Dutch Auction - Stock Market Business Solution

By: Boris Mann
Submitted: 2007-01-17 16:16:37
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Dutch auction is descending price auction where the bidding process is used to find an optimal market price at which the issuing company can sell its shares. It is in complete contrast to the traditional method of the price range set by the underwriters and people can only bid in between that range.

How the process works

Taking a simplified example, I will try to explain how the whole process works. Like the traditional underwriter method the company appoints underwriter for their issue.

The applicant first has to open an account with the underwriter before the process starts.

Next the applicant will receive all the information provided by the company in form of prospectus and other documents.

After getting prospectus ahead of auction the bidder must obtain a unique ID. These ID’s can’t be given once the bidding process starts.

Once the applicant qualifies, he or she can make a bid for the number of shares they want and at price they want. The price in Dutch auction is not range bound and one can quote above or below the range speculating that the demand may be lower or higher. The important issue here is that all the bids are confidential.

The final IPO price will be determined once the auction is closed. The underwriters will then calculate the cut off price. The people who bid above the cut off price will get shares.

How is this Cut–Off Price Determined

Suppose the company is willing to issue 1000 shares in the market and it received bids for 100000 shares. The break-up of 100,000 shares is as follows

A $1000 - 100 shares - 900 shares left

B $100 - 700 shares - 200 shares left

C $50 - 200 shares - 0 shares left

D $ 49.95 - 10000 shares

E $48 - 89000 shares

As we can see the company has only 1000 shares so they will go to A,B,C and D&E won’t have any shares. The cut-off price or the IPO opening price in stock market will be $50.

It may seem so unfair to A as he gets shares at such a high price but this very aspect of the process keeps away the speculators in opening trades and thus avoids the kind of Pop-ups we had during the dotcom burst in late nineties.

Boris Mann did his Master's in finance. He regularly advises clients on personal finance issues. He also writes business term papers from time to time for Write Term Papers. You can contact him for any business & financial term paper query.

Article source: Expert Articles

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