Related to the issuance of shares there are different kinds of “puzzles” which motivate to take a closer look at: Short-run ‘underpricing’, hot and cold issue markets, spread clustering and longrun underperformance. Even though these phenomena are frequently discussed in several scientific papers and journals, there is no conclusively completed theory. This work will concentrate on the various approaches developed to explain ‘underpricing’. As an introduction into the topic it will also provide a summary of the process of an Initial Public Offering (IPO).
Table of Contents
1. Introduction
2. The Process of an IPO
3. The ‘Underpricing’ Phenomenon
Conclusion
References
Appendix
Objectives and Topics
This essay examines the mechanisms of Initial Public Offerings (IPOs) and critically evaluates the theoretical frameworks proposed to explain the pervasive phenomenon of IPO underpricing.
- Fundamentals of the IPO process and the role of investment banks
- Mechanics of the 'bookbuilding' method in equity issuance
- Theoretical explanations for underpricing based on asymmetric information
- Analysis of agency conflicts and signalling models
- Behavioral finance perspectives on issuer and investor incentives
Excerpt from the Book
3. The ‘Underpricing’ Phenomenon
In primary markets securities are offered the first time to investors, while in secondary markets investors can trade shares from already listed companies. There is empirical evidence for a significant price difference between the issuing price on one side and the opening price (first-day closing price) on the other side. This phenomenon is called ‘underpricing’ (or first-day return). Loughran, Ritter and Rydqvist (2006) illustrate the average ‘underpricing’ in different countries, for a selection see Table 1.
In a world of efficient markets with symmetric information ‘underpricing’ would be not explainable. To interpret this phenomenon a lot of possible theories and approaches have been developed during the past decades. Main categories are based on asymmetric information, agency conflicts, the influence of issuing banks and signalling models, but there are a lot of other explanatory approaches as well.
Summary of Chapters
1. Introduction: This chapter introduces the "puzzles" associated with share issuance, specifically highlighting short-run underpricing as the primary focus of the analysis.
2. The Process of an IPO: This chapter details the motivations for going public and describes the operational stages of the bookbuilding process, including the roles of underwriters and institutional investors.
3. The ‘Underpricing’ Phenomenon: This chapter reviews empirical evidence of first-day returns and evaluates various theoretical models, such as asymmetric information, agency theory, and behavioral finance, to explain why IPOs are systematically underpriced.
Conclusion: This chapter summarizes the findings, noting that while various theories provide partial insights, no single framework fully accounts for the complexity of IPO underpricing.
References: This section provides a comprehensive bibliography of the academic literature and scientific papers utilized throughout the essay.
Appendix: This section offers additional detailed notes on specific theories, including the "lemons" problem, winner's curse, and further nuances of bookbuilding.
Keywords
Initial Public Offering, IPO, Underpricing, Bookbuilding, Asymmetric Information, Investment Banking, Agency Conflicts, Signalling Models, Winner's Curse, Prospect Theory, Equity Story, Market Efficiency, First-day Return, Institutional Investors, Financial Markets
Frequently Asked Questions
What is the core subject of this paper?
The paper focuses on the financial mechanics and theoretical explanations surrounding Initial Public Offerings (IPOs), with a specific emphasis on the phenomenon of share underpricing.
What are the central themes discussed?
The central themes include the process of taking a company public, the role of investment banks, information asymmetry between market participants, and the various academic theories that attempt to rationalize first-day pricing anomalies.
What is the primary objective of the research?
The primary objective is to explain the IPO issuance process and critically evaluate existing economic theories that account for the apparent underpricing of new issues.
Which methodology is employed in this work?
The work utilizes a literature-based analytical approach, critically appraising and synthesizing existing scientific research, empirical data, and theoretical models from financial economics.
What is covered in the main body of the work?
The main body covers the practical steps of an IPO—such as the beauty contest, pre-marketing, and bookbuilding—followed by an in-depth review of academic models addressing adverse selection, signalling, and agency theory.
Which keywords best describe this study?
Key terms include IPO, Underpricing, Bookbuilding, Asymmetric Information, Agency Theory, and Prospect Theory.
How does the "bookbuilding" process help mitigate information asymmetry?
Bookbuilding allows underwriters to gather feedback and information from institutional investors during the marketing phase, which helps in determining a more accurate price range for the issuance.
What role does "Prospect Theory" play in explaining underpricing?
Prospect Theory suggests that issuers may be relatively neutral toward underpricing if they perceive their post-market valuation to be higher than expected, valuing their personal gain in wealth over the optimization of total issuance revenue.
Why is the "Winner's Curse" relevant to IPOs?
The Winner's Curse describes a situation where uninformed investors obtain full allotments of poor-quality issues, leading to negative returns; underpricing is seen as a way to compensate these investors to ensure they remain active in the market.
- Quote paper
- Henning Padberg (Author), 2006, Initial Public Offering (IPO) and theories of underpricing, Munich, GRIN Verlag, https://www.grin.com/document/79585
