Principles of Finance
1. Which of the following has higher risk for the issuer: an underwritten offering or a best effort offering?
2. Explain the relationship between risk and return? What can investors do to reduce risk?
When shareholders of a company want to dilute their stake in the company and sell the shares held by them to others there are many ways in which this can be done. Usually a firm that specializes in the sale of securities is given the task of managing the stake sale. In an underwritten offering, the securities firm agrees to buy the entire stake that the shareholders (or issuer) want to sell. The price at which the shares are bought is negotiated between the issuer and the securities firm. It is usually lower than the market value of the shares as perceived by the securities firm. After the shares are bought, the firm sells the shares in the open market at the highest price that it can get. If the firm is unable to sell a part of the stake, the shares are not returned to the issuer but held by the securities firm. The issuer in this case is assured of the entire stake being sold though the price at which it has to part with the shares is lower.
In a best efforts offering, the securities firm given the task of managing the stake sale, sells as many shares as it can. The remaining shares are returned to the issuer. Here, the issuer gets the market rate of the shares which could be higher than the price the securities firm would have offered in an underwritten offering. But there is no certainty of the price; also, the issuer is not assured of being able to sell the entire stake. A best effort offering carries a higher level of risk for the issuer.
When an investor makes an investment, it is done with an assumption that the value of the investment would increase in the future and the return would be positive. Every investment has a risk associated with it and this has a close correlation with the expected returns. Usually, as the risk increases, so does the expected return. For instance, an investor buying shares in the stock market expects high returns on the investment made. But there is no certainty of this actually happening. A risk averse investor could buy treasury bonds that carry a very low risk but the return on the investment is also relatively low.
To reduce risk, investors should not make their entire investment in a single asset class. A diversified portfolio with appropriate levels of investment made in several asset classes goes a long way in reducing risk.