Gross Spread Meaning, Working Mechanism, Example

Gross Spread Meaning

The gross spread is a term used in the financial industry to refer to the difference between the price at which an underwriter buys securities from an issuer and the price at which the underwriter sells those securities to investors. It is a key component of the underwriting process and represents the compensation that underwriters receive for their services.

The gross spread serves as a source of revenue for underwriters and compensates them for the risks and costs associated with underwriting securities. It covers various expenses, including due diligence, marketing, legal fees, and the underwriter’s profit margin. The size of the gross spread can vary depending on factors such as market conditions, the type of securities being offered, and the reputation of the underwriter.

During the underwriting process, underwriters purchase the stocks from the issuer at a discounted price. They then sell these stocks to the public at a higher price, allowing them to make a profit. The difference between the purchase price and the sale price is the gross spread.

The gross spread is typically expressed as a percentage of the offering price. For example, if a stock is sold to the public at $10 per share and the underwriters purchased it from the issuer at $9 per share, the gross spread would be $1 per share or 10% of the offering price.

Working Mechanism of Gross Spread

1. Underwriting Process

The gross spread is primarily earned by underwriters who facilitate the issuance and sale of securities. The underwriting process involves several steps:

1. Due Diligence: The underwriter conducts thorough research and analysis of the issuer’s financials, business model, and market conditions to assess the risks associated with the securities.
2. Pricing: Based on the assessment, the underwriter determines the offering price for the securities.
3. Agreement: The underwriter and the issuer enter into an underwriting agreement, which outlines the terms and conditions of the offering.
4. Marketing: The underwriter promotes the securities to potential investors through roadshows, presentations, and other marketing efforts.
5. Allocation: Once the offering is oversubscribed, the underwriter allocates the securities to investors.

2. Gross Spread Calculation

The gross spread is calculated as a percentage of the offering price. It represents the underwriter’s compensation for assuming the risks associated with the issuance and sale of the securities. The formula for calculating the gross spread is:

For example, if the offering price of a security is $10 and the underwriter purchases it from the issuer at $9, the gross spread would be:

3. Distribution of Gross Spread

The gross spread is typically divided between the underwriter and other parties involved in the underwriting process, such as selling group members and brokers. The exact distribution varies depending on the terms of the underwriting agreement.

The underwriter’s portion of the gross spread compensates them for their role in managing the underwriting process, assuming the risks, and providing liquidity to the market. The remaining portion may be shared among selling group members and brokers who assisted in selling the securities.

How Gross Spread is Calculated and Distributed

The calculation and distribution of the gross spread in stocks is an important aspect of the financial market. It helps determine the compensation received by the underwriters or intermediaries involved in the issuance of stocks.

The gross spread is typically calculated as a percentage of the offering price of the stocks. This percentage is agreed upon between the issuer and the underwriters. The offering price is the price at which the stocks are sold to investors during the initial public offering (IPO) or any subsequent offering.

The net spread is then divided among the various parties involved in the issuance of stocks. This includes the underwriters, the selling group (if any), and the issuer. The allocation of the net spread is typically based on pre-determined agreements and may vary depending on the specific circumstances of the offering.

Finally, the issuer receives the remaining portion of the net spread. This amount is used to cover various costs associated with the offering, such as legal fees, marketing expenses, and other administrative costs.

Example of Gross Spread in Stocks

Let’s consider a hypothetical example to understand how gross spread works in the context of stocks. Suppose there is a company called ABC Inc. that is planning to go public and offer its shares to investors through an initial public offering (IPO). The investment bank, XYZ Bank, is responsible for underwriting the IPO and facilitating the sale of shares to investors.

Before the IPO, XYZ Bank and ABC Inc. agree on the price at which the shares will be offered to the public. Let’s say the agreed-upon price is $10 per share. XYZ Bank believes that there is significant demand for ABC Inc.’s shares and expects to sell a large number of shares to investors.

On the day of the IPO, XYZ Bank starts selling the shares to investors. They offer the shares at a higher price than the agreed-upon price of $10 per share. Let’s say they sell the shares at $12 per share. The difference between the selling price and the agreed-upon price is the gross spread.

The gross spread is an essential component of the underwriting process and serves as a source of revenue for investment banks. It compensates them for the risks and efforts involved in bringing a company to the public market and facilitating the sale of its shares to investors.

An Illustration of Gross Spread in a Real-life Stock Transaction

Scenario:

Company XYZ is a publicly traded company, and its stock is listed on a stock exchange. Investor A wants to buy 1,000 shares of Company XYZ at the current market price of $50 per share. Investor A contacts their broker, who executes the trade on their behalf.

Gross Spread Calculation:

The gross spread is the difference between the price at which the broker buys the shares from the market and the price at which they sell them to Investor A. Let’s assume that the broker buys the shares from the market at $49 per share and sells them to Investor A at $50 per share.

Distribution of Gross Spread:

Broker’s Share = Gross Spread * Broker’s Percentage

Broker’s Share = $1,000 * 70% = $700

Other Parties’ Share = Gross Spread * Other Parties’ Percentage

Other Parties’ Share = $1,000 * 30% = $300

Conclusion:

This illustration demonstrates how the gross spread is calculated and distributed in a real-life stock transaction. It is important to note that the actual percentages and distribution may vary depending on the specific transaction and the agreements between the parties involved.