Chapter 1. Primary Market Making--- Underwriting Theory. Investment Bank Reputation Theory. (A) Assumptions. Two period model, t=0, t=1. Three risk neutral agents: entrepreneurs, investment banks, and investors, risk-free rate=0
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Primary Market Making---
r: prob. of good evaluation to a bad firm.
r [p,1], p>0. prob(e=G∣f=G)=1; Prob(e=G∣f=B)=r
α0 : Prob. of no cost type investment bank
2. Investment Bank Objective
(1) High-cost type Investment Bank
(2) No-Cost type Investment Bank
Proceed from direct sale:
Proceed from investment Bank sale:
Choice of firm type f at t:
(1) Investment Bank Choices:
Both high cost and no cost investment banks market only the equity of firms that obtain good evaluation by the above evaluation standard.
(2) Entrepreneur choices:
Investor beliefs off the equilibrium path: at either date, investors set Prob(I=N)=0, in response to out-of-equilibrium choices by investment banks. They set Prob(f=G)=0 in response to out-of-equilibrium choices by entrepreneurs.
The equilibrium evaluation standard set by the high-cost type represents a unique interior solution
if the magnitude of the marginal cost of changing the evaluation standard, is a constant that satisfies the parametric restriction:
(i) For low reputation values , the high-cost investment bank’s evaluation standard is stricter as its reputation is greater, ie. is decreasing in
(ii) For tending to 1, the high-cost investment bank’s evaluation standard becomes less strict as its reputation is greater, ie. is increasing in
(i) The high-cost investment bank’s time 0 evaluation
standard is stricter as the fraction k of the surplus value
charge as a fee increase.
(ii) The high-cost investment bank’s time 0 evaluation
standard is less strict as the marginal cost, c, of setting
a stricter standard increases.
(iii) For low reputation values, small, and >1/2, the
variance of the true value of firms marketed by the
high-cost type at time 0 is decreasing in its reputation.
Underwriters with greater reputation capital charge larger fees and therefore have higher gross incomes than their less prestigious rivals.
4. Reputation and equity offer proceeds:
The proceed, net of underwriting fees, accruing to issuing firms are increasing in underwriting reputation.
5. Reputation and underwriter choice:
Firms prefer to use the services of the most prestigious investment bank that agrees to market their equity, even when the amount charged as fees is larger for more prestigious investment banks.
Firms that face an asymmetrically informed equity market prefer to make underwritter equity offering rather than market the equity directly.
Increase prob. of success
: net impact of strategic actions between new venture and asset of strategy investor.
then, if >0, S has a complementary asset
if <0, S has a substitute asset.
V is active investor (hold a board seat)
Suppose S and V are equally able,
(i) if Pure S financing.
(ii) if Pure V-financing.
(iii) if mix financing, where V is active and S is passive