IPO Pricing in “Hot” Market Conditions: Who Leaves Money on the Table?

Two concerns IPO researchers have are the apparent short-run underpricing (the stock trades up in the secondary market) and the longer run underperformance (stock falls during long event window). Previous research has been only partially successful in explaining the continued existence of these two conflicting and seemingly contradictory anomalies. Some of these previous attempts include Chowdry and Nanda 1996 who show that stabilization activity can explain some of the initial underpricing. Fama (1998) suggests that the difficulty of matching samples may explain the apparent long run underperformance. However due to disagreement of studies, IPO pricing remains troubling. Derrien models these two findings and shows that if noise traders (presumed to be individual investors) are overly optimistic, they will bid up prices even when the initial price is higher than most valuation models would predict. That is: because the price is going to go higher, informed investors will participate in the offering since they can profitably trade out of the security in the aftermarket. If this is true (and it is supported by a sample of French IPOs that demonstrate initial return and turnover is positively related to individual investor demand), then investment bankers knowingly overprice the issue (relative to intrinsic value) but underprice relative to the short-run demand. Why underprice? One explanation is that by knowingly overpricing the shares, the investment banker would be exposed to higher stabilization (and legal) costs if the noise traders realized the shares were in fact overpriced. (Interesting!) [FinanceProfessor.com Annotation]

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