CFA Level IEquity InvestmentsMedium
A technology company conducts an initial public offering (IPO), selling 5 million newly issued shares at $20 per share to the public. The deal is underwritten on a firm commitment basis by an investment bank. Which statement best describes this transaction?
- AIt is a secondary market transaction because the shares will later trade on an exchange
- BIt is a primary market transaction in which the company receives proceeds and the underwriter bears the risk of unsold shares
- CIt is a primary market transaction, but the underwriter bears no risk because it is a best-efforts offering
- DIt is a secondary market transaction because existing shareholders are selling their shares to new investors
Show answer & explanationAnswer & explanation
Correct answer: B. It is a primary market transaction in which the company receives proceeds and the underwriter bears the risk of unsold shares
An IPO of newly issued shares is a primary market transaction because proceeds flow to the issuing company. Under a firm commitment underwriting, the investment bank purchases the entire issue from the company and resells it to investors, bearing the risk of any unsold shares.
Why the other options are wrong
- A. Incorrect; subsequent exchange trading is secondary market activity, but the IPO itself is primary market.
- C. Incorrect; firm commitment (not best-efforts) means the underwriter does bear risk of unsold shares.
- D. Incorrect; new shares are being sold by the company, not existing shareholders, so this is primary market activity.
Primary Market / Firm Commitment Underwriting
The primary market is where new securities are issued directly by companies to raise capital; in firm commitment underwriting, the investment bank buys the entire issue and assumes the risk of reselling it.
- Primary market = new issuance; proceeds go to issuer
- Secondary market = trading among investors, no new capital raised
- Firm commitment shifts unsold-share risk to underwriter; best-efforts does not
Memory trick: Primary pays the company; secondary just swaps shares.