Risk, Exclusivity, and Reward
Once the underwriting agreement is struck, the underwriter bears the risk of being unable to sell the underlying securities, and the cost of holding them on its books until such time in the future that they may be favorably sold.
If the instrument is desirable, the underwriter and the securities issuer may choose to enter into an exclusivity agreement. In exchange for a higher price paid upfront to the issuer, or other favorable terms, the issuer may agree to make the underwriter the exclusive agent for the initial sale of the securities instrument. That is, even though third-party buyers might approach the issuer directly to buy, the issuer agrees to sell exclusively through the underwriter.
In summary, the securities issuer gets cash up front, access to the contacts and sales channels of the underwriter, and is insulated from the market risk of being unable to sell the securities at a good price. The underwriter gets a nice profit from the markup, plus possibly an exclusive sales agreement.
Also, if the securities are priced significantly below market price (as is often the custom), the underwriter also curries favor with powerful end customers by granting them an immediate profit (see flipping), perhaps in a quid pro quo. This practice, which is typically justified as the reward for the underwriter for taking on the market risk, is occasionally criticized as unethical, such as the allegations that Frank Quattrone acted improperly in doling out hot IPO stock during the dot com bubble.
Read more about this topic: Underwriting
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