society, vol. 105(432), pages 1130-1144, September.
    3. Smith, Jennifer C, 1996. "Wage Interactions: Comparisons or Fall-Back Options?," Economic Journal, Royal Economic Society, vol. 106(435), pages 495-506, March.
    4. Roger Beaton & Paul Fisher, 1995. "The Construction of RPIY," Bank of England working papers 28, Bank of England.
    5. David Barr & Bahram Pesaran, 1995. "An assessment of the relative importance of real interest rates, inflation and term premia in determining the prices of real and nominal UK bonds," Bank of England working papers 32, Bank of England.
    6. Joanna Paisley & Chris Salmon, 1995. "How Cyclical is the PSBR?," Bank of England working papers 34, Bank of England.
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    Cited by:

    1. Svensson, Lars E. O., 1997. "Inflation forecast targeting: Implementing and monitoring inflation targets," European Economic Review, Elsevier, vol. 41(6), pages 1111-1146, June.
    2. Marco Bianchi & Gylfi Zoega, 1998. "Unemployment persistence: does the size of the shock matter?," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 13(3), pages 283-304.
    3. Anthony Yates & Bryan Chapple, 1996. "What Determines the Short-run Output-Inflation Trade-off?," Bank of England working papers 53, Bank of England.
    4. Prasanna Gai, 1996. "International Bank Lending to LDCs - an Information-Based Approach," Bank of England working papers 43, Bank of England.
    5. Andrew G Haldane, 1995. "Rules, Discretion and the United Kingdom's New Monetary Framework," Bank of England working papers 40, Bank of England.
    6. Andy Haldane & Bennett McCallum & Chris Salmon, 1996. "Base Money Rules in the UK," Bank of England working papers 45, Bank of England.
    7. Nicola Anderson & Francis Breedon, 1996. "UK Asset Price Volatility Over the Last 50 Years," Bank of England working papers 51, Bank of England.
    8. Marco Bianchi, 1996. "A Comparison of Methods for Seasonal Adjustment of the Monetary Aggregates," Bank of England working papers 44, Bank of England.
    9. Charles Nolan & Eric Schaling, 1996. "Monetary Policy Uncertainty and Central Bank Accountability," Bank of England working papers 54, Bank of England.
    10. Clive Briault & Andrew Haldane & Mervyn King, 1996. "Independence and Accountability," Bank of England working papers 49, Bank of England.
    11. Spencer Dale & Marco Rossi, 1996. "A Market for Intra-day Funds: Does it Have Implications for Monetary Policy?," Bank of England working papers 46, Bank of England.
    12. Francis Breedon, 1996. "Why do the LIFFE and DTB bund futures contracts trade at different prices?," Bank of England working papers 57, Bank of England.
    13. Marco Rossi, 1996. "The information content of the short end of the term structure of interest rates," Bank of England working papers 55, Bank of England.
    14. Matthew B Canzoneri & Charles Nolan & Anthony Yates, 1996. "Feasible Mechanisms for Achieving Monetary Stability: a Comparison of Inflation Targeting and the ERM," Bank of England working papers 52, Bank of England.

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