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The name might not suggest what the topic is all about, green shoe is a term used in stock markets.
Why such an amusing name?
The company that started this phenomenon was ‘Green Shoe Manufacturing Company’. Though green shoe is not a legal term, the legal term used is ‘over allotment option’

GS

 

Green shoe is provision available in an IPO (Initial Public Offer) prospectus. It allows underwriters to buy upto an additional 15% shares (in excess to the ones issued) at the offering prices.

The role of the green shoe option is to stabilize the prices.
Suppose that the prices of the shares shoot up then to bring it down to the original level the green shoe option is exercised and more shares are sold to stabilize the prices. Underwriters buy the shares from the company and sell them in the market and the difference is their profits. In the similar way, the other situation works out as well.

There are various types of green shoe options:

  1. Partial Green shoe- This option says that you can buy only some shares before the prices gets higher.
  2. Full Green shoe- This option says that you cannot buy any shares until and unless the prices rise.
  3. Reverse green shoe- It is the other situation in our example. If the share prices fall then the underwriters need to buy shares in the market and sell them back to the investors, the difference again is their profits. The fact to note here is that they are buying at the market prices while selling at the offering price and that’s where the difference comes. This is known as reverse Green shoe.

    One of the most important role of Green shoe is stabilizing the prices, when prices fluctuates it doesn’t pose a very good image of the company in front of the investors and that is why, price stabilization is important.

    Alibaba used the similar option and earned couple of billions more. Here is the story

 

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